Complete teaching guides for units 1–10 of The Economy 2.0: Macroeconomics, plus the list of building blocks. This page is structured for machine reading.
How this page is organised
The Economy 2.0 – Macroeconomics contains a new feature called “building blocks”. These are self-contained sections or groups of sections that explain certain concepts and techniques. Where building blocks are used in later units, a hyperlink is always provided there which opens the required material in a separate tab, making it easy for students to read the prerequisite material, either to provide the necessary background knowledge when the unit it comes from has not previously been covered, or to refresh their memories. Building blocks are designed to provide instructors with greater flexibility in the way the course is structured, because prerequisite knowledge is easily identifiable.
The use of building blocks in The Economy 2.0 – Macroeconomics makes it easier for instructors to customize the structure of their class to suit their specific audience and context. There are only two cases where a whole unit is required as a prerequisite for another unit. These units are as follows: (TO UPDATE)
| Prerequisite Units | Where used as a prerequisite |
|---|---|
| Unit 1 | Unit 2 |
| Unit 1, 2 & 3 | Unit 4 |
| Unit | Section(s) | Title of Building Block | Where required? | Where linked as optional reading? |
|---|---|---|---|---|
| 1 | 1.5, 1.6, 1.7 | The WS-PS model of the supply side of the macroeconomy | Unit 3, Unit 5 | None |
| 3 | 3.6, 3.7, 3.8 | The multiplier model | Unit 5, Unit 9 | None |
| 4 | 4.5, 4.6 | The Phillips curve | Unit 5 | None |
| 4 | 4.7, 4.8 | The business cycle model | Unit 5 | None |
| 5 | 5.2, 5.3, 5.4 | Role of fiscal and monetary policy | Unit 7 | None |
| 5 | 5.9, 5.10 | Monetary policy and inflation | Unit 7 | None |
| 5 | 5.13, 5.14 | The domestic and exchange rate channels for the transmission of monetary policy | Unit 7 | None |
| 5 | 5.14 | Monetary policy and the exchange rate | Unit 7 | None |
| 6 | 6.2-6.4 | Debt, financial sector, and banks | Unit 8 | None |
| 6 | 6.6 | Introducing the central bank | Unit 8 | None |
| 8 (Micro) | 8.2 and 8.3 | Demand and supply curves | Unit 8 | None |
| 1 (Micro) | 1.2 | History’s hockey stick | Unit 9 | None |
| 10 (Micro) | 10.3 and 10.5 | Addressing external effects | Unit 9 | None |
| 10 (Micro) | 10.6 and 10.7 | Public Goods | Unit 10 | None |
| 4 & 5 (Micro) | 4.5 and 5.3 | Pareto efficiency and fairness | Unit 10 | None |
| 4 (Micro) | 4.3 and 4.3 | Game Theory and Nash equilibrium | Unit 10 | None |
| 5 (Micro) | 5.12 | Measuring economic inequality: The Gini coefficient | Unit 10 | None |
| 3 (Micro) | 3.2-3.4 | Solving constrained choice problems | Unit 10 | None |
| 3 (Micro) | 3.7 | Income and substitution fees | Unit 10 | None |
| 7 (Micro) | 7.5 | Demand, elasticity, and revenue | Unit 10 | None |
| 6 (Micro) | 6.6 | Getting the work done: Contracts, principals, and agents | Unit 10 | None |
Conceptual prerequisites:
Building blocks in this unit:
Unit overview: This unit provides an introduction to macroeconomics and introduces (un)employment and real wages as key macroeconomic outcomes. It also introduces the WS-PS (supply-side) model. The main decision instructors will need to make is how much detail to provide about the background of this model. This would depend on how much time you have to teach the unit as well as your students’ strengths and weaknesses. Units 1 and 2 go together in the sense that unit 1 teaches the model and unit 2 provides various extensions and applications. Even if you do not teach all of unit 2, it would be good to use at least one section to let students work with the model after you have finished teaching unit 1. This will help your students so that the model does not seem abstract to them. Unit 2 also discusses the measurement of inequality via Lorenz curves and the Gini coefficient.
Key concept: Labour market statistics
the level of employment, unemployment and labour force participation are defined and students learn how they are calculated.
https://www.iz.sk/en/projects/eu-regions/SKhttps://www.bls.gov/opub/mlr/2023/article/labour-force-and-macroeconomic-projections.htm and this article provides detailed reasons for being out of the labour force, broken up by demographic characteristics: https://www.bls.gov/opub/btn/volume-4/people-who-are-not-in-the-labour-force-why-arent-they-working.htm You could ask your students to pull out two statistics that they find particularly interesting and share them with the class (e.g. post them on a discussion forum).Key concept: Real wages
students learn about nominal wages, the CPI price index and how real wages are nominal wages divided by the price level.
Key concept: Overview
The WS-PS model is introduced in unit 1 and applied in unit 2. It is used in the modelling of inflation in unit 4 and to describe the impacts of fiscal and monetary policy in unit 5. It is therefore important that students become comfortable with this model.
Key concept: The WS curve
The WS curve shows the real wage that firms must pay at different levels of employment in order to recruit a sufficient number of workers and motivate them to work hard. At the most basic level, students should understand that real wages tend to be high in “tight” labour markets when unemployment is low, and lower when unemployment is high. In a more detailed way, it will be helpful if students understand the meaning of the firm-level no-shirking wage curve which lies behind this model.
Key concept: The PS curve
The two things students really need to know are 1) the real wage w is determined by the nominal wage W (set by the HR department) and the price level P (set by the marketing department). Firms set prices to maximize profits based on the cost of production (wages, which depend on the extent of the firms’ power in labour markets) and a markup, which is higher when the firm has more power in product markets. Higher prices mean a lower real wage for workers. And 2) The real wage given by the PS curve shows how real output is split between workers (as real wages) and the owners of the firm (as real profits).
Key concept: Equilibrium and Disequilibrium
Section 1.8 describes why there must always be some unemployment, and explains how the economy would move back toward equilibrium from a state of disequilibrium (where the real wage on the WS curve is either higher or lower than the real wage on the PS curve).
https://www.economist.com/finance-and-economics/2018/05/17/lawmakers-are-trying-to-curb-contracts-that-make-it-harder-to-change-jobs] and discuss the following questions: 1) To what extent are relationship-specific and firm-specific assets a plausible explanation for the widespread use of non-compete agreements in America? 2) Analyse the costs and benefits of non-compete agreements on firms, workers, and the whole economy.Key concept: Section 2.11: Germany and Spain
Unit 1 starts with a puzzle and the last section of unit 2 directly answers that puzzle. Even if you do not have time to teach all of unit 2, it would be helpful for your students if you include a discussion of section 2.11 which compares macroeconomic outcomes (unemployment and real wages) in Germany and Spain. This helps them tie the threads together and provides at least one compelling application.
Key concept: Studying the economy as a whole
Section 1.9 explains the difference between microeconomics and macroeconomics and discusses aggregation, general equilibrium and some interesting paradoxes
https://www.nobelprize.org/prizes/economic-sciences/2015/popular-information/ The discussion of the representative consumer is interesting and highly relevant to this section.Conceptual prerequisites:
Building blocks in this unit:
Key concept: Lorenz Curves and the Gini Coefficient
Inequality is a key theme of this unit. Section 2.2 introduces the Lorenz curve as a way to depict the distribution (e.g. of income) within a society and shows how the Lorenz curve can be used to calculate an estimate of the Gini coefficient. The Gini coefficient was also introduced in unit 5 of the microeconomics text.
https://goodcalculators.com/gini-coefficient-calculator/). The exercise suggests calculating the Gini coefficient for heights of the students in the class. You could also calculate the Gini coefficient for distance from the university to their hometown.https://www.ncbi.nlm.nih.gov/pmc/articles/PMC9183946/] and Verick et al. (2021) [https://doi.org/10.1111/ilr.12230]. Students could draw on these articles to discuss in what ways the two crises had similar impacts on inequality and in what ways the impacts were different.https://www.ft.com/content/24e88c30-bc5f-11e6-8b45-b8b81dd5d080. To discuss: 1) Choose one of the graphs in the article and describe, in your opinion, the most interesting feature. 2) Explain what is meant by the Gini coefficient. Explain what the article suggests has happened to income inequality since the 1970s. (Instructors can also ask students to look up income inequality statistics for their country or a country of their choice and compare it with those in the article).https://www.core-econ.org/the-economy/book/text/19.html)https://www.core-econ.org/insights/a-world-of-differences/text/01.html)https://www.labxchange.org/library/pathway/lx-pathway:947bd402-9d3a-40f0-bcac-31c660f34459)Key concept: Lorenz curves and the WS-PS model
section 2.3 demonstrates how the WS-PS model and the Lorenz curve model are related. This is an important section because throughout unit 2, the effects of various policies will be demonstrated using these two models in connection with each other. This unit uses both diagrams to demonstrate the effects of a change in product market competition – which is discussed further in relating to the US in section 2.9. It is important that students understand why the PS curve moves UP when product market competition INCREASES (i.e. because the price markup falls and P is in the denominator of the w = W/P equation).
