INTERMEDIATE

MACROECONOMICS

TOPIC 4: MACROECONOMIC
SHORT-RUN THEORIES (3)
Macroeconomic Models: A
Guideline
Macroeconomic aggregates
• Key (measurable and available) economic aggregates:
• Output (𝑌).
• Inflation rate (𝜋).
• Unemployment rate (𝑈).
• Real interest rate 𝑖 − 𝜋 .
• Real wage 𝑊/𝑃.
• Money stock.
• The expected inflation 𝜋 𝐸 .
Functional relationship
• Well-known functional relationships using historical data:
• Phillips Curve: negative relationship between unemployment and inflation
(price/wage in the old versions and output gap in the modern version).
• Okun Law: negative relationship between unemployment and GDP growth
rate.
• Central bank’s reaction function (such as: the Taylor rule): high inflation and
expected inflation → central banks raise their policy rates.
• How about direction of causality: which aggregate causes which
aggregate to change?
 Okun Law: The US case
Change in The Unemployment Rate = 0.6*(Real GDP Growth Rate - 2)
5.0
4.0
Quarterly Real GDP

3.0
Growth Rate

2.0
1.0
0.0
-1.0
-2.0
-3.0
-1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0
Quarterly Change in the Unemployment Rate
5
Data source: FRED
 Phillips Curve

Source: [Link]
Causality in macroeconomics
• Correlation does not imply causation.
• In principle, everything is connected to everything else.
• Which (macro aggregates) cause which (aggregates) to change?
Which are “innocent” in the process of changes?
• The feedback loop between macroeconomic aggregates can be two-
way and complicated.
→ It is very hard to provide a definite answer for these questions in
social science.
Macroeconomic models
• Researchers develop a comprehensive frameworks (models) to specify
casual relationships between aggregates.
• Macroeconomic models become essential for macroeconomic analysis or
forecasting (but please do not believe that models are the real world!).
• We use models intensively in economics for reasoning and analysis.
• We also use a flowchart in this course.
• Different perspectives (Classical, Keynesian under various branches…) →
its own models and their corresponding quantitative approaches.
Modern macroeconomic models
A system of (linear or non-linear) equations include:
• Endogenous (internal) variables: are the ones that are determined
within the model (under the model’s equilibrium).
• Exogenous (external) variables: the ones which values are
determined outside the model and are considered independent from
the other variables within the model
Modern macroeconomic models are constructed in the probabilistic
form.
changes in
• interest rate (𝑖) Inflation (𝝅)
• autonomous consumption (𝐶)ҧ
• intended investment (𝐼)ҧ Output (𝒀)
• supply shock (e.g. import price) Unemployment (𝑼)
• …
Examples of Intermediate-
level Macroeconomic Models
The AD curve
• The aggregate demand (AD) function:
𝑌 𝐷 = 𝐶ҧ + 𝑚𝑝𝑐 𝑌 + 𝐼 𝑖 − 𝜋 + 𝐺ҧ
with 𝑖: the market interest rate,
𝜋: the inflation rate,
𝑖 − 𝜋: real interest rate.
• The central bank influence the nominal market interest rate by
setting its policy rate:
𝑖 = 𝑖ҧ
The AS curve
• The AS curve as the relationship between supply and inflation rate:
𝜋 = 𝜋 𝐸 + 𝜙 𝑌 − 𝑌𝑛 + 𝑣
with 𝜋 𝐸 as the expected inflation, 𝑌𝑛 as potential output (full-capacity
output), 𝜙 as parameter relating 𝑌 − 𝑌𝑛 to the actual inflation rate, 𝑣 as
random supply shock.
𝑌 − 𝑌𝑛 is called the output gap.
• The expected inflation (𝜋 𝐸 ) can be inferred using the previous period
inflation rate 𝜋𝑡−1 . This is the modern version of the Phillips Curve.
The model
• In equilibrium, we have a system of two equations:

