1. Macroeconomics Theory and Policy
Dr Kenneth Creamer

2. Overview of Course Course outline:
Lecture 1 – 4: AD and AS, imperfect competition and the IS-PC-MR model
Lecture 5 – 6: Open economy macroeconomics
Lecture 7 and 9 : Fiscal and Monetary Policy
Lecture 8, 10 and 11: Financial crises and macroeconomic policy
Lectures: Thursdays from 17:00 to 18:30 in SEBS Seminar Suite
Lecture Notes:
Texts:
"Macroeconomics - Imperfections, Institutions and Policies" by Wendy Carlin and David Soskice; Published in 2006 by Oxford University Press
"Macroeconomics – Institutions, Instability and the Financial System" by Wendy Carlin and David Soskice; Published in 2014 by Oxford University Press
Assessments: Mid-term Test 50% (7 April); Exam 50%

3. Outline of Lecture 1
1.1 Distinguishing short-run and long-run models 1.2 Introducing the short-run IS-PC-MR model 1.3 Aggregate Demand 1.4 Aggregate Supply 1.5 Wage setting – in imperfect competition model 1.6 Price setting – in imperfect competition model 1.7 Labour Market with imperfect competition 1.8 Conclusions – summarising key facts of the model

4. 1.1 Short-run and Long-run models
Macroeconomics uses two broad types of models
Models for analysing output, unemployment, inflation and the exchange rate (short and medium-run models)
Models for analysing growth (long-run models)
Focus of this course is short and medium-run models – assisting in an understanding of monetary policy and fiscal policy

5. Questions that models assist in answering
Short and medium-run
How are levels of output and employment determined and why do they fluctuate
Why does inflation occur and why is it a concern
How does government policy affect inflation and unemployment
Why is unemployment high for lengthy periods in some countries
How do trade and capital flows affect exchange rates and employment and inflation
Typical equations:
Phillips curve relation: π = π-1 + α(y – ye)
Taylor rule: r0 – rs = 0.5(π0 – πT) + 0.5(y0 – ye)
Long-run
Why are some countries rich and others poor
Why is there convergence (catching-up) in some countries but not in others
Typical equation:
Solow’s growth model: y(t) = K(t)a(A(t)L(t))1-a
References:
“Why nations fail” Acemoglu and Robinson (2012)
“The wealth and poverty of nations” Landes (1999)

6. What are macro economic models used for?
Macroeconomics is the study of the relationship between and among aggregate variables in the economy such as employment, output, inflation, productivity, etc.
Models to seek to simplify, clarify and formalise the relationship between macro variables to see you they effect and influence each other
Models allow you to analyse (breakdown) and synthesise (bring together) economic concepts with an aim to gaining clarity about economic phenomenon
As argued by Dani Rodrik in “Economics Rules” (2015) - Models reveal ‘a’ truth rather than ‘the’ truth about the economy
Model selection is very important, as different models explain different phenomena, depending on particular circumstances
Eg our 2006 textbook uses the IS-PC-MR model to show how a central bank would operate to keep inflation under control
Our 2014 text book, by the same authors, also introduces models to explain asset bubbles, and financial instability, which are not explained by the IS-PC-MR model

7. 1.2 Introducing the IS-PC-MR model
A three equation New Keynesian IS-PC-MR model widely used in Central Banks and in modern monetary economics
earlier models focused on controlling the money supply, the IS-PC-MR model focuses on the policy rate (or interest rate) as the key instrument
IS: y – ye = -a(r – rs) (-ve rels r and y, AD)
PC: πE = π-1 + α(y – ye ) (+ve rels y and π, S-side)
MR: y – ye = -b(π – πT) (-ve rels π and y, policy rule)

