• the value added domestically (that is, within the country); or
• the value added by domestically owned factors of production?
The two definitions are not the same. Some domestic output may be produced by capital owned by foreigners, while some foreign output may be produced by capital owned by domestic residents.
The answer is that either definition is fine, and economists use both. Gross domestic product (GDP), the measure we have used so far,corresponds to value added domestically. Gross national product (GNP) corresponds to the value added by domestically owned factors of production, and is synonymous with gross national income (GNI), which is more commonly used now. GNP is equal to GDP plus net factor payments from the rest of the world (factor payments from the rest of the world minus factor payments to the rest of the world).While GDP is now the measure most commonly mentioned. GNP was widely used until thc early 1990s, and you will still often encounter it in newspapers and academic publications.
For most countries, the difference between GNP and GDP is typically small, because factor payments to and from the rest of the world roughly cancel each other out. For Australia in 2008, the difference between GDP and GNP was about 4.5 per cent of GDP. (This is a number that has gradually increased over the last forty years as Australia has become a larger net debtor country.)
There are a few exceptions. One is Kuwait. When oil was discovered in Kuwait, Kuwait's government decided that a portion of oil revenues would be saved and invested abroad rather than spent, to provide future Kuwaiti generations with investment income when oil revenues came to an end. Kuwait ran a large current account surplus, steadily accumulating foreign assets. As a result, it now has large holdings of foreign assets and receives substantial investment income from the rest of the world.Table I gives GDP. GNP and net factor payments for Kuwait from 1989 to 1994.
Note how much larger GNP is compared with GDP throughout the period. But note also how net factor payments decreased after 1989.This is because Kuwait had to pay its allies for part of the cost of the 1990-91 Gulf War and for reconstruction after the war. It did so by running a current account deficit—equivalently, by decreasing its net holdings of foreign assets. This in turn led to a decrease in the income from foreign assets and, by implication, to a decrease in net factor payments.
• II you want to learn more about international trade and international economics, a very good textbook is one by Paul Krugman and Maurice Obstfeld, International Economics, Theory and Policy, 8th edn (New York: Pearson, 2008).
I rom thc* information in panel (c) we can characterise the behaviour ol net exports—the difference between exports and imports (X - IM/e)—as a Iunction ol output. At output level V, for example, exports are given by the distance AC and imports by thc distance AB, so net exports are given by the distance ВС.
This relation between net exports and output is represented as the line ,VX (for net exports) in Figure 19.1, panel (d). Net exports arc a decreasing function of output. As output increases, imports increase and exports are unaffected, leading to lower net exports. Call Y/д (ТВ for trade balance the level ol output at which the value ol imports is just equal to exports, so that net exports are equal to zero. Levels of output above Y/ц lead to higher imports, leading to a trade deficit. Levels of output below Yjb lead to lower imports and a trade surplus.
19.2 EQUILIBRIUM OUTPUT AND THE TRADE BALANCE
The goods market is in equilibrium when domestic output equals the demand for domestic goods:
У = Z
Collecting the relations we derived lor the components ol the demand for domestic goods, Z:
У = CO' - T) + KY.r) + С - IM(Y,e)/e + X(Y*,e) (19.4)
The goods market is in equilibrium when production is equal to the demand for domestic goods. At the equilibrium level of output, the trade balance may show a deficit or a surplus.
An increase in government spendirg leads to an increase in output and to a trade deficit
• domestic demand for goods 430
• demand tor domestic goods, 430
• coordination, 438
Wc now have the elements we need to understand the movements ol output, the interest rate and the exchange rate.