Key concept: Labour market policies
education and training; wage subsidies and unemployment benefits
https://www.econstor.eu/bitstream/10419/145286/1/dp9995.pdf) and South Africa (https://www.researchgate.net/profile/Tim-Koehler/publication/359745477_Wage_subsidies_and_COVID-19_The_distribution_and_dynamics_of_South_Africa%27s_TERS_policy/links/624dea6f4f88c3119ce45680/Wage-subsidies-and-COVID-19-The-distribution-and-dynamics-of-South-Africas-TERS-policy.pdf). Possible discussion – how were the two programs similar and different? Did they achieve their purpose of supporting employment during the economic crisis?https://data.oecd.org/benwage/benefits-in-unemployment-share-of-previous-income.htm); International Labour Organization (https://www.ilo.org/global/about-the-ilo/newsroom/news/WCMS_007901/lang--en/index.htm). In groups, students could use this information to discuss how the reservation wages of workers may differ across countries and groups in society (e.g. gender, age, type of occupation).https://www.core-econ.org/doing-economics/book/text/06-02.html#part-61-looking-for-patterns-in-the-survey-data]. Instructors can set a few questions for homework or an in-class exercise.Key concept: Labour unions
Section 2.5 describes how unionization could be represented by an upward shift the the WS curve. The “union voice effect” would shift the WS curve in the opposite direction. Unions can impact productivity negatively or positively (this would shift the PS curve, though that is not shown in the diagrams). The section discusses the different impacts of unions that act inclusively (showing restraint due to the impact on the whole economy) in contrast to unions that do not act inclusively (pushing for higher wages in their own corner of the economy).
https://www.bls.gov/news.release/pdf/union2.pdfhttps://home.treasury.gov/news/featured-stories/labour-unions-and-the-us-economyKey concept: Segmented labour markets
Section 2.6 uses the Lorenz curve to show how inequality amongst workers (in primary and secondary labour markets) introduces an additional source of inequality and leads to an increase in the Gini coefficient
https://www.bls.gov/charts/employee-benefits/percent-access-paid-leave-by-wage.htm. Paid vacation: https://www.bls.gov/ebs/factsheets/paid-vacations.htm. Employer provided health insurance: https://www.bls.gov/opub/ted/2023/coverage-in-employer-medical-care-plans-among-workers-in-different-wage-groups-in-2022.htmhttps://www.core-econ.org/espp/book/text/06.html#614-another-kind-of-business-organization-the-gig-economy]. Students can also read this Financial Times article on worker monitoring in the gig economy [https://www.ft.com/content/88fdc58e-754f-11e6-b60a-de4532d5ea35] and compare it with worker monitoring in traditional firms.Key concept: Taxes and Imported Materials
Sections 2.7 and 2.8 show how the equation of the PS curve can be modified to demonstrate how taxes (consumption and labour taxes) and the cost of imported materials will effect the outcomes of the model
Key concept: Competition and Inequality in the US
http://abcnews.go.com/Politics/ftc-started-takes-amazon-meta-chair-lina-khan/story?id=109928219Key concept: Danish “flexicurity”
Section 2.10 discusses the Danish response to the COVID-19 pandemic as well as Denmark’s long-running tradition of “flexicurity”
Key concept: Germany and Spain
Section 2.11 answers the puzzle that was introduced at the start of unit 1. If you already discussed this section when you taught unit 1, you could revisit it here briefly now that your students have seen a more detailed explanation of the potential impacts of unemployment benefits, union coverage and taxes.
Key concept: Sections 2.12 and 2.13 discuss what the model does well as well as some limitations including 1) it may take a long time (decades) to reach the long-run equilibrium so what is observed in the data at any given point in time may not match that and 2) it does not include aggregate demand, which is the topic of the following unit
Required Building Blocks:
Building blocks in this unit:
(Section 3.2-3.4)
These sections provide an in-depth discussion of how GDP is measured, how it is made comparable across time and across countries, and its limitations as a measure of wellbeing.
Key concept: GDP
Students should know the three ways to measure GDP (expenditure, output, income) and why they are equivalent (refer to the circular flow representation in Figure 3.3). For more detail on the “value added” (income) approach, instructors can refer to Extension 3.3. Students should also know how GDP measures are adjusted for comparisons: nominal GDP measures are made comparable over time by using prices in a specified base year (the result is known as real GDP or GDP at constant prices). GDP per capita is also made comparable across countries by using purchasing power parity (PPP) prices.
https://www.cdhowe.org/sites/default/files/attachments/research_papers/mixed/What to the Different Measures of GDP Tell Us.pdfKey concept: Components of GDP
From a national accounting perspective, students should be aware of what is included in each component of GDP (consumption, fixed investment, changes in inventories, government spending, and the trade balance (exports minus imports)) and what isn’t included (to avoid double-counting). For example, government transfers are not included as a component of GDP because these transfers are already counted as consumption and/or investment.
https://www.core-econ.org/doing-economics/book/text/04-02.html#part-41-gdp-and-its-components-as-a-measure-of-material-wellbeing. Questions 3-5 are suitable (individually or together) for a short homework exercise or the whole Part 4.1 could be a longer assignment. This activity is available in Excel, R, Google Sheets, and Python.https://www.ft.com/content/b54cda40-3659-11e8-8b98-2f31af407cc8. Discussion question: How have the components of GDP (specifically, consumption and investment) for China changed over time and why does the author of the article think these changes are a positive sign?https://www.economist.com/finance-and-economics/2008/01/03/an-old-chinese-myth. Discussion questions: 1) Compare the components of GDP mentioned in the article (net exports, investment, consumption) for China and the US. Which country is likely to be more affected by a fall in exports from that country? 2) Explain why value-added is a more accurate way to measure exports (compared to gross revenue), and how this measure changes the way we think about China’s economic growth in the 2000s. 3) How have the components of China’s GDP changed since the article was written (in 2008)?https://www.core-econ.org/insights/financing-american-government/text/01.html (Instructors may want to leave this activity until Unit 5, after covering fiscal and monetary policy in more depth).https://www.core-econ.org/insights/public-debt/text/01.html (Instructors may want to leave this activity until Unit 5, after covering fiscal and monetary policy in more depth).Key concept: Interpretation of GDP
Students should know the key measurement issues associated with GDP (does not account for changes in quality, excludes non-market activity, excludes the underground/illegal economy), and be aware of GDP’s limitations as a broader measure of national wellbeing.
https://www.ons.gov.uk/peoplepopulationandcommunity/wellbeing/bulletins/qualityoflifeintheuk/may2023https://www.core-econ.org/doing-economics/book/text/04-02.html#part-42-the-hdi-as-a-measure-of-wellbeing. The whole part will take a few weeks to complete (in class or in students’ own time) so is suitable for a semester-long assignment. This activity is available in Excel, R, Google Sheets, and Python.https://tinyco.re/6386280). Based on the data, instructors could then ask students to determine whether differences in GDP per capita would be smaller/larger when accounting for PPP compared to current exchange rates.https://www.economist.com/briefing/2016/04/30/the-trouble-with-gdp. Discussion questions: 1) Discuss some of the measurement issues associated with calculating GDP. 2) How useful is GDP as a measure of living standards?(Section 3.1 and 3.5)
Section 3.1 introduces the idea that falling economic output can cause affect individual prosperity and wellbeing. Section 3.5 uses data from the UK to demonstrate that economic growth (measured by percentage changes in GDP) is not smooth: it has peaks (booms) and troughs (recessions). Investment also tends to be more volatile than consumption. Sections 3.9-3.13 discuss some reasons why.
Key concept: The business cycle
The movement from boom to recession and back to boom is known as the business cycle. Students should know the two definitions of a recession (declining output vs economic output below its “normal level”). The concept of “normal output” will be discussed further in Unit 4.
https://www.economist.com/finance-and-economics/2018/04/19/economists-still-lack-a-proper-understanding-of-business-cycles. Discussion question: Compare and contrast the views of neoclassical and New Keynesian economics. How did the 2008 financial crisis challenge these views?https://www.economist.com/finance-and-economics/2019/04/26/americas-strong-growth-this-year-surprises-economists. Discussion question: Using the GDP decomposition in the unit, explain why US GDP grew by more than expected in the first quarter of 2019. Which components of GDP might be a concern for policymakers?https://www.core-econ.org/doing-economics/book/text/13-01.html. The full project will take at least a few weeks to complete, so instructors may assign parts or individual questions for week-long homework exercises. This project is available in Excel, R, and Google Sheets.(Section 3.6-3.8)
These sections introduce the multiplier model, which is a model of aggregate demand that includes the multiplier process. The concepts of equilibrium and exogenous shocks are essential for understanding this model; these are covered in Section 2.8 of the Microeconomics volume.
