2024
Olivier Blanchard
Macroeconomics (8th
edition) Chapters 1-9, 17-
19 Summary
ECO2004S - UCT
LAUREN WILLIAMS
,Table of Contents
Chapter 1: A Tour of the World....................................................................5
1.1: The Crisis...........................................................................................5
1.2: The Euro Area....................................................................................8
Can European Unemployment Be Reduced?.........................................8
1.3: The United States..............................................................................9
1.4: China...............................................................................................10
Chapter 2...................................................................................................12
2.1: Aggregate output............................................................................12
GDP: Production and Income...............................................................12
Nominal and Real GDP........................................................................13
GDP: Level vs Growth Rate..................................................................13
2.2: The unemployment rate..................................................................14
2.3: The inflation rate.............................................................................15
The GDP deflator.................................................................................15
The Consumer Price Index...................................................................16
Why do Economists care about inflation?...........................................17
2.4: Output, Unemployment, and the Inflation Rate: Okun’s Law and the
Phillips Curve..........................................................................................18
Okun’s Law..........................................................................................18
Phillips Curve.......................................................................................19
2.5: The short run, the medium run and the long run............................20
Summary:...............................................................................................20
Chapter 3: The Goods Market....................................................................22
3.1: The composition of GDP..................................................................22
3.2: The demand for goods....................................................................22
Consumption (C).................................................................................23
Investment (I)......................................................................................24
Government Spending (G)..................................................................24
3.3: The determination of equilibrium output........................................25
3.4: Investment equals saving...............................................................28
Chapter 4: Financial Markets.....................................................................30
1
, 4.1: The demand for money...................................................................30
Deriving the Demand for Money.........................................................31
4.2: Determining the interest rate I........................................................32
Money Demand, Money Supply, and the Equilibrium Interest Rate....32
Monetary Policy and Open Market Operations....................................34
Choosing money or choosing the interest rate?..................................36
4.3: Determining the interest rate: II......................................................36
4.4: The liquidity trap.............................................................................39
Summary:...............................................................................................41
Chapter 5: Goods and Financial Markets: The IS-LM Model.......................42
5.1: The goods market and the IS relation.............................................42
Investment, Sales, and the Interest Rate............................................42
Determining Output............................................................................42
Deriving the IS curve...........................................................................43
Shifts of the IS Curve...........................................................................44
5.2: Financial Markets and the LM relation.............................................45
Real Money, Real Income, and the Interest Rate.................................45
Deriving the LM Curve.........................................................................46
5.3: Putting the IS and LM relations together.........................................46
Fiscal Policy.........................................................................................47
Monetary Policy...................................................................................48
5.4: Using a policy mix...........................................................................49
4.5: How does the IS-LM model fit the facts?.........................................50
Summary:...............................................................................................51
Chapter 6: Financial Markets II: The Extended IS-LM Model......................53
6.1: Nominal vs Real Interest Rates........................................................53
6.2: Risk and Risk Premia.......................................................................55
6.3: The role of financial intermediaries.................................................55
6.4: Extending the IS-LM model.............................................................58
6.5: From a housing problem to a financial crisis...................................60
Summary:...............................................................................................65
Chapter 7: The Labour Market...................................................................67
7.1: A tour of the labour market.............................................................67
2
, 7.2: Movements in Unemployment........................................................67
7.3: Wage Determination.......................................................................69
Bargaining...........................................................................................70
Efficiency Wages.................................................................................70