C.oods-market equilibrium implies that output depends, among other lactors, on the interest rale and the exchange rate:
V = C(Y - T) + /(Y,i) + G + NX(Y, Y*,E)
The assumption of perfect capital substitutability is a fair approximation to what happens between countries with highly developed financial and goods markets and stable political and economic systems, such as Australia, the United States, the United Kingdom and Japan. For example, the government bonds issued by these countries have very similar risk characteristics, and the volatility of the exchange rate (which affects the comparison of their yields) is modest in size. This is why we assumed in the chapter that investors care only about the expected returns from investing in a portfolio of domestic and foreign bonds. Our investors weren't concerned about the default or currency risk of their portfolios.The two types of bonds are then perfect substitutes from the investor's point of view. This led us to the interest parity relation (20.4a), which played an important role in the Mundell-Fleming model:
1 + i, = (1 +
This relation is unsatisfactory when we are comparing portfolios of bonds from countries with a high default risk or with substantial currency volatility (or exchange rate risk).Then the bonds of the two countries are likely to be imperfect substitutes. When comparing the returns of bonds from two countries with these varying risk characteristics, investors will demand a relative risk premium on the return from the riskier country, if both
The aggregate supply shifts down over time, leading to a decrease in the price level, a real depreciation and an increase in output. The process ends when output has returned to the natural level of output.
output the aggregate supply shilts down. The reason: When output is below the natural level of output, the price level turns out to he lower than was expected. This leads wage setters to revise their expectation of the pricc level downward, leading to a lower price level at a given level ot output, and thus to a shift down of the aggregate supply curve.
So. starting Irom /1, the economy moves over time along the aggregate demand curve, until it reaches H. At B. output is equal to the natural level ol output, l he price level is lower than it was at A: by implication, the real exchange rate is lower than it was at A. In words: So long as output is below the natural level of output, the price level decreases. The decrease in the price level over time leads to Го summarise: In the medium run, despite the lact that the nominal exchange rale is lixed, the economy achieves the real depreciation needed to return output to iis natural level. This is an important qualification to the conclusions reached in the previous chapter, where we were focusing only on the short run:
• In the short run. a fixed nominal exchange rate implies a lixed real exchange rate.
Suppose a country is operating under a lixed exchange rate. Suppose financial investors start believing thai there may soon be an exchange rate adjustment—either a devaluation or a shilt to a flexible exchange rale regime accompanied by a depreciation.
We iust saw why this might be the case:
• The domestic currency may be overvalued. A real depreciation is called tor. While this could be achieved in the medium ain without a devaluation, financial investors may conclude that the government will take lhe quickest way out—and devalue.
Such an overvaluation often happens in countries ihai lix thc nominal exchange rate while having an inflation rate higher than the inflation rate in the country they are pegging to. Higher relative inflation implies a steadily increasing price of domestic goods relative to foreign goods, a steady real appreciation, and so a steady worsening of the trade position. As time passes, the need for an adjustment ol the real exchange rate increases, and linanciai investors become more and more nervous.
• September 5-6: The ministers of finance of the European Union meet in Bath, England. The official communique at the end of the meeting reaffirms their commitment to maintaining existing parities within the exchange rate mechanism (ERM) of the European Monetary System (EMS).
• September 8:The first attack.The attack comes not against one of the currencies in the EMS but against the currencies of Scandinavian countries, which are also pegged to the deutschmark (DM). The Finnish authorities give in and decide to let their currency, the markka, float—that is. be determined in the foreign-exchange market without central bank intervention. The markka depreciates by 13 per cent against the DM. Sweden decides to maintain its parity and increases its overnight interest rate to 24 per cent (at an annual rate).Two days later, it increases it further, to 75 per cent.
• September 10-1 I The second attack. The Bank of Italy intervenes heavily to maintain the parity of the lira, 'eading the bank to sustain large losses of foreign-exchange reserves. But on 13 September the lira is devalued by 7 per cent against the DM.
• September 16-17:The third attack. Speculation starts against the British pound, leading to large losses in fore gn-exchange reserves by the Bank of England.The Bank of England increases its overnight rate from 10 per cent to 15 per cent. However, speculation continues against both the pound and (despite the
An increase in the interest rate to last for five years leads to an immediate appreciation of the exchange rate today, followed by expected depreciation over the next five years.
Thc open economy IS-LM, AS-AD and interest parity relations arc depicted in Figure 21.6.