Key concept: Aggregate demand
Aggregate demand is the total of the components of planned spending in the economy. When the economy is not in goods market equilibrium (Y = AD), unplanned inventories (II) are nonzero. Students should know each variable in the aggregate demand equation (e.g. autonomous consumption/investment, marginal propensity to consume, interest rate, marginal propensity to import) and which variables change the intercept vs the slope of the aggregate demand line.
https://www.ncbi.nlm.nih.gov/pmc/articles/PMC7382353/) Instructors can compare the class’ average MPC and distribution of MPC to the EU data (17 countries) in Figure 1 and Table 2 of the Drescher paper.https://www.ft.com/content/b5b764cc-d657-11e6-944b-e7eb37a6aa8e. Discussion questions: 1) What did the Obama administration do to try and manage the economic recession in 2008-9, and what were the outcomes? 2) Do you think the US government went “far enough” to address the recession?Key concept: The multiplier
The multiplier process is the mechanism through which the direct effect of an increase (or decrease) in aggregate spending is amplified through indirect effects that further increase (or decrease) aggregate output. Figure 3.15 illustrates each step in the multiplier process from initial shock to new equilibrium. Students should know how to derive the equation of the multiplier and how each variable affects the size of the multiplier.
https://www.core-econ.org/experiencing-economics/book/text/05.html) is a game about the multiplier process. Some of the homework questions use the Excel multiplier simulation.https://www.economist.com/economics-brief/2016/08/11/where-does-the-buck-stop. Explain the arguments on both sides of the debate (Keynes’ view and those who disagree with him). Which view is more consistent with what happened in real-world economies?https://www.economist.com/finance-and-economics/2009/09/24/much-ado-about-multipliers. Why is it so difficult to estimate the size of the fiscal multiplier in practice? What are the potential consequences of deciding policy based on an incorrect value of the multiplier?(Section 3.9-3.10, 3.13)
These sections develop the life cycle model of consumption, which is a model of consumption spending in which individuals’ current consumption depends not only on their current income, but also on their expected future income, and their assets, allowing for savings and debts. This model is used to explain why consumption is relatively smooth (compared to investment), and how constraints on households’ ability to smooth consumption affect the economy-wide marginal propensity to consume. Section 3.13 uses China’s post-pandemic aggregate demand problem to illustrate how government social insurance policies affect consumption.
Key concept: Consumption smoothing
A key assumption of the life cycle model is that households prefer to smooth consumption (spread it relatively evenly across time periods rather than having large fluctuations in consumption from period to period). This principle of consumption smoothing explains why households may react differently to permanent vs transitory income shocks. Students may find consumption smoothing unintuitive because they are often credit-constrained and unable to smooth their own consumption. Relating this concept to students’ experiences (for example, student loans that they must repay in the future before saving for retirement) and that of their families can help here. Instructors can also refer to Section 9.3 of the Microeconomics volume for a more detailed explanation of why households may prefer to smooth consumption.
Limits to consumption smoothing: Section 3.10 discusses three limits – credit constraints (Figure 3.18), present bias (Figure 3.19), and limited co-insurance. It is important for students to understand that features of the economy, such as the level of inequality, may influence the number of credit-constrained households—and have consequences for the aggregate economy. It also shows students the importance of modelling economies with heterogeneous individuals because their differing responses to exogenous events may have material consequences for economic outcomes. Instructors can refer to Section 9.9 of the Microeconomics volume for a more detailed discussion of credit constraints and credit market exclusion.
https://www.economist.com/special-report/2005/09/24/anatomy-of-thrift. Discuss: Which of the article’s explanations for the low saving and investment rates do you find the most/least convincing, and why? 2) Why do people not save and invest as much as economic theories suggest? (Instructors may want to supplement this discussion with more recent articles from after the pandemic).https://www.economist.com/finance-and-economics/2009/05/14/smooth-operators). Discussion questions: 1) Compare and contrast the methods that the poor and the rich use to manage their finances. 2) How are the poor able to the smooth consumption despite limited access to conventional banks? Students can also read household stories on how the poor make ends meet around the word, taken from “Portfolios of the Poor” (http://www.portfoliosofthepoor.com).https://www.ilo.org/wcmsp5/groups/public/---ed_protect/---soc_sec/documents/publication/wcms_817572.pdf) and discuss why social protection is important and how countries responded differently to the COVID-19 crisis.https://docs.iza.org/dp9674.pdf); for country-specific questionnaires, instructors can download them from the Global Preferences Survey website: https://www.briq-institute.org/global-preferences/downloads). Students can answer the questions and compare their responses to their country’s average and other countries: https://www.briq-institute.org/global-preferences/maps. Students could complete this activity asynchronously and share results with the class.https://www.myfico.com/fico-credit-score-estimator/estimator). Students should consider how the criteria used to assess creditworthiness may advantage/disadvantage certain groups in society. This website on factors used to calculate a credit score may also be helpful: https://myhome.freddiemac.com/blog/notable/20210831-factors-credit-score). Students could complete the questionnaire asynchronously and bring their answers to class.https://gflec.org/initiatives/national-financial-capability-study/) contains summary statistics on financial inclusion in the US; students can also download the data and construct summary statistics of credit market exclusion/constraints (alternatively; instructors can find equivalent surveys for non-US countries).https://www.core-econ.org/doing-economics/book/text/09-01.html) gets students to use Ethiopian household survey data to identify credit-constrained and credit-excluded households, and factors that affect a household’s credit status. Part 9.1 examines households who did not get a loan; Part 9.2 examines characteristics of households who did get a loan. Each part will take one week if done in full, but instructors can select specific questions as a shorter exercise (e.g. have students with the cleaned data).https://www.social-protection.org/gimi/WSPDB.action?id=809) to compare the types of co-insurance/social insurance provided by different countries.(Section 3.11-3.12)
These sections explain the aggregate investment function in more detail, and use the concept of virtuous/vicious cycles (Figure 3.21) to explain why investment tends to be volatile. Extension 3.11 provides a more formal treatment of investment decisions as a coordination game. Instructors who want to cover this content should ensure students are familiar with the game theory concepts in Sections 4.2, 4.3, and 4.13 of the Microeconomics volume.
Key concept: Aggregate investment
Aggregate investment is modelled as function of the interest rate (slope) and profit expectations (vertical intercept). Figure 3.24 illustrates how investment changes in response to each of these variables.
https://www.core-econ.org/experiencing-economics/book/text/02.html) has students play an investment coordination game to understand why investment follows virtuous and vicious cycles.https://www.economist.com/books-and-arts/2017/12/14/businesses-investment-decisions-can-have-unexpected-consequences. Discussion questions: 1) Discuss the challenges involved with measuring intangible investment/assets. 2) What is “intangible investment” and why is it so important for explaining economic growth in developed countries?Conceptual prerequisites:
Required Building blocks:
Building blocks in this unit:
(Section 4.1-4.3)
Section 4.1 introduces the topic with descriptive data on inflation across countries and time, including the most recent spike in inflation after the pandemic. Section 4.2 explains how inflation is measured using price indices and discusses some measurement issues with the “representative basket” method of calculating the consumer price index (substitution bias, quality changes). Section 4.3 covers key definitions (inflation, deflation, disinflation) and explains why inflation can be “bad” (it alters the distribution of real income and creates uncertainty about future prices), but that a low and predictable level of inflation can be desirable.
Key concept: Inflation, deflation, disinflation
Students need to know the distinction between these three terms. Students often find it hard to understand that the term “inflation” is used to refer to the growth rate of prices, so that when inflation is positive, prices are rising and when it is negative, prices are falling. A slower rate of inflation is often mistakenly referred to as deflation, and for this reason, this unit distinguishes between deflation (a cause for alarm!) and disinflation. Working with some numerical examples (e.g. the data in Question 4.1) might be helpful. Students should also understand the difference between inflation or constantly rising prices, and accelerating inflation, where the rate of inflation itself is rising.
https://tinyco.re/6386280) to discuss how the cost of living can be measured and compared across countries. For example, do students agree with the items being used?https://studentsforliberty.org/blog/five-myths-about-inflation/) and this YouTube video by Professor Antony Davies (https://www.youtube.com/watch?v=vsuSYJc3JuA).https://www.ft.com/content/4de1d464-0172-11dc-8b8c-000b5df10621. Discuss: What is the author’s argument about official measures of inflation? What measures do you think policymakers should use to assess price changes/price stability in the economy?https://www.economist.com/special-report/2019/10/10/technology-is-making-inflation-statistics-an-unreliable-guide-to-the-economy. Discussion questions: 1) How is technology challenging the way that we interpret and measure conventional indicators of living costs or living standards, such as GDP and inflation? 2) What are the consequences of mis-measuring inflation?https://www.economist.com/special-report/2019/10/10/inflation-is-losing-its-meaning-as-an-economic-indicator. Discuss: 1) To what extent is long-term low inflation consistent with economic models and theory, as discussed in the article? 2) Why do you think the author of the article is concerned about disinflation? 3) This article was written in 2019; how do events that happened afterwards change the way you view the arguments in the article?https://www.ft.com/content/d9f9955e-d932-11e4-a8f1-00144feab7de. Discuss: The author argues that high inflation is needed in some economies to help economic growth in the longer term. To what extent do you agree with this argument? (Note: this article was written in 2015.)https://www.imdb.com/list/ls026442468/)(Section 4.4-4.6)
These sections model inflation as arising from bargaining gaps (conflicting claims on output between workers and firms) and introduce the inverse relationship between inflation and unemployment (known as the Phillips curve). Section 4.6 shows how expected inflation can shift the Phillips curve (Figure 4.15 illustrates a wage-price spiral). These sections discuss the supply-side of the economy so require students to be familiar with the WS-PS model; instructors should ensure that Sections 1.5-1.7 are covered before teaching Unit 4. The unemployment rate in supply-side equilibrium is now interpreted as the inflation-stabilizing unemployment rate (or NAIRU).