Wage, Prices, and Unemployment.......................................................71
The Expected Price Level....................................................................71
The Unemployment Rate.....................................................................72
The Other Factors................................................................................72
7.4: Price Determination.........................................................................73
7.5: The natural rate of unemployment.................................................73
The Wage-Setting Relation..................................................................74
The Price-Setting Relation...................................................................74
Equilibrium Real Wages and Unemployment.......................................75
7.6: Where we go from here...................................................................76
Summary:...............................................................................................77
Chapter 8 – The Phillips Curve, the Natural Rate of Unemployment, and
Inflation.....................................................................................................79
8.1 – Inflation, Expected Inflation, and Unemployment..........................79
8.2 – The Phillips Curve and its Mutations..............................................81
The Original Phillips Curve..................................................................81
The De-anchoring of Expectations......................................................81
The re-anchoring of expectations........................................................84
8.3 – The Phillips curve and the natural rate of unemployment.............85
8.4 – A summary and many warnings....................................................86
Summary:...............................................................................................89
Chapter 9 – From the Short to the Medium Run: The IS-LM-PC Model.......92
9.1 – The IS-LM-PC Model.......................................................................92
9.2 – From the Short to the Medium Run................................................97
9.3 – Complications and how things can go wrong.................................99
9-4 – Fiscal Consolidation Revisited......................................................102
9-5 – The effects of an increase in the price of oil................................104
9-6 – Conclusions.................................................................................110
Summary:.............................................................................................111
3
,Chapter 17 – Openness in Goods and Financial Services........................112
17-1 – Openness in Goods Markets......................................................113
17-2 – Openness in Financial Markets..................................................121
Conclusions and a look ahead..............................................................130
Summary:.............................................................................................131
Chapter 18 – The Goods Market in an Open Economy............................133
18-1 – The IS Relation in the Open Economy........................................133
The Demand for Domestic Goods.....................................................133
18-2 – Equilibrium Output and the Trade Balance................................137
18-3 – Increases in Demand – Domestic or Foreign..............................138
18-4 – Depreciation, the Trade Balance, and Output............................144
18-5 – Saving, Investment, and the Current Account Balance.............150
Summary:.............................................................................................151
Chapter 19 – Output, the Interest Rate, and the Exchange Rate.............153
19-1 – Equilibrium in the Goods Market................................................153
4
,Chapter 1: A Tour of the World
1.1: The Crisis
From 2000 to 2007 the world economy had a sustained expansion. Annual average
world output growth was 4.5%, with advanced economies (the group of 30 or so
richest countries in the world) growing at 2.7% per year, and emerging and
developing countries growing even faster at 6.6% per year.
In 2007, however, signs that the expansion might be coming to an end started to
appear. US housing prices, which had doubled since 2000, started declining.
Housing prices continued to decline. Many of the mortgages that had been sold
during the previous expansion were of poor quality. Many of the borrowers had taken
too large a loan and were increasingly unable to make the monthly payments. And,
with declining housing prices, the value of their mortgage often exceeded the price of
the house, giving them an incentive to default. The banks that had issued the
mortgages had often bundled and packaged them together into new securities and
then sold these to other investors and banks. The result is that many banks, instead
of holding the mortgages themselves, held these securities, which were so complex
that their value was nearly impossible to assess.
This complexity and opaqueness turned a housing price decline into a major
financial crisis, a development that few economists had anticipated. Not knowing the
quality of the assets that other banks had on their balance sheets, banks became
reluctant to lend each other for fear that the bank to which they lent might be unable
to repay. Unable to borrow, and with assets of uncertain value, many banks found
themselves in trouble. On September 15, 2008, a major bank, Lehman Brothers,
went bankrupt. Because the links between Lehman and other banks were so
opaque, many other banks appeared at risk of going bankrupt as well.
5
,6
,The financial crisis turned into a major economic crisis. Stock prices collapsed. Hit by
the decrease in housing prices and the collapse in stock prices, and worried that this
might be the beginning of another Great Depression, people sharply cut their
consumption. Worried about sales and uncertain about future, firms sharply cut their
investments. With housing prices dropping and many vacant homes on the market,
not many homes were built. Despite strong actions by the Fed, which cut interest
rates down to zero, and by the US government, which cut taxes and increased
spending, demand decreased and so did output. In the third quarter of 2008, US
output growth turned negative and remained so in 2009.