• In panel (a), the medium-run equilibrium ol the IS-LM model is shown at point Л„. The central bank has set the interest rate at i„ and output is at the natural level, Y„. The IS relation is the same as the one you saw in equation (20.6) except that the expected exchange rate is no longer assumed fixed. The LM relation is thc same as equation (20.7). The central bank now selects thc interest rate using a rule that depends on deviations of the price level Irom its target. P', and it is the same as the one we used in equation (7.4). Since the price level is equal to the target in medium-run equilibrium, the interest rate is set at its medium-run equilibrium value, i„.
• in panel (b), which gives the interest parity relation (21.6), the initial interest rate (i„) is associated at point Д, with the medium-run value of the nominal exchange rale, E,„ In medium-run equilibrium, thc current exchange rate will be constant and thus equal to the expected future exchange rate. From the interest parity relation, wc can then deduce that i„ = i*—the central bank must set the interest rate equal to the foreign interest rate in the medium run.
• Panel (c) shows the AS-AD model, and medium-run equilibrium at point A() has output at Y„ and the price level at the ccntral bank's initial target, P/,. Thc AS relation is exactly the same as the one we used in Chapter 7, equation (7.2). I he open cconomy AD relation extends the closed economy one (equation [7.5]) by adding a second effect of price level changes on output. The lirst eflcct is that a higher price level causcs thc ccntral bank to raise thc interest rate, which reduces investment (as in the closed economy), while thc second effect is that it leads to a real exchange rate appreciation (both directly through the higher price, and indirectly via the higher interest rate that increases thc nominal exchange rate), which reduces net exports and aggregate demand. Therefore, the open economy AD curve is Hatter than the closed economy one—a higher pricc level leads to a lall in investment ami net exports.
Let us do one experiment—a monetary policy contraction. We will leave our other favourite
experiments as exercises, but give you some hints at the end of this section.
In medium-run equilibrium, output is ot the natural level, the interest rate equals the foreign rate, and the price level equals the target
Monetary policy contraction—the medium run
The easiest to explain arc the medium-run effects. What will change from the initial to the final medium am alter a permanent monetary policy contraction? Just as you saw in the closed economy analysis of Chapter 7, the medium-run effects of monetary policy changes are neutral—real variables are unaffected in the medium ain. This means that output will return to Y„, and the real exchange rate will he back to its original value, €0.
From our monetary policy atle, a monetary policy contraction is a reduced price level target, which lalls Irom Pj, to P\. This is shown in Figure 21.7 in panel (c). In the medium run, the /IS and AD curves will have both shifted to go through A, at thc lower price level, and at thc original natural level of output. The AD curve shifts to ADt because at the unchanged natural level of output, the price level must fall to the lower targe; value P\ so that aggregate demand remains equal to Y„. The /IS curve shifts down because the expected price level decreases as the actual price approaches the lower price target.
A monetary policy contraction is a reduction in the price level target, which leads to a stronger nominal exchange rate but no real effects in the medium run.
When the pricc level reaches the lower target in the medium run, the interest rate set by the central hank returns to <„. With medium-run output unchanged at Y,„ and the real exchange rale unchanged ai Co, the IS and LM curvcs return to their original positions in panel a , and the new medium-run equilibrium is identical to the old one.
Since the real exchange rate is the same in ihe new medium run and the price level is now lower at Since t = EPiP'. * Pj, ihe nominal exchange rale must appreciate lo E, in the new medium-run equilibrium. The stronger if labelled IP0 to the flatter curvc IP, in panel (bi. Thus, the new medium-run equilibrium is at A,, where the interest rate again equals i„ ■ i*. and the nominal exchange rate equals E, - E'[.
A monetary policy contraction leads in the short run to an increase in the interest rate, о fall in output, a small fall in the price level, and an overshooting appreciation of the nominal exchange rate beyond the medium-run effect.
Lets go back to our analysis in Chapter 17, based on Figure 17.3. As a quick reminder, there were two key extensions to the basic IS-LM model of Chapter 5.
