Macroeconomics 1 - Exercise Class for "Hold 6"

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# E-mail address: paul.sharp@econ.ku.dk
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# You need this program! 
# Compulsory homework to be handed in to me in weeks 10, 14 and 18. There will be a test on Thursday, 12 May 2005 from 13-15 at Peter Bangs Vej 36, lok. E1, E2, E3 og E4. Three of these must be passed by me if you wish to participate in the exam in June.
# NB! Hvis din opgave ikke blev godkendt, skal du enten aflevere igen, eller aftale en tid at mødes med mig i Cafelitten, så vi kan gennemgå den sammen. Begge måde resulterer i, at du får den godkendt!
# NB! It is VERY important that you download, read and understand the suggested answers to lynprøven here. Fejlen er nu rettet.
# Resultat af den interne evaluering
# Resultat af den eksterne evaluering

Classes 10-13 every Wednesday


Required preparation

(in addition to following the lectures and reading the associated required reading to date)

What we did

6: February 9   None! After an introduction to macro, I went through "Introduktion til modelanalyse", which you can buy at studiekontoret. We looked at some examples of "kausalanalyse", and then you had a chance to try for yourselves, with Exercise 2 here.
7: February 16

N.B. We will be in Vester A21!

Hjemmeopgave 1, 2000, opgave 1.8 ANSWERS * Read "Introduktion til modelanalyse", including the full answers to the exercises we went through last time. Some of the (economic) details will be a bit beyond you at this stage, but we will (I promise!) work through the intuition in due course. Right now, it is important that you understand how to use "kausalanalyse", and how to solve the model using substitution. Don't worry too much about "5. Totaldifferentiering". This isn't too important at this stage, and we will return to it later.

* You should also make sure that you have finished Hjemmeopgave 1, 2002, opgave 2 (not 2.5) which you started in class. I will quickly go through this with you.

* If you have time, it is a good idea if you look at Exercise 1 here, which should be fairly easy, apart from the last two questions . . . I will go through it in class.

First we went through Hjemmeopgave 1, 2002, opgave 2 (see link above), though not 2.5.

We then went through Hjemmeopgave 1, 2000, opgave 1. Answers to question 1.8 are available under "downloads".

Finally, you had a chance to look at the exercise here in class.

8: February 23

What can IKEA learn from micro theory and the Law of Demand?

OECD: Kun reformer sikrer vækst

SOLUTION to Hjemmeopgave 1, 2003, 2.5

The exercises we are looking at now are relevant for working with Mankiw Chapter 3. Here we are introduced to the so-called "classical model" where GDP is supply determined, that is given by the supply of production factors. For this reason, changes in demand factors (for example a rise in government spending or private consumption) will not impact on GDP. (How does this relate to what you read in the newspapers? Are changes in GDP usually discussed as being exclusively related to changes in the number of workers and the capital stock?)

We also concentrate on a closed economy, which does not trade with the outside world. In this context, we look at what GDP/income/production is used for: the three demand components, private and government consumption, and investment. How are these determined?

* Read my answer to Hjemmeopgave 1, 2000, opgave 1.8! (Above, under downloads.) If you have difficulties with reaching the results given, then send me a mail!

* Make sure that you have completed Hjemmeopgave 1, 2004, which you started in class. We will go through this together.

* If you have time, look at Exercise 2 here.

We discussed the OECD's advice for Denmark (see article from Børsen 16/2-05 under downloads) in relation to Hjemmeopgave 1, 2004. Their recommendations concerned long-run growth and we could already see - even in our simple model - that we could understand a possible economic basis for their arguments.

We then went through Hjemmeopgave 1 from 2003, Exercise 2. Question 2.6 onwards are not relevant until you have been through the chapter on unemployment - maybe we will go through them later. The solution to 2.5 is available under downloads.

9: March 2 Note on total differentiation We are now ready to start with exercies relevant to Mankiw chapter 4 about money. Economists typically love money, so it will be interesting to see what new conclusions we get. Why doesn't Nationalbanken just print more of the stuff, to make us all richer? The answer to this question and more will be answered by our new improved models. Two really important concepts are important to understand here: that of real vs. nominal variables, and "the classical dichotomy". 