𝑌 ∗ = 𝐶ҧ + 𝑚𝑝𝑐 𝑌 ∗ + 𝐼 𝑖 ҧ − 𝜋 ∗ + 𝐺ҧ
൝ ∗
𝜋 = 𝜋𝑡−1 + 𝜙 𝑌 ∗ − 𝑌𝑛 + 𝑣
• These are two functions with two unknown (endogenous) variables:
𝑌 ∗ and 𝜋 ∗ .
• If we know the values of all parameters and other (exogenous)
variables, we can solve the system and get the equilibrium values for
𝑌 ∗ and 𝜋 ∗ .
Intermediate-level models you may
encounter
• The previous one is a simplified version of the Dynamic Aggregate
Demand – Dynamic Aggregate Supply (DAD-DAS) model. You can
find a version in Mankiw’s textbook.
• We have other popular models:
• AD-SRAS-LRAS model (e.g. Mankiw’s textbook)
• Static IS-LM (e.g. Mankiw’s textbook).
• IS-LM-PC (e.g. Blanchard’s textbook).
Static IS – LM
• The two equations of this model are:
𝑌 = 𝑚𝑝𝑐 𝑌 − 𝑇 + 𝐼 𝑟 + 𝐺ҧ IS curve,
𝑀/𝑃 = 𝐿 𝑟, 𝑌 LM curve
• The IS (investment–saving): each point on the IS curve represents
equilibrium in the goods market – how equilibrium income level
(𝑌) depends on the interest rate (𝑟).
• The LM (liquidity preference – money supply): captures the equilibrium in
the money market – the quantity of real money balances demanded (𝑀/𝑃)
is negatively related to the interest rate (𝑟). and positively related to
income level (𝑌) .
The IS-LM-PC model
Source: Macroeconomics (2022) by Gregory Mankiw
The IS-LM model
Source: Macroeconomics (2022)
by Gregory Mankiw
IS-LM-PC
• The IS-LM-PC (IS-LM and Phillips Curve) model:
𝑌 = 𝑚𝑝𝑐 𝑌 − 𝑇 + 𝐼 𝑌, 𝑟 + 𝐺ҧ IS,
𝑖 = 𝑖ҧ LM,
𝛼
𝜋 − 𝜋ത = 𝑌 − 𝑌𝑛 PC.
𝐿
with 𝑖 = 𝑖 ҧ the interest rate is determined by the central bank, 𝜋ത as the
targeted interest rate of the central bank.
• The Phillips Curve (PC) states that the output gap 𝑌 − 𝑌𝑛 is positively
related to the difference between actual inflation and the expected
inflation rates (𝜋 − 𝜋).
ത
The IS-LM-PC model
Source: Macroeconomics (2021) by Oliver Blanchard
Common ideas among these models
• The economy (more or less) is able to return to its long-run trajectory
which is determined by the supply factors. Various types of shock
(demand or supply) cause economic fluctuations.
• There exist long-run natural variables (long-run equilibrium points),
such as: natural rate of unemployment, potential GDP trajectory.
• In the short run, demand determines outputs → room for intervention
from the government and the central bank.
• Inflation is caused by too much demand in the market or supply shock.
• Expectation and market imperfection play important roles in the short run.
Alternative ideas
• The Goodwin cycle: feedback loop from investment, to output, to
unemployment and back to unemployment.
• The Wicksell cycle: a positive feedback loop involving investment,
inflation and real interest rates.
• Minsky’s Financial Instability Hypothesis (FIH): a financial boom-
bust process that are built-in to the economy without any external
shocks.
 fiscal policy
Government

government
credit spending (G)
availability
consumption (C)
nominal real interest
output (Y)
interest rate rate investment (I)
multiplier
Okun law

profits
monetary unemployment (U)
policy

nominal Phillips
wage Curve
Central bank
inflation (𝝅)
CBs set its policy rate basing on
inflation and unemployment

supply shock
Case Study: Recent Inflation
Hike in the US
Causes of inflation
• Demand-pull: inflation rises with increases in overall demand of the
economy.
• Cost-push: inflation will also increase with increases in overall
production costs.
• Changes in inflation expectation: people's beliefs about future price
increases influence their current decisions, which can affect overall
price and wage levels.
Macro indicators
• Output: [Link]
• Job market pressure: [Link]
• Unemployment rate: [Link]
• Inflation: [Link]
Demand side
• Manufacturing demand: [Link]
• Manufacturing PMI: [Link]
• The Purchasing Managers Index (PMI) is a index summarizing economic activity in
the manufacturing sector.
• It is based on a survey of manufacturing supply executives. Participants are asked to
gauge activity in a number of categories like new orders, inventories, and production
and sub-indices.
• PMI>50: an overall expansion of the manufacturing economy
PMI<50: a shrinking of the manufacturing economy
 Consumption stimulus
Direct payments from the US government to
support its citizens from negative economic
impacts of the Covid lockdown:
• March 2020: $1,200 per eligible adult, $500
per kid.
• December 2020: $600 per adult, $600 per
kid.
• March 2021: $1400 per adult, $1400 per
dependent.
Supply side
• Import price index: [Link]
• Nominal wage: [Link]
• Real wage: [Link]
• Inflation expectation: [Link]
CPI’s Subcomponents
• [Link]
• [Link]
• [Link]
 Greedflation
hypothesis
• “Greedflation — roughly, inflation
driven entirely by rising corporate
profits”.
• “Retailers and suppliers saw big
increases in operating profit, too. …
that firms able to grow operating profit
faster than revenues.”

[Link]
grocery-prices/
[Link]
[Link]
corporate-greedflation
Diagnosis and solution
• Expansionary fiscal and monetary policy → more spending → general
high economy-wide inflation.
Solution: contractionary policies.
• High confidence in the economy → more demand for workers → nominal
wage → inflation → high expected inflation → high inflation of wage and
inflation. Then, a negative wage-price spiral that lasts long.
Solution: taming down expected inflation and wage control.
• Temporary supply problem → inflation in certain sectors.
Solution: cannot do anything in short-run. In the long run, mechanism to
quickly alleviate the effect of supply shock (higher level of inventories).
CBO report
• [Link]