Key concept: Bargaining gap
The bargaining gap is the distance between the wage on the WS curve (the wage workers expect to get) and the wage on the PS curve (the wage workers actually get). Students should understand that inflation arises from changes in bargaining power associated with movements along the wage-setting curve, rather than shifts of the entire wage-setting curve. Working through the steps in Figures 4.9 and 4.10 will help students understand the relationship between the bargaining gap and inflation.
https://www.epi.org/productivity-pay-gap/).Key concept: The Phillips curve
This curve represents the inverse relationship between the rate of inflation and the rate of unemployment. Students should understand the difference between movements along the Phillips curve (changes in the bargaining gap) and shifts of the curve (changes in expected inflation).
https://www.ft.com/content/91bb9cd4-292e-11e8-b27e-cc62a39d57a0. Discuss: What is the key debate discussed in the article, and why does it matter for policymakers?https://www.economist.com/finance-and-economics/2017/06/15/inflation-has-not-yet-followed-lower-unemployment-in-america. Discuss: 1) To what extent is the Phillips curve relationship a useful concept in practice? 2) What factors could explain why the Phillips curve relationship fails to hold in the real world? (Students can refer to the discussion and Figure 15.6 in Section 15.6 of The Economy 1.0: https://www.core-econ.org/the-economy/v1/book/text/15.html#155-what-happened-to-the-phillips-curve)https://www.economist.com/special-report/2019/10/10/economists-models-of-inflation-are-letting-them-down. Discuss: Assess the evidence for a non-linear Phillips curve presented in the article. How can technological progress explain the real-world relationship between inflation and unemployment?https://www.economist.com/economics-brief/2017/08/26/the-natural-rate-of-unemployment. Questions: Discuss issues with measuring the natural rate of unemployment. How useful is the natural rate of unemployment in practice?Key concept: Inflation expectations/Expected inflation
CORE takes expected inflation to be equal to last year’s inflation, which is a simple form of adaptive expectations. Another interpretation is that HR includes inflation over the past year in the wage settlement, to make up for the shortfall in the real wage that workers experienced because inflation turned out to be higher than expected. Students should understand how inflation expectations affect inflation: inflation this period is the sum of expected inflation (last period’s inflation) and the bargaining gap (this period). Figure 4.16 can help students understand how inflation evolves in this model. Inflation will only be stable at the unemployment rate of supply-side equilibrium. Unit 5 will discuss the concept of anchoring inflation expectations.
https://personal.lse.ac.uk/tenreyro/understandinginflation.pdf) explains how the Bank of England measures inflation expectations and discusses how (and why) inflation expectations vary across demographic groups in the UK. Instructors could ask students to read this article and discuss the findings in small groups.(Section 4.7-4.11)
These sections build a three-diagram model of the business cycle that brings together the demand-side and supply-side of the economy (Figure 4.18): the multiplier diagram (Unit 3), the WS-PS diagram (Unit 1), and the Phillips curve diagram. The business cycle model is used to analyse aggregate demand shocks (Figure 4.19) and supply-side shocks (Figures 4.20-4.21). Section 4.11 applies this model to explain post-pandemic inflation in the UK and makes some cross-country comparisons. Aside from familiarity with the WS-PS model (Sections 1.5-17), students should also be familiar with the price-setting curve equation allowing for imported input materials (Section 2.8).
Key concept: The business cycle model
This model brings together the supply-side WS-PS model (with the Phillips curve), and the demand-side multiplier model to explain how the economy fluctuates around the supply-side equilibrium over the business cycle. Figure 4.18 is crucial for demonstrating how the three diagrams relate to each other. CORE’s approach to modelling the macroeconomy is different from the “traditional” approach (IS-LM/AD-AS diagram) for three reasons: 1) CORE makes explicit that money supply is not exogenously supplied to the economy and that setting the interest rate is the lever that governments (or central banks) have to influence money supply. 2) CORE also explicitly models the product markets with imperfect competition (technically this is possible with the upward-sloping AS curve). 3) CORE also models the labour market with incomplete information so that unemployment is an equilibrium outcome.
https://www.economist.com/finance-and-economics/2017/01/14/inflation-is-on-the-way-back-in-the-rich-world-and-that-is-good-news?zid=295&ah=0bca374e65f2354d553956ea65f756e0. Ask students to choose two causes of inflation mentioned in the article and use the wage-setting/price-setting model and Phillips curve diagrams in the unit to illustrate their effect on rich economies.Key concept: The causes of inflation
Section 4.10 reviews four causes of inflation – cost-push inflation (Fig 4.20, 4.21, 4.24), demand-pull inflation (Fig 4.15, 4.19), expectations-driven inflation (Fig 4.9 vs 4.15), and profit-push/sellers’ inflation (Figure 4.26). Sellers’ inflation arises due to capacity constraints: firms can widen their markup when capacity utilisation rises. Students should know the differences between these four causes and the appropriate diagrams to illustrate each situation.
https://www.ft.com/content/a55933f2-3bc5-11e7-ac89-b01cc67cfeec. Instructors can ask students to relate the content of this article to post-pandemic inflation (what’s similar/different?).Required Building blocks:
Building blocks in this unit:
None
(Section 5.1-5.2, 5.4)
These sections introduce the two goals of macroeconomic policy (low and stable inflation, unemployment at/close to supply-side equilibrium), the two broad types of policies (fiscal and monetary), and the economic actors who implement these policies (governments and central banks).
Key concept: Fisher equation
Students should understand that the policy rate set by the central bank is a nominal interest rate, but it is the real interest rate that is relevant for spending and saving decisions in the economy. The Fisher equation defines the relationship between real and nominal interest rate: real interest rate = nominal interest rate – expected inflation. Sections 5.9-5.10 discuss the importance of the Fisher equation for monetary policy.
Key concept: Different monetary and fiscal policy regimes
While in many countries there is a division of labour between fiscal and monetary policymakers, with a central bank that is independent from the government, other countries follow different policy regimes. The unit discusses three alternative approaches: common currency areas, fixed/target exchange rate regimes, and direct control of fiscal and monetary policy by the government.
https://dash.harvard.edu/bitstream/handle/1/41426668/1093%20329576755.pdf?sequence=1). Their methodology to estimate preferences uses regression analysis, so instructors can provide an intuitive explanation and focus on the results.https://www.economist.com/leaders/2019/04/13/the-independence-of-central-banks-is-under-threat-from-politics). Questions: 1) Discuss the key threats to central bank independence. 2) Why is central bank independence important?https://www.economist.com/special-report/2019/10/10/how-to-make-economic-policy-fit-for-a-world-of-low-inflation). Discussion question: To what extent do you think monetary policy should be governed by economic theory, rather than depend on external forces such as the government’s fiscal policy or political pressure?Key concept: Statistical terminology
Some parts of the unit (e.g. Section 5.7) require an understanding of statistical terms typically taught in an introductory statistics module. Students should know the meaning of line of best fit, reverse causality, natural experiments, and the difference between correlation and causation.
https://tinyco.re/8861803) and ask students to identify the ‘unseen factors’ driving the observed relationship.(Section 5.6-5.8)
These sections outline the various ways that government spending decisions can dampen fluctuations (Section 5.6), and factors that affect the impact of fiscal policy. Section 5.7 builds on the concept of the multiplier from Unit 3, while Section 5.8 discusses austerity policy and why governments might not want to cut spending during a recession (the paradox of thrift).
Key concept: How governments can dampen fluctuations
Government spending has a stabilizing impact in 3 ways: 1) direct impacts on aggregate demand (due to its size and lower volatility compared with other components), 2) automatic stabilization of fluctuations that arises from the tax and transfer system, which indirectly affect consumption spending, and 3) the deliberate use of tax, transfer, and spending decisions (called discretionary fiscal policy) to offset shocks to aggregate demand. Students should understand why governments have an important role in providing social insurance – private markets cannot insure against economy-wide losses due to correlated risk, moral hazard, and asymmetric information. Instructors may find it helpful to review these market failures (Sections 10.8-10.10 of The Economy 2.0 Microeconomics volume). Students should also understand how the size of the multiplier affects the impact of fiscal policy.
https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19) summarises the economic policies that governments implemented during the COVID-19 pandemic (up until July 2021). Students could choose 2-3 countries and compare the fiscal policies implemented.Key concept: Government budget
Government expenditure and transfers must be paid for in the longer term, if not immediately. If the government spends more in total than it receives in tax revenue, the government budget is in deficit. However, during a recession, there is a tradeoff between budget balance and aggregate demand in the short run: cutting spending (austerity policy) can reinforce the recession by further lowering aggregate demand (the paradox of thrift).
https://www.ft.com/content/e7f1dfba-513a-11e5-b029-b9d50a74fd14). Questions: 1) Summarise Brazil’s fiscal problems and the policy options. 2) This article was written in September 2015 – do some research to find information and data on what the Brazilian government has done since then and how has it affected government debt.https://ifs.org.uk/election-2024/be-chancellor?mc_cid=fc4449feb6&mc_eid=e180beb77e) – Students can choose tax and government spending plans and see the effects on borrowing and debt under different assumptions about growth and interest rates.(Section 5.5, 5.9-5.10)
These sections explain how central banks use the policy interest rate to influence inflation and how central banks are limited by the zero lower bound. Section 5.5 illustrates the policy dilemma faced during a negative supply shock and emphasizes the importance of central banks reacting swiftly and proportionately. Sections 5.9-5.10 explain how central banks use inflation targets to help anchor inflation expectations.