The US crisis quickly became a world crisis. Other countries were affected through
two channels:
1. Trade: As US consumers and firms cut spending, part of the decrease fell on
imports of foreign good. Other countries exports went down, so their output
also did.
2. Finance: US banks needed funds, so they repatriated funds from other
countries, creating problems for banks in those countries. As those banks got
in trouble, lending came to a halt, leading to a decrease in spending and
output. Also, in several European countries, governments had accumulated
high levels of debt and were now running large deficits. Investors began to
worry about whether debt could be repaid and asked for much higher interest
rates. Confronted with those high interest rates, governments drastically
reduced their deficits through a combination of lower spending and higher
taxes. This led to a further decrease in demand and output.
Strong monetary and fiscal policies and the gradual repair of the financial system
turned economies around and they started to recover.
7
,1.2: The Euro Area
In 1957, six European countries decided to form a common European market – an
economic zone where people, goods and services could move freely. The total is
now 27 (since the UK withdrew) and this group is known as the European Union
(EU). In 1999, the EU started the process of replacing national currencies with one
common currency, called the euro. Nineteen countries now belong to their common
currency area, known as the euro area. The euro area is a strong economic power.
At the current exchange rate between the euro and the dollar, its output is equal to
two-thirds of US output. Growth in the euro area after the crisis remained anemic.
Growth in 2012 and 2013 was negative, and has now increased, reaching 2% in
2018, but the unemployment rate remains high at 8.3%. Inflation remains too low,
below the 2% target of the European Central Bank.
The euro area faces two main issues today:
1. How to reduce unemployment
2. Whether and how it can function efficiently as a common currency area.
Can European Unemployment Be Reduced?
- Part of the high unemployment rate today is probably still a result of the crisis
and the sudden collapse in demand. A housing boom that turned into a
housing bust, plus a sudden increase in interest rates, triggered the increase
in unemployment from 2008 on.
Some economists believe the main problem is that European states protect workers
too much. To prevent workers from losing their jobs, they make it expensive for firms
to lay off workers. One of the unintended results of this policy is to deter firms from
hiring workers, thus increasing unemployment. Also, to protect works who become
unemployed, European governments provide generous unemployment insurance,
which decreases the incentives for unemployed people to take jobs rapidly, which
increases unemployment. They argue that the solution is to be less protective and
eliminate these labour marker rigidities.
Others are more sceptical. They point to the fact that unemployment is not high
everywhere in Europe. The problem may lie not so much with the degree of
protection but with the way it is implemented.
8
, 1.3: The United States
To answer how big a country is from an economic point of view, economists look at
output – the level of production of the country as a whole. And to answer what is its
standard of living, they look at output per person.
The US had an output of $20.5 trillion in 2018, accounting for 24% of world output.
And the standard of living is high: Output per person is $62500.
When economists want to look at the health of the country, they look at:
- Output growth – the rate of change of output
- The unemployment rate – the proportion of workers in the economy who are
not employed and are looking for a job
- The inflation rate – the rate at which the average price of goods in the
economy is increasing over time.
What macroeconomic problems do US policymakers face?
- In the short run: whether policy makers have the necessary tools to handle a
recession. When the recession comes, the question will be what policymakers
can do to limit the decline in output. The Fed will have to play a central role
because part of the mandate of the Fed is to fight recessions and also
because it has the best policy instrument to do so, namely control of the
interest rate. By decreasing the interest rate, the Federal Reserve can
stimulate demand, increase output and decrease unemployment. By
increasing the interest rate, it can slow down demand and increase
unemployment. The interest rate cannot be negative. If it were, then nobody
would hold bonds, and everyone would want to hold cash instead because
cash pays zero interest rate. This constraint is known as the zero lower bound
and is the bound the Fed ran into in December 2008.
