EUROPEAN MACROECONOMICS

EUROPEAN MACROECONOMICS

EUROPEAN MACROECONOMICS Robert Barro and Vittorio Grilli M MACMILLAN

Robert J. Barro and Vittorio Grilli 1994 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1P 9HE. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. First published 1994 by THE MACMILLAN PRESS LTD Houndmills, Basingstoke, Hampshire RG21 2XS and London Companies and representatives throughout the world ISBN 978-0-333-57764-6 ISBN 978-1-349-27904-3 ( ebook) DOI 10.1007/978-1-349-27904-3 A catalogue record for this book is available from the British Library. Copy-edited and typeset by Povey-Edmondson Okehampton and Rochdale, England

Contents 1 The Approach to Macroeconomics 1 4 The Intertemporal Budget Macroeconomics and the World Constraint and the Demand for Economy 1 Credit 67 Output, Unemployment, and the Budget Constraints for Two Periods 67 Price Level in the Major Preferences for Consuming Now Industrialized Economies 3 versus Later 70 Some Key Facts About Business Choosing Consumption over Two Fluctuations 6 Periods 71 The Approach to Macroeconomics 15 Wealth and Substitution Effects 71 A Note on Mathematics and Choosing Work Effort at Different Economic Reasoning 20 Dates 73 Elements of National-Income Budget Constraints over Many Accounting 21 Periods 74 Choices over Many Periods 76 2 The Economics of Robinson Crusoe 31 Shifts in the Schedule for Labour's Marginal Product Production Technology 31 79 Money and Households' Budget Tastes for Consumption and Leisure 33 Deciding How Much to Work 37 Constraints 80 Summary Shifts in the Production Function 38 82 Wealth Effects 39 Substitution Effects for Work 5 The Basic Market-Clearing Model 85 Versus Consumption 41 Aggregate-Consistency Conditions Combining the Wealth and and the Clearing of Markets 85 Substitution Effects 43 Clearing the Commodity Market 87 Summary 44 The Quantity of Money Equals the Quantity Demanded 90 3 The Basic Budget Constraint and General Market Clearing 90 Supply Shocks the Demand for Money 49 91 Changes in the Stock of Money 97 The Commodity Market 49 Changes in the Demand for Money 99 The Credit Market 50 Summary 100 The Budget Constraint 51 The Nature of a Monetary Economy 52 6 The Labour Market 105 A Model of Optimal Cash Setup of the Labour Market 105 Management 54 The Demand for Labour The Velocity of Money 60 Labour Supply and Consumption 106 Empirical Evidence on the Demand Demand 107 for Money 62 Clearing of the Labour Market 109 Summary 63 Clearing of the Commodity Market 110

VI Contents The Behaviour of the Real Wage The Central Bank 183 Rate 111 Effects of Central Bank Actions 191 Nominal Wage Rates 114 Summary 195 The Labour Market in the Macroeconomic Model 114 Summary 114 11 International Monetary Linkages 199 Different Monies and Exchange Rates 199 7 World Markets in Goods and Arbitrage in Goods and Services: Credit 117 Purchasing-Power Parity 202 One Currency World 118 Arbitrage in Assets: Interest-Rate International Borrowing and Parity 206 Lending 118 Flexible Exchange Rates 210 The Role of the International Credit Fixed Exchange Rates 212 Market 121 The European Monetary System 216 The Terms of Trade 124 Purchasing-Power Parity under Summary 134 Flexible and Fixed Exchange Rates 220 Exchange Rates and the Current- Account Balance 223 8 An Introduction to Inflation and Interest Rates 137 Summary 224 Cross-Country Data on Inflation and Monetary Growth 137 12 Investment and Real Business Time Series Data on Inflation and Monetary Growth 140 Actual and Expected Inflation 142 Real and Nominal Interest Rates 142 Summary 150 Cycles 229 The Capital Stock and Investment in the G-6 229 Real GNP and its Components during Recessions 233 Capital in the Production Function 234 9 Money, Inflation, and Interest Investment Goods and Consumer Rates in the Market-Clearing Goods 235 Model 155 Depreciation 235 Incorporation of Inflation and Characteristics of Existing Capital 236 Monetary Growth into the Investment Demand 236 Model 155 Investment and Households' Budget Market-Clearing Conditions 158 Constraints 239 Clearing of the Commodity Market Monetary Growth, Inflation, and in a Closed Economy 241 the Nominal Interest Rate 158 Real Business Cycles 242 Saving and Investment in an Open Real Effects of Inflation 166 Economy 247 Summary 168 Summary 248 The Superneutrality of Money 158 The Dynamics of Inflation 163 13 Unemployment 253 10 Financial Intermediation 173 A Model of Job Finding 254 Checkable Deposits and M1 173 Job Separations 255 Financial Intermediaries and the Job Separations, Job Finding, and Credit Market 174 the Natural Unemployment Rate 257

Contents Vll The Behaviour of Unemployment 17 The Public Debt 343 Rates in the G-6 260 Public Debt in the Long Run: The Employment and Unemployment Historical Behaviour of Public during Recessions 269 Debt in the United Kingdom and Summary 275 in the United States 343 Characteristics of Government Bonds 345 14 Economic Growth 279 The Government's Budget Changes in the Stock of Capital 279 Constraint 345 Convergence 282 Public Debt and Household's Population Growth 283 Budget Constraints 348 Technological Progress 283 The Effect of a Deficit-Financed Evidence from the US History 285 Tax Cut 351 Evidence on Convergence from the Open-Market Operations 351 US States and Regions of Western Why Does the Public Debt Matter 352 Europe 287 The Timing of Taxes 354 Evidence on Convergence across The Conventional View of a Deficit- Countries 288 Financed Tax Cut 355 Recent Theories of Economic Social Security and Saving 357 Growth 294 Summary 364 Summary 296 15 Government Purchases and Public Services 301 Data on Government Expenditures 301 The Government's Budget Constraint 305 Household's Budget Constraints 306 Temporary Changes in Government 18 Investment and Fiscal Policy in the World Economy 369 The Current Account with Investment and Government Spending 369 Fiscal Policy in the World Economy 371 Fiscal Policies and Exchange Rates 375 Summary 379 Purchases 307 Clearing of the Commodity Market 308 19 The Interplay between Nominal Evidence from Wartime Experiences 310 and Real Variables 381 Permanent Changes in Government The Phillips Curve 382 Purchases 315 The Relationship between Summary 317 Unemployment and the Rates of Change of Wages, Prices, and Money: Long-Term Evidence for 16 Taxes and Transfers 321 the United Kingdom and the Sources of Government Revenues 321 United States 383 Types of Taxes of Central Cross-Country Relations between Governments 323 Nominal and Real Variables 385 An Income Tax in the Theoretical The Cyclical Behaviour of Money Model 329 and the Price Level 386 A Change in the Tax Rate 331 Does Money Affect the Economy or Transfer Payments 336 is it the Economy that Affects Summary 338 Money? 389

Vlll Contents Implications of the Evidence 393 Cyclical Properties of the Keynesian Summary 393 Model 429 Sticky Prices in the Keynesian 20 Money and Business Fluctuations Model 430 in the Market-Clearing Model 397 Summary 433 The Structure of a Model with Local Markets 397 22 Monetary Policies, Credibility and Imperfect Information about Money International Coordination 439 and the General Price Level 401 Rules versus Discretion in Monetary Summary 409 Policies 439 Making Monetary Policies Credible 443 21 The Keynesian Theory of Business Summary 455 Fluctuations 413 A Simple Keynesian Model 413 Bibliography 457 IS/LM Analysis and the Role of the Interest Rate 421 Index 467