INSTRUCTORS GUIDE

Instructors Guide

to accompany

Macroeconomics: A European Text

Michael Burda
Charles Wyplosz

OXFORD 1997

Oxford University Press, Walton Street, Oxford OX2 6DP

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Michael Burda and Charles Wyplosz 1997

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INTRODUCTION

In this Instructors Guide to the second edition of

Macroeconomics: A European Text, we would like to
share with teachers our approach to teaching the
subject. More concretely, we review some of the most
important ways in which this book differs from other
textbooks on the market, and provide instructors with
some hints -- based on our experience -- in making the
material digestible and even appealing to students. Each
chapter provides a short summary of the important
concepts, as well as a short list of further reading which
may help users of this textbook to obtain more
perspective on the strengths and weaknesses of our
approach to teaching macroeconomics.

Lectures and readings

There is a big difference between what is said in class
and what the students read in the textbook. This is why
the time spent in class and on the textbook should be
seen as complements, not substitutes. We have found
that lectures are best devoted to a limited number of the
issues covered in the book, usually at a basic level.
While it is important to make the material look as easy,
clear, and interesting as possible in class, students can
be made responsible for a much larger range of
material not covered in class. Those students who study
the book carefully before lectures -- hopefully the
majority -- are rewarded in two ways: they can check
that they have understood what matters and why, and
they have a chance of asking detailed questions.
Following this recipe, each chapter can be covered in a
class lasting about 90 minutes, although Chapters 4, 10,
11, and 13 are best spread over several lectures. Of
course, teachers who have more time might spend
commensurately more hours on all the material.

Examples, not proofs or literature reviews

What makes this textbook different is the large number
of examples drawn from all over Europe and elsewhere.
Examples serve two purposes. First, they break the

usual monotony and offer a breather. Second, they offer

a reality check on the theory with which students are
trying to understand for the first time. The immediate
relevance of the theory has been, in our experience, an
important incentive for the students to retain what they
have learned. This is why we have tried systematically
to present an example whenever a new concept is
introduced or a new result is established. This is a
recipe we have experimented with in class with great
success. Students enjoy relating their own experiences
to the principles they learn. We strongly encourage
teachers to present some of these examples in class
(overhead projectors are great teaching devices) and
take the time to comment extensively on them. The
improved quality of the transparencies supplied as an
add-on should make this option more attractive.
Of course, examples are not proofs. Yet it is our
belief that it is inappropriate to submit theories to
formal analysis in an introductory textbook. Informal
inference and introspection can generate many of the
propositions and theories that we present, which to our
minds represent a consensus view of macroeconomics
in the 1990s. We intentionally shield the student at this
level from the nuances of the empirical (and
econometric) literature; we feel that our presentation of
macro is relatively well-established in the literature and
are confident that the facts will continue to be
supported by further research. In the forefront was our
concern not to reinforce the familiar stereotype of twohanded economists unwilling to take a stand.

Topics
A shorter course may limit itself to the first fifteen
chapters, possibly skipping Chapter 7 which, like
Chapters 18 and 19, deals with exchange rates while
Chapters 20 and 21 cover special topics. For an even
shorter course the teacher may want to focus on the
basics and accordingly drop Chapters 15 to 17. Older
texts typically cover growth (Chapter 5) and labour
markets (Chapter 6) at a much later stage. Nowadays
this is hardly acceptable. Since the real economy
occupies a central role in our presentation it is essential

Instructors Guide

Introduction

to establish long-run growth and labour markets at the

heart of macroeconomics. Similarly, we understand
better now how dangerous it is to separate too cleanly
the short run (business cycles) from the long run
(economic growth). Yet, if hard pressed by a tight
programme, a teacher could drop Chapter 5, and, as a
last resort, Chapter 6.

the global economy context, highlighting determinants

the world rate of interest, inflation, output, etc.
We are particularly excited about our survey of
business cycles, Chapter 14. Not only is this an
opportunity to apply the AS-AD model and explain a
durable feature of capitalist economies, but also an
opportunity to highlight two very different ways of
looking at the world. This treatment parallels that of
Chapter 10: the AS-AD, sticky price variant
corresponds to the Keynesian short-run analysis, while
the real business cycle view parallels the classical flexprice analysis. To motivate discussion, we provide
some "stylised facts" on the cycle -- some of which we
think are not well-known -- using the reference cycle
methodology of Burns and Mitchell, and considering
averages over a number of OECD countries. Our
conclusion is agnostic, meaning that the both views of
the business cycle have merits and difficulties.

Order
The preface to the textbook suggested two possible
tracks: an aggregate demand/business cycles track
moving quickly to the IS-LM and demand/supply
approach familiar from previous popular textbooks; and
a neoclassical/microfoundations track which moves
slowly to equilibrium emphasising behavioural
relationships first. In the end, it is a matter of taste.
Yet we encourage teachers to cover at least Chapter
3 early on. The IS-LM analysis is very useful but
students should understand that it is a short run
approach, not only because of price and wage rigidity,
but also as a result of intertemporal budget constraints.
It is our experience that students quickly grasp and
retain the particularly useful message that most
macroeconomic choices (consumption and spending,
investment, budget imbalances) are fundamentally
intertemporal, that intertemporal budget constraints
bite, and that with forward-looking financial markets
they bite relatively quickly.

Mathematics
Wherever the students level permits, we encourage
teachers to use maths in class. Most chapters have a
mathematical appendix which offers the backbone of
the material covered in the main text. It is primarily
designed for classroom use when possible.
On the other side, if the students are not at ease with
mathematics, there is a real danger of their focusing
most of their learning efforts on the formalization
instead of grasping the underlying economic meaning.
This is especially true of introductory macroeconomics
courses. In such cases, mathematics is better assigned
as optional reading.

Changes from the first edition

The second edition is different from the first in a
number of significant ways. Obviously, we have
updated and streamlined tables and figures and have
tried to add more current examples. Second, we added
some new exercises and deleted other which were too
difficult or repetitive. Third, we edited and revised
most of the chapters significantly -- examples being
Chapters 4, 7, and 11 (old Chapter 10). Fourth, we have
switched the order of Chapters 5 and 6, reflecting a
desire for more continuity.
Most significantly, we have added two new and
important chapters, responding to many demands from
instructors:
Chapter 10 is the much-sought after integration of
the real parts of the macroeconomy with the monetary
sector in the usual classical (flexible price) but also
Keynesian (fixed price) analyses. Rather than calling it
a "closed economy detour" we prefer to think of it as

Exercises
Each chapter (with the exception of the first and last
two) contains roughly twenty exercises. A first group,
labelled theory, directly relates to the material
presented in the text. These exercises are designed to
check the understanding of key results; sometimes they
offer extensions. A second group, labelled applications,
is meant to train the students to translate concepts and
results into useful tools. These applications are
sometimes ambiguous, with more than one acceptable
answer, just like real life. Teachers may use them to
expose students to the limitations of a social science.
Within each group, exercises are normally presented in
order of ascending difficulty.

ii

Instructors Guide

Introduction

The second edition of Macroeconomics: A European

Text contains a number of important changes which are
aimed at improving pedagogy as well as streamlining
and unifying content. In addition to describing these
changes, the accompanying Instructors Guide offers a
complete set of solutions to both the theoretical and
applied exercises at the end of each chapter. We hope
that this improvement will make teaching with the book
a more convenient and pleasurable experience.

Acknowledgements, present and future

In preparing the guide, we have kept in mind the
reactions of early users of the textbook. Their questions
have reminded us that what is clear and simple to one
person may be problematic to another, which makes
teaching challenging and fun. In addition to the scores
of contributors mentioned in the acknowledgements, we
are particularly grateful to Simon Burgess for his
helpful review in the Economic Journal of May 1994.
Successive waves of students at INSEAD, Berlin and
Geneva continue to tell us how they like and dislike the
exercises and have led us to rethink a great many of
them. We continue to receive helpful comments and
suggestions from both colleagues and students and will
continue to exploit them in future editions of the
textbook and this guide.

Michael Burda and Charles Wyplosz

iii

CHAPTER 1
WHAT IS MACROECONOMICS?

This chapter corresponds to the very first lecture,

maybe just fifteen minutes if the schedule is tight.
Advance reading by the students is desirable, but not
indispensable. We see this chapter as both a motivating
introduction to the subject matter and a declaration of
intent. In this introduction we make it clear that, in our
view, it is important to take time early on to look
carefully at some macroeconomic data. This activity
conveys the message that macroeconomics is about
explaining facts and that these facts are given by
aggregated data. The danger exists, however, that eager
students will want to explain everything immediately.
For that reason the lecturer should avoid an overload of
data which may be dizzying or even discouraging.
We begin with this is what I shall talk about: it
presents the key concepts of macroeconomics: (real)
GNP, growth, and cycles; factors of production and
income distribution; inflation; the link between the real
economy and financial markets; and, of course,
openness. No precise definition is offered, as the sole
purpose is to appeal to intuition and stimulate interest.
Section 1.2 moves from issues to the social role of
macroeconomics. It is designed to alert the student to
the broad implications of what he is about to study. We
have chosen to claim that policies inspired by
macroeconomic theory have altered the shape of
business cycles, because we believe that this is the case,
but we know that it is controversial. Even the
staunchest anti-Keynesians and real business cycle
theorists would agree that the behaviour of prices has
changed since World War II (Fig. 1.5) and lay the
blame on (bad?) macroeconomic policy!
The tone changes in Section 1.3, which stresses that
macroeconomics is not a description but an analysis of
the facts. The distinction between exogenous and
endogenous variables is introduced early on to
emphasise that we work with models. We find it useful
to warn that while macroeconomics is a scientific field
-- in its rigour and the methods that it uses -- it is
nevertheless plagued or blessed with the particular
difficulty of dealing with social phenomena. This is the
time, we feel, to refute the newspaper allegations that
economists chase irrelevant theories.

CHAPTER 2

MACROECONOMIC ACCOUNTS

Objectives
There is no short cut: students must know the bare
minimum about national income accounting before they
can study macroeconomics. We have clearly chosen the
light touch with respect to accounting, but this dry
material can be effectively used to paint the big picture
both efficiently and rigorously. The presentation can be
structured around the flow diagram in Fig. 2.2, which
maps out the flow of goods and services in the
macroeconomy. The large circle represents how income
flows from producers to customers and back to
producers. The smaller circles correspond to the three
sectors of the economy: the private sector, the
government, and the rest of the world. This sectoral
breakdown of the economy is the backbone of the book.
Students should understand that what comes in is
not the same as what goes out because any of the three
sectors can be out of balance, with the imbalance
matched by a build-up or draw-down of (net) assets.
Imbalances arise when one sector attempts to spend
more, or less, than it earns. Despite the fact that total
balance requires that the three sector imbalances cancel
out as shown in (2.7), intertemporal budget constraints
imply restrictions for each sector in the future. Playing
up this result exposes students to the concept of market
equilibrium and to the distinction between ex ante and
ex post behaviour as well as preparing for the next
chapter (intertemporal balances).

GDP and related concepts

Like the rest of the industrialized world, we now
emphasise GDP over GNP. This required us to rework
many of the definitions, but with little loss along the
way. The first two definitions of GDP -- total spending
and total factors income -- serve later on to clinch the
concept of general aggregate equilibrium. This is why it
is essential to stress this point over and over again.
Students typically like to discuss ad infinitum about the
underground economy and other limitations of GDP
data. They should be told early on that aggregate data

are inaccurate but that most of the time we use them to

measure growth rates, not levels. The margin of error is
reduced with growth rate as long as distortions do not
vary systematically.
The next important distinction is nominal versus
real. Having defined deflators it is natural to contrast
them with price indices. Another more important
distinction, between GDP and GNP, is often too subtle
to grasp at first blush. Just mentioning it early on
should suffice as we shall return to it more formally in
Chapter 3. On the other hand, the concepts factor
income and factors of production recur frequently and
it is useful to stress them early on.

The circular diagram

It pays to work carefully through the diagram, because
it leaves students with a good insight flow to
understand the accounting terms. It is best to start from
the left where GDP is shown and ask students what
happens to sellers incomes.
As we pass the bifurcation between consumption
and saving on the right of the large circle, we move
from the incomes breakdown of GDP (Y=C+S+T) to the
spending breakdown (Y=C+I+G+X-Z). It is worth
showing the two relationships at this stage and later on
to derive the identity as (I-S)+(G-T)+(X-Z)=0, noting
what it implies for the three circles.
The diagram misses out a few connections or details
which may be brought to the students attention (as
proposed in some exercises):
- corporate and personal savings (and therefore
private income and private disposable income) are
not distinguished. Corporate savings may be
represented explicitly by a pipe going to the private
sector circle and originating where national income
is written: after the bifurcation we would have
national disposable income.
- trade in assets is not shown. Each sectors imbalance
is financed somehow, but the diagram does not say
by whom. Our view was that with a fully integrated
world capital market, it really doesnt matter.

Instructors Guide

Chapter 2

Additional pipelines would be necessary -- perhaps

in another colour -- to illustrate this
counterbalancing flow of assets. These would all
hook up with the world capital market which
allocates world savings and investment. The
logistics of the current diagram are already quite
daunting, and we have decided to leave it be at this
stage.

Balance of payments
In the same way as for national income accounts, the
challenge is to make accounting interesting. It is
relatively easy to do so, emphasising that the current
account is the pivotal concept: it separates out real
(trade in goods and services) from financial
transactions ones (trade in assets). As is well known,
the distinction between trade in goods and services and
trade in assets is not completely airtight, but it is very
important to stress the distinction early on. It leads
directly to stressing that, because the current account
represents the net external lending or borrowing of the
nation, the lower part of the balance of payments,
private and official financial transactions, simply
matches the current account, hence (2.9). This is the
time to recall the identity Y = C+I+G+CA and show that
CA = Income - Spending.
It is also useful to signal early on the difference
between fixed and flexible exchange rate regimes by
explaining the role of official interventions and of the
monetary authorities. As the residual ex ante overall
imbalance, official interventions show what the
monetary authorities have done to prevent the price of
domestic currency -- the exchange rate -- from moving
all the way until the overall account is balanced ex ante.

CHAPTER 3

INTERTEMPORAL BUDGET CONSTRAINTS

Objectives
This chapter provides students with an understanding of
intertemporal trade and its graphical representation.
The chapter can be extended, according to the
instructors preferences, to include more detailed
discussions of bond prices and interest rates as well as
other aspects of intertemporal budget constraints.
Two-period diagrams are used throughout as a
simplifying but intuitive device. The main drawback of
this approach is that it rules out second period
investment because the economy ends afterwards.
Intentionally, we do not delve into the associated
difficulties. These are discussed in more detail below.
This is one chapters where mathematics is really
essential; most instructors will agree that the simple
algebra of discounting should be part of everyones
tool-kit.
An important distinction is introduced for the first
time here, which the instructor will should be familiar
with for the inevitable questions which arise. This is the
distinction between overall public or external deficits or
surpluses versus primary deficits or surpluses, which
exclude interest payments or more generally investment
income receipts. This distinction will prove helpful
when, later on, debt service will be shown to be a major
source of instability.1

makes it clear that each term refers to net saving, i.e. a

shift of resources over time.

Constraints and optimisation

This chapter sets out budget constraints but refrains
from dealing with preferences or optimal behaviour. An
alternative is to teach consumption in one shot -- that is
combining constraints and optimal choice, followed by
investment and the current account. This functional
approach is possible by pairing the corresponding
sections of Chapters 3 and 4:
- Consumption: Sections 3.3 and 4.2
- Production and Investment: Sections 3.4 and 4.3
In our view, there are good reasons for separating
constraints and behaviour. First, the very notion of
intertemporal trade is hard to grasp when first
introduced. Limiting this first contact to constraints is a
way of reducing complexity. Second, showing the
similarities and differences between the three sectors
constraints has great pedagogical appeal. Third, the
aggregation of sectors offers a natural link with national
accounts, and extends neatly to the foreign sector
(current account). Finally, it allows us to give a nearly
complete and yet relatively simple treatment of
Ricardian equivalence without studying the relevant
behavioural assumptions.2

Motivation
Varying the level of difficulty
A good way of starting is to recall the circular flow
diagram of the previous chapter (Fig. 2.2) and point out
that one task of macroeconomics is to study the
relationship between output, inflation, interest and
exchange rates, to imbalances in the three circles. Then
the accounting identity which shows the link between
the imbalances:
CA = (S - I) + (T - G)

Since the chapter starts with accounting and ends at the

frontier (Ricardian equivalence), the teacher must take
a decision on how far to go. This in turn may have
ramifications for material which can be treated later on.
For a short course, focusing on essentials means
using the two-period diagram to explain that the interest
rate is a relative price and to show graphically what is a
2

It is also one reason why the IS-LM model is a short-run

analysis.