Real variables are those, like C and Y, which are amounts of goods. Nominal variables are those like M (money supply, the amount of money in the economy) and P (prices), which are in amounts of kroner (dollars, pounds or whatever).

Remember that we are looking at long-run "classical" models. This means that the "classical dichotomy" applies. This states that nominal variables cannot impact on real variables - so we will expect to see M, P, etc. at the bottom of our arrow diagrams. Already now you should be able to answer the question we asked earlier. If Nationalbanken was to print more money (increase M) it would have NO effect on Y (real BNP, our income). But remember - this is a LONG-RUN conclusion!

* The next exercise requires a knowledge of total differentiation. So look at section 5 in "Introduktion til modelanalyse". You may find it a bit tricky, but read it anyway. If you have time, have a look at questions 3.e, 6, 7 and 8 in the same note.

* Try and solve Exercise 1 here. There is unemployment in this model, but not so much that we can't go through it anyway! The important new additions to this model are MONEY and PRICES. 

We talked about total differentiation and went through a couple of examples using this (3e and 7 in "Introduktion til modelanalyse"). I have written a short note about this, which is available under downloads.

We went through 1.1-1.5 in Hjemmeopgave 2, 2000, Exercise 1.

10: March 9   We will complete our look at Hjemmeopgave 2, 2000, Exercise 1.

Until now we have looked at models for a closed economy. This meant that we could not look at the role of trade or exchange rates. We now turn to chapter 5 in Mankiw and the open economy. This is obviously a more realistic assumption for an economy like Denmark's. Note also, that we look at a model for a small open economy. This has important implications, which we will discuss. The point is that a small economy cannot impact in any way on foreign variables, such as the foreign rate of interest.

We are still looking at the long-run classical model, so GDP is supply determined and money is neutral. Our look at the open economy brings us many interesting insights. For example, we see that whether a country has a trade surplus or deficit is per definition determined by the difference between it's level of saving and investment. (Remember that we learnt that a closed economy must always have S=I.)

We will also learn that the real rate of interest can no-longer play the equilibriating role we have seen until now (since it is determined by the foreign level). The real exchange rate becomes all important here. An important concept to understand is that of purchasing power parity. This is a generalization of the law of one price which states, for example, that under certain assumptions a TV set in the UK should have the same (exchange rate adjusted) price as an identical TV set in Denmark. Think about why this might be - what would happen if this wasn't the case?

* Have a look at Exercise 2 here. Here we look at the difference between a country with a fixed exchange rate (a convenient example being Denmark, where the krone is tied to the euro) and a country which chooses a floating exchange rate (like the vast majority of countries in the world).

We started by discussing "forårspakken" from last year in relation to the classical model for the long run. This was mainly so you remember that production is supply determined in the long run, so policies to promote demand, such as lower taxes, do not increase GDP.

We then completed Hjemmeopgave 2, 2000, Exercise 1 and we started going through Exercise 2. We got as far as 2.4.

11: March 16 Pengepolitik i Danmark

Nationalbankens Kvartalsoversigt 1. Kvartal 2005

We will go through hjemmeopgave 1 and then finish the exercise we started last time.

* Read the suggested answer to Hjemmeopgave 1 here. I will assume that you have done this, so that I don't need to use too much time going through it (at least not on the easiest questions).

* Look at Exercise 2 here. This exercise again looks at fixed exchange rate systems, and also the effects of increasing confidence in Denmark's ability to maintain the kroner's euro-peg.

We went through the rest of the exercise from last time. In relation to this we looked at figure 4.1 in "Pengepolitik i Danmark" (Nationalbanken), which shows the close relationship between the exchange rate and inflation. The book is an excellent introduction to how monetary policy is managed in Denmark. It is free from Nationalbanken or you can get it from the link under "downloads".

We then went through hjemmeopgave 1.