Let's go back to the argument we developed earlier about why output tends to return to its natural level in the medium run. The easiest way to present thc argument is in terms of the IS-LM graph in Figure 23.1, with the nominal interest rate on the vertical axis and output on the horizontal axis. The argument developed in Chaptcr 7, with a central bank fixing the money stock, went like this:
• Suppose that an adverse shock has led to a decrease in output, so the economy is at point A, with a ReC3"that the n3tural level of output, Y, below the natural level of output, Y„ in Figure 23.1. The nature of the shock isn't
• The fact that output is below its natural level will lead, in turn, to a decrease in the price level over equal to the natural lime. Given the nominal money stock, the decrease in thc pricc level will increase the real money unemployment rate. See stock. This increase in the real money stock will shift thc LM curve down, leading to a lower interest Ciapter 6.
• Real money growth—nominal money growth minus inflation—is now equal to 5% - 3% = 2%. Equivalently, the real money stock increases by 2 per cent.
Suppose that this increase in thc real money stock leads to a decrease in the nominal interest rate from, say, 7 per cent to 6 per cent. This is the first effect you saw above: lower inflation leads to an increase in the real money stock and a lower nominal interest rate.
• Suppose that the decrease in inflation leads people to expect lhat inflation this year will be 2 per cent lower than it was last year, so expected inflation decreases from 5 per cent to 3 per cent.
This implies that, at any given nominal interest rate, the real interest rate increases bv 2 per cent. This is the second effect you saw earlier: at a given nominal interest rate, lower expected inflation leads to an increase in the real interest rate.
• Combining the two ellects, the nominal interest rate decreases from 7 per cent to 6 per cent. Expected inflation decreases from 5 percent to 3 percent. So, the real interest rate moves from 7% - 5% = 2% to 6% - 3% = 3%.
In words: The net effect of lower inflation is to increase the real interest rate, not to decrease it.
We have just looked at what happens at the start of the adjustment process. But it is easy to describe a scenario in which things go from bad to worse over time. The decrease in output from У to У" leads to a further decrease in inflation and a further decrease in expected inflation. This leads to a further increase in thc real interest rate, which leads to a further decrease in output, and so on. In other words, the initial recession can turn into a fully Hedged depression, with output continuing to decline rather than returning to its natural level. The stabilising mechanism described in earlier chapters simply breaks down.
In 1929 the LIS unemployment rate was 3.2 per cent. By 1933 it had increased to 24.9 per cent! Not until ten years later, in 1442, was it back down to 4.7 per cent. (Figure 23.7 shows the evolution of the unemployment rate from 1420 to 1950.) This Great Depression was worldwide: thc average unemployment rate from 1930 to 1938 was 18.2 per ccnt in Australia. 15.4 per cent in the United Kingdom, 10.2 per cent in France and 21.2 per cent in Germany. We will focus in the text only on what happened in thc United States, but further details on the Australian experience can be found in the tocus box The Great Depression in Australia'. We take up three questions:
1. What triggered the initial increase in unemployment?
2. What made thc depression last so long?
3. How did thc economy eventually reatrn to low unemployment?
Table 23.1 gives the evolution ol the US unemployment rate, the growth rate of output, the consumer pricc index and thc money stock from 1929 to 1942. Focusing only on unemployment and output for the moment, two (acts emerge from the data:
• For more on the Great Depression, Lester Chandler, America's Greatest Depression (New York: Harper & Row, 1970) gives the basic tacts. So docs lohn A. Garraty in The Great Depression (New York: Harcourt Brace Jovanovich, 1986).
• Peter Temin's Did Monetary Forces Cause the Great Depressioni New York: W.W. Norton, 1976) looks more specifically at the macroeconomic issues. So do the articles in a symposium on the Great Depression in thc Journal of Economic Perspectives, Spring 1993.
• For a look at the Great Depression in countries besides the United States, read Peter Tcmin. Lessons from the Great Depression Cambridge, MA: MIT Press, 1989>.