Key concept: Policy interest rate; Zero lower bound
Central banks adjust the policy interest rate (nominal interest rate) by ‘enough’ so that the real interest rate changes. One limitation of the policy interest rate is the zero lower bound: the nominal interest rate cannot be negative, but in a severe recession, a zero nominal interest rate is not low enough to boost aggregate demand. (Instructors should refer to the Fisher equation (Section 5.2) to explain the reasoning.)
https://www.ft.com/content/f0c755e8-cc0c-37ec-852c-ac3b789e88a3. Discussion question: Explain what the Term Funding Scheme is and why the Bank of England implemented it alongside a cut in interest rates.https://www.economist.com/special-report/2018/10/11/central-bankers-will-fight-the-next-recession-with-their-backs-against-the-wall). Questions: 1) Evaluate the costs and benefits of using quantitative easing (QE) during a recession. 2) What other policies might be more effective?https://www.economist.com/finance-and-economics/2019/09/12/the-ecb-cuts-interest-rates-and-restarts-quantitative-easing). Questions: 1) Define quantitative easing (QE) and explain why the ECB chose to adopt this policy. 2) Use the 3-diagram model to illustrate the potential effects of the ECB’s monetary policy. Do you think that the ECB’s policies would be more effective when done in conjunction with appropriate fiscal policies? (Note: The ECB had a slightly negative interest rate in 2014-2019: https://www.ecb.europa.eu/stats/policy_and_exchange_rates/key_ecb_interest_rates/html/index.en.html).Key concept: Inflation targeting; anchored inflation expectations
Central banks try to influence inflation expectations as well as inflation, and committing to an inflation target is one way to do so. There is no consensus on which target rate to pick, though most central bank targets are in the 2-3% range. Due to the zero lower bound, some economists argue that the inflation target should be higher (such as 4%). Figure 5.14 illustrates how anchored expectations reduce the cost (in terms of employment/aggregate demand) of getting inflation back to target after a negative supply shock, even if the central bank delays its policy response.
https://core-econ.org/the-economy/v1/book/text/15.html#154-inflation-and-unemployment-constraints-and-preferences)https://www.ft.com/content/34f7848e-39a7-11de-b82d-00144feabdc0. Questions: 1) Explain how monetary policy contributed to the 2008 global financial crisis. 2) What other measures should central banks target besides inflation, and why?https://www.ft.com/content/4b6276f8-df95-11df-bed9-00144feabdc0. Questions: 1) Discuss the advantages and disadvantages with establishing an inflation objective. 2) Explain how central banks communicate their commitment to an inflation target. (Find some examples of central bank communications and use these to support your answer.)https://www.economist.com/the-economist-explains/2015/09/13/why-the-fed-targets-2-inflation). Questions: Explain why the Fed has adopted an official inflation target. What are the consequences of choosing too high or too low of an inflation target?(Section 5.12-5.14)
These sections discuss the various channels through which monetary policy affects inflation and aggregate demand. Sections 5.12-5.13 cover the domestic channels: market interest rates, asset prices, expectations/confidence (summarized in Figure 5.20), and Section 5.14 covers the exchange rate channel (summarized in Figures 5.21-5.22).
Key concept: Asset prices and investment
Asset prices depend on interest rates -> another channel through which monetary policy affects the economy. Students should know the formula and intuition for the present value criterion (firms will only undertake projects with a positive net present value). The present value criterion explains why aggregate investment depends on the interest rate and expected future profits (first discussed in Section 3.12).
Key concept: Exchange rate
Central banks must account for how changes in the interest rate could influence the exchange rate. Students should know how to identify an exchange rate depreciation and appreciation, and the difference between the nominal exchange rate (market rate at which one currency is exchanged for another) and real exchange rate (relative price of foreign goods and services compared to those produced domestically). Students should also know the causal chain between interest rates, real exchange rate, and inflation/aggregate demand.
https://www.ft.com/content/90c0fb30-a988-11e5-955c-1e1d6de94879. Questions: 1) Use a flowchart diagram to analyse the effects of higher US interest rates on the eurozone. 2) The article was written in 2015; find appropriate data to illustrate the Federal Reserve’s actual monetary policy decisions since the article was published and its effects on the eurozone.https://www.economist.com/finance-and-economics/2019/06/22/low-interest-rates-and-sluggish-growth-may-lead-to-currency-wars). Questions: 1) Draw appropriate diagram(s) (e.g. flowcharts) to explain why other countries might object to the ECB’s monetary policy. 2) Discuss the role of politics in the choice of monetary policy. Why are currency wars more likely when GDP growth is low?(Section 5.3, 5.11, 5.15)
These sections use the 3-diagram model and empirical data to illustrate the fiscal and monetary policy responses to demand shocks and supply shocks. Section 5.11 discusses the monetary response to the Russia-Ukraine war, and Section 5.15 discusses the UK’s fiscal and monetary responses to supply shocks between 1950-2023.
Key concept: Demand vs supply shocks
These two types of shock have different policy implications. Demand shocks are ‘easier’ for policymakers to handle than a supply shock. For a demand shock, both fiscal and monetary policy point in the ‘same direction’ (Figures 5.4-5.5): any efforts to increase employment will also reduce inflation. For a supply shock, there is a policy dilemma: any efforts to lower inflation will also reduce aggregate demand.
https://coreecon.github.io/voici/render/inflation.html) – students use interactive simulations to learn how the central bank could react to an oil shock, and consider different scenarios according to the central bank’s priorities (inflation vs unemployment).https://www.economist.com/free-exchange/2012/08/14/feeling-a-drought). Questions: 1) Use the model in the unit to illustrate the effect of the supply shock discussed in the article. 2) Why is the author of the article concerned about the Fed’s policy response to this shock?Conceptual prerequisites:
Required Building blocks:
Building blocks in this unit:
(Section 6.1-6.2)
Section 6.1 introduces a question considered throughout this unit: how do you live if you don’t work? Through the lives of two people (Kwame in Ghana and Sophia in the US), this section explains how the financial sector, family, and the state can help people during times they are not working (childhood, unemployment, retirement). Section 6.2 introduces a simple economy without money or a financial sector, where individuals can enter bilateral debt contracts to consume and invest when they do not have an income. Balance sheets are used to illustrate the effects of borrowing and lending on an individual’s assets and liabilities.
Key concept: Balance sheet
A balance sheet summarizes the assets and liabilities of an entity at a particular point in time. The difference between a person’s assets and liabilities is their net worth, also known as their wealth. Students should be familiar with the balance sheet format presented in Figure 6.3.
https://www.economist.com/britain/2014/12/30/the-balance-sheet-boom). Questions: (1) Draw and explain household balance sheets to represent i) the years before the financial crisis, ii) the crisis years, iii) the years after the financial crisis. (2) How have household debt-to-income and the savings rate evolved from 2005-2015? (3) Find some more recent data on these variables and check if the article’s predictions about household debt were correct.https://www.ft.com/content/ba0da31c-0f61-11de-ba10-0000779fd2ac). Questions: (1) Based on the information in the article, draw a balance sheet to illustrate how household net worth changed. (2) Aside from house and asset prices, what could have affected households’ net worth after the 2007-09 financial crisis and recession?Key concept: Borrowing and lending
Students should know how to represent a bilateral loan contract in a balance sheet, for both the borrower and lender (Figure 6.3). Borrowing and lending does not change net worth (debt ‘cancels out’ when considering combined wealth) but can still benefit both parties.
https://www.oecd.org/en/topics/sub-issues/public-pensions.html) How might individuals in these countries plan differently for when they don’t work?https://www.ft.com/content/516d05e0-3de5-11e6-8716-a4a71e8140b0) and discuss the possible impact of higher interest rates.(Section 6.5)
This section explains the role money plays in modern economies (the three functions of money). It also explains the concepts of commodity money and bank money.
Key concept: Functions of money
Students should understand the three functions of money (means of exchange, store of value, unit of account).
Commodity money – In an economy without a well-developed banking system, people may use a particular commodity such as gold, as money. The commodity is typically a basic good that is widely valued, but can also act as a means of exchange, a store of value, and a unit of account.
Bank money – Deposits in commercial banks constitutes bank money. Exercise 6.5 uses bank balance sheets to show students how bank deposits functions as a means of exchange.
https://www.bbc.com/travel/article/20180502-the-tiny-island-with-human-sized-money). How did the Yap stones satisfy the three functions of money?https://www.ecb.europa.eu/stats/money_credit_banking/monetary_aggregates/html/index.en.html)(Section 6.3-6.4, 6.8, 6.12)
Commercial banks are the main financial intermediary covered in Unit 6. Section 6.3 introduces the role of financial intermediaries and the financial sector. Section 6.4 discusses bank balance sheets (Figure 6.8) and how banks make profits from charging interest on loans (Figure 6.9). Section 6.8 explains how commercial banks create money by lending, and the constraints banks face when lending (demand for loans, capital adequacy requirements, and reserve requirements).