What is lost is mainly the whole question of bequests and

altruism across generations. One exercise (Theoretical
Exercise 6) provides an opportunity to introduce the idea.

Instructors Guide

Chapter 3

present value; this is applied to the consumer, the firm,

and the government but consolidation is not shown
(skip Sections 3.4.4, 3.5.2, 3.5.3, 3.5.4 and 3.6.).
For longer courses and/or advanced audiences, one
key issue the instructor must decide is how extensively
to treat Ricardian equivalence. One possibility is to just
present the consolidation of accounts in successive
logical steps (Sections 3.4.4, 3.5.2 and 3.6) and leave it
at that. Another is to state the equivalence proposition
(Section 3.5.3) and explain in a few words why it may
fail to hold in practice.
Full treatment implies using the material presented
in the more demanding Section 3.5.4. We take the
middle-road view that Ricardian equivalence is an
interesting theoretical idea with mixed empirical
support.3

productive technology, an alternative means of

converting resources today into resources tomorrow, is
the production function. The desirability of this
technology is determined by how well it stacks up
against the opportunity cost of resources today versus
tomorrow (the market interest rate). Making this clear
and simple is the real challenge of this chapter.
Net wealth of the consumer can be read in terms of
todays consumption on the horizontal axis of the twoperiod diagrams. (It can also be read in terms of
tomorrows good as well on the vertical axis, but this is
suppressed to avoid confusing students.) The value of
the firm can also be read -- in terms of tomorrows good
-- as the vertical distance between the production
function F(K) and the cost-of-borrowing line OR in Fig.
3.5.
Note that we assume the absence of existing
productive capital (fruit-bearing trees) so that
investment today and capital stock tomorrow are
identical. This makes the presentation simpler but
unrealistic. Box 3.3 alerts students to this fact and
Chapter 4 will extend the model appropriately. (In
addition, the planting season restricts Crusoe from
planting coconuts he could borrow in the financial
markets, a point that the smartest students will quickly
pick up!).
The discussion of the production function at this
juncture will give the instructor an opportunity to
remind students of the distinction between physical
investment (expanding the productive capital stock) and
financial investment (swapping existing assets).

Two-period Crusoe
Irving Fisher introduced Robinson Crusoe to economics
in his pioneering work on intertemporal aspects of
economic decisions. Since then, there have been two
categories of textbooks which present the topic: those
with Robinson, and those without. We think the Crusoe
model represents an important and robust
microfoundation of macroeconomics, and is the source
of much useful intuition about the subject. We have
toned down the parable in deference to those who may
find the device too simple or even offensive. No doubt,
there are two categories of teachers, those who use
Robinson and those who dont.
With Fishers two-period framework almost all that
must be understood in an introductory course can be
presented compactly with two periods (present and
future). In addition it prepares the students for thinking
in terms of short and long run. This is why, throughout
the text, we interpret the first period (today) as the short
run and the second period (tomorrow) as the long run.
It is a trick which works almost all the time4. Some
indications of its shortcomings are given below.
Appendices to this and other chapters show the
transition from the two-period case used in the text to
an infinite horizon.

Consolidation
The consolidation of the private sector -- consumers
and firms -- requires that we flip the production
function around the vertical axis. Indeed in Fig. 3.7
investment is read off the horizontal axis from right to
left in contrast with Fig. 3.4. In Fig. 3.7 it is worth
emphasising the fact that the production rise above BB
indicates that productive technology raises wealth, the
last term in the second line of (3.9). Of course, the
optimal level of investment can be deduced from Fig.
3.7, but this task is left for Chapter 4.

The intertemporal budget constraint

Consolidation in the two-period framework with
investment in both periods

For both the consumer and the government, the budget

constraint is a line whose slope is given by the gross
market interest rate (1+r). It is a technology which
allows resources today to be converted into resources
tomorrow. For the firm which has access to a
3
4

It was assumed that there is no productive capital to

start with, so that investment today and the capital stock
tomorrow are identical. An alternative presentation is
as follows. Endowments are the outcome of

Two references are Barro (1974) and Bernheim (1987).

A good reference is Frankel and Razin (1987).

Instructors Guide

Chapter 3

previously accumulated capital -- trees in existence at

time 0:

preferences and behaviour. Our intention was twofold.

First we wanted to use the equivalence principle as a
convenient application of the intertemporal budget
constraint without taking a stand on its ultimate
veracity. Second, we thought it important to stress that
Ricardian equivalence indeed arises first and foremost
from budget constraint considerations: once the
aggregate private sector realises that it will pay future
taxes, the solvency of the government implies that
purposeful and rational private agents will take note of
this fact.
The discussion which follows then allows to focus
on a number of points that students may remember.
These are: the deeper meaning of consolidation (ex post
it is just a matter of accounting while ex ante it carries
the strong implication of equivalence); the difference
between interest rates faced by the public and private
sectors and the income effects associated with public
borrowing; the notion of credit constraints;
distortionary taxation; the disconnectedness of
taxpaying generations; and uncertainty stemming from
the mortality of taxpayers.

Y1 = F(K0) and Y2 = F(K1).

Resources available for consumption in both periods
are now:
C1 = F(K0) - I1 and C2 = F(K1).
In present value terms:
C1 + C2/(1+r) = Y1 - I1 + Y2/(1+r).
Although there is no second period investment (end of
the world) so that I2=0, it is correct and more general,
therefore, to write:
C1+I1 + (C2+I2)/(1+r) = Y1 + Y2/(1+r).
It can then be shown that (3.20) is just the consolidated
budget constraint of the nation by recalling the two
budget constraints:
- private sector:
C1+I1 + (C2+I2)/(1+r)
= Y1-T1 +(Y2-T2)/(1+r)+rF0.
which is (3.9) modified in two ways: 1) I2 has been
added; 2) if Y is GDP and not GNP, we need to add the
income earned on net foreign wealth F0.
- public sector

References

G1 + G2/(1+r) = T1 + T2/(1+r).

Barro, Robert (1974) Are Government Bonds Net

Wealth?, Journal of Political Economy, 82: 1095-117.

which is (3.11) with rG = r.

Adding up these two equations gives:

Bernheim, Douglas (1987) Ricardian Equivalence: An

Evaluation of Theory and Evidence, NBER
Macroeconomics Annual, 2: 263-303.

C1+I1+G1 +(C2+I2+G2)/(1+r)
= Y1+Y2/(1+r)+r F0.
which is (3.23). Note that Y=C+I+G+PCA since Y is
GDP. So the last equation can be rewritten as:

Frenkel, Jacob, and Razin, Assaf (1987), Fiscal

Policies and the World Economy, The MIT Press,
Cambridge, Mass.

PCA1 + PCA2/(1+r) = - F0.

or assuming that interest is paid at the end of the period
as in (3.21)
PCA1 + PCA2/(1+r) = - (1+r)F0.
If we want Y to represent GNP, then it includes the
return on net foreign assets and F0 disappears in the
private sector budget constraint as well as in the
consolidated account. Now, however, Y=C+I+G+CA
(see (3.22) and we have:
CA1 + CA2/(1+r) = 0.
Ricardian equivalence
Some teachers may be surprised that the issue of
Ricardian equivalence is taken up before consumer

CHAPTER 4

DEMAND OF THE PRIVATE SECTOR

Objectives
The student should finish Chapter 4 equipped with a
consumption function and an investment function.
Given a level of output and government purchases,
these two functions are the primary determinants of the
primary current account. The strategy is to begin with
first principles and then to inject realism. Teachers
impatient to go to the IS-LM analysis faster may skip
this chapter -- and return later -- provided that they
offer justification for the behavioural relationships (4.4)
and (4.7) or (4.23), as well as the primary current
1
account function of Chapter 7.
This chapter is probably the most difficult to teach.
The big stumbling block is the q-investment function.
In response to many suggestions, the second edition has
been modified in a number of ways to make this
complex material more palatable, even to students with
a limited knowledge of microeconomics.

Consumption
There is no major difficulty in shifting from the intratemporal apparatus of standard consumption theory to
the intertemporal interpretation. Students only need to
be warned that consumption today or tomorrow really
represents a basket of goods.
Impressing students with the central result that the
consumption function, in theory, depends on wealth
alone, is justified by the principle of consumption
smoothing -- a principle which does not generally apply
to other components of national expenditure, such as
investment, government spending, or exports. Yet it is
healthy to follow up by pointing out the well-known
limitations of this elegant theory: borrowing
constraints, uncertainty about future income and rates
of interest. It is also helpful for the short run IS-LM

Chapter 11 now begins with a quick motivation for the

primary current account (net export) function, so this is less
important than was the case with the first edition.

analysis to derive results which will justify a Keynesian

consumption function.
The distinction between permanent and temporary
changes in income is not only a good way for students
to check their understanding, it is also an important tool
of analysis. The examples provided are designed to
illustrate the importance of this distinction.
The role of the real interest rate in the consumption
function is usually more difficult for students to grasp.
It often helps to start by asking whether saving (the
mirror image of consumption) should increase or
decline when the real interest rate rises. Details may be
skipped if time is short.2

Net wealth
The emphasis on endowment may leave the impression
that wealth is just the present value of earned incomes.
It is important to remind students that in general,
financial assets and liabilities inherited from the past
also enter in .

Physical investment
In the first edition we pushed the q-theory of
investment for a number of reasons, which we still
consider valid. First, is the only one consistent with the
intertemporal forward-looking approach adopted in this
text and by modern macroeconomics. Second, it
establishes a clean link between aggregate demand and
the stock markets. Finally, even though empirical
support for the q-theory is not as strong as one might
like, empirical support for the alternative (that the real
2

Users of the first edition will no doubt note that Box 4.4 has
disappeared. Many found it too advanced for an
undergraduate text; others found the distinction made by
Summers (1981b) and others to be uninteresting. On the
other hand, some found it useful for sorting out the channels
by which interest rates influence consumption. To
accommodate these demands, we have introduced Figure 4.9
and the accompanying text.

Instructors Guide

Chapter 4

interest rate is the prime determinant of investment) is

even weaker. The sad truth is that the only theory
which works well empirically is the accelerator, but we
know this has as much to do with the limitations of the
3
data as with those of theory.
The treatment of investment was arguably the
hardest part of the first edition. We have now changed
it to allow for a modular treatment of interest rates
(Sections 4.3.1 and 4.3.2) and the accelerator (Section
4.3.3) for those instructors who would like to omit
Tobins q. For those who would like to offer a "baby
version" of the q-theory, we offer Section 4.3.4. The
harder underlying economics -- which still derive from
the two-period model and are intact from the first
edition -- is laid out in Section 4.3.5.
With this new structure, it is possible to teach
investment in four steps, with increasing degree of
difficulty. First, use microeconomic principles to find
the (long-run) optimal capital stock as a function of the
real interest rate.4 Second, provide a simple justification
for the investment accelerator.5 Third, define Tobins q
and link investment to the market value of capital
already installed (in place). Finally (optionally)
introduce costs of adjustment to obtain the q-investment
function.

the second panel of Fig. 4.18 the horizontal axis

represents investment, not the capital stock; the vertical
axis is discounted back to today.
Ways to make this difference clear:
- recall magnitudes: that the capital stock is
considerably larger than annual investment (K/Y is
about 3, I/Y is about 0.2). What we explain in step 2
is the (small) addition to the existing capacity of
production.
- stress that investment represents new bets on the
future, while the optimal capital stock is the sum of
many more decisions which turned out, on average,
to be correct (otherwise the capital stock would
have been depreciated away).
Installation costs are less intuitive for students and
often appear too insignificant to justify the centre stage
that they are often given. One way to clarify the idea is
that the representative firm is an approximate stand-in
for the economy; although individual firms do not
recognise these installation costs, the economy as a
whole behaves as if this were the case (because of
pecuniary or nonpecuniary negative externalities, shortrun decreasing returns in the investment goods sector,
etc.).
One way to stimulate students interest is the
following sequence of points:
- define Tobins q as the ratio of the value of installed
capital to that of un-installed (or replacement)
capital. Thus q is a relative price in the same way
that 1/(1+r) is the price of coconuts tomorrow in
terms of coconuts today.
- observe that the value of installed capital (and all
other forms of capital, for that matter) is determined
by stock markets. Why does a firms value often
exceed the replacement cost of its capital? (Why
cant Daimler-Benz be reproduced merely by buying
de novo all the physical equipment which comprises
it?)
- note that the present value of expected dividend
payments (plus realisable capital gains at selling
time) is the market valuation of a firm, hence the
numerator in Tobins q.
- finally note that when Tobins q is larger than unity
it pays to install capital -- all at once!
This all leaves the students with some intuition for
investment. It also poses a puzzle. The intuition is that
the larger q is the stronger are the incentives to invest.
The puzzle is: how can q remain above unity? The
answer is: installation costs.7

Deriving Tobins q
It is the final step which is hardest to digest. There are
many reasons: installation costs are hard to make
intuitive and students often find it hard to believe that
investment moves slowly to the optimal capital stock
(especially in the absence of uncertainty); implicitly at
least this is not a two-period analysis;6 and what is
meant by the marginal return on investment -- the full
stream of expected returns on a marginal increment to
the capital stock -- often appears obscure. In presenting
this material, it is essential that students understand the
important differences between Fig. 4.14 and 4.18: in
3

For an extensive survey of the empirical evidence, see

Chirinko (1993).
4
Recall that, because the second period is the last, all capital
is lost at the end, hence MPK=1+r and not MPK=r when
capital remains in place (possibly depreciated in which case
the rate of depreciation must be subtracted). This is stressed
in Boxes 4.6 and 4.7 in the second edition.
5
In the long run the optimal capital stock is in place and
MPK=1+r. With a homogeneous production function, MPK
is a function of the ratio K/Y so K/Y=g(r). In the special case
of a Cobb-Douglas production function we obtain the simple
linear relationship (4.12) in the text.
6
Alternatively, we cut today into smaller sub-periods (as is
explicitly shown in the Appendix). This is needed to
represent the fact that we do not jump straight ahead to the
optimal capital stock because it is costly to do so in one leap.

Some instructors might prefer to stress time-to-build

considerations, which would require a multiperiod setting to
treat adequately. For a nice review of the q-theory of
investment in a multiperiod setting, see Summers 1981a).

Instructors Guide

Chapter 4

The next step is to show why investment depends

upon q, represented on the vertical axis when the cost
of new capital is unity. Maybe the hardest part is to
convince the students that 1 on the vertical axis is the
price of capital in terms of consumption goods. It is
possible, in fact, to start the graphical exposition with
the nominal cost of new capital on the vertical axis.
What corresponds to point A is not q, but the nominal
expected return on investment.
A short-cut -- recommended for shorter courses -consists of Section 4.3.4. and restates the q-theory
exactly as Tobin (1969) originally did. Firms can raise
money on the stock market to buy new equipment.
Once installed, though, equipment is worth more to the
firm because it is combined with previously installed
capital and the firms labour force. The ratio of the
value of installed capital to new equipment, Tobins q,
is thus a measure of how desirable it is to borrow and
invest, hence I=I(q). Tobins q, on the other hand,
depends on expected future returns from the newly
installed capital, i.e. future MPKs.

References
Chirinko, Robert (1993) "Business Fixed Investment
Spending: A Critical Survey of Modeling Strategies,
Empirical Results, and Policy Implications," Journal of
Economic Literature 31, 1875-1911.
Frenkel, Jacob, and Razin, Assaf (1987), Fiscal
Policies and the World Economy, The MIT Press,
Cambridge, Mass.
Sachs, Jeffrey D. (1981) The Current Account and
Macroeconomic Adjustment in the 1970s, Brookings
Papers on Economic Activity, 81/1: 201-68.
Summers, Lawrence H. (1981a) Taxation and
Corporate Investment: A q-Theory Approach,
Brookings Papers on Economic Activity, 81/1: 67-140.
Summers, Lawrence H. (1981b) Capital Taxation and
Accumulation in a Life-Cycle Model, American
Economic Review, 71: 533-44.