- How to increase productivity growth in the long run. In the short run, what
happens to the economy depends on movements in demand and the
decisions of the central bank. In the longer run, growth is determined by other
factors, the main one being productivity growth. Without productivity growth,
there cannot be a sustained increase in income per person. One particular
9
Olivier Blanchard
Macroeconomics (8th
edition) Chapters 1-9, 17-
19 Summary
ECO2004S - UCT
LAUREN WILLIAMS
,Table of Contents
Chapter 1: A Tour of the World....................................................................5
1.1: The Crisis...........................................................................................5
1.2: The Euro Area....................................................................................8
Can European Unemployment Be Reduced?.........................................8
1.3: The United States..............................................................................9
1.4: China...............................................................................................10
Chapter 2...................................................................................................12
2.1: Aggregate output............................................................................12
GDP: Production and Income...............................................................12
Nominal and Real GDP........................................................................13
GDP: Level vs Growth Rate..................................................................13
2.2: The unemployment rate..................................................................14
2.3: The inflation rate.............................................................................15
The GDP deflator.................................................................................15
The Consumer Price Index...................................................................16
Why do Economists care about inflation?...........................................17
2.4: Output, Unemployment, and the Inflation Rate: Okun’s Law and the
Phillips Curve..........................................................................................18
Okun’s Law..........................................................................................18
Phillips Curve.......................................................................................19
2.5: The short run, the medium run and the long run............................20
Summary:...............................................................................................20
Chapter 3: The Goods Market....................................................................22
3.1: The composition of GDP..................................................................22
3.2: The demand for goods....................................................................22
Consumption (C).................................................................................23
Investment (I)......................................................................................24
Government Spending (G)..................................................................24
3.3: The determination of equilibrium output........................................25
3.4: Investment equals saving...............................................................28
Chapter 4: Financial Markets.....................................................................30
1
, 4.1: The demand for money...................................................................30
Deriving the Demand for Money.........................................................31
4.2: Determining the interest rate I........................................................32
Money Demand, Money Supply, and the Equilibrium Interest Rate....32
Monetary Policy and Open Market Operations....................................34
Choosing money or choosing the interest rate?..................................36
4.3: Determining the interest rate: II......................................................36
4.4: The liquidity trap.............................................................................39
Summary:...............................................................................................41
Chapter 5: Goods and Financial Markets: The IS-LM Model.......................42
5.1: The goods market and the IS relation.............................................42
Investment, Sales, and the Interest Rate............................................42
Determining Output............................................................................42
Deriving the IS curve...........................................................................43
Shifts of the IS Curve...........................................................................44
5.2: Financial Markets and the LM relation.............................................45
Real Money, Real Income, and the Interest Rate.................................45
Deriving the LM Curve.........................................................................46
5.3: Putting the IS and LM relations together.........................................46
Fiscal Policy.........................................................................................47
Monetary Policy...................................................................................48
5.4: Using a policy mix...........................................................................49
4.5: How does the IS-LM model fit the facts?.........................................50
Summary:...............................................................................................51
Chapter 6: Financial Markets II: The Extended IS-LM Model......................53
6.1: Nominal vs Real Interest Rates........................................................53
6.2: Risk and Risk Premia.......................................................................55
6.3: The role of financial intermediaries.................................................55
6.4: Extending the IS-LM model.............................................................58
6.5: From a housing problem to a financial crisis...................................60
Summary:...............................................................................................65
Chapter 7: The Labour Market...................................................................67
7.1: A tour of the labour market.............................................................67
2
, 7.2: Movements in Unemployment........................................................67
7.3: Wage Determination.......................................................................69