Key concept: Commercial banks
Banks are capitalist firms that act as intermediaries between borrowers and lenders. Students should understand that banks face two types of risk: (1) When banks make loans, there is a risk of default, which they can mitigate by diversifying. Banks whose liabilities exceed their assets are insolvent. (2) Banks also face a liquidity risk, as their assets (loans to others) are illiquid while their liabilities (deposits) are liquid.
https://www.ft.com/content/7d15057c-d633-11e5-829b-8564e7528e54). Discuss: What is bank capital and why does it matter?https://www.ft.com/content/2719da9c-9560-11dd-aedd-000077b07658) Questions: Explain why, as mentioned in the article, banks were less willing to lend to each other during the financial crisis. Why did the interbank lending rate increase above the policy rate?https://www.economist.com/special-report/2019/05/02/the-banking-revolution-is-great-for-customers). Questions: (1) Discuss the benefits and potential problems of non-bank firms that offer financial services. (2) Discuss the similarities and differences between ‘traditional’ high-street banks and their newer competitors.https://www.economist.com/finance-and-economics/2018/09/20/the-fed-stalls-the-creation-of-a-bank-with-a-novel-business-model). Questions: (1) Explain how a narrow bank’s balance sheet differs from that of a traditional bank. (2) What are the potential advantages and disadvantages of the Narrow Bank’s business model? (3) Explain whether or not you agree with the Narrow Bank’s legal complaint. Do you think that narrow banks should be given the same rights to operate as traditional banks?https://www.law.uw.edu/news-events/news/2023/svb-collapse; Bank of England explainer: https://www.bankofengland.co.uk/explainers/what-happened-to-silicon-valley-bank-uk)https://getpenfold.com/pension-guides/what-is-a-pension-fund; https://corporatefinanceinstitute.com/resources/career-map/sell-side/capital-markets/pension-fund.) (Note that the details of workplace pension schemes and pension funds may vary across countries.)Key concept: Money creation by lending
Students should understand how banks create bank deposits (and therefore money) when they make loans (Figures 6.12a and 6.12b). Students should also know the three constraints on the amount of loans banks will make (and therefore, on the amount of money they create): demand for loans (influenced by the interest rate), capital adequacy requirements, and reserve requirements.
https://www.ft.com/content/e336ea7e-0d33-11e5-a83a-00144feabdc0). Discuss: How does traditional economic theory underestimate the importance of banks’ money creation role?(Sections 6.6-6.7)
The model of banking in Sections 6.1-6.5 relied on commodity money and bank money. Section 6.6 introduces base money (reserves plus currency), which is managed by the central bank. Section 6.7 explains the central bank’s balance sheet and the relationship between the central bank, government debt, and monetary policy (managing inflation and quantitative easing).
Key concept: The central bank’s role
The central bank supplies two forms of base money: currency (notes and coins) and reserves, which are the deposits commercial banks have in their accounts at the central bank. The central bank is also responsible for monetary policy (discussed in Units 4-5); Section 6.7 explains quantitative easing in more detail. Students should be able to identify the central bank’s assets and liabilities (Figure 6.10) and explain why these liabilities are a form of government debt.
https://www.economist.com/finance-and-economics/2018/05/26/central-banks-should-consider-offering-accounts-to-everyone). Questions: (1) Explain why individual central-bank accounts could benefit consumers and policymakers. What factors need to be accounted for when implementing this proposal? (2) Analyse the costs and benefits of individual central bank accounts, and explain whether or not you think it is a good idea.https://www.rba.gov.au/education/resources/explainers/cryptocurrencies.html)) How do these two digital currencies differ? Can cryptocurrencies replace traditional forms of money? Why/why not?(Sections 6.9-6.11)
Financial markets are a key element of the financial sector. Section 6.9 explains the role that financial markets play in the wider economy: Figure 6.13 shows how both banks and financial markets enable households to channel their savings into different forms of productive capital. Section 6.10 discusses how businesses make investments, while Section 6.11 discusses household investment decisions.
Key concept: Leverage
Leverage (or gearing) refers to the process of increasing investments or asset purchases by borrowing. Students should be aware that leverage can be defined in various ways, but CORE uses the proportion of the investment financed by borrowing (the leverage ratio is the ratio of debt to assets). Figures 6.14a and 6.14b illustrate the benefits and downsides of leverage.
Key concept: Capital gain
If the market value of an asset increases, the owner of an asset receives a capital gain equal to the difference between the current and previous market prices. Students should know this formula: rate of return (%) = capital gain or loss (%) + income (%). Students should also understand the trade-off between risk and return (Figure 6.18 shows this relationship empirically).
https://www.core-econ.org/espp/book/text/10.html#108-the-value-of-an-asset-expected-return-and-risk (Students who have learned Unit 3 of the microeconomics volume will be familiar with the general framework.)Key concept: Collateral and inequalities in asset ownership
Students should understand the role collateral plays in loans and why asset ownership is so unequal across quartiles of household net worth (Figure 6.16). Section 9.9 of the microeconomics volume explains the role of collateral in alleviating credit constraints.
https://www.ft.com/content/3d260e6c-956b-11e3-8371-00144feab7de). Discuss: Many small businesses were excluded from credit markets after the financial crisis. What was the impact of the credit crunch on inequality?https://www.fca.org.uk/publication/research/financing-inequality.pdf. For each source of inequality, ask students to think of ways to address the underlying issue.https://www.economist.com/special-report/2015/05/07/from-the-people-for-the-people) Questions: (1) Discuss the role of information in loan provision, and the potential issues with collecting data for credit-scoring. (2) Compare and contrast peer-to-peer lending and traditional bank lending. (3) What kind of regulation do you think should apply to peer-to-peer lending?https://www.economist.com/finance-and-economics/2019/10/10/a-group-of-fintech-firms-are-changing-the-way-consumers-borrow) Questions: (1) Compare and contrast fintech firm loans and credit card loans. How might these new loans help/worsen inequality? 2) To what extent is there a conflict of interest between lenders and borrowers in the fintech firm loans mentioned in the article?Conceptual prerequisites:
Required Building blocks:
Building blocks in this unit:
Unit overview: Unit 7 will be very useful for students / instructors who want to go beyond the model of monetary policy introduced in unit 5 where a country has an independent central bank that sets a credible inflation target, as well as a flexible exchange rate. It can be used in different ways depending on the context and goals of the class.
For instructors in countries with a fixed exchange rate, such as members of a common currency area:
Sections 1 and 2 provide an important introduction.
Section 4 focuses specifically on countries with a fixed exchange rate, and in particular those within a common currency area. It uses the multiplier and PC models to demonstrate how an aggregate demand shock effects competitiveness and the fact that the individual country cannot use monetary policy in response to the shock. It also discusses long-run competitiveness and inflation outcomes as well as reasons for joining a common currency area. Key points are illustrated by data on Spain and Germany.
Section 6 describes exchange rate regimes in practice and provides data on how common these regimes are. Instructors could highlight which regime the country they are teaching in belongs to.
Section 7 is quite important for FIX economies because it discusses how fixed exchange rate regimes are generally effective in pinning down inflation as well as caveats that indicate fixing exchange rates is not the only or possibly not the optimal way to do so, depending on the institutional context.
Sections 8 through 9 examine how different monetary / exchange rate regimes work within global financial markets focusing on the ‘uncovered interest parity’ condition. They are especially relevant for countries which have a fixed exchange rate and their own currency (and no capital controls) as they show that although governments have power to set the nominal policy interest rate, when exchange rates are truly fixed, markets rather than the policymaker determine interest rates, as the foreign and domestic policy rates must be equal.
Section 10 is more relevant for countries that experience high inflation. Section 11 concludes by illustrating the close negative relationship between institutional quality and inflation rates.
For instructors in countries with a flexible exchange rate, where there is no credible inflation target / where the central bank is not independent:
Sections 1 and 2 provide an important introduction.
Section 3 focuses specifically on countries with a FlexNIT system – a flexible exchange rate but no credible inflation target set by an independent central bank.
Section 6 describes exchange rate regimes in practice and section 7 highlights that FlexNIT countries often have high inflation.
Section 8 and 9 serve to explain how exchange rate regimes interact with global financial markets, and introduce the ‘uncovered interest parity’ condition. Though the implications for FlexNIT regimes are mentioned, section 9 focuses more on FlexIT and FIX regimes.
The issue of high inflation outcomes in FlexNIT countries is examined in sections 10 and 11, which discuss the roles of debt and monetary finance as well as governance quality. These sections are especially relevant for FlexNIT economies and can be understood even if sections 8 and 9 are not covered in detail. Section 11 provides data on the relationship between inflation and governance quality.
For instructors who want to teach the whole unit, as part of one of the following courses: introduction to macroeconomics, international finance, or economic development.
This unit includes material that is more challenging and would work well in upper-division elective classes, however, it would also work well in a first-year class as it builds on the framework established in unit 1 through 6. It provides students with an extension to unit 5 that explains how monetary policy is implemented in a variety of countries worldwide. There is extensive use of real-world data and case studies (e.g. Spain and Argentina) which help to make the material relatable and engaging for students at various levels.