The primary current account

The PCA function is now postponed until Chapters 7
and 11. At this point we motivate that to a large extent
it can be understood from the national income identity:

Tobin, James (1969) A General Equilibrium Approach

to Monetary Theory, Journal of Money Credit and
Banking, 1: 15-29.

PCA = Y - C - I - G
given the consumption and investment functions. Thus
it is simply derived from previous results, which will be
inadequate later on when two goods and relative prices
are introduced. More theorising on this function is
provided in Chapter 7.
The interpretation of the current account as national
savings can be repeated at this juncture. The reaction of
the current account of an economy of consumption
smoothers in response to investment booms (Spain in
the 1980s), sudden increases in government spending
(wars), or changes in terms of trade (Fig. 4.6) will be to
respond in the same direction. The irrationality of
running persistent primary current account surpluses (at
least from the consumers point of view) can be
justified using the theory presented in this chapter. A
quick look at Fig. 3.16 will remind students that high
surplus countries have also seen periods of current
account deficits and will see them again in the future
(for example, Germany as a consequence of unification,
and probably in Japan as consumers begin to enjoy
more consumption and leisure).8

For more on the current account in an intertemporal

context, see Sachs (1981) or Frenkel and Razin (1987).

CHAPTER 5
EQUILIBRIUM OUTPUT AND GROWTH

General equilibrium
Objectives
As we stress in the introductory chapter, economic
growth may well be the most important topic in
macroeconomics. Over periods of a decade or more, the
average persons well-being is more closely linked to
issues of growth in per capita output and income than to
business-cycle fluctuations. Thanks to recent work at
the frontier, these issues are now firmly rooted in the
realm of macroeconomics, where they belong; yet
despite the revival of the Solow (1956) model inspired
by the newer empirical work summarised in Barro and
Sala-i-Martin (1995), considerable ignorance remains.
A mixture of enthusiasm and caution sets the tone of
this chapter. The Maddison data serve to catch the
students eye while the Solow decomposition, and its
mysterious residual, reminds us that the residual
technical progress still explains a large part of growth.
That growth is presented early on in the book
follows from the real-nominal dichotomy which is later
stressed in Chapter 10. It is more natural, in our view,
to elucidate a long run toward which the economy
gravitates. The chapters objectives are simple. First,
motivate economic growth as an equilibrium process
(Section 5.2) resulting from growth or accumulation of
factors of production working through the production
function. Second, demonstrate using the Solow
decomposition just how much (or little) of growth can
be accounted for in this way. Third, introduce the
Kaldor stylised facts as a guidepost for viable growth
theories (and introduce the notion of a stylised fact in
general, which will help in Chapter 14, among other
places). Next, introduce the Solow model of balanced
growth and point out the importance of technological
change in this model. Finally, take the student to the
frontier of the field in the discussion of what technical
progress really is.

Section 5.2 sits a bit uncomfortably at the beginning of

this chapter and can be skipped if time is short. It does
serve two important functions. First, after a chapter
linking output and capital (Chapter 4) it meets the need
for bringing output, capital, and labour together in a
1
form of general macroeconomic equilibrium. Second,
it introduces the aggregate production function, the
work-horse of both growth theory and analysis of the
economys supply side. Fig. 5.1 is meant to symbolise
that we now operate in three dimensions rather than
sub-spaces.
In addition, this section is used to introduce some
concepts which will be needed later on: returns to scale
and technological change, in particular. While some
teachers may find it a bit too dry to sustain their
audiences interest, it is important to define the
aggregate production function and explain what returns
to scale mean for the macroeconomy.
This section also fills an important gap: Section
5.2.2 provides a quick account of the determination of
the world interest rate in the long run. The kissing
tangency in Fig. 5.4 is a classic. It will be taken up in
more detail again in Chapter 10 (Figure 10.7).

The Solow decomposition and balanced growth

The Solow decomposition is a central organising
framework for the material of the chapter. One way to
look at it is as just an exercise in accounting and the
early part of the chapter takes this approach. Once we
realise that the residual accounts for only about half of
growth performance, the attention shifts from
1

In swapping the order of the labour and growth chapters in

the second edition, we are forced to downplay the
households decision to work, implicitly assuming completely
inelastic labour supply. Later in Chapter 6 this omission is
amended. As a result, we treat labour as a fixed input to the
production process and derive the labour demand curve
informally from the MPL=w rule.

Instructors Guide

Chapter 5

accounting to analysis. An alternative approach is to

derive the decomposition rigorously from a general
production function with the usual attributes. Equation
(5.6) is the cornerstone of this chapter and deserves
special emphasis in the classroom. It is also useful to
fix students ideas about the magnitudes involved: the
normal rate of growth of countries, the contribution of
inputs, and the size of the residual.
Following tradition, we focus on balanced growth,
which occurs when particular ratios of economic
interest are constant. Balanced growth paths can be
thought of as a subset of steady-state growth paths, in
which all variables are growing at constant but not
necessarily equal rates. We chose, as Kaldor did, to
focus on the relative stability of K/Y (the US is the most
outstanding example). It is important to explain to
students that especially for countries like Germany and
Japan which lost considerable capital stock in the war,
K/Y increasing can be consistent with a transition to a
steady state value. The balanced growth condition,
combined with constant returns and the Solow
decomposition, generates a tight link between economic
growth, population growth, and technical progress.
We do not pretend that this standard choice is
obvious. In fact, the data shown in Tables 5.6 and 5.7
should remind the student that stylised facts are
regularities, not iron laws. Countries vary in many ways
that are not captured by the model. The stylised facts
are useful in that they impose restrictions on the
aggregate production function, which in turn lead to an
emphasis on the role of total factor productivity in
determining per capita growth.

Later in the chapter we note that all is not well with the
simple two-factor growth model: high savers seem to
grow faster than low savers (despite the fact that
savings rates do not affect steady-state growth in the
Solow model); and that poor countries fail to catch up
richer countries. A good pedagogical approach for
highlighting these issues is to propose the convergence
hypothesis: that GDP per capita converge
asymptotically so that per capita income levels in poor
countries should catch up to those in richer ones (Figure
5.13). The fact that convergence seems to occur only
among the wealthier countries invariably generates
much interest.
Three resolutions of these difficulties are then
proposed, leaving the reader free to choose among, or
accept all three extensions.2 First, it is shown that once
human capital is added as a third factor to the aggregate
production function both facts can be explained. The
rehabilitation in Mankiw et al. (1992) has given new
life to the neoclassical, constant returns approach to
growth. Second, the same is true if one adds public
infrastructure.3 Finally, endogenous growth, the theory
developed in the late 1980s, gives a role to increasing
returns to scale and externalities and also allows us to
account for the role of saving and the absence of
convergence.
It may therefore be useful to close the presentation
by suggesting extensions of the two-factor model.
Human capital is the most frequently and successfully
modelled third factor. Further additions may include
natural resources or public infrastructure, that can be
incorporated into the Solow decomposition. Some of

Bringing in theory

This agnosticism is motivated by the fact that, at the time of

writing, the verdict on endogenous growth was still out.
Writing this guide in late 1996, we are unsure about where
the empirical literature on growth is taking us (for a critical
review see Solow (1994)). On the empirical side (see Levine
and Renelt (1992)), three results seem important: 1)
investment in human capital is positively associated with
growth (Mankiw et al. 1992); 2) public infrastructure also
seems to matter; 3) convergence of per capita income seems
to occur within regions of a country (Barro and Sala-i-Martin
1991) at roughly 2% per year, when the steady state to which
the local economies are converging is appropriately
controlled for. Externalities and returns to scale may explain
the distribution of activities within a country -- the new
discipline of economic geography -- but may be less useful
for national growth performance.
3
These two explanations must be combined with the idea of
conditional convergence. Technically, if one is willing to
admit
out-of
equilibrium behaviour,
conditional
convergence may also account for the positive association of
growth rates and savings rates (countries with higher savings
rates have a higher steady state to which they converge, will
accumulate capital at a faster rate, and will therefore grow
more rapidly as in Figure 5.13).

Balanced growth is the accepted way of putting more

structure on the analysis. The distinction between
balanced growth and steady state deserves perhaps
more emphasis than it receives in the text. Balanced
growth paths are a restricted subset of steady-state
growth paths which requires that some selected
variables grow at the same rate.
The next step is the Solow model, which has a
pedagogical elegance which is seldom found in our
field. We derive the model in the usual way, although
leaning more heavily on the diagrams than on the
maths. The key result, of course, is the invariance of
growth with respect to the savings rate -- a difficult
result to explain but nevertheless one of central
importance. As promised, an appendix with this and
other elementary formal aspects of growth theory has
been included in the second edition.
Limitations and Extensions

11

Instructors Guide

Chapter 5

the exercises at the end of the chapter drive home this

point.

Feldstein-Horioka
Why introduce the Feldstein-Horioka puzzle in a
chapter devoted to growth? The answer is that our
textbook is dedicated to the open economy, and as such
needs to confront this fascinating fact.4 In texts
devoted to the closed economy, the link between saving
and growth is assumed since saving (public and private)
equals investment (public and private) by definition. In
the open economy, this link can be broken by
international borrowing or saving. Yet it survives, as
Feldstein and Horioka showed. In a sense, the solution
to the puzzle might have to do with sovereign risk (no
country can sustain growth solely on foreign capital
without being tempted to confiscate it in the end and
avoid repayment) or the high correlation of permanent
investment opportunities across countries in the long
run (as opposed to transitory ones, to which optimally
smoothed consumption would respond with currentaccount fluctuations).

References
Barro, Robert J. and Sala-i-Martin, Xavier (1995)
Economic Growth, New York: McGraw Hill.
Feldstein, Martin and Horioka, Charles (1980)
"Domestic Saving and International Capital Flows,"
Economic Journal, 90: 314-29.
Levine, Ross and Renelt, David (1992), A Sensitivity
Analysis of Cross-Country Growth Regressions,
American Economic Review, 82: 942-63.
Mankiw, N. Gregory, Romer, David, and Weil, David
(1992), A Contribution to the Empirics of Economic
Growth, Quarterly Journal of Economics, 107: 407-38.
Solow, Robert M. (1956), A Contribution to the
Theory of Economic Growth, Quarterly Journal of
Economics, 70: 65-94.
______ (1994), Perspectives on Growth Theory,
Journal of Economic Perspectives, 8: 44-54.

The reference is Feldstein and Horioka (1980).

12

CHAPTER 6

LABOUR MARKETS AND EQUILIBRIUM UNEMPLOYMENT

Objectives
This chapter explains unemployment in the long run:
why does the rate of unemployment fluctuate around a
level which is far from small in most countries, and has
risen considerably in Europe over the last two decades?
One effective way we have found to teach this
chapter is first to propose a standard demand and
supply analysis, in which all unemployment is the
outcome of voluntary choice. The paradox of how to
interpret the unemployment which we observe arises
immediately, and the teacher then proceeds to unearth
the sources of involuntary unemployment.1
The central message is that labour is a very
particular commodity: once we take into account what
makes it particular, the paradox disappears. Given the
many different reasons why labour is special, the
chapter does not offer an all-encompassing theory of
unemployment. Instead it looks at each explanation one
by one, leaving the reader to add them up, and allowing
the instructor leeway to stress his or her own preferred
(or locally relevant) cause. Many of these aspects have
been removed from Chapter 6 and can now be found in
Chapter 17 (supply side).

distinction of equilibrium unemployment between

frictional and structural. We find these distinctions very
helpful in the classroom and, we hope, roughly correct.

Approach
It is thus fruitful for the teacher to remember that the
results are ultimately summarised in (6.7)
Equilibrium = Frictional +
unemployment unemployment

Structural
unemployment

This distinction refers to the two classes of reasons why

the demand-supply framework is inadequate:
- static causes of unemployment, i.e. reasons why
wages are prevented from clearing the market. This
is interpreted as the cause of structural
unemployment.
- dynamic causes of unemployment, i.e. reasons
which increase the inflow into unemployment or
slow down the process of job take-ups. This is
interpreted as the determinants of frictional
unemployment.

Static causes of unemployment

Controversial distinctions
We have chosen to separate out actual (i.e. observed
and quoted in newspapers) unemployment into two
parts: equilibrium and cyclical. While this accords well
with intuition and current econometric practice, it may
be at variance with the recent flow approach to
unemployment or with recent developments of the
disequilibrium view.2 The same applies to the
1

Some might argue that the distinction is largely

meaningless, i.e. that all unemployment has an involuntary
element; for a convincing case, see Lucas (1978) or
Pissarides (1989). We take a neutral stand.
2
Two references are C. Pissarides (1989, 1990) and C. Bean
and J. Drze (eds.) (1991). The text presents the flow view in
Section 6.4, and part of the disequilibrium view in Section
6.3.

Trade union theory (see Booth, 1995, for a recent

review) relies on the distinction between individual
labour supply decisions and the outcome of
collective bargaining. The trade-union mediated
"collective labour supply curve" (wage-offer curve)
cannot be to the right of the individual supply curve
because trade unions cannot force workers to work
more than they wish. It is further to the left the
more the trade union values real wages relatively to
jobs. A good illustration is to show the effect of
increased labour supply (demography, immigration,
entry of women into the labour force) as a shift of
the individual supply curve -- possibly matched by a
shifting labour demand curve as the result of capital
accumulation or technological change. If the trade

Instructors Guide

Chapter 6

union does not change its wage offer schedule,

3
involuntary unemployment can increase.
efficiency wages (see Katz, 1986, for a survey) can
be introduced to justify rigid real wages.
minimum wages is a straightforward example of
wage rigidity.
regulations and taxes may be represented as
drawing a wedge between supply (both individual
and collective) and demand: they both increase the
cost of labour to the firm without raising net aftertax workers income. If net after-tax real wages are
shown on the vertical axis, the demand curve shifts
down: employment declines as real wages fall.

Facts and institutions

There is hardly any other branch of macroeconomics
which is so intertwined with local institutions and
traditions. The text emphasises this point in various
ways: the choice of topics (the flow approach is highly
tied to institutional aspects including benefits),
discussions of the effects of national institutions (e.g.
collective bargaining structures), and by examples
(contrasts between European and US labour markets is
a natural way of illustrating the issue). Teachers profit
from drawing on their own national experiences for
alternative examples.

Static causes of unemployment

Numbers
The dynamic considerations of Section 6.4 are not
easily cast in the demand-supply framework. This is
what may make this part hard to convey in class. Table
6.5 which presents unemployment flows, as well as the
standard diagram in Fig. 6.18, signal the change of
approach. These flows include those who are fired or
whose firms go bankrupt (more important in Europe),
as well as those who enter unemployment from the
labour force or quit into unemployment (less
important). The magnitudes shown in the table are
convincing evidence that gross movements are not
trivial, and are part of the mechanism by which the
stock relationships, which form the core of the analysis,
are maintained. For more evidence in the European
context see our paper (Burda and Wyplosz 1994).

Students want to know how high equilibrium

unemployment actually is (so do a lot of policymakers!). There are few good estimates around,
unfortunately, and those that exist do not always
coincide. References are the studies in Bean and Drze
(1991) or various studies by the OECD and IMF (which
are really estimates of the NAIRU studied in Chapter
12). Table 6.8 produces some unpublished OECD
estimates which, as always, should be sold as estimates
surrounded by the usual bands of statistical
imprecision.

Economics and politics

Markets are not perfect and economists must deal with
that as best they can. This is especially true for labour
markets. There is however a serious risk that students,
frustrated by the persistence of high unemployment in
Europe, will react to the material with sweeping
conclusions: ban or restrict trade unions, or abolish
minimum wages, slash unemployment benefits, etc. It
is the teacher's responsibility to remind them that
economics is just one component of a larger social
game. Indeed, such conclusions can make sense from a
narrow economic viewpoint (efficiency wages, for
example). But political science and sociology also have
much to say about the unemployment phenomenon, and
they may contradict economic reasoning, which means
that civil order and social harmony have a price. In the
end, we economists can even explain why economic
principles should not be followed too closely!

Off-the-curve equilibria
Many interesting results occur when either workers are
off their individual (or even collective) supply curves or
firms are off their demand curves. This is one way of
capturing the popular wisdom that unemployment is
painful and that firms suffer because of redundancies or
unfilled vacancies. Bargaining models in which neither
firms nor workers are on their demand and supply
curves are not discussed in the text but may be worth
exploring (for a review see Booth, 1995).