We started looking at Hjemmeopgave 2, 2003, Exercise 2, but only got as far as 2.2. However, we did manage to discuss the government's statements before the euro referendum on April 3, 2000 in relation to subsequent experience. A major argument was that adopting the euro would save the interest rate differential between the krone and the euro. The government suggested that voting no would result in interest rates ½-1 %-point higher than a yes. Since the no, interest rates have fallen dramatically, and the Danish rate is now almost identical to that in Euroland. See the report on "Det 10-årige rentespænd mellem Danmark og Tyskland" in Nationalbankens Kvartalsoversigt 1. Kvartal 2005 under "downloads". Think about why this might be!

12: March 23   EASTER BREAK: No teaching ;-)

* But please remember to fill in the evaluation form!!!

13: March 30 Statistics from The Economist We will finish the exercise we started last time.

We are now ready to move on to one of the most topical subjects in economics for many European countries at this time: Unemployment (Mankiw Chapter 6). There is a natural rate of "frictional" unemployment, due to the fact that some people are always changing jobs, but in many countries unemployment is rather higher than this. This is always due to the wage level being higher than the equilibrium wage. If the wage level is free to adjust to clear the labour market (so that supply = demand) then there will only be "natural" unemployment. If for some reason the wage level is forced higher than that, then unemployment will be increased: there is "structural" unemployment. Why might this be? Three reasons are normally given: minimum wages, labour union power and "efficiency wages", the fact that some firms are willing to pay above the going rate for various reasons.

* In connection with this, look at Exercise 1 here  (not 1.13 & 1.14). This exercise concentrates on modelling the impact of labour unions on the economy. We will also see the effect of a fall in the level of compensation given to the unemployed (dagpenge etc.).

We completed the exercise we started last time. You may remember that we had difficulties of determining whether dNX/d(ro) (ro is the Greek letter that looks like a p) was positive or negative. This is because NX=S-I and when ro falls, there are two opposing effects. Interest rates decrease, so I increases. At the same time, increased I leads to increased K and therefore increased Y. Although C also increases, S=Y-C-G increases, because the effect through Y is strongest. This means that while I increases, S also increases, so it is not clear whether NX increases or falls.

We briefly discussed recent unemployment statistics (see under downloads) and got as far as 1.4 in Hjemmeopgave 2, 2001, opgave 1.

14: April 6 Euro-vækst


We will finish the exercise we started last time.

Until now we have looked at models which attempt to explain the economy in the long run. "Classical" economics stopped there. However, as Keynes once famously remarked: "In the long run, we're all dead." He therefore wrote his famous "The General Theory of Employment, Interest and Money" in 1936 after the Great Depression, which more than anything illustrated the importance of short-run economic fluctuations (konjunkturer). It is impossible to overstate the importance of these theories for the way that economies work and people think today. For example, everytime you hear a politician recommending increased government spending to boost the economy, they are taking a leaf out of Keynes' book. Prior to Keynes, in the world of classical economics, nobody would recommend increased government spending to boost growth - we all know that it would just lead to crowding out! It turns out, however, that it is perhaps not quite that simple.

We turn, therefore, to the short run, which is introduced in Mankiw chapters 10 and 11. We use the "IS-LM" model, based on Keynes' theories, to explain economic fluctuations and to suggest possible ways of alleviating the distress caused by sudden downturns in income (Y). His policy recommendations are, however, not uncontroversial so - like everything you learn here - remember that the models we use are good for illustrating important economic mechanisms, but are not necessarily a good guide to the workings of a real economy!

* Look at Exercise 2 here and Exercise 3 here. These are simple IS-LM models. In class we will try to understand the mathematics and the intuition behind the IS-LM model.

We finished the exercise we started last time.

I introduced the importance of demand and nominal variables in determining short-run growth with reference to two articles, one from the Financial Times 5 April 2005, and the other from Børsen 11 January 2005 (see under "downloads"). Contrast this with supply determined GDP and classical dichotomy in the long-run models.