Bargaining...........................................................................................70
Efficiency Wages.................................................................................70
Wage, Prices, and Unemployment.......................................................71
The Expected Price Level....................................................................71
The Unemployment Rate.....................................................................72
The Other Factors................................................................................72
7.4: Price Determination.........................................................................73
7.5: The natural rate of unemployment.................................................73
The Wage-Setting Relation..................................................................74
The Price-Setting Relation...................................................................74
Equilibrium Real Wages and Unemployment.......................................75
7.6: Where we go from here...................................................................76
Summary:...............................................................................................77
Chapter 8 – The Phillips Curve, the Natural Rate of Unemployment, and
Inflation.....................................................................................................79
8.1 – Inflation, Expected Inflation, and Unemployment..........................79
8.2 – The Phillips Curve and its Mutations..............................................81
The Original Phillips Curve..................................................................81
The De-anchoring of Expectations......................................................81
The re-anchoring of expectations........................................................84
8.3 – The Phillips curve and the natural rate of unemployment.............85
8.4 – A summary and many warnings....................................................86
Summary:...............................................................................................89
Chapter 9 – From the Short to the Medium Run: The IS-LM-PC Model.......92
9.1 – The IS-LM-PC Model.......................................................................92
9.2 – From the Short to the Medium Run................................................97
9.3 – Complications and how things can go wrong.................................99
9-4 – Fiscal Consolidation Revisited......................................................102
9-5 – The effects of an increase in the price of oil................................104
9-6 – Conclusions.................................................................................110
Summary:.............................................................................................111
3
,Chapter 17 – Openness in Goods and Financial Services........................112
17-1 – Openness in Goods Markets......................................................113
17-2 – Openness in Financial Markets..................................................121
Conclusions and a look ahead..............................................................130
Summary:.............................................................................................131
Chapter 18 – The Goods Market in an Open Economy............................133
18-1 – The IS Relation in the Open Economy........................................133
The Demand for Domestic Goods.....................................................133
18-2 – Equilibrium Output and the Trade Balance................................137
18-3 – Increases in Demand – Domestic or Foreign..............................138
18-4 – Depreciation, the Trade Balance, and Output............................144
18-5 – Saving, Investment, and the Current Account Balance.............150
Summary:.............................................................................................151
Chapter 19 – Output, the Interest Rate, and the Exchange Rate.............153
19-1 – Equilibrium in the Goods Market................................................153
4
,Chapter 1: A Tour of the World
1.1: The Crisis
From 2000 to 2007 the world economy had a sustained expansion. Annual average
world output growth was 4.5%, with advanced economies (the group of 30 or so
richest countries in the world) growing at 2.7% per year, and emerging and
developing countries growing even faster at 6.6% per year.
In 2007, however, signs that the expansion might be coming to an end started to
appear. US housing prices, which had doubled since 2000, started declining.
Housing prices continued to decline. Many of the mortgages that had been sold
during the previous expansion were of poor quality. Many of the borrowers had taken
too large a loan and were increasingly unable to make the monthly payments. And,
with declining housing prices, the value of their mortgage often exceeded the price of
the house, giving them an incentive to default. The banks that had issued the
mortgages had often bundled and packaged them together into new securities and
then sold these to other investors and banks. The result is that many banks, instead
of holding the mortgages themselves, held these securities, which were so complex
that their value was nearly impossible to assess.
This complexity and opaqueness turned a housing price decline into a major
financial crisis, a development that few economists had anticipated. Not knowing the
quality of the assets that other banks had on their balance sheets, banks became
reluctant to lend each other for fear that the bank to which they lent might be unable
to repay. Unable to borrow, and with assets of uncertain value, many banks found
themselves in trouble. On September 15, 2008, a major bank, Lehman Brothers,
went bankrupt. Because the links between Lehman and other banks were so
opaque, many other banks appeared at risk of going bankrupt as well.
5
,6
,The financial crisis turned into a major economic crisis. Stock prices collapsed. Hit by
the decrease in housing prices and the collapse in stock prices, and worried that this
might be the beginning of another Great Depression, people sharply cut their
consumption. Worried about sales and uncertain about future, firms sharply cut their
investments. With housing prices dropping and many vacant homes on the market,
not many homes were built. Despite strong actions by the Fed, which cut interest
rates down to zero, and by the US government, which cut taxes and increased
spending, demand decreased and so did output. In the third quarter of 2008, US
output growth turned negative and remained so in 2009.