Andrew Oswald has rightfully pointed out that monopolists

do not have "supply curves"; by calling the outcome a
"collective labor supply curve" we try to avoid pinning the
mechanism on a monopoly union. The term "wage offer
curve" used in the first edition may be preferred by the
purists. It should also be that the slope of the curve will
generally depend on the nature of the shock; only if
everything is linear will all shifts to labor demand result in
the same collective labor supply schedule.

14

Instructors Guide

Chapter 6

References
Bean, Charles and Drze, Jacques (1991)
Unemployment in Europe, Cambridge, Mass., MIT
Press.
Booth, Alison (1995) The Economics of the Trade
Union, Cambridge, UK: Cambridge University Press.
Burda, Michael and Wyplosz, Charles (1994) "Gross
Worker and Job Flows in Europe," European Economic
Review, 38:1287-1315.
Katz, Lawrence (1986), 'Efficiency Wage Theories: A
Partial Evaluation', NBER Macroeconomics Annual, 1:
235-76.
Lucas, Robert E. Jr. (1978) 'Unemployment Policy,'
American Economic Review Papers and Proceedings,
68: 353-357.
Pissarides, Christopher (1989), 'Unemployment and
Macroeconomics', Economica, 56: 1-14.
____________ (1990) Equilibrium Unemployment,
London, Basil Blackwell.

15

CHAPTER 7

THE REAL EXCHANGE RATE

Objectives
So far it has been implicitly assumed that there is just
one good in the world; this chapter introduces a second.
This step is necessary to give content to the question:
what is the role of the real exchange rate -- an
intratemporal price -- for an open macroeconomy? It
also allows us to deal with a number of ideas and
results normally overlooked in textbooks which mostly
focus on the closed economy: why do price levels differ
across countries? What are the terms of trade? Could
there be a link between growth and inflation (the
Balassa-Samuelson effect)?
Because of its central importance in the open
economy, Chapter 7 has been modified and updated in
a number of ways. The real exchange rate is used so
frequently that, we now begin Section 7.2 with a
thorough discussion of both the concept and its
practical implementation and measurement. We
proceed then to motivate heuristically the primary
current account function: how the real exchange rate -still loosely defined as the price of foreign goods in
terms of domestic goods -- positively influences the
current account (surplus). The use of the notation
PCA(,...) is meant to signal both that everything else
is held constant and that more is to come. As before, we
firmly establish that the exchange rate is measured in
European terms (how many units of domestic currency
or goods are required to purchase one unit of foreign
currency or goods).
Next we take one way of looking at the real
exchange rate and explore it more deeply, namely the
real exchange rate as the relative price of traded goods
in terms of nontraded goods. Users of the first edition
will notice the shift in emphasis away from a second
definition used more extensively in the first edition,
namely the relative price of imports in terms of
1
exports.

Following the general strategy of first anchoring the

long run, Section 7.4 derives the equilibrium real
exchange rate as that necessary to balance the
intertemporal budget constraint. It begins with the
observation that a countrys intertemporal budget
constraint imposes a steady-state restriction on the
primary current account and suggests that one
mechanism by which the intertemporal budget
constraint is obeyed is via reallocation of productive
resources towards goods that can be exported (rather
than a reduction of absorption).
Following this line, the long-run equilibrium or
fundamental real exchange rate is defined as the one
which balances intertemporal trade. Two examples of
this approach in the literature for infinite horizon
models are Sachs (1982) and Dornbusch (1983)
(although the latter addresses somewhat different
issues); a more recent application to an interesting
historical episode which stresses the exports/imports
distinction is Wyplosz (1991).

Position of the chapter

This chapter is placed at the end of the sections dealing
with the real economy. As such it can be seen as an
extension of what precedes it, and is consistent with our
treatment of the real economy, microeconomic
foundations, and intertemporal budget constraints. It
may, however, be taken up at different stages in a
course. For example, it could as well fit between
Chapters 18 and 19 in a course on international
monetary economics. The order of topics could be: the
exchange rate: institutions and markets (Chapter 18),
the exchange rate in the long run (this chapter), and the
exchange rate in the short run (Chapter 19). In that
case, before starting Chapter 11 and the open economy
treatment of the IS-LM model, the teacher should
remember that Chapter 7 defines the nominal and real
exchange rate in section 7.2.1.

Feedback from users signalled difficulties with the notion of

"exports" versus "exportables" so we ended up putting the
exports/imports distinction into a Box 7.3. This frees up

teaching time to focus on difficult issues raised in Section

7.4.

Instructors Guide

Chapter 7

Dornbusch, Rudiger (1983), Real Interest Rates, Home

Goods, and Optimal External Borrowing, Journal of
Political Economy, 91: 141-53.

The long-run budget constraint and the equilibrium

real exchange rate

Sachs, Jeffrey D. (1982), The Current Account in the

Macroeconomic Adjustment Process, Scandinavian
Journal of Economics, 84: 147-59.

Sections 7.4 conveys a simple message already

emphasised in Section 3.6: in the long run the primary
current account ceases to be a choice variable. In
practice, because most developed countries net external
positions are relatively small the steady-state primary
current account is close to balance (the highly indebted
countries reached a debt at the peak of about 40% of
their GDP implying a debt service to GDP ratio of
about 5%).2
Students are often surprised, even sceptical, when
presented with this conclusion. Fig. 7.1 shows that
Germany can run current account deficits -- data for the
1990s show that this can repeat itself -- while Italy can
also have surpluses! Additional long term data can be
found in Maddison (see references in the textbook). We
find it easy to convince the students that in the long
run, on average, the primary current account must be
small.
The novelty is that a new relative price - the real
exchange rate - supplies an economy with an additional
degree of freedom for meeting the national
intertemporal budget constraint. A real appreciation
reduces the production (and consumption) of
3
nontradable goods in favour of tradables. The real
exchange rate thereby becomes endogenous, and the
teacher can follow up with Section 7.4 and the
conclusion that in the long run, on average, the real
exchange rate or "competitiveness" must be such that
the primary current-account imbalance is small
enough, hence motivating the equilibrium real
exchange rate. The rewritten version of Chapter 7
stresses this even more by postponing the discussion of
the equilibrium real exchange rate until the end.

Wyplosz, Charles (1991), A Note on Exchange Rate

Effects
of
German
Monetary
Union,
Weltwirtschaftliches Archiv, 127: 1-17.

References

In addition, growing countries can afford even lower

current-account imbalances if the objective is to stabilise the
net external position as a proportion of GDP.
3
Arguing from the perspective of Box 7.3, it could also
involve a shift in resources away from the production of
importables towards exportables, as well as a decrease in the
consumption of importables.

17

CHAPTER 8

MONEY AND THE DEMAND FOR MONEY

Objectives
This chapter is standard. It reviews the definitions and
functions of money and prepares for the next chapter
with a presentation of consolidated balance sheets (Fig.
8.1). The money-demand function is not derived from
first principles: it is simply presented and motivated by
the transactions approach, recognising the dependence
of demand on opportunity cost of holding money, the
nominal interest rate.1 The Appendix derives the
inventory theory of money demand in the tradition of
Baumol and Tobin.
The chapter is somewhat innovative in two
directions, buttressing an otherwise descriptive and
institutional chapter with central analytical results.
First, the chapter discusses money-market equilibrium,
assuming an exogenously set real money supply
(Section 8.6). The student is thus exposed early on to
the equilibrating role of the interest rate.2
Second, a long run interpretation locks in the
principle of homogeneity of degree 1 in nominal
magnitudes, here between money, prices and the
nominal exchange rates. It also provides the first
opportunity to present the Fisher principle. In contrast
to the first edition, the second edition postpones
discussion of the concepts of dichotomy and monetary
neutrality to Chapter 10, in which all major markets of
the economy can be considered simultaneously.

What is highlighted and what is de-emphasised

More formal models (cash-in-advance or money-in-theutility function) would increased the level of complexity well
beyond that of an introductory text. See Blanchard and
Fischers (1989) textbook for a nice derivation of the most
useful approaches.
2
The assumption is, of course, that the central bank can fix
the real money supply. This cannot be true in a world with
flexible prices, as Section 8.7 makes clear, so an instructor
must either assume a given (but perhaps not fixed) price
level, or derive the demand for money in nominal terms.

We emphasise a number of well-known ideas and

results that do not always get attention in macro
textbooks. First, we stress that money has aspects of a
public good -- namely its acceptability in transactions
vis--vis unknown or unpredictable trading partners.
Furthermore, an individuals use of money makes it
more valuable for others by increasing this
acceptability. Confidence sustains the value of money,
and the lack of it can undermine the stability of banking
systems. Second, care must be taken to distinguish
carefully between nominal and real variables affecting
money demand. Third, the nature of market clearing
depends on the time horizon. In the short run (given a
price level), real balances are given so the nominal
interest rate clears the money market. In the long run,
the price level and the inflation rate are endogenous,
and are determined by the level of real activity and the
rate of growth of the money supply chosen by the
monetary authority.
On the other side, we pay relatively little attention
to some features which often figure prominently in
other textbooks. First, we gloss over details concerning
monetary aggregates and institutions. Although more
information is provided in Chapter 9, we do not spend
much time on the definitions of money because they
vary from country to country and even over time within
a particular country. Teachers may want to elaborate
these aspects using a supplementary, perhaps nationalbased text. Showing and explaining a central-bank
balance sheet is a good use of classroom time. Second,
we do not spend much energy on the concept of
velocity. While a number of teachers use this concept,
we feel it easily confuses students, who tend to give it a
life of its own. We prefer to emphasise the fact that it is
nothing more than a transformation of the demand for
money and stress the role of nominal interest rates and
conversion costs.3

Velocity is shown in (8.2) to be a function of real GDP, the

interest rate, and the technology of money or liquidity
services (captured by parameter c).

Instructors Guide

Chapter 8

The effects of price on money demand

Students often find it difficult to separate out the two
effects of price increases on money demand. Fig. 8.3
attempts to clarify the issue. The first is a level effect
which works through the fact that money demand is a
demand for real cash balances. Nominal money
demand can be written as M=PL: ceteris paribus, there
is a one-to-one effect of an increase in the price level
on nominal money demand or, equivalently, no effect
on real money demand. The second effect is the rate of
growth effect. The Fisher effect implies that an increase
in the inflation rate increases the nominal interest rate
by the same amount; real money demand declines
because the cost of holding money increases. Nominal
money demand increases over time, but not quite as fast
as the price level, so real balances decline. The
examples shown in Fig. 8.12 may seem to weaken the
latter argument: it is a good occasion to remind students
that the Fisher principle involves expected (ex ante),
not actual (ex post) inflation. Such a discussion serves
as a lead-in for future discussions on the credibility of
monetary policy.

References
Blanchard, Olivier J. and Fischer, Stanley (1989),
Lectures in Macroeconomics (Cambridge, Mass.: MIT
Press), 4, esp. 4.1-4.3.
Goldfeld, Stephen M. (1990), The Demand for Money
in Friedman and Hahn, eds., Handbook of Monetary
Economics (Amsterdam: North Holland).

19

CHAPTER 9
THE SUPPLY OF MONEY AND MONETARY POLICY

Objectives
There are three good reasons for dealing with money
supply after money demand and money market
equilibrium. First, an understanding of the equilibrating
role of the interest rate in the money market greatly
helps the exposition of open-market operations.
Second, openness and international capital movements
profoundly affect monetary policy via the interest rate.
Third, if the mechanics of money supply gets relatively
less emphasis, it is because monetary policy in most
European countries emphasises interest rate or
exchange rate policy as well as bank regulatory aspects.
Indeed, a key difficulty of presenting monetary
policy to students living in an open economy is that
they know that foreign interest rates are the central
constraint. This is why this chapter de-emphasises the
money multiplier and stresses the linkage between
monetary policy and exchange-rate policy, establishing
the link between a money-market intervention and an
exchange-market intervention. While a full resolution
of this issue will have to wait until Chapter 11 and the
open-economy version of the IS-LM model, students
are ready to think about these issues.
Another aspect of monetary policy often saved for
later receives here a special early treatment: monetary
financing of budget deficits and independence of the
central bank. This issue is paramount in several
European countries and has been given a central
treatment in the discussions surrounding monetary
union in Europe. Presenting the idea early on is
advisable, despite details provided later in Chapter 15.
Overall, the instruments available to the monetary
authorities can be presented quickly in a summary
form. Similarly, teachers short of time may skip the
balance-sheet approach which is very useful but timeconsuming. One important change in this edition is a
rewriting of the parts of Section 9.3 to reflect the
increasing importance of open market operations in
European monetary policy -- as well as the prospect of
a European Central Bank by the year 2000. We see this
bank -- to the extent it becomes a reality -- as operating

in a manner similar to the Bundesbank and have added

Boxes 9.3 and 9.4 to highlight these issues.

Different national institutions, yet the same process

Because monetary institutions differ from country to
country, the chapter adopts a neutral presentation of the
money-supply process: it does not go into national
specifics and instead focuses on common elements.1
For instance, reserve-holding behaviour is central to
legal reserve requirements, yet reserve holding may or
may not be regulated in the particular country under
study. Similarly, the relationship between central and
commercial banks also differs across countries, and this
has important policy implications. For example, Fig.
9.7 studies three approaches: i) a strict monetary
control as practised in the US in the early 1980s; ii)
strict interest rate control as currently practised in many
smaller European countries as well as the UK and
France; iii) the newer hybrid approach targeting a short
term interest rate with open market policy, either via
auctions of reserves (via repos as in Germany) or
dealings in Treasury securities (as in the US).
Yet, it is useful to emphasise the crucial role of
bank reserves, be they voluntary or regulated. Again,
using the balance sheets introduced in the previous
chapter can be an effective way of presenting in one
step the two main aspects of money supply: the moneymultiplier process and the effective control of money
supply.
In doing so, the text introduces two multipliers: the
reserves multiplier (the ratio of M1 or any other money
aggregate to banks reserves) in Section 9.2.2.1, and the
monetary-base multiplier (the ratio of M1 or any other
money aggregate to the monetary base M0) in Section
9.2.2.2. In our view the latter is a more effective, and

Those interested in delving into national detail might well

consider a historical approach which outlines how the
institutions arose. For an excellent treatment, see Goodhart
(1990).

Instructors Guide

Chapter 9

less misleading, way of presenting the two concepts of

multiplier and control.2

their capital base to the levels required by the ratios;

second, with the fall in house prices, a number of bank
customers have failed to keep up payments on their
loans leaving banks with collateral -- such as houses -which are worth less than their book values, thus
4
eroding the asset side of the banks balance sheets.
The other example is the issue of lender of last
resort treated in Section 9.6.2. There is no agreement
on whether or how this function should be performed
by a future European Central Bank. The German
Bundesbank seems to oppose making commitments for
fear of entering into a commitment to create money.
The Bank of England is less reticent, probably having
been more sensitised to the risk of instability in its
(much more developed) financial markets. This is great
material for classroom discussions or examination
questions.

Step-by-step multiplication versus aggregate effect

Section 9.2.3 deals in great detail with the money
multiplier. In principle, the one-step aggregate effect
presented earlier should suffice in terms of
macroeconomics. Yet students often correctly suspect
that there is more going on among banks. The step-bystep presentation fills that gap. Yet it can be quite timeconsuming in class, and impossible to stop once started.
One way of dealing with this is simply to refer curious
students to the full treatment in the text and stick to the
one-step approach represented in Fig. 9.2.

Policy dilemmas
Students often note that, according to the principles,
central banks should be able to control money supply
effectively and yet they often miss their pre-announced
targets. This provides a good lead-in: teachers should
not be afraid of telling students that central banks may
well have several objectives: long-run price stability
which calls for the control of money growth; a shorterrun preoccupation with the business cycle which can be
addressed by varying the interest rate; and very shortrun exchange-rate targets -- even under a flexible
exchange rate regime central banks care about the value
of the currency. More often than not, these objectives
stand in conflict with each other, creating a dilemma
for the monetary authorities and leading to
compromises. Several examples of this problem are
presented in the text (a more recent example is
monetary policy in Germany after unification and the
UK after the EMS crisis of September 1992).

References
Brunner, Karl and Meltzer, Allan (1990), Money
Supply in Friedman and Hahn, eds., Handbook of
Monetary Economics, (Amsterdam: North Holland).
Goodhart, Charles A., (1990), The Evolution of Central
Banks (Cambridge, Mass., MIT Press).