8. Introducing the IS-PC-MR model
The IS curve y – ye = -a(r – rs) models aggregate demand (negative slope - if r up y down)
The Phillips curve (PC) πE = π-1 + α(y – ye ) represents the imperfectly competitive supply side of the economy:
s-r output and inflation have positive relationship e.g. if inflation rises then short-run increase in output as producers not sure if price increase in general or relative to their own goods (positive sloping short-run PC)
l-r output independent of inflation (vertical long-run VPC)
The monetary rule (MR) MR: y – ye = -b(π – πT) represents the policy behaviour of an inflation targeting central bank (negative slope because if inflation is up then output must be brought down (through raising r) in order to reduce inflation) i.e. CB reduces inflation by rising r to reduce AD

10. Questions answered by the model
The model must be able to answer the following questions:
How is current level of output and employment determined?
What determines the medium-run equilibrium level of unemployment (i.e. the level of unemployment at which inflation is stable ye)
How does the economy adjust from its current position to medium run equilibrium and what factors influence the speed and smoothness of adjustments.
We start by analysing a closed economy version of the model and then in a later lecture extend the model to include open economy factors such as international trade, capital flows and the exchange rate

11. Defining time-frames in the model
Short-run – the period during which output and employment can change, but due to institutional / legal factors prices and wages cannot / are assumed not to respond to changes in output and employment (months rather than years)
Medium-run – the period during which it is assumed that wages and prices can respond to changes in output and employment i.e. the supply-side adjusts to a level of equilibrium output (ye,) where inflation is constant again (the NAIRU). The size of capital stock and the labour force are assumed to be fixed i.e. it is about deployment of the existing labour force on the existing capital stock.
Long-run – growth theory seeks to explain the impact of growth in the population, the physical capital stock, the human capital stock and changes in knowledge and technology

12. Market imperfections in the model
The IS-PC-MR is a New Keynesian model where there are market imperfections (on the supply side) which are defined broadly to include:
the exercise of market power (e.g. where firms are price makers rather than price takers leading to price rigidities)
lack of complete information
Sticky wages due to contractual periods, efficiency wages, etc.
Sticky prices due to strategic pricing, hierachies, menu costs, etc.
New Keynesians argue that imperfect market model is a more generally applicable than the “special case” of perfectively competitive markets.

13. IS-PC-MR model – responding to inflation
If AD rises (eg due to fiscal expansion or temporary boost in C or I – IS shifts up)
output (y) and employment will rise (and unemployment falls) (to B’ shift in IS curve)
workers demand higher wages (there are fewer unemployed workers)
price setters will raise prices (as higher wages result in higher costs for firms)
i.e. a rise in AD leads to a rise in inflation (move from A to B on PC curve)
Policy response:
In the IS-PC-MR model the central bank raises interest rates to steer the economy towards lower inflation
Move to C’ on IS curve and C on MR line in order to reduce AD, reduce output and employment and reduce inflationary pressure
Due to low AD at C inflation will continue to fall and r will be lowered back to rs until the economy returns to desired point at Z (where inflation target πT is achieved at ye)

15. Diagramatic representation of IS-PC-MR
if actual employment = ERU then inflation is constant (no change to r)
if employment > ERU then inflation rises (and CB must raise r to bring inflation back to πT)
If employment < ERU then inflation falls (and CB must cut r to bring inflation back to πT)

17. 1.3 Aggregate Demand
AD is driven by real components C + I + G + X – M (IS curve) and monetary components (LM curve)
On the IS side (goods market) one can analyse:
Shifts in consumption or investment
Changes in fiscal policy eg tax or spending changes
On the LM side (money market) one can analyse:
Shifts in money demand
Changes in monetary policy (changes in money supply)
Note: IS-PC-MR model operates without an LM curve, as the key policy instrument is the interest rate, rather than the money supply, essentially:
if r rises this is equivalent to a LM contraction, and
if r falls this is equivalent to an LM expansion

18. The IS curve IS curve shows:
Combination of interest rates and output at which there is equilibrium in the goods market
Where planned expenditure = real output
With planned expenditure being made up explicitly of the following components C + I + G (closed economy)
Each component is modeled as dependent on other variables:
C on income and taxes and wealth (disposable income)
I on r and A (interest rates and investor confidence)
G on govt fiscal policy