The US crisis quickly became a world crisis. Other countries were affected through
two channels:
1. Trade: As US consumers and firms cut spending, part of the decrease fell on
imports of foreign good. Other countries exports went down, so their output
also did.
2. Finance: US banks needed funds, so they repatriated funds from other
countries, creating problems for banks in those countries. As those banks got
in trouble, lending came to a halt, leading to a decrease in spending and
output. Also, in several European countries, governments had accumulated
high levels of debt and were now running large deficits. Investors began to
worry about whether debt could be repaid and asked for much higher interest
rates. Confronted with those high interest rates, governments drastically
reduced their deficits through a combination of lower spending and higher
taxes. This led to a further decrease in demand and output.
Strong monetary and fiscal policies and the gradual repair of the financial system
turned economies around and they started to recover.
7
,1.2: The Euro Area
In 1957, six European countries decided to form a common European market – an
economic zone where people, goods and services could move freely. The total is
now 27 (since the UK withdrew) and this group is known as the European Union
(EU). In 1999, the EU started the process of replacing national currencies with one
common currency, called the euro. Nineteen countries now belong to their common
currency area, known as the euro area. The euro area is a strong economic power.
At the current exchange rate between the euro and the dollar, its output is equal to
two-thirds of US output. Growth in the euro area after the crisis remained anemic.
Growth in 2012 and 2013 was negative, and has now increased, reaching 2% in
2018, but the unemployment rate remains high at 8.3%. Inflation remains too low,
below the 2% target of the European Central Bank.
The euro area faces two main issues today:
1. How to reduce unemployment
2. Whether and how it can function efficiently as a common currency area.
Can European Unemployment Be Reduced?
- Part of the high unemployment rate today is probably still a result of the crisis
and the sudden collapse in demand. A housing boom that turned into a
housing bust, plus a sudden increase in interest rates, triggered the increase
in unemployment from 2008 on.
Some economists believe the main problem is that European states protect workers
too much. To prevent workers from losing their jobs, they make it expensive for firms
to lay off workers. One of the unintended results of this policy is to deter firms from
hiring workers, thus increasing unemployment. Also, to protect works who become
unemployed, European governments provide generous unemployment insurance,
which decreases the incentives for unemployed people to take jobs rapidly, which
increases unemployment. They argue that the solution is to be less protective and
eliminate these labour marker rigidities.
Others are more sceptical. They point to the fact that unemployment is not high
everywhere in Europe. The problem may lie not so much with the degree of
protection but with the way it is implemented.
8
, 1.3: The United States
To answer how big a country is from an economic point of view, economists look at
output – the level of production of the country as a whole. And to answer what is its
standard of living, they look at output per person.
The US had an output of $20.5 trillion in 2018, accounting for 24% of world output.
And the standard of living is high: Output per person is $62500.
When economists want to look at the health of the country, they look at:
- Output growth – the rate of change of output
- The unemployment rate – the proportion of workers in the economy who are
not employed and are looking for a job
- The inflation rate – the rate at which the average price of goods in the
economy is increasing over time.
What macroeconomic problems do US policymakers face?
- In the short run: whether policy makers have the necessary tools to handle a
recession. When the recession comes, the question will be what policymakers
can do to limit the decline in output. The Fed will have to play a central role
because part of the mandate of the Fed is to fight recessions and also
because it has the best policy instrument to do so, namely control of the
interest rate. By decreasing the interest rate, the Federal Reserve can
stimulate demand, increase output and decrease unemployment. By
increasing the interest rate, it can slow down demand and increase
unemployment. The interest rate cannot be negative. If it were, then nobody
would hold bonds, and everyone would want to hold cash instead because
cash pays zero interest rate. This constraint is known as the zero lower bound
and is the bound the Fed ran into in December 2008.
- How to increase productivity growth in the long run. In the short run, what
happens to the economy depends on movements in demand and the
decisions of the central bank. In the longer run, growth is determined by other
factors, the main one being productivity growth. Without productivity growth,
there cannot be a sustained increase in income per person. One particular
9