Regulations
While not traditionally presented in macroeconomic
texts, the regulatory aspects of central banks merit
some attention, especially in Europe. Two examples
might convince the sceptical teacher. The Cooke
Ratios presented in Section 9.6.3 are widely believed to
have been the main source of monetary stringency in
the early 1990s, in the USA, Europe, and Japan. Two
reasons have been presented and may be discussed in
class with the help of press reports, especially in Japan
3
and France. First, it takes time for banks to build up
2
3

The recent collapse of Barings and enormous reported

trading losses of Metallgesellschaft and Sumitomo have
important implications for the banking sector. Students may
need to be told that banks are virtually always involved when
businesses suffer losses or go bankrupt.

A useful reference here is Brunner and Meltzer (1990).

See also Theoretical Exercise 9.

21

CHAPTER 10
OUTPUT, EMPLOYMENT, AND PRICES

Objectives
This chapter stitches together the patchwork of the
previous nine chapters into the general equilibrium
framework most commonly used in macroeconomics.
The centerpiece of the chapter is the so-called
neoclassical model, which assumes perfectly flexible
nominal prices and fixed output, given factor
endowments. It is the product of the first three sections,
culminating in Figure 10.6. In an effort to be balanced,
we conclude the chapter with the fixed price, variable
output version of the model, which can be understood
using the same IS and LM curves developed in
preceding sections and is meant to provide a stepping
stone for the Mundell-Fleming analysis of Chapter 11
(previously Chapter 10).
Key concepts introduced in this chapter are:
macroeconomic general equilibrium (an extension to
the discussion of Chapter 5); the IS-LM diagram, which
is presented for the first time; the concepts of monetary
neutrality and dichotomy; and the Keynesian
assumption and its implications.

The return of the closed economy

A number of users of the first edition will be relieved at
the addition of this chapter. Initially, we were confident
that deriving the open economy IS-LM model from the
outset would be a straightforward exercise. In the end,
many users as well as our own experience convinced us
that the closed economy version was necessary, not
because the closed economy is particularly relevant
(especially in the European context) but because it is
the most suitable means of drawing together the loose
ends of the previous chapters. (Chapter 11 retains the
emphasis of the Mundell-Fleming open economy model
and the regime-dependency of fiscal and monetary
policy.) We thought that students deserved a last look at
the long run, stressing the value of the classical
framework for understanding long run trends, while
continuing to think about these issues within the
confines of the two-period model.

One interesting application of the closed economy

model is to motivate more fully the long run
determination of the world real interest rate. Figure
10.7 (Box 10.1) adds flesh to the bones of the first
attempt in Figure 5.4 and shows how "crowding out"
can occur in a purely classical framework, even if there
is Ricardian equivalence, when the government
increases its claim on resources. This may be
supplemented by analyses of related changes, such as
an increase in the economys endowment today, which
would tend to decrease the interest rate in equilibrium,
versus a "technology shock" (an increase in marginal
productivity at any particular capital stock), which
would tend to increase the interest rate.

Structure
Although the analysis is classical as in Patinkin (1948)
or Sargent (1987: Chapter 1), it begins with the
traditional "Keynesian cross" or 45 line diagram used
to interpret demand-determined cyclical fluctuations
and in deriving the IS schedule.
Next comes the derivation of the IS and LM
schedules. They are derived ceteris paribus, i.e. without
reference to other constraints on output and interest
rates. Derivation of the aggregate supply side occurs in
a natural way and provides the first explicit link
between the labour market (Chapter 6) and equilibrium
output (which figures importantly in Chapter 12 and
13).
Both IS and LM schedules are derived in the
standard way, but with the exception of Figure 10.12
they are not "moved around"; that chore is left for
Chapter 11. In this sense Chapter 10 is a treatment of
the theoretical issues, and should be understood by the
student as a preparation for the "action" in subsequent
chapters.
Finally these curves are integrated in a six-panel
diagram that will be familiar to some and new to many.
We think it will provide a crystallisation point for the
many ideas of previous chapters -- in a single picture.
This diagram allows the instructor to illustrate the key

Instructors Guide

Chapter 10

propositions of monetary neutrality and dichotomy, as

well as the failure of these when prices are not fully
flexible.

few of the short cuts we have taken in writing Chapter

10 which may turn into stumbling blocks down the
road:
Two periods or one? This is the last time the
two-period framework is mentioned in any significant
fashion. The chapter completes the transition to the
short-run, suppressing subscripts and treating the entire
analysis as if it were "first period." This is a transition
also for the next chapter, which is exclusively
concerned with the (Keynesian) short run. Observant
students will ask: what happens if the potential output
of the economy changes? Clearly, teachers can finesse
the point by focusing on temporary changes -- those
occurring in with no long-term implications for wealth,
investment, and output. Longer run changes bring us
back to Chapter 5.

Equilibrium
A central concept in this chapter is the idea of
macroeconomic equilibrium. Equilibrium is introduced
early on as a state in which no forces exist which would
move the economy away from that state. Of course,
equilibrium is always defined with reference to a
choice of exogenous and endogenous variables and we
have tried to use the development of the chapter to
convey this distinction. One example is the Keynesian
cross diagram, which we decided to leave in for those
who like to emphasise it. Given the nominal interest
rate i, the desired demand curve can be thought of as in
equilibrium with output, assuming that output is
supplied elastically. Similarly, the IS and LM curves
intersect to give a level of output and interest rates
given that this is supplied -- leaving open either a
classical or Keynesian interpretation.

"The fourth market." The classical model is

usually thought of in terms of four markets: goods,
labour, money and "bonds" -- where bonds mean all
interest-bearing alternatives to money. The bond
market is usually ignored (an application of Walras
Law for a system of asset demands in equilibrium), and
this may cause some confusion among better students.
It is important to stress that bonds and money are
markets for stocks -- as opposed to markets for flows
(goods and labour services both today and tomorrow).
The short cut is invalid for the flow markets: since
investment is occurring, there are goods tomorrow and
labour tomorrow as well. Difficult stuff best left for a
graduate level course.

Deriving the IS and LM schedules

Even when derived mathematically as in the Appendix,
teachers should reinforce students intuition for what
the IS and LM curves stand for, to prevent their being
used mechanically, and possibly incorrectly. We have
found that it is best to proceed in a heuristic manner
initially. The text performs the what if exercise to
derive the slopes of the schedule (going from A to C to
B in Fig. 10.2 and 10.3). Second, ask what off-schedule
points represent1 and how equilibrium can be restored
(both Y and i can move and do the job; explain why and
how).
Chapter 11 provides detailed information about the
slopes of the schedules, so this may be left out at the
time of the first presentation: the whole apparatus is
often hard to grasp and students should be led to focus
on the essentials. Thus, asking what happens as one
moves along each schedule requires a more extensive
development of the components of aggregate demand
(especially the primary current account, which is not
addressed in Chapter 10).

IS-LM, aggregate demand and equilibrium.

Strictly speaking, our presentation of the IS and LM
curves yields the level of aggregate demand, but in
Figure 10.6 we draw the demand for money defined at
the equilibrium level of output. In that sense the money
demand curve in the upper right panel of Figure 10.6
does not shift when the economy is out of equilibrium
in the flexible price case.

The neoclassical assumption: price flexibility

While not particularly plausible in the short run, the
idea that price-flexibility defines the long run and is of
central importance in macroeconomics.
In the model presented in this textbook, the
assumption of price flexibility and that all nominal
prices are indexed to the price level delivers the
neutrality of money and the dichotomy proposition -that the real and nominal sides of the economy do not
influence each other in a substantial way. It reinforces
the intuition that, in the long run, increases in real

A few stumbling blocks and helpful simplifications

Perceptive students always find problems with any
instructors presentation, and we have written down a
1

This is the object of Exercise 3 in the theory section.

23

Instructors Guide

Chapter 10

output are only possible if aggregate supply makes it

possible. This point can be made effectively using
Figure 10.9.

The Keynesian assumption

towards the more general AS-AD without any

particular policy usefulness of its own.

References

It is important to warn the students of the problematic

nature of the fixed-price assumption that underlies the
IS-LM analysis. One idea is to announce that this
chapter deals with the very short-run (a year, say),
while the next one introduces inflation covering longer
horizons, all the way to the dichotomised long-run.
Another is to treat it exclusively as a stepping stone

24

Patinkin, Don (1948) "Price Flexibility and Full

Employment," American Economic Review, 38: 54364.
Sargent, Thomas J. (1987), Macroeconomic Theory,
New York: Academic Press, Ch. 1.

CHAPTER 11

AGGREGATE DEMAND AND OUTPUT

Instructors familiar with the previous edition will notice

that the PCA function, previously introduced in Chapter
4, has now been moved to the present chapter. The
PCA function is inherently Keynesian and is naturally
introduced here. It is based on the traditional import
function. For the sake of continuity with the microfoundations, we start by modelling imports as a
function of total absorption, and then link up absorption
to the GDP. The end result is in fact the Keynesian
marginal propensity to import --although we dont call
it that in order to avoid stuffing students with
concepts which are not really essential.

Objectives
Following the closed economy IS-LM model, the
present chapter moves to its open economy version, the
so-called Mundell-Fleming model. The flexible price
version is abandoned, i.e. the focus is decisively on the
short-run.
The opening-up involves two steps: introducing the
trade linkage (via the primary current function) and the
international financial link (via a simplified version of
the interest parity condition, further elaborated upon in
Chapter 19). The main goal is to derive the benchmark
Mundell-Fleming table which depicts up the policy
ineffectiveness results. The second goal is to use this
table to help students think about intermediate cases.

The open economy IS and LM schedules

The IS and LM schedules have already been introduced
in Chapter 10. They are derived again here. Repetition
is not only superficial, however. A second, slower,
exposition of this essential tool of macroeconomic
analysis has pedagogical merit. In addition, the open
economy versions differ from their closed economy
counterparts; this justifies a careful treatment. For
mathematically-oriented courses, much can be learnt by
contrasting the formulae in the Appendices to both
chapters.
Another advantage of this new exposition is that
here we take time to insist on the importance of
separating out endogenous and exogenous variables.
This is made possible as we now adopt the Keynesian
assumption of fixed prices. This distinction is used to
address one key difficulty that students face at this
stage: grasping when to move along the schedules, and
when do the schedules shift.

The Mundell-Fleming table

The key difficulty of this chapter is that the exchange
rate regime radically affects the working of the model:
with full capital mobility monetary policy is ineffective
under fixed exchange rates while under flexible rates it
is fiscal policy which fails to affect the economy.
Consequently, we cannot just open up and show how
the results are modified. We have to separate out the
two polar cases: full flexibility and perfectly credible
fixity of exchange rates. These are extreme cases,
especially as they additionally assume full capital
mobility.
The result is Table 11.4, the chapters key result,
which can be used to: 1) help the students grasp the
dizzying variety of sharp results; 2) guide the student to
less clear-cut cases (less than perfect capital mobility
with an upward-sloping financial integration line),
expected de- or revaluations (shift the financial
integration line); 3) discuss intermediary regimes
(managed float) and the case of monetary union (in fact
the permanently fixed exchange rate case).

The financial integration line

Teachers will know that in the Mundell-Fleming model
expectations are omitted, or assumed to be static so that
i = i* + a constant term. Later chapters, starting with
Chapter 13, will introduce more realism and
complexity. In a first pass it is essential, we believe, to
stick to this simplification, even if some alert students

The PCA function

25

Instructors Guide

Chapter 11

suspect that it is not quite right. Going in the direction

of introducing endogenous exchange rate expectations
is like opening Pandoras box at this stage.
As with the IS and LM schedules, students should
understand what is happening off this schedule, why
does the economy promptly returns onto the schedule,
and what shifts the schedule - including possibly
expectations of appreciation or depreciation.
The financial integration schedule assumes full
capital mobility and substitutability: then, and only
then, are all assets perceived as identical. Of course,
that is not a very realistic assumption, just a
benchmark. Two interesting deviations may be
considered.
The first case is that of full mobility but imperfect
substitutability. Early models in the Mundell-Fleming
tradition used to draw an upward sloping schedule to
account for less than perfect substitutability.
Subsequent research has tried to understand the
corresponding "exchange risk premium". It is hardly
plausible that an upward sloping schedule makes sense:
the premium is believed nowadays to be small and
highly variable. This is why we do not follow the older
tradition, and instead tell the students to assume full
asset substitutability. Again, as a first order of
approximation, it is perfectly acceptable. And there is
no graphical second order of approximation.
The second case of less than full mobility
corresponds to the existence of capital controls. These
controls - presented in Chapter 19 and 21 - break the
link between domestic and foreign interest rates. There
is no simple way of representing them graphically,
certainly not with an upward sloping schedule. In the
advanced countries with developed financial markets,
the best approximation remains the horizontal line
because it is known that, given time, controls are easily
circumvented.

Policy mix
Sections 11.3.3 and 11.4.3 present how a fiscalmonetary policy mix operates. This may seem a little
bit like hair splitting. In fact, it is an excellent way of
checking students understanding. It can easily be left
out of a busy classroom schedule.

26

CHAPTER 12

AGGREGATE SUPPLY AND INFLATION

Everything else being equal, lower rates of

unemployment are associated with rising inflation. This
is the Phillips curve, and it is indeed visible when
everything else remains equal. But, in general,
everything else does not remain equal. Inflationary
expectations -- which enter the determination of core
inflation can and do change -- as well as the
equilibrium unemployment rate itself, due to factors
that often have nothing to do with the business cycle.

Objectives
This chapter derives the aggregate supply curve. This
analytical tool remains controversial; while most
economists would probably accept the notion of a
short-run aggregate supply curve and admit that the
schedule becomes vertical in the long run,
disagreements persist regarding the microeconomic
foundations. This is why we propose a fairly openminded approach: inflation accounting in the tradition
of Friedman and Phelps, with an eclectic view with
respect to the foundations. More strongly opinionated
teachers can choose to rationalise the aggregate supply
curve in terms of a specific model: Lucass monetarymisperceptions or error-extraction mechanism, the
Fischer-Taylor overlapping contracts, staggered price
setting, or menu costs, for example.1
The proposed strategy starts with the following
fairy-tale presentation of the Phillips curve: it used to
exist, it disappeared, but may have returned, and in any
case theory says it has to end up vertical. The inflation
accounting exercise is reasonable, and makes sense of
the stylised fact of a short-run inflation unemployment
trade-off which is nonetheless interrupted by detectable
breakdowns in the relationship. Most importantly it
need not take a stand on the source or nature of the
underlying nominal rigidities. This is followed by a
rehabilitation of the Phillips curve in its modified form.
To move from the unemployment-inflation space to
the output-inflation space we use Okuns law. Okuns
law is often less robust than a law should be -- and
Chapter 6 presents many reasons why. Still, we believe
that Okuns law ought to be in every students toolkit. It
may be useful to warn students that employment
fluctuations typically lag behind those in output.

Price level or inflation?

In constructing the aggregate supply curve, theory often
leads us to operate in the output-price space rather than
in the output-inflation space. A frequent strategy is to
start with the price level and then go to inflation; some
textbooks keep the discussion in the levels throughout.
We have found that students are puzzled, if not
confused, by the change (they often have a hard time
distinguishing price levels from the inflation rate), but
want to know about inflation, which seems more
relevant politically and comparable internationally.
Indeed, we must eventually be able to explain inflation
because realistic steady states are ones in which prices
rise at a constant rate. This is why the textbook moves
directly to inflation, at the cost of some short cuts
which at first glance may be less appealing to some
instructors, but which ultimately allow students to
direct their energies to a smaller number of models.

Core inflation
The concept of core inflation is intentionally left
somewhat vague in the main text. It is the component of
current inflation which is not attributed to capacity
utilization, tension in the labour market, or supply
disturbances. The term appears frequently in the
financial press and seems to have assumed a meaning
not too different from ours (close substitutes are
underlying or trend inflation, but we steered clear of the
term inflationary expectations, the term used in
popular macroeconomic textbooks from the last
decade). Our loose treatment is partly due to the lack of
conclusive empirical evidence on the subject, partly
due to the role that nominal wage indexation, collective
bargaining, and other national institutions may play in

The Phillips curve as a stylised fact

The Phillips curve is an important component of this
chapter, and we recognize it as an important historical
statistical regularity. What the students should
remember from the chapter comes in two steps:

For a catalogue of sources of nominal rigidities which

might lead to a less than vertical supply curve, see Blanchard
(1990), or Romer (1995).

