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Macroeconomic models Introduction

we will analyze how these variables fit together and present models that explain the main macroeconomic variables.

Using these models we can, for example, analyze what happens when the government increases consumption, when the central bank increases the target interest rate and when domestically produced goods do well in foreign markets. We can also understand important observations of the economy, such as cyclical fluctuations in growth, correlation between unemployment and inflation and the relationship between interest rates and foreign exchange rates.

Macroeconomics is not an exact science such as physics. Noone knows exactly how the macroeconomic variables are related. Instead, there exist a number of models that try to explain various observations and relationships between macroeconomic variables. Unfortunately, not all of these models consistent - one model may predict that unemployment will fall if the central bank lowers the target interest rate while another may claim that such a change will not affect unemployment.

This type of problem is something you have to get used to and accept. Economics is not a subject where you can perform an experiment to find out what is really "true". Observed phenomena may have different explanations in different models and different models will lead to different predictions of macroeconomic variables. If you conclude that "An increase in x will lead to an increase in y" you really should not think of this as a property of the real world but rather as the property of a particular model.

One model that is very popular in virtually all basic courses in macroeconomics all over the world is the so-called neo-classical synthesis. As the name suggests, this is a combination or a synthesis of two models, namely the classical model and the Keynesian model. In short, the neo-classical synthesis claims that the Keynesian model is correct in the short term while the classical model is correct in the long run. The rest of this book builds up the neo-classical synthesis. Note that there are actually many minor variations of the neoclassical synthesis. I try to present the most common version.

Common assumptions

All models require a number of assumptions to be able to say anything of interest. In this section we will describe the assumptions that will apply throughout the rest of the book.

Unemployment and hours worked are directly related

In all models we assume a negative relationship between the number of hours worked and unemployment. If the number of hours worked increases, the unemployment will fall and vice versa. This assumption will be true if the workforce is constant and individuals in the labor force either work full time or not at all.

In reality, this relationship need not hold. We may see an increase in the labor force (for example from immigration) that is larger than the increase in employment which would lead to an increase in both hours worked and unemployment but we disregard this possibility.

The central bank has complete control over money supply

Remember that the money supply is equal to the money multiplier times the monetary base. We will assume that the money multiplier is constant and since the monetary base is completely under the control of the central bank, the central bank will control the money supply.

Monetary policy = change in money supply

The central bank actually has other monetary policy instrument apart from being able to determine the money supply. The most important one is the target interest rate for the overnight market. In this book we will not consider the possibility of changing the target interest rate. However, we know that there is a negative relationship between the target rate and the money supply. Therefore, if you want to investigate the effect of an increase in the target interest rate, you may just as well investigate a decrease in the money supply.

There is just one interest rate

Including different interest rates with different maturities would complicate the models but it would not buy you very much. Since interest rates with different maturities are highly correlated, they typically move in the same direction and the direction of a variable is typically what we are interested in. If you like, think of "the interest rate" as the one-year interest rate on government securities.

Exchange rate

In all models except those in Chapter 16 we will assume that the exchange rate is flexible. Furthermore, we assume that the exchange rate is determined by the ratio of the domestic price level to the foreign price level. If, for example, domestic prices increase by 10% while foreign prices are constant, the domestic currency will depreciate by 10% against the foreign currency. Motivation for this assumption and the consequences of this assumption can be found in section 16.2.

With this assumption, exports and imports may be assumed to be independent of the domestic price level. If domestic prices increase by 10% while the currency loose 10%, the price of domestically produced goods abroad will be unchanged. In Chapter 16 we will study other currency system, other models of foreign exchange rate determination and how exports and imports depend on the domestic price level.

Capital Flows

In all models, the domestic interest rate is not affected by foreign interest rates. With free capital flows, this is a very unreasonable assumption. If we the domestic interest rate increase against the foreign interest rates, capital would flow into our country which would drive down the domestic interest rate again.

Most reasonable models in which the domestic interest rate is affected by foreign interest rates are more complicated. To understand such models, you must first understand the models where this complication does not arise. Also, the predictions from models where the domestic interest rate is not affected by foreign interest rates are fairly similar to the more realistic models which allows for capital flows. 

we will look at a very simple model which allows for capital flows and for the domestic interest rate to be affected by foreign interest rates, the so-called Mundell-Fleming model.

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