Key concept: Section 1 describes what it is like to live with high inflation in Argentina and shows that various countries have seen extremely high rates of inflation
https://www.worldbank.org/en/research/brief/inflation-database Inflation data are available for download in excel and stata and the database is updated twice per year.Key concept: Section 2 introduces several important cornerstones of this unit and it is important to spend enough time on it to lay the foundation for the rest of the unit
– fixed and flexible exchange rates
– the three monetary / exchange rate regimes (FlexIT, FlexNIT and FIX)
– A section which models an aggregate demand shock in a FlexIT economy using the Phillips curve and multiplier models from unit 5. This is the benchmark against which the other two regimes are compared
Key concept: Section 3 discusses the FlexNIT regime
a country without a credible inflation target, and where the exchange rate is flexible.
This section describes a process by which the policymaker, in trying to hold unemployment below the supply-side equilibrium, allows a spiral of high inflation and rapid exchange rate depreciations to take hold. This section introduces the rate of exchange rate depreciation (discussed further in the extension to this section) and the implications for competitiveness. The PC and Multiplier models are used to illustrate how rapid increases in inflation can take hold under this regime.
https://manifold.bfi.uchicago.edu/projects/monetary-fiscal-history-latin-america-1960-2017 Instructors could apply the data on Argentina to further illustrate the model presented in this section, or this could be set for students as an exercise.Key concept: Section 4 discusses the FIX regime, and more specifically, countries within a common currency area.
The PC and Multiplier models are used to illustrate the effects of a positive AD shock that affects only one member country.
The determinants of long-run inflation are discussed as well as the reasons for joining a monetary union.
The data focuses on Spain, in comparison to Germany
https://www.iz.sk/en/projects/EU-indicators/hicp-inflation-rate and https://www.iz.sk/inflationhttps://www.iz.sk/inflationKey concept: Section 5 is a short section that summarizes the early parts of the unit. This will be especially useful for instructors who want to compare the different approaches.
Key concept: Section 6 provides a description of exchange rate regimes as they are practiced, including ‘Dollarization’ and ‘euro-ization’, as well as ‘Managed’, ‘target’, and ‘shadow’ exchange rate regimes
This section also provides data about the share of population living under different exchange rate regimes
Key concept: Section 7 provides data on the relationship between the exchange rate and inflation across a large number of countries, spanning all the monetary regimes described in the previous section.
Countries that have experienced very little exchange rate depreciation relative to the $US have also enjoyed low inflation rates. However, using case studies of Spain and Argentina, this section argues that fixing the exchange rate is not a silver bullet for dealing with inflation.
Key concept: Section 8 explains the constraints that policymakers in different regimes face in terms of setting policy interest rates. To do it, it moves away from the policymaker’s perspective and examines the world from the viewpoint of a global investor.
Key assumption: No capital controls
Key concept: This section provides a relatively straightforward introduction to the principle of uncovered interest parity. This is based on the relationship of ‘equal expected returns’ and the argument that trading in financial markets will always ensure that this relationship holds. The extension to this section provides further algebra as well as data on whether the UIP condition holds in practice.
Key concept: Section 9 demonstrates that in a flexible exchange rate regime, the policymaker sets the policy interest rate, and the exchange rate is set in the market. In the long-run, the real interest rate is set in the market. On the other hand, in a fixed exchange rate regime, the policymaker fixes the exchange rate, and the market determines the interest rate. This section focuses on FlexIT and FIX regimes and the following section focuses on FlexNIT regimes.
https://www.bbc.com/news/business-34178247Key concept: Section 10
this section describes how FlexNIT countries often have high deficits and use monetary finance combined with high inflation to finance them. Mechanisms leading to hyperinflation are described.
“Tying ones hands” – in a FlexIT country, the interest rate is used by an independent central bank to control inflation, thus it cannot be used by government to lower borrowing costs.
In a FIX regime, the government sets the exchange rate and interest rates are determined in the market, thus the government cannot manipulate interest rates in order to bring down borrowing costs.
In a FlexNIT regime, no such constraints exist. The government can set the nominal interest rate, and can achieve negative real interest rates by financing expenditure through monetary financing (expanding the money supply) and allowing high inflation. This allows the government to have persistent, large deficits, even when they find it difficult to borrow in international markets. Possible motivations for doing this are discussed. In general, this could benefit the government but make life extremely difficult for the citizens of that country.
Key concept: Section 11 demonstrates that countries with high inflation rates are often also those with poor scores on the World Bank’s measures of governance quality. We have seen that in both FlexIT and FIX regimes, the hands of the government are tied in some way. Countries with higher quality governance may have the institutional context which makes it possible to tie the hands of the government, in this sense.
Conceptual prerequisites:
Required Building blocks:
Building blocks in this unit:
(Section 8.1-8.3)
Section 8.1 introduces the theme of out-of-equilibrium dynamics. Section 8.2 covers key concepts related to dynamics (stability of equilibria and feedback processes). Section 8.3 applies these concepts to poverty traps by discussing a field experiment by Balboni et al. (2022) where villagers in Bangladesh were randomly selected to receive a major asset.
Key concept: Stable/unstable equilibrium
Students should be able to distinguish between stable and unstable equilibria. For stable equilibria, there is a tendency for the equilibrium to be restored after it is disturbed by a small shock. For unstable equilibria, if a shock disturbs the equilibrium, there is a subsequent tendency to move even further away from the equilibrium. The ‘ball on a hill’ analogy (Figure 8.3) can be a helpful visual representation.
Tipping point: A tipping point is an unstable equilibrium at the boundary between two regions characterized by distinct movements in some variable.
Positive/negative feedback: A negative feedback process counteracts (pushes back against) movement away from equilibrium. Positive feedback processes amplify (reinforce) a movement away from equilibrium. Students commonly confuse the direction of movement (larger/smaller horizontal axis value) with positive/negative feedback, respectively. Instructors should emphasise that the word positive/negative relates to the original equilibrium (movement away/towards, respectively).
(Section 8.4-8.6)
Section 8.4 introduces the concept of asset price bubbles, using data from the US housing market before the 2007-09 financial crisis. Sections 8.5 and 8.6 use a two-dimensional diagram with a price dynamics curve to model out-of-equilibrium behaviour. This diagram is a simple representation of a discrete-time dynamic system. This model is applied to asset price bubbles (but is more general and will be applied to environmental processes and green technology adoption later in the unit). Disequilibrium is modelled initially as an exogenous change which shifts the supply or demand curves. The focus is then on endogenous changes within the model which restore or move the economy back towards equilibrium.
Key concept: Asset price bubble
An asset price bubble is a sustained and significant rise in the price of an asset, fuelled by expectations of future price increases. Students should know what features of assets make them subject to bubbles (such as resale value/speculation).
https://www.ft.com/content/cb405410-a40f-3421-858e-1ba3be193e3d. Which view discussed in the article seems best descriptive of financial markets over the past decades? (Note: The article was written in 2013; instructors can ask students to find more recent data to answer this question. What (if anything) has changed since the article was written?)https://www.economist.com/finance-and-economics/2019/03/23/why-book-value-has-lost-its-meaning. Questions: With reference to the article, explain the distinction between the price of an asset and its value. Discuss the limitations of using price to measure the value of an asset. Why is measuring the value of an asset so difficult?https://www.economist.com/christmas-specials/2018/12/18/the-great-texas-emu-bubble. Questions: Explain why there was a bubble in the market for emus in Texas, and why the bubble popped. What lessons for policymaking can we learn from this example?https://www.economist.com/finance-and-economics/2019/08/22/the-onset-of-a-downturn-is-as-much-a-matter-of-mood-as-of-money. Questions: To what extent are recessions caused by changes in public sentiment rather than other shocks? Discuss the role of ‘animal spirits’ in the business cycle.Key concept: Price dynamics curve (PDC); multiple equilibria
The price dynamics curve shows the relationship between the price in the current period and the price in the next period. Points where the PDC intersects the 45-degree line are equilibria, and the slope of the PDC at that point determines whether the equilibrium is stable (<45 degrees) or unstable (>45 degrees). Students should be familiar with the S-shaped price dynamics curve (which is used in other applications later in the unit), and how to distinguish between movements along the PDC (changes in price due to shifts in demand/supply) vs movement of the whole PDC (changes in beliefs for reasons other than a change in the price itself). Figures 8.14-8.16 illustrate these concepts and show how shifts in the PDC can affect the number of equilibria.
(Section 8.7-8.8)
Section 8.7 explains a mechanism that contributed to the US housing price boom in the early 2000s (the financial accelerator) and its effect on aggregate consumption and output. Section 8.8 discusses the unequal effects of the 2007-09 financial crisis on households depending on their wealth levels.
Key concept: Housing price bubble, financial accelerator
The financial accelerator refers to mechanism through which firms’ and households’ ability to borrow increases when the value of the collateral they have pledged to the lender (often a bank) goes up. Instructors can refer to the aggregate demand model in Unit 3 to explain household behaviour when housing prices rise and fall, referring to the concepts of consumption smoothing, target wealth, and precautionary saving.
https://www.ft.com/content/4c6731ae-5fca-11dc-b0fe-0000779fd2ac How did the securitisation of mortgage debt affect financial stability when house prices fell in 2007?https://www.economist.com/graphic-detail/2019/06/29/for-now-residential-property-prices-are-likely-to-keep-rising. Questions: Choose two countries mentioned in the article and explain where you think they are on the price-dynamics curve in Q1 2019. This article was written in 2019; discuss the effects of major economic events since then (such as the COVID-19 pandemic) on the price dynamics curve and housing prices. Why is it so important for policymakers to monitor trends in housing prices?https://wid.world) may be a useful data source.)(Section 8.9-8.10)
Section 8.9 discusses the role of banks in the 2007-09 financial crisis, and why the banking system is unstable. Section 8.10 outlines the incentive problem (moral hazard due to being ‘too big to fail’) and the regulations implemented after the financial crisis to address the financial system’s instability.