27

Instructors Guide

Chapter 12

inflation is needed, so convergence will include points

above point Z.4
None of these complexities are mentioned in the
text because we believe that it is far too complicated.
Even the appendix to Chapter 13, which presents a
formal model, depicts dynamics in a simple fashion.
Clever students, however, will often see the need to
overshoot point Z during the convergence process.

its evolution. In the text we have tried to present a story

acceptable to the largest number of colleagues; teachers
with strong opinions will always stress whatever they
believe is the most convincing approach.2
In developing the concept of core inflation we find
it useful and convincing to tell students to think of what
is being bargained over in wage negotiations.
Especially in Europe, negotiators explicitly assume a
rate of inflation to factor into wage settlements, and
they generally end up agreeing on a rather precise
figure. Because national institutions differ, it is not
always clear how much this figure corresponds to a
catch-up on past inflation and how much it represents
an attempt at guessing future inflation. Such aspects as
the frequency at which wage negotiations take place,
whether wages are indexed, and how high and uncertain
the inflation rate is, seem to play important roles in
determining core inflation. To a large extent,
disagreements largely centre around the relative
importance of backward- and forward-looking elements
in the formation of core inflation.3

Which space?
Section 12.6 constructs the aggregate supply curve
simultaneously in the two spaces: unemployment
inflation and output inflation. Since the chapter starts
with the Phillips curve and ends up with the aggregate
supply curve -- most naturally represented in the output
inflation space -- it is unavoidable that a step be taken
at some point from one space to the other.
This is time-consuming in class, though. Teachers
who are short of time may have to make a choice. Our
advice, then, is to skip the Phillips-curve and Okunslaw part and build up the aggregate supply curve
directly in output-inflation space. In equations (12.7),
(12.9), (12.10) and (12.11) this requires replacing the
cyclical indicator (U-U) by (Y-Y) as in (12.12). All the
reasoning goes through with this limited change.

Dynamics
The presentation in Section 12.5.3 of the transition
from the short to the long run is intentionally sketchy.
What is certain are both the starting point (point A in
Fig. 12.11) and the steady state under long-run
neutrality of money (point Z). How we move from A to
Z depends on the dynamics of the underlying model
which is not fully specified here, among other things
because the model is incomplete -- the demand side is
missing and is introduced in Chapter 13. Even the postpolicy change point (point B) depends on the relative
speed of the effects of monetary policy (the movement
along the short-run Phillips curve) and of the shifts of
the Phillips curve. Most models will predict that the
convergence of inflation to point Z over time is not
monotonic, for the simple reason that as long as we are
below point Z, inflation has not risen by as much as the
rate of money growth so the real money supply has
increased. Since the real money stock must, in steady
state, return to its initial level, a period of higher

References
Blanchard, Olivier J. (1990), Why does Money Affect
Output: A Survey, in B. Friedman and F. Hahn, eds.,
Handbook of Monetary Economics, (Amsterdam: North
Holland).
Bruno, Michael, and Sachs, Jeffrey D. (1985), The
Economics of World Stagflation, (Cambridge, Mass.:
Harvard University Press).
Romer, David (1995) Advanced Macroeconomics, New
York, McGraw-Hill.

See Bruno and Sachs (1985) for a detailed discussion of

wage and price behaviour and the Phillips curve in OECD
countries.
3
Autoregressive inflationary expectations are another
potential source of persistence in core inflation, although this
idea is not stressed in the text. Judging from the performance
of economic forecasters (whose view are often consulted in
collective bargaining in Europe), it reasonable in our view to
assume weak rational expectations, or that expectational
errors are orthogonal to information available when the
forecast was made. This puts the blame for non-neutrality of
money squarely on nominal price rigidities.

Naturally, this is not exactly correct in a growing economy.

With a sufficiently rapid real growth rate, steady state real
money demand may rise fast enough to eliminate the need for
higher inflation.

28

CHAPTER 13
AGGREGATE DEMAND AND AGGREGATE SUPPLY

Objectives
This is the central chapter which provides the synthesis
of the macroeconomic model, which in some form or
another, is the common basis for dialogue between
macroeconomists of whatever direction or school.1 As
is customary, it presents the aggregate demand and
supply analysis. A key difference is, in line with
Chapter 11, that this chapter deals separately with fixed
and flexible exchange rates, by-passing the closed
economy and thus differing from presentations found in
most macroeconomics textbooks.
Having derived the aggregate supply schedule in the
previous chapter, the first order of business here is to
derive the aggregate demand curve. It is done by
introducing inflation into the IS-LM model in a fairly
conventional manner.
Under fixed exchange rates, nominal money is
endogenous and adjusts to inflation so that the money
supply remains in line with demand. Inflation has shortrun real effects on aggregate demand because, with a
fixed nominal exchange rate, it leads to a real
appreciation. Under flexible exchange rates, nominal
money growth is exogenous. Higher inflation means a
contraction in the real money supply which, through the
usual mechanisms, reduces aggregate demand.
In both cases the aggregate demand curve is
downward sloping. Yet, students should be reminded
that the mechanism at work is different. A careful
derivation of the demand schedule along the lines
sketched above is one way of driving the point home.
Another way is to manipulate the AD and AS curves in
tandem with the IS-LM system when studying shifts in
exogenous real spending or policy variables. This can,
however, be a difficult exercise. Those who are
interested should refer to theoretical problem 14.3 and
the proposed answer.

We think that even real business cycle theories can be

couched in terms of this framework, although it does not
stress the sources of real fluctuations (i.e. productivity, labour
supply, or taste shocks). Empirical evidence that demand and
supply disturbances are both important for the USA can be
found in Gali (1992).

29

Two-step reasoning: the short-run and the long-run

anchor
A large component of this chapter is about dynamics,
but dynamics is difficult and, by and large, beyond the
level of this textbook.2 To circumvent the difficulty and
still allow students to understand the general direction
of dynamic adjustment, the treatment focuses on two
points in time, the short run and then the steady state.
Filling the gap in between is done heuristically through
reasoned guess-work.
The short-run effect is found by asking whether the
disturbance affects the demand side, the supply side, or
both. Moving the corresponding schedule(s)
accordingly gives the new temporary position. The long
run is found through a different reasoning: domestic
inflation is determined by foreign inflation under fixed
rates and by domestic money growth with flexible rates;
output returns to its trend level, which in the meantime
may be higher. The dynamics can only be sketched
because the full dynamic behaviour is not completely
specified but in most cases it involves gradual
adjustments of the supply (and possibly demand)
schedule until both curves pass through the long-run
equilibrium point.3

The output gap

In the output inflation space the horizontal axis
represents the output gap, not output itself. The reason
is practicality: with steady state growth output, the long
2

Graphically it requires the use of phase diagrams; more

importantly, it requires a stand to be taken on the source (i.e.
wages versus prices) and nature (overlapping contracts,
misperceptions cum signal extraction, menu costs) of
nominal rigidities.
3
In the notes to the preceding chapter this point is
developed. The position of the aggregate demand curve may
also depend on output last period, which will complicate the
analysis considerably (for those who remember, Dornbusch
and Fischers (1987) textbook took this tack in a linear
framework).

Instructors Guide

Chapter 13

interpretation in class. This can be accompanied by

relevant press clippings.
Since the chapter is meant to be a synthesis of
previous chapters, teachers should not hesitate to return
to earlier results (e.g. emphasising the role of labour
markets in determining the speed of adjustment to
shocks and possibly trend output). Later chapters are
mainly devoted to doing just that but any time devoted
to that effect is well spent.
An important issue in this regard is largely
sidestepped: the empirical slopes of the AD and AS
curves. This is clearly important for predicting the
outcomes of various shocks and policy interventions. A
few estimates exist (see Gali, 1992) but, in principle,
simple reasoning can take us a long way. For example,
in Japan, the near perfect harmonization of wage
bargaining plus extensive profit sharing reduces
nominal rigidities originating in labour markets to near
zero; those coming from the price-setting side remain,
leading to a relatively steep AS curve. In the USA, a
semi-open economy in which long-term nominal
contracts are important, explicit cost-of-living
adjustment is rare and where unions represent a minor
factor in wage determination, one would expect the AS
curve to be relatively flat (Sachs, 1980). Europe, with
annual but overlapping bargaining and a strong tradeunion movement and often institutionalized inflation
compensation, is somewhere in between. In more
advanced courses, instructors may also wish to stress
the endogeneity of the slope of the AS curve: it may
depend on the variability of inflation (Lucas, 1973) or
the level (Ball et al., 1988).

run aggregate supply curve would move to the right

continuously, rendering the graphical analysis
cumbersome and messy. Using the output gap gets
around this difficulty but creates a problem of its own.
Some disturbances may have a permanent level effect
on output, i.e. they change the trend growth path but
not the rate. In the output gap inflation space this might
go unnoticed.
The way to capture this is somewhat complicated; a
simpler alternative is to change the horizontal axis back
to the level of output rather than the output gap (this is
done in Exercise 1 of Chapter 17).
Teachers might find a sketch of the solution to be
useful.4 Fig. 1a illustrates a once and for all drop in
trend output which then resumes its old growth rate.
Actual output is shown to recover its new trend
gradually. In Fig. 1b this is shown as a leftward shift of
the long-run aggregate supply line and the associated
short-run supply schedule AS. At the initial point A, as
in Fig. 1a output is above its new trend growth path. If,
for example, money growth is unchanged, long-run
inflation remains the same and the long-run equilibrium
must be at point B. The post-shock position is at point
C. Convergence will include shifts in both the demand
and supply schedules. While the shifts of the supply
schedule are familiar, that of the demand schedule is
not. What happens though is that wealth (or permanent
income) falls (see Fig. 1a) so demand falls accordingly.
If the downward adjustment in demand were
immediate, the AD schedule would instantaneously
move to its new position, passing through point B. The
various paths depicted in Fig. 1a are all possible,
depending on the dynamics (as well as assumptions
about the consumption function and other components
of spending).

Using the AS-AD framework

Merely understanding the AS-AD framework is not
really sufficient. Since this is the single most important
and useful tool to be brought away from a
macroeconomics course, it is essential that students
recognize how powerful it is for thinking about the real
world. The examples provided in Section 13.4 deal
with the most obvious cases. The model is also
extensively used in the next chapter to provide an
interpretation of business cycles. Several exercises are
also designed to provide good practice. One recipe for
hammering in the usefulness of the AS-AD model when
first exposed, is to identify a head-line economic issue
at the time of teaching and provide an AS-AD

Figure 1a and 1b from chap. 12 of the Instructors

Guide, 1/e here

It might be used to provide an extension of the treatment of

the oil shocks in Section 13.4.1 where this point is
intentionally downplayed.

30

Instructors Guide

Chapter 13

Dornbusch, Rudiger, and Fischer, Stanley (1987),

Macroeconomics, 4th ed. (New York: McGraw-Hill).
Gali, Jordi (1992), How Well Does the IS-LM Model
Fit Postwar US Data?, Quarterly Journal of
Economics, 107: 709-38.
Lucas, Robert E. Jr. (1973), Some International
Evidence on Output-Inflation Tradeoffs, American
Economic Review, 63: 326-34.

Interest parity
The financial integration line in the underlying IS-LM
model can be troublesome because the interest parity
condition involves exchange rate expectations. In the
fixed exchange rate case, it is simply assumed that the
existing parity is credible so that i=i*. With flexible
exchange rates, this is no longer a tenable assumption.
The reasoning implicitly assumes that the financial
integration line does not move, which is actually
incorrect. A full treatment is presented in Chapter 19.
As an example for advanced students, consider the
case of a monetary expansion under flexible exchange
rates as in Section 13.3.3. The rightward shift of the AD
schedule in Fig. 13.10 corresponds to a shift of the LM
schedule met along a supposedly unchanged financial
integration line by a new IS which has moved rightward
to reflect the real depreciation. But as inflation rises
along the AS schedule (from A to B) it must be the case
that the exchange rate depreciated even more than
prices rose. Does it not affect the expected rate of
depreciation and therefore the financial integration
line? One answer is the overshooting result (see
Chapter 19 and references therein) which implies an
expected appreciation and a downward shift of the
financial integration line. This provides the appealing
result that the domestic interest rate temporarily falls
after a monetary relaxation. Over time, though, the
financial integration line rises to reflect the fact that, in
the long run, a higher rate of money growth leads to
more inflation and a permanently higher rate of
depreciation (or a lower rate of appreciation). The
underlying IS and LM schedules both shift to the left
during the transition to reflect the fact that rising
inflation (AS moves up along the AD schedule) reduces
competitiveness and the real money supply.

References
Ball, Lawrence, Mankiw, N.Gregory, and Romer,
David (1988), The New Keynesian Economics and the
Output-Inflation Tradeoff, Brookings Papers on
Economic Activity, 1: 1-65.

31

Sachs, Jeffrey D. (1980), The Changing Cyclical

Behavior of Wages and Prices in the United States,
1890-1976, American Economic Review, 70: 78-90.
Students can also be referred to existing
macroeconomic models. Most of them are built around
the AS-AD model. Instructors will be familiar with the
models in use in their own countries. At the
international level, the IMFs MULTIMOD has the
merit of using rational expectations. It is presented in:
Masson, Paul (1990) MULTIMOD Mark II: A Revised
and Extended Model, IMF Occasional Paper.

CHAPTER 14
BUSINESS CYCLES

Objectives
This chapter is new to the second edition. It presents
the student with an exposition of: 1) the main empirical
features of business cycles; 2) the role of price
stickiness in explaining cyclical fluctuations, thus
introducing the Real Business Cycle (RBC) theory.
The other chapters mostly attempt to downplay
controversies between the various schools of thought. It
is impossible to do so for business cycle theories.
Instead, we use this chapter to illustrate the importance
of assumptions about the degree of price flexibility.
Indeed, one way of presenting this chapter is that it
provides another exposition of the principles presented
in Chapter 13. The AS-AD framework is put to work to
reproduce business cycles. Its flexible price version
is the backbone of our presentation of the RBC. While
it is not completely possible to subsume the debate on
business cycles to the issue of price flexibility, doing so
offers continuity and coherence of exposition.
The strategy adopted here parallels that used in the
growth chapter (Chapter 5), and the two are
complementary as both deal with GDP growth, the
former focusing on the trend, the present one with
fluctuations around trend. In both cases, we present
stylised facts, setting objectives for the theory to be
developed. Thus students know what to look for, and
they are given a motivation to work through the
theoretical material.

The stylised facts

We have resurrected the old Burns-Mitchell diagrams,
which had fallen into some sort of disrepute following
the attacks from the Cowles Commission in the early
post-war period. This approach has enjoyed a revival,
recently (Quah (1994), King and Plosser (1994)).
Nowadays, we feel, economists are sufficiently well
equipped in rigorous statistical methods to study
business cycle regularities (e.g. spectral analysis) that
there is little risk of being carried away by the naked
eye. In any case, the results that we brand as stylised
facts are also well-established in the professional

32

literature (see some references at the end of this

Chapter.
The procedure that we used to construct these
diagrams is described in Figure 14.3. Because we use
standardised data we only look at period since 1970,
which limits the number of completed cycles and may
reduce the generality of the stylised facts that we
wish to reveal. For this reason, we have decided to use
averages over several countries. We have not detrended
the data mainly because we wish students to see the
relative size of the growth trend and of cyclical
fluctuations. In the classroom, instructors may present
Burns-Mitchell
diagrams
which
include
the
uncompleted cycle under-way: this allows a discussion
about the particularities of the current cycle which is
likely to echo familiar debates in the media.
While presenting the stylized facts we find it sound
to refer to the microeconomic principles developed
much earlier (Chapters 2 to 6). At this stage, students
often think that IS-LM is enough and that the
microeconomic foundations have not be much used in
the subsequent chapters. The variability of components
of aggregate demand offers a nice opportunity to revive
interest for microeconomic principles and also to
prepare the presentation of the RBC theory.