• For thc argument that the NIRA actually slowed down the recovery, read Harold Cole and Lee Ohanian, The Great Depression in the United States Irom a neoclassical perspective'. Federal Reserve Hank of Minneapolis Quarterly Review, Winter 1999.
• A description of thc Great Depression through the eyes of those who suffered through it is given in Studs Terkcls Hard Times: An Oral History of the Great Depression in America (New York: Pantheon Books, 1970).
• A good book on the Japanese economy, although a hit out ol date, is Takatoshi Ito's The lapancse Economy Cambridge, MA: MIT Press. 1992 .
• See also Adam Posen's Restoring Japan's Economic Growth (Washington, DC: Institute lor International Studies, 1998).
• An Empirical Assessment of Monetary Policy Alternatives at the Zero Bound i Brookings Papers on Economic Activity, 2004), by Ben Bernanke, Vincent Reinhart and Brian Sack, discusses what monetary policy can and cannot do when thc economy is in a liquidity trap.
We have derived two relations:
• A relation between seignorage, nominal money growth and real money balances (equation [24.2J).
• I here must be a liscal reform and a credible reduction of thc budget delicit. This reform must take place on both the expenditure side and the revenue side of the budget.
An underlying theme ol the core of this book was that, while output fluctuated around its natural level in the short run, it would tend to return to the natural level ol output in the medium run. And, if the adjustment was too slow, liscal and monetary policy could be used to help and shape thc adjustment. Most
SOURCES Tlie material in tins box draws largely from Jeffrey Sachs.'The Bolivian liyperinflation and stabilization*. NBER working paper. 1986 Sachs was one of thc architccts of the stabilisation program. See also Juan Antonio Morales. Thc transition from stabilization to sjstained growth in Bolivia', in Michael Bruno et al. (eds). Lessons of Economic Stabilization and hs Aftermath (Cambridge. MA- MIT Press. 1991).
Stabilisation
There were many attempts at stabilisation along the way. Stabilisation programs were launched in November 1982. November 1983, April 1984, August 1984 and February l985.The April 1984 package was an orthodox program involving a large devaluation, the announcement of a tax reform and an increase in public-sector prices. But the opposition of trade unions was too strong, and the program was abandoned.
After the election of a new president, yet another attempt at stabilisation was made in September 1985. This one proved successful.The stabilisation plan was organised around the elimination of the budget deficit. Its main features were:
• Fiscal policy. Public-sector prices were increased; food and energy prices were increased: public-sector wages were frozen: and a tax reform, aimed at re-establishing and broadening the tax base, was announced.
• Monetary policy. The official exchange rate of the peso was adjusted to what the black-market rate (the actual exchange rate at which one could exchange pesos for US dollars before the stabilisation program) had been pre-stabilisation.The exchange rate was set at I. I million pesos to the US dollar, up from 67.000 pesos to the dollar the month before (a 1,600 per cent devaluation). The exchange rate was then left to float, within limits.
• Re-establish international creditworthiness: Negotiations were started with international organisations and commercial banks to restructure the debt. An agreement with foreign creditors and the IMF was reached nine months later, in June 1986.
As in the previous attempt at stabilisation, the unions called a general strike. In response, the government declared a state of siege, and the strike was quickly disbanded. After so many failed attempts to end hyperinflation, public opinion was clearly in favour of stabilisation.
The effects on inflation were dramatic. By the second week of September the inflation rate was actually negative! Inflation didn't remain negative for very long, but the average monthly rate of inflation was below 2 per cent during 1986-89. As Table I shows, the budget deficit was drastically reduced in 1986, and the average deficit was below 5 per cent of GDP for the rest of the decade.
• For more on the German hyperinflation, read Sieven Webb, Hyperinflation and Stabilization in the Weimar Republic (New York: Oxford University Press, I989>.