I then went through the intuition behind the IS-LM model.

Finally, I went through Lynprøve 1, 2000, Exercise 2.

15: April 13   We will go through hjemmeopgave 2.



We only managed to go through hjemmeopgave 2. I am generally impressed with how you managed to answer the assignment. The main problem was lack of economic explanations for the results you find. Remember this next time!
16: April 20   We will continue our look at the closed economy in the short run.

* Look at Exercise 1 here and Exercise 2 here.

We went through Lynprøve 1, 2001, Exercise 3 and Lynprøve 2004, Exercise 2.
17: April 27   We will go through the exercise we didn't have time for last time (Hjemmeopgave 3, 2003, Exercise 1). We started by going through lots of "check" questions, and then we went through the exercise.
18: May 4 "Thank heaven for floating rates"




05/05/05: Blair wins an historic victory! More seats in parliament than all other parties put together, but with just 35% of the vote!


35.2% = 356 seats (out of 646)


32.3% = 197 seats

Until now we have only looked at short run models for a closed economy. The IS-LM model we have looked at until now describes mechanisms whereby it is possible to counteract economic fluctuations (a fall in Y). There are two possibilities: 1) expansionary fiscal policy (G up or T down) which increases demand, shifts the IS curve to the right and increases Y; 2) expansionary monetary policy (M up), which shifts the LM curve to the right and increases Y.

The Mundell-Fleming model, described in Mankiw Chapter 12, introduces the open economy in a way which should be familiar from Chapter 5. We assume perfect capital mobility, so r=r*, and now E=C+I+G+NX(e). NX depends on the nominal exchange rate, but we do not need to define a real exchange rate, since prices are fixed in the short run, and it would simply move with the nominal exchange rate.

We will describe the intuition behind the (Mundell-Fleming) IS*-LM* diagram, which is very similar to that for the closed IS-LM model. This framework provides a convenient way to analyse the relative merits of floating and fixed exchange rate systems. It is very important that you remember these main conclusions:

1) Under floating exchange rates, fiscal policy is useless, but monetary policy still works;

2) Under fixed exchange rates, monetary policy is useless, but fiscal policy still works. However, a country with fixed exchange rates has a new way of influencing Y: they can devalue (or revalue) their currency.

* Look at Exercise 2 here and Exercise 2 here.

I introduced the Mundell-Fleming model: the intuition and the main conclusions.

We also discussed an article about the problems with fixed exchange rates (see under "downloads").

We went through the exercise from 2001, but only just managed to start the exercise from 2003.

19: May 11   First we will finish the exercise we started last time.

Then we will go through hjemmeopgave 3.

We went through hjemmeopgave 3, and then went through the first exercise from the last three lynprøver.
20: May 18   We will go through lynprøven. For those you didn't go, the text is here.

* Read the answers from HJ here before you come.

* Fill in the external evaluation here!

We only had time to go through lynprøven. You should know that HJ says it is VERY important that you have read his suggested answers. So DO IT - and if there is anything you don't understand - ASK!
21: May 25 Artikel fra Børsen 17. maj 2005

Artikel fra Børsen 26. april 2005

Exam tips

We are now ready to look at exercises related to Mankiw chapter 13 about aggregate supply. The important concept here is that of the "Phillips curve", which suggests a short run tradeoff between inflation and unemployment. If it is possible to increase inflation unexpectedly, then there will be an increase in output and a decline in unemployment. Three theories are presented as to why that might be.

* Look at Exercise 3 here and Exercise 2 here.

These are the last two exercises we need to go through. I have reserved our room for an extra hour, so we have time for a few extra things:

- Total differentiation. We will have another look at this exciting maths.

- What have we learned? We will quickly go through the key conclusions.

- Why is it important? Have we been wasting our time?

- Paul's Famous Exam Tips. Find out how to maximize your examination function.

We went through the exercises etc. The articles we discussed and my exam tips are available under downloads.

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Summer vacation Why not visit Lamberhurst, Kent here? (Where I come from in England.)