Deterministic versus stochastic cycles

Students are often told about either deterministic cycles
or about standard cycles (as presented in Box 14.1).
We take a skeptical view about these rather mechanical
views, partly on the basis of modern statistical analysis.
The difference should not be overplayed. For example,
Kondriateff cycles can be seen as stochastic cycles
triggered by major discoveries which turn out to occur
at frequencies of 40-60 years.
More interesting is the generality of the impulse
propagation mechanism. Yet, the presentation is tricky.
On the one hand it is important to show students how
noise is transformed into cycle-like fluctuations. This
will equip them with a healthy skepticism when it
comes to explaining month-to-month wiggles. On the
other hand, we do not want to give the impression that
anything can be explained away. Instructors may

Instructors Guide

Chapter 14

underplayed in the IS-LM and AS-AD analyses. Even

if they have doubts that RBC theory in and by itself
provides a complete interpretation of business cycles,
instructors may point out that these mechanisms can be
at work in economies with sticky-prices.
Another way of presenting the RBC theory is that it
asserts that, given exogenous productivity shocks,
economic agents are as well-off as they can be, given
the circumstances. For this reason, no policy action can
improve their inter-temporal welfare: any benefit
provided by a temporary policy action will have to be
more than paid for later on.

want to emphasise that macroeconomics is precisely

useful because it explains the nature of propagation.
We present a few lags (Robertson, Lundberg) as
examples of the more general fact that empirical
macreoconomic relationship include various lags or
various duration. What must be made clear to the
student is that it is the presence of lags which makes
propagation more than just transmission. This is what
the multiplier-accelerator example is designed to show.
This is just an example: real life is more complex, of
course, much like different wave-lengths interfere to
produce a rich visual or sound outcome.
Mathematically, we just want to have difference
equations to produce dynamics. Wherever possible,
instructors should spend some time presenting
difference equations, including the possibility of
generating cyclical responses. Box 14.2 and Figure
14.10 provide some material to that effect.

RBC vs. sticky prices

Our intention here is to build up a solid basis for the
debate Keynesian vs. Classical economics which
appears in Chapter 16 (instructors should be aware that
this topic is taken up explicitly later on). We attempt to
point out how data can be made the referee of this
controversy. This is why we display some additional
Burns-Mitchell diagrams at the end of the chapter.
Three stylised facts presented there merit attention.
First, real money is usually found to be a procyclical
leading indicator, which accords with sticky prices
models, but not easily with RBC theory. Second, as
predicted by the RBC, productivity is procyclical, while
it is expected to be counter-cyclical in sticky price
models. Third, real wages turn out to be acyclical, not
procyclical as expected in RBC models or
countercyclical as predicted by most Keynesian
models.

Using AS-AD
Implicitly at least, the dynamic use of the AS-AD
framework involves many lags. The result is a fairly
complicated dynamic behaviour, as the Appendix
shows. Accordingly, in the main text, we refrain from
pretending to show the detailed evolution of the system.
We posit the short-run effect, the long-run equilibrium,
and sketch a few principles which can guide the
analysis of the transition. Students often want to see
more at this stage. It is not a good idea to attempt to
study the details since the exercise is rather daunting
(e.g., whether convergence is oscillatory or not depends
on parameter values). Instructors are advised to stick to
the few principles that are unambiguous and show how
they help broadly map out the systems evolution. One
of us has had enormous success "simulating" live a
simple Hicks-Samuelson model on white noise, using a
spread-sheet program.
On the other hand, for technically advanced
courses, instructors may want to show the details: one
of the simplest possible AS-AD models is presented in
the Appendix and displays quite some richness (e.g. it
shows when and why loops occur). Note that this model
assumes perfect foresight and sticky prices, unlike the
Sargent-Wallace models which rely on imperfect
information to obtain deviations from full employment
equilibria.

Trends and cycles

For more technically-oriented courses, this chapter
provides an opportunity of discussing standard
treatments of macroeconomic time series. Here are few
ideas of what can be done:
- seasonality: time series like private consumption real
money (not to mention output in agriculture) typically
exhibit seasonality (Christmas shopping dominates).
Procedures to deseasonalize include the use of moving
averages or the so-called X-11 Census method which
removes estimated seasonal factors.
- stationarity: students may be presented with the
definition of stationarity (stable moments) and with the
difference between zero and first-order of integration,
and to be told that most macroeconomic time series are
I(1).
- procedures can be discussed which separate trends
from cycles. They are briefly presented in the
Appendix.

Real business cycles

There are two ways of looking at the material presented
under this heading. One is that it is possible to explain
business cycles even with purely flexible prices.
Second, it shows how the macroeconomic implications
of the principle of intertemporal substitution, largely

33

Instructors Guide

Chapter 14

Simkins, Scott P. (1994): Do Real Business Cycles

Really Exhibit Business Cycle Behavior?, Journal of
Monetary Economics, 33: 381-404.

Additional literature
A simple and lucid presentation of the RBC theory is in
McCallum (1989). A critical review is in Summers
(1986) (see text). King (1995) presents in a clear way
the modern methodology of business cycle research.
Simkins (1994) offers a critical review.
Some of the references provided refer to debates on the
role of price rigidities to explain historical episodes,
and may be more informative than stylised facts alone.
Students often enjoy (re)visiting the Great Depression:
two classics are quoted in the text -- Kindleberger
(1986) and Temin (1989). Additional readings to
suggest include Mankiw (1989) and Bernanke and
Parkinson (1991): they deal with the procyclicality of
productivity during the Great Depression. Romer (1986)
looks at long time series to challenge the view that real
GDP has become more stable after World War II.

References
Bernanke, Ben and Parkinson, Martin (1991)
Procyclical Labor Productivity and Competing
Theories of Business Cycles: Some Evidence from
Interwar US Manufacturing Industries, Journal of
Political Economy, 99: 439-59.
King, Robert G. (1995) Quantitative Theory and
Econometrics, Federal Reserve Bank of Richmond
Economic Quarterly, 81: 53-105.
King, Robert G. and Plosser, Charles I. (1994) Real
Business Cycles and the Test of the Adelmans,
Journal of Monetary Economics, 33: 405-38.
Mankiw, N. Gregory (1989) Real Business Cycles: A
New-Keynesian Perspective, Journal of Economic
Perspectives, 3: 79-90.
McCallum, Bennett (1989) Real Business Cycles, in:
R. Barro (ed.) Modern Business Cycle Theory, Chicago
University Press, Chicago.
Quah, Danny (1994) Measuring Some UK Business
Cycles, unpublished, London School of Economics.
Romer, Christina (1986) Is the Stabilization of the
Postwar Economy a Figment of the Data? American
Economic Review, 76(3): 314-34.
Sargent, Thomas (1987) Macroeconomic Theory,
Academic Press, New York.

34

CHAPTER 15
FISCAL POLICY, DEBT, AND SEIGNIORAGE

material here may be presented in a more cursory

fashion.

Objectives
Thus far fiscal policy has been presented rather
mechanically. This chapter plugs a number of holes left
over by the previous chapters preoccupation with
reaching the AS-AD synthesis as fast as possible.
First, the chapter presents the welfare arguments for
public spending. This is not really macroeconomics, so
the presentation is brief.
Second, the text returns to the early chapters focus
on optimal intertemporal choices. This is used here to
ask when and how the government should use its taxing
and spending powers to ease out cyclical fluctuations.
Consumption smoothing plays a central role here and
leads to tax and public-spending smoothing results.
Attention is drawn to the fact that active fiscal policy
must be based on market failures and some cases are
discussed, e.g. credit rationing or price and wage
rigidities.
Third, the conventional automatic stabilizers are
presented. This allows us to draw attention to the
partial endogeneity of budget figures, i.e. the
distinction between discretionary and non-discretionary
spending.
Fourth, the explosive nature of the public-debt
process is discussed in depth, since national
indebtedness is a perennial favourite of policy-makers
and politicians alike. Among other things, this allows a
full treatment of the budget constraint in a growing
economy and the link between the deficit, seigniorage,
and inflation.

Use of the material

This chapter is a first opportunity to draw together a
number of results from previous chapters. It also offers
background for discussing current issues. Now that the
students understand the broad picture (the AS-AD
framework) they can fully appreciate debates about
fiscal policies, and press clippings may profitably be
distributed and discussed in class or in take-home
assignments. Of course, in shorter courses, most of the

35

Welfare
Because debates on the size and role of the government
involvement are so highly politicized, the text adopts a
fairly narrow economic point of view. Using
comparative data, as in Tables 15.2, 15.3 and 15.9, is
often a good way of escaping parochial debates. More
comparative data on budgetary issues are available in
OECD publications and provide the basis for
interesting class discussions.

Public debt
In principle, what matters are levels of net public debt.
However, in Table 15.6 we present gross debts (as a
percentage of GDP). Available net debt figures (e.g.
from the OECD, like the gross figures that we use) take
into account public holdings of state-owned firms and
other commercial properties. Our choice is due to the
serious limitations of net figures. First, the valuation of
state properties is highly arbitrary (e.g. state owned
firms are not priced on stock markets). Second, some
state assets include loans which may never be repaid in
full. Third, these estimates overlook a number of
potential and important assets and liabilities. For
example, current retirement legislation implies future
pensions which will be quickly rising when the baby
boom generation born after World War II reaches
retirement age: these are unmeasured liabilities (Table
15.4 elaborates on this point). Probably in recognition
of the limits of net debt figures, the Maastricht treaty
sets limits on gross, not net national debt.1

Debt dynamics

See Buiter et al. (1993) for details on the debt ceiling and
the debate over its necessity in a future European Monetary
Union.

Instructors Guide

Chapter 15

The material in Section 15.4 is most easily presented

using mathematics, as in the Appendix. The text
attempts to avoid maths as much as possible and is
written to be comprehensible to students with no proper
maths background. Teachers may want to check that the
technical difficulties are not a barrier to understanding.
An intuitive way of making the point on debt
stabilization is to describe the evolution of the debtGDP ratio as a race between the numerator (growing at
the rate of the public sector borrowing requirement
divided by the current debt stock) and the denominator
(growing at the GDP growth rate). When the primary
budget is in balance, the numerator growth rate is
determined by debt service, i.e. by the interest rate
times the debt level.2 This is why it is essential to
compare the interest rate and the GDP growth rate:
either the nominal interest rate versus the nominal GDP
growth rate, or the real interest rate versus the real GDP
growth rate.

International Evidence and the Swedish Experience,

Swedish Economic Policy Review.
The May 1996 issue of IMFs bi-annual publication,
World Economic Outlook, focuses on fiscal policy. It
includes a wealth of analyses and data which provide
excellent classroom material. See also the June 1996
issue (No. 59) of the OECD Economic Outlook.

Stabilising debts
European public debts have risen to high levels over
the 1980s, an evolution unheard of in peacetime. This
is one reason why nearly everywhere debt reduction has
become the main objective of economic policy. The
priority given to debt reduction is further reinforced by
the Maastricht Treaty (which is fully described in
Chapter 21). This has led to a new economics of fiscal
stabilization. Instructors who wish to develop this
question can use two recent articles. Alesina and Perotti
(1995) show which measures work (cutting spending on
public employment) and which ones fail (cutting public
investment). Giavazzi and Pagano (1996) show that in
some cases fiscal retrenchment can be expansionary (a
strongly non-Keynesian effect), as may have been the
case in Ireland and Denmark in the late 1980s.

References
Alesina, Alberto and Perotti, Roberto (1995) Fiscal
Adjustments: Fiscal Expansions and Adjustments in
OECD Countries, Economic Policy, 21:205-248.
Buiter, Willem H., Corsetti, Giancarlo, and Roubini,
Nouriel (1993), 'Excessive Deficits: Sense and
Nonsense in the Treaty of Maastricht,' Economic
Policy, 16: 57-100.
Giavazzi, Francesco and Pagano, Marco (1996) NonKeynesian Effects of Fiscal Policy Changes:
2

Of course, in reality the national debt is rarely financed at

the current short term interest rate, but rather at a whole
spectrum of short and long maturities.

36

CHAPTER 16
THE LIMITS OF DEMAND MANAGEMENT
link with policy-making which can be easily shown
with the AS-AD apparatus, and which relates directly to
the issue of voluntary versus involuntary
unemployment. Finally, it also provides a lead into
another inevitable and related topic: the costs of
inflation.

Objectives
This chapter is meant to be fun for both students and
instructors alike. It reviews old and highly popular
material -- the inevitable discussion of Keynesians
versus Monetarists -- as well as going over more recent
and exciting research on the interaction between
expectations and policy. Like Chapter 15, it provides
many opportunities to apply results established in
earlier chapters and to discuss current issues.
The main purpose of this chapter is to continue the
task of the previous one, namely to convey some of the
more subtle aspects of macroeconomic policy and to
remove some of the optimism conveyed by the AS-AD
framework of Chapter 13. Chapter 15 hinted that fiscal
policy is not as effective, even in the short run, as
suggested by the AS-AD framework. Chapter 16 is
intended to amplify this scepticism to government
demand policy in general.

Time and expectations

Section 16.3 presents the results which have so
profoundly changed the field of macroeconomic policy
in the late 1970s. They all hinge on the importance for
policy of expectations, and how policy and
expectations affect each other. This leads to the
concepts of reputation and credibility. The general
implication is that the effectiveness of policy (demand
management) is further constrained by the fact that
policies are predictable; once they are predicted, they
lose some or all of their effectiveness.
Students usually find it intuitive, and enjoy the idea
that the public tries to out-guess the authorities (and has
an interest in doing so!) and that the authorities, having
once lost their ability to surprise the public, are better
off bound by rules.

The great debate

No macroeconomics course can be complete without
some discussion of the on-going debate between
Keynesians and Monetarists. In the text, so far, this
debate has been suppressed because we believe that
students should not be told that "economists disagree
about everything" and therefore know nothing. This is
both untrue (we hope) and highly demotivating for the
students (we know). We also think that classes should
first be presented with a framework that they can understand and then shown which of its components are
controversial.
In presenting the debate we have intentionally
suppressed discussion of issues which, we believe, have
been resolved: the slopes of the IS and LM curves, the
liquidity trap, whether or not the slope of the long-run
Phillips curve is vertical. Rather we have cast the
debate in terms of the desirability of government
interventions. As many have pointed out, the central
issue is the rigidity of nominal wages and prices.
Assuming the foundation of Chapters 6, 12, and 13
have been well laid, this will be relatively easy for the
student to grasp. In addition the chapter establishes a

Political economy
Recent work has reduced the gap between economics
and political science. Technically, policy actions used
to be considered as the archetypal exogenous variables.
The new literature endogenizes the behaviour of policymakers -- by noting that they merely respond to
political conditions which are themselves shaped by
economics. Put in an extreme form, policy-making is
reactive, not active. Because the literature is still in its
infancy and shaped by US institutions we give only a
brief summary.1

References
Alesina, Alberto (1988), Macroeconomics and
Politics, NBER Macroeconomics Annual, 3: 13-62.
1

Readers interested in more details can see the surveys in

Nordhaus (1989) and Alesina (1988).

37

Nordhaus, William (1989), Alternative Approaches to

the Political Business Cycle, Brookings Papers on
Economic Activity, 2: 1-49.

38

CHAPTER 17
SUPPLY-SIDE AND UNEMPLOYMENT POLICY

useful because it represents the evolution of policymaking and also because most of the issues are
politically controversial.
For this reason, we have presented a large selection
of policy issues to motivate the theory. Hopefully, at
the time this class is taught, instructors will be able to
refer to current policy debates and ask students to
prepare relevant economic arguments. Alternatively,
the chapter can be taught in reverse: starting with either
tax reform or unemployment as a policy issue, then ask
what principles are needed to think through the policy
options, and thus come back to the principles exposited
in Section 17.2.

Objectives
The two previous chapters showed the limits of
demand-side policies. Supply-side policies have been
believed to be the response to disenchantment with
demand-side policies. Usually it means less government
but not always. The common idea is that every
economy contains pockets of inefficiencies which can
be rooted out either by more efficient functioning of
markets or by the state. This chapter organizes the ideas
which lie at the heart of most of the supply-side policies
which have been tried over the past decade or so.
By way of examples, we focus on two areas where
the principles of supply-side policies are readily
applicable: taxation and labour markets. This choice is
obvious: tax reform is on the political agenda of many
countries in Europe while unemployment is arguably
Europes worst supply-side failure.

Public goods and taxation

Section 17.3 returns to a theme already discussed in
Chapter 15: public goods are needed but the taxes
which finance them are distortionary and are associated
with welfare costs. While Chapter 15 used this idea to
caution against activist fiscal policies, the approach
taken here asks rather what are the public goods that
governments must provide and how they can be
provided in the most efficient way.
Most of the answers come from the literature on
public finance (e.g. the principles of efficient taxation).
The principles involved are mostly applied, however, to
macroeconomic concepts developed in earlier chapters
-- savings, labour, capital accumulation -- thus closely
echoing the themes developed in the chapter on growth
(Chapter 5).