• Two good reviews of what economists know and don't know about hyperinflation arc: Rudiger Dornbusch, Federico Sturzenegger and Holgcr Woll, Extreme inflation: Dynamics and stabili¬zation', Brookings Papers on Economic Activity, 1990 92, pp. l-84; and Pierre Richard Agcnor and Peter Montiel, Development Macroeconomics (Princeton. NJ: Princeton University Press, 1995) chapters 8 to II. Chapter 8 makes tor easy reading,- the other chapters are more difficult,
• The experience of Israel which went through high inflation and stabilisation in the 1980s, is described in Michael Bruno's Crisis, Stabilization and Economic Reform (New York: Oxford University Press 1993), especially chapters 2 lo 5. Michael Bruno was the head of Israel's central bank for most of lhat period.
• One of the classic articles oil how to end hyperinflations is The ends of lour big inflations by Thomas Sargent, in Robert Hall (ed.), Inflation: Causes and Effects (Chicago: NBFR and ihe University of Chicago, 1982», pp. 41-97. In that article, Sargent argues that a credible program can lead to stabilisation at little or no cost in terms ol activity.
• Rudiger Dornbusch and Stanley Fischer, Stopping hyperinflations, past and present'. Weltwirt- schaftlichers Archiv, 1986-1, pp. 1-47, gives a very readable description of the end ol hyper¬inflations in Germany, Austria and Poland in the 1920s, in Italy in 1947 and in Israel and Argentina in 1985.
T
т
7 9 II
Index of central bank independence
Less independent More independent
• Л leading proponent ol the view that governments misbehave and should be lightly restrained is lames Buchanan, from George Mason University, in the United Stales. Buchanan received the Nobel Prize in 1986 lor his work on public choice. Read his book, written with Richard Wagner, Democracy in Deficit: The Political Legacy of Lord Keynes ( New York: Academic Press, 1977).
• For a survey ol thc politics oi liscal policy, read Alberto Alesina and Roberio Perotti, Thc political economy ol budget deficits IMF Staff Papers 1995. Also look at lames Poterba. Do budget rules work?', in Alan Auerbach fed.1. Fiscal Policy. Lessons from Economic Research 'Cambridge, MA: MIT Press. 1997).
• For more on the politics of monetary policy, read Alberto Alesina and Lawrence Summers, 'Central bank independence and macroeconomic performance: Some comparative evidence', journal of Money, Credit and Banking, May 1993, pp. 289 97.
• The modern statement ol ihe Ricardian equivalence proposition is by Robert Barro. Are government bonds net wealth?'. Journal of Political Economy. December 1974, pp 1095—1 17.
• F.ach year, the Australian federal government presents its forthcoming budget ю parliament, and all
As we come to ihe end ol this brief history of macroeconomics, and to the end ol the book, let us restate thc basic set of propositions on which most macroeconomists agree:
• In the short rim, shilts in aggregate demand afleci output. Higher consumer confidence, a larger budget deficit, lower interest rates or faster growth of money arc all likely to increase output and to dccrcasc unemployment.
• In thc medium run. output returns lo its natural level. This natural level depends on thc natural rate ol unemployment which together with the size of the labour force, determines thc level ol employ¬ment on the capital stock and on ihe slate ol technology.
• In the long run. two main lactors determine the evolution of the level of output: capital accumula¬tion and technological progress.
• Monetary policy allects output in thc short run, but not in thc medium run or the long run, A higher rale of money growth eventually translates oric-for-one into a higher rate of inllation.
• Fiscal policy has short-run. medium-run and long-run effects on output. Higher budget deficits are likely to increase output in the short run. They leave output unalfccted in thc medium run. And they arc likely to dccrcasc capital accumulation and output in thc long run.
These propositions leave room for disagreements:
• One is about the length of the short run the period of time over which aggregate demand alfccts output. At one extreme, real business cvclc theorists start Irom ihe assumption that output is always at ihe natural level ol output: the short run is very short! Ai the other extreme, the study of slumps and depressions (which wc explored in Chapter 23) implies lhat the cffccts of demand may be extremely long-lasting, that the short run' may be very long.
• For more details on how the Australian Bureau ol Statistics compiles the national accounts, read Australian National Accounts: Concepts, Sources and Methods', ABS, cat. no. 5216.0 (available at the ABS website
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