Micro- and macroeconomics

We call supply-side policies all those interventions
which aim at improving an economy's overall
efficiency or productivity. Because a large patchwork
of policies falls under this rubric, the chapter starts by
examining the most common sources of inefficiency.
This has the virtue of providing a unifying framework,
strengthening the analytical content of the chapter, and
establishing links with previous results.
We start by a reminder of the principle of laissezfaire in economies characterised by perfect
competition. This is used to motivate a review of the
main sources of deviations from the perfect competition
paradigm. Here again the students will note that the
border between micro- and macroeconomics is fuzzy.
Supply-side policies mainly draw the macroeconomic
implications of a variety of microeconomic principles.

Structural unemployment
Section 17.4 can be seen as a sequel to Chapter 6. It
can be taught separately from the rest, if only to
develop the analysis of equilibrium unemployment that
was only briefly exposited. Instructors who consider
dropping this chapter could -- in our view, should -still use the material of this section, either on its own or
when presenting Chapter 6.

A difficult chapter to teach

This is a difficult chapter to teach. It covers a lot of
(mostly microeconomic) ground. It deals with a domain
where there is still little empirical evidence available on
which to judge the effectiveness of policies. Yet, it is

39

Instructors Guide

Chapter 17

Barro, Robert (1991), 'Economic Growth in a Cross

Section of Countries,' Quarterly Journal of Economics,
106, May: 407-44.
The three curves
Blanchard, Olivier J. (1991) Two Tools for Analysing
Unemployment, in: M. Nerlove (ed.)
Macroeconomics and Econometrics,
IEA Conference
Volume 99: 102-27, New York University Press, New
York.

This chapter introduces three empirical curves. Each of

them requires qualification but can be used to motivate
theoretical developments.
The Laffer curve easily attracts attention. Its logic
seems inescapable and, for this reason, should be
heavily qualified.1 Students typically see its relevance
and they recognize that the issue is being publicly
debated.
The Beveridge curve, an empirical regularity with
respectable microfoundations (see Blanchard (1991)),
provides a possible pretext for the discussion of
information and a search in the macroeconomy.
The Calmfors-Driffill (1988) hump-shape curve
has also received some microfoundation, but its
empirical status is often debated. It is a very useful
instrument to focus the students mind on labour
bargaining, the role of trade unions and governments,
the existence of labour strikes, etc.

Calmfors, Lars and Driffill, John (1988), "Bargaining

Structure,
Corporatism
and
Macroeconomic
Performance,"Economic Policy 6: 16-61.
Lindsey, Lawrence (1987), 'Individual Taxpayer
Response to Tax Cuts: 1982-1984', Journal of Public
Economics, 33: 173-206.

Other avenues
One subject which has received little attention in this
chapter but which can be developed alongside public
goods, is the role of infrastructure investment and
education. These topics were discussed in Chapter 5.
While the evidence on the role of public investment in
cross-country growth performance is weak (Barro,
1991), this line of thought is clearly behind the
European Commissions plans to increase spending on
highways, roads, and bridges as part of a long term
supply-side policy to improve total factor productivity.
The transformation of Eastern and Central Europe can
be seen in a similar light. Reference can also be made
to the literature on economic development and to
strategies applied in developing countries. The usual
growth-literature papers citing the importance of human
capital (again Barro, 1991 or the references in Chapter
5) can be used to motivate supply-side policies which
target improved education and training.

References

There is some evidence from the United States (Lindsey

1987) that the behaviour of taxpayers changed after the tax
cuts of the Reagan administration -- due less to increased
labour supply than to increased income reporting and fewer
tax avoidance activities.

40

CHAPTER 18
FINANCIAL AND EXCHANGE MARKETS

Objectives
This chapter marks a transition between open-economy
macroeconomics and a section devoted to the
determination of the exchange rate. It has two main
purposes: 1) to present key features of financial and
exchange markets; 2) to develop the principle of market
efficiency.

Further references
Several commercial banks publish booklets for their
customers, designed to explain financial and exchange
markets. These booklets are usually very simple and
contain many details on institutions and/or instruments.
The Bank for International Settlements in Basel
presents useful data in its Annual Report, especially on
Euro-markets.

Market institutions and instruments

The sections on financial and exchange markets are
mostly descriptive. They can be left to reading at home,
teachers simply summarizing the key points in class as
they are listed in the summary section. Depending on
student interest, there may be no need to explain these
instruments in detail.1 It may also be useful to check
that students know how to compute a one-week or onemonth yield at annual rate.

Market efficiency
Students must clearly understand the concept of market
efficiency: it rules out systematic, but not random and
unpredictable gains. They should be able to distinguish
arbitrage (no risk involved) from speculation (risk
taking). The discussion on bubbles in Section 18.3.3.3
may seem esoteric but it is worth going over for three
reasons. First, it provides a check on students
understanding of arbitrage. Second, it illustrates clearly
what is meant by fundamentals. Third, it may be highly
relevant to the early 1990s, which saw spectacular
declines of stock and house prices in many countries. In
the UK, Sweden, France, Finland, Japan, among others,
banks have been nearly bankrupted as a result of the
heavy losses suffered in real estate investments.

An exception is that of forward contracts which play an

important role in Chapter 19.

41

CHAPTER 19
EXCHANGE RATES IN THE SHORT RUN

presenting the parity relationships is to prevent students

from being confused about when each one holds, and
how it all relates to forward premiums. The use of
different symbols for different premiums and the
summary Table 19.3 are designed to clarify matters. It
should be emphasised however that the risk premia
introduced in (19.4) and (19.9) are really symbolic
rather than derived from a proper theory, and that there
is no presumption whatsoever as to their sign. In fact
they are known to be very unstable, both in sign and
size.2
It is also well worth going over the decomposition
(19) of the forward forecast error between the risk
premium and the market forecast error. Note that
forecast errors are no proof of market inefficiency as
long as they are not systematically exploitable for
profit.

Objectives
The theory of exchange rate determination is both
difficult and exciting. This chapter proposes an
efficient short cut without giving up much substance.
The challenge is to cover the material in a way that is
clear and simple. We have proposed the following
sequence of topics:
- Establish the tension between the long run view of
the exchange rate in Chapter 7 with the data, as well
as with Mussas stylised facts.
- Start with the interest parity conditions already
presented in Chapter 11. Then, by manipulating this
condition, it is possible to show the essentials of
exchange rate determination: forward-looking,
unpredictable jumping.
- With a little bit more complexity and simply using a
graphical apparatus, it is then possible to establish
the overshooting proposition and, at the same time,
to link the short run, developed in this chapter, with
the long run as established in Chapter 7.1

Forward looking exchange rate

Interest parity has been briefly introduced -- and

extensively used -- earlier. Here it is explained in detail
and with greater precision. The main difficulty when

Notice that all terms in the interest parity condition

(19.15) are endogenous so that the whole exercise
conducted in Section 19.3 should not be interpreted as
a theory of exchange rate determination. Yet repeated
substitutions yield an important intuition for the
forward-looking nature of the exchange rate (as for all
assets).
It is often difficult to make Fig. 19.5 understandable
to students on the first try. There are two ways of
proceeding. The easy way is to say that when the
interest rate rises, capital flows in and the exchange rate
appreciates. This is true of course but it misses the
whole idea that exchange rates are forward looking. So
it is worth confusing students a bit by observing that a
higher interest rate means that the exchange rate is
expected to depreciate: as long as the expected rate of
depreciation equals the interest differential (plus a risk
premium factor, if applicable) there are no capital flows
at all. To understand what happens to the exchange rate

Mussas stylised facts

Stating ex ante what is to be explained serves three
main purposes. First, it gives students a clear view of
where the lecture is leading. Second, students attention
can be maintained by reminding them which stylized
fact is being explained each time a new result is
achieved. Finally, it represents an anchor in a storm of
fairly complex material. Use of a transparency listing
the stylised facts and checking them, is advisable.

The interest parity relationships

If Chapter 7 has been skipped earlier, as is entirely possible

-- see instructions in this Guide -- it must be covered before
Chapter 19.

Some instructors may prefer to assume that the risk

premium is zero, and attribute deviations from UIP to the
peso problem.

42

Instructors Guide

Chapter 19

now, there is no short cut: we must use theory to help

us pin down the nominal exchange rate in the long run
(see below).
Time spent interpreting (19.19) is a good
investment. In particular, it is a good idea to point out
very early that the link between the short run (and the
enormous amount of volatility) and the long run is that
the long run exchange rate is always present in the
background as captured by the mast or leading term
Et+n+1.

Frankel, Jeffrey, and MacArthur, Alan (1988), Political

vs. Currency Premia in International real Interest
Differentials, European Economic Review, 32: 1083114.
Frankel, Jeffrey, and Meese, Richard (1987), Are
Exchange Rates Excessively Variable?, NBER
Macroeconomic Annual, 2: 117-62.

Overshooting
The formal presentation of the Dornbusch model in the
Appendix can easily be avoided, where necessary,
thanks to the graphical apparatus developed in Section
19.4. There are three key intuitions which must be
established.
First it is price rigidity which forces an exchange
rate to move too much. Appealing to the principle of
physics, that when there is excess pressure in a system
it must find one way or another to escape, is a useful
analogy.
Second, note that the mix of highly volatile
exchange rates and sticky prices implies that the real
exchange rate, by and large, moves like the nominal
exchange rate in the short run. This means that nominal
fluctuations -- nominal interest rates pushing around
nominal exchange rates -- have real effects via the real
exchange rate. This is a key channel for transmission of
monetary policy in open economies under flexible rates
as argued in Chapter 11 and after.
Third, the so-called fundamental determinants of
the exchange rate mostly consist of expected future
variables such as money and real aspects of
competitiveness. The past matters relatively little. This
immediately establishes a link, somewhat underemphasised in the text, with the authorities credibility
in pursuing a particular set of policies. Note also that
the overshooting result predicts that the exchange rate
is likely to deviate frequently by a wide margin from
what is warranted by the equilibrium real exchange rate
presented in Chapter 7.

References
Dornbusch, Rudiger (1976), Expectations and
Exchange Rate Dynamics, Journal of Political
Economy, 1161-76.

43

CHAPTER 20

THE INTERNATIONAL MONETARY SYSTEM

Objectives
In this chapter many of the earlier results are illustrated
as the history of international monetary relations
unfolds. The gold and other metallic standards, which
occupied centre stage for so long, bring home to roost
many of the important ideas of Chapters 8 and 9. The
issues underlying the Hume mechanism are simply
Chapters 11 and 13 cast in a historic setting. The issue
of credibility of policy (Chapter 16) is important for
understanding the working of the gold standard: the
often cited increasing nominal rigidity in the world
economy may be an result of moving to a fiat money
standard in which downward adjustment is no longer
assumed to be necessary.
A section covers the standard debate on the choice
of an exchange-rate regime. Reflecting on why systems
emerge and collapse it is useful to think about current
issues such as the European Monetary System and
discussions on monetary co-operation among the larger
countries.
There are no exercises for this chapter.

44

CHAPTER 21
POLICY CO-ORDINATION AND EXCHANGE RATE CRISES: THE EMS AND EMU

Objectives
A study of the EMS provides the background for
covering a number of analytical issues such as: policy
co-ordination, balance of payments crises, the theory of
an optimum currency area. Like the preceding chapter,
it offers a lot of data and experience to which the
results developed earlier can be applied. In the years
preceding the launch of a monetary union, these are
burning issues of independent interest for European
students.
This chapter has been entirely rewritten following
the dramatic events of 1992-93. No doubt, the years
1997-1999 will be historical for European monetary
integration. As we wrote this chapter, we were painfully
aware that events will surprise us, one way or another.
Instructors will fill the vacuum and correct unfulfilled
speculation on our part!

Self-fulfilling speculative attacks

The crises of 1992-93 have revived interest in
speculative attacks. Box 21.2 presents the theory of
speculative attacks and concludes that a currency which
pursues policies incompatible with a fixed exchange
rate must eventually give up and float. Six currencies
have come under sharp attack during the autumn 1992.
Only two of them conform to this view: the lira and
sterling indeed have left the ERM and begun to float
after a sharp (about 10%) depreciation. This has led to
the development of the theory of self-fulfilling attacks
which is briefly presented in Section 21.3.4. The paper
by Obstfeld (1995) quoted in the text, as well as
Eichengreen, Rose and Wyplosz (1995), offer a fuller
treatment.

Teaching
Optimal currency area
This chapter is relatively easy to teach, and a nice
conclusion of the course. European students know the
facts and the challenges. The chapter is structured
along historical lines, which is a natural, but timeconsuming, way of introducing the issues.
An
alternative is to select some topics and use them while
teaching the relevant principle. A list of topics is:
- the Mundell-Fleming model under fixed exchange
rate: the N-1 problem and German dominance (Section
21.3.3)
- the role of perfect capital mobility in the MundellFleming model: the impossible trilogy (Section 21.3.5)
- credibility: one reason for German dominance
(Section 21.3.3)
- the role of expectations: crises in the EMS (Section
21.3.4)
- the long-run real exchange rate (Chapter 7) and the
optimum currency area (Section 21.4.1)
- balance of payments and mutual assistance (Section
21.2.3)

It is now fashionable to research the conditions under

which monetary union is feasible and welfare will
improve. Following Mundell (1961), the two criteria
seem to be a high correlation of regional supply and
demand shocks and/or a high degree of factor mobility.
In the USA the latter seems to obtain either because of
necessity or national culture (see Blanchard and Katz
1992). This does not seem to be the case in Europe, nor
has the integration of product and factor markets
removed sources of asynchronization of disturbances in
European regions (von Hagen and Neumann (1994)),
Decressin and Fats (1995). The imaginative instructor
might introduce some of the convergence discussion
that appeared in Chapter 5 'through the back door' as
well as arguments for and against a more federal
European tax and expenditure system.1

See Bean (1992) for a survey of the debate surrounding

EMU.

45

Instructors Guide

Chapter 21

Union - The Macro Issues', Monitoring European

Integration, CEPR, London.
Blanchard, Olivier J., and Katz, Lawrence (1992),
'Regional Evolutions,' Brookings Papers on Economic
Activity, 1: 1-76.

Future steps
The subject of this chapter will evolve quickly over the
next few years. Instructors will have to fill in the latest
developments and the economic principles needed to
analyze them. Here are a few markers which may, or
may not, turn out to be useful:

Decressin, Jrg and Fats, Antonio (1995) 'Regional

Labor Market Dynamics in Europe,' European
Economic Review, 39 (9):1627-1655.

- not all countries will join the EMU. What

arrangements will link those who are in and those who
are out? The simple Mundell-Fleming model will be of
help to judge the arrangement. Add the theory of
speculative attacks to bring in some spice of realism.

Eichengreen, Barry, Andrew, Rose, and Wyplosz,

Charles (1995) Exchange Market Mayhem: The
Antecedents and Aftermath of Speculative Attacks,
Economic Policy, 21: 249-312.

- there are discussions of a stability pact constraining

budget deficits for the countries after the EMU is
formed (not just to get in). Here again MundellFleming is useful: with a permanently fixed exchange
rate (i.e. a currency union), fiscal policy is the only
demand-management instrument left. Will countries
easily give up this instrument? Will they negotiate
some form of mutual support? Will such a pact be
forgotten as soon as it is accepted? Can sanctions be
enforced?

Giavazzi, Francesco, and Giovannini, Alberto (1989),

Limited Exchange Rate Flexibility: The European
Monetary System, MIT Press, Cambridge, Mass.
Hagen, Jrgen von, and Neumann, Manfred J. M.
(1994), 'Real Exchange Rates Within and Between
Currency Areas: How Far Away is EMU?', The Review
of Economics and Statistics, 2:236-244.
Kenen, Peter (1969), 'The Theory of Optimum
Currency Areas: An Eclectic Approach', in R. Mundell
and A. Swoboda (eds.) Monetary Problems of the
International Economy, University of Chicago Press.

- the new European Central Bank will be untested.

What will be its credibility? This is a nice test of issues
presented in Chapter 16.

Mundell, Robert (1961), 'A Theory of Optimum

Currency Area' American Economic Review, 51: 65765.

References

As a supplementary reading, or for the instructors own

interest, one might use:

Bean, Charles (1992), 'Economic and Monetary Union',

Journal of Economic Perspectives, 6: 31-52.

Kenen, Peter (1995) Economic and Monetary Union in

Europe, Cambridge University Press.

Begg, David, Giavazzi, Francesco, Spaventa, Luigi,

and Wyplosz, Charles (1991), 'European Monetary

46