Key concept: External effects; Moral hazard
As discussed in Unit 6, leverage is critical to how banks make profits. Figure 8.21 shows how leveraged banks were before the financial crisis, due to misaligned incentives: banks took on excessive risks because they knew the government would bail them out (moral hazard). The banks’ decisions had external effects on the rest of the economy (Figure 8.24 provides a useful summary).
https://www.core-econ.org/espp/book/text/10.html#1014-banking-markets-and-morals).Key concept: Policies to address financial system instability
Students should be able to identify post-crisis policies that were implemented (restrictions on leverage, resolution regimes) and explain why these policies help prevent similar crises from happening in the future.
https://www.core-econ.org/insights/too-big-to-fail/text/01.html)https://www.ft.com/content/4b84d45e-8bec-11e7-9084-d0c17942ba93. What lessons did policymakers learn from the financial crisis and what policies could they implement as a result?https://www.economist.com/finance-and-economics/2010/07/22/agents-of-change. Questions: With reference to the article, explain the challenges with getting accurate predictions about the economy. Explain how economists’ approach to modelling the economy have changed since the financial crisis.https://www.economist.com/finance-and-economics/2017/12/16/a-decade-after-it-hit-what-was-learnt-from-the-great-recession. Questions: Compare and contrast the effectiveness of the policies adopted by the US during the 1930s Great Depression and the 2008 Great Recession. To what extent was the policy response to the Great Recession not ‘dramatic’ enough?https://www.core-econ.org/doing-economics/book/text/10-01.html) uses World Bank’s Global Financial Development Database to compare stability of financial institutions before and after the 2007-09 financial crisis.(Section 8.11-8.13)
The same S-shaped dynamics curve model from Sections 8.5-8.6 is now applied to two types of environmental tipping points. The first type is ‘negative’, referring to environmental collapse (Arctic sea ice; Section 8.11). The second type is ‘positive’, referring to green technology adoption (electric vehicles; Section 8.13). Section 8.12 discusses policies that are suitable for addressing environmental tipping points.
Key concept: Environmental dynamics curve; Adoption dynamics curve
The environmental dynamics curve shows how an environmental variable changes from period to period, whereas the adoption dynamics curve shows how the number of electric vehicle users changes from period to period. Unlike the housing prices model, the equilibria in both models can be labelled as ‘good’ or ‘bad’.
https://report-2023.global-tipping-points.org/resources/https://www.core-econ.org/experiencing-economics/instructors/book/text/07.htmlKey concept: Environmental tipping points; Prudential policies
The ‘middle equilibrium’ in the S-shaped dynamics curve diagram is the tipping point. For environmental processes, there is some uncertainty over where this tipping point is. Prudential policies place a very high value on reducing the likelihood of a disastrous outcome, even if this is costly in terms of other objectives foregone. Such an approach is often advocated where there is fundamental uncertainty about the conditions under which a disastrous outcome would occur. Students should understand the difference between risk and uncertainty, and why prudential policies are important in the latter case.
https://youtu.be/2dIaGkFo2G0; https://youtu.be/QFp_R9ZXPs0https://youtu.be/A8aOfrvc43khttps://www.economist.com/briefing/2019/08/01/the-amazon-is-approaching-an-irreversible-tipping-point. Questions: Use the tipping point model in the unit to explain the potential effects of Amazon rainforest deforestation. Where on the environmental dynamics curve do you think we currently are? Use the concept of external effects to explain the issues surrounding the deforestation of the Amazon rainforest.https://doi.org/10.1080/1350178X.2022.2040740. Discuss: What are the problems with the current models (Integrated Assessment Models), and alternative approaches do the authors recommend?Conceptual prerequisites:
Optional Building blocks:
Building blocks in this unit:
(Sections 9.1 – 9.2)
This unit starts by describing rapid economic growth in China, and then by discussing how we measure economic growth, introducing the concepts of ratio scales, CAGR and the rule of 70.
Key concept: Economic growth
This unit introduces various concepts related to economic growth and development. Instructors could start with a game that touches on some of these concepts.
https://journalofeconomicsteaching.org/devsim-a-powerpoint-based-choose-your-own-adventure-game-for-teaching-economic-development-fabianhttps://upgrader.gapminder.org.Key concept: Economic development
This unit focuses on economic growth and does not examine in detail the question of growth vs economic development. However, the text does examine the limitations of GDP as a measure of well-being in Micro Unit 1 Extension 1.2
https://books.core-econ.org/doing-economics/book/text/04-01.html As an extension to this project, students could focus on an interesting pair of countries (similar to Section 9 on Botswana and Tanzania and section 10 on Bangladesh and Pakistan).https://books.core-econ.org/doing-economics/book/text/0-3-contents.html) and Project 9 on Credit Excluded Households in a Developing Country (i.e. Ethiopia) (https://books.core-econ.org/doing-economics/book/text/09-01.html) are also both relevant to the contents of this unitKey concept: Economic development in China
China is provided here as an interesting and important case study of rapid transformation. The later parts of the unit do not discuss China’s development in detail, because it is a bit exceptional. However, the following section (on growth rates, CAGR and the rule of 70) uses data for China, and can be taught together with the hook section as a single introduction.
https://www.gapminder.org/tools/#$chart-type=bubbles&url=v2) and see how China has caught up with and overtaken many other countries. The dip in incomes and especially life expectancy that occurred during the Great Leap Forward (1958 – 1962) is also clearly visible in this animation.Key concept: Measuring Economic growth
this section introduces ratio scales, Compound annual growth rates (CAGR), and the rule of 70. It does not require students to know what logarithms are.
https://unstats.un.org/unsd/snaama/downloads(Sections 9.3 – 9.5)
These sections examine the role that capital accumulation and investment, as well as technological progress, play in economic growth, using theory and data.
Key concept: Production functions
Section 9.3 discusses production functions. This concept can be understood without any background knowledge, but if instructors want to extend the discussion, students may find the earlier material on production functions helpful, especially Micro section 1.6, as well as 2.4 (including the extension) and possibly extension 5.4.
https://books.core-econ.org/the-economy/microeconomics/02-technology-incentives-04-firms-technology-production.html#figure-e2-1a A full set of similar graphs can be found here: https://www2.hawaii.edu/~fuleky/anatomy/anatomy.html The most relevant graph that matches up with Figure 9.4 is the middle graph in the “constant returns” section. In this case, we are holding labour constant and changing capital (in Figure 9.4 this is expressed in per capita terms).Key concept: Labour productivity (Y/N), total factor productivity (z), capital intensity (K/N), average product of capital (APK)
Students should become comfortable with these concepts, linking them all back to the production function.
https://books.core-econ.org/insights/government-debt-and-wealth/00-highlights.htmlKey concept: Accounting for growth
Section 4 explains how growth can be decomposed into three components (capital, labour and everything else). Work through the tables and graphs so that students can see how they fit together.
Key concept: Investment and saving
This section again uses both theory and data to describe the role of investment in economic growth. Be sure that students are connecting the theory with the real-world evidence provided.
(Sections 9.6 – 9.7)
This section discusses education, infrastructure and co-ordination failures as barriers to growth, and describes the important role of institutions, both in terms of economic systems (planned vs capitalist economies) as well as the quality of economic institutions.
Key concept: Infrastructure and Education
ideally instructors could supplement this section to draw on examples that are relevant to your country (or which your students would be interested in)
https://energyforgrowth.org/article/how-does-energy-impact-economic-growth-an-overview-of-the-evidencehttps://www.gapminder.org/tools/#$model$markers$line$encoding$y$data$concept=primary_completion_rate_total_percent_of_relevant_age_group&source=sg&space@=geo&=time;;&scale$type:null&domain:null&zoomed:null;;;;;;&chart-type=linechart&url=v2https://www.dw.com/en/poverty-keeps-countless-nigerian-children-out-of-school/video-70275327Key concept: Co-ordination failures
Section 9.6 discusses a specific example of coordination failure where a vicious cycle perpetuates low demand for electricity and skilled workers and low investment in the modern sector.
https://books.core-econ.org/experiencing-economics/instructors-preview/book/text/02.htmlhttps://www.bbc.com/worklife/article/20180417-a-thrilling-mission-to-get-the-swedish-to-change-overnight). This 1.30-minute video explains how history influenced the side of the road that countries drive on[https://www.businessinsider.com/uk-china-countries-drive-left-side-road-traffic-ancient-rome-sword-fight-2016-12?r=US&IR=T]https://www.clevelandfed.org/publications/economic-commentary/2007/ec-20071101-coordination-failures-in-the-labour-marketKey concept: Institutions
Section 9.7 first describes how planned economies fared after transitioning to a new economic system, highlighting differences between economies that were more or less industrialized when they implemented a planned system. Secondly, the section discusses research on institutional quality, highlighting the legacies of colonialism in settler and extractive colonies.
(Section 9.8)
This section introduces a model of economic growth which helps explain both low growth traps as well as dynamic economic growth. It is related to the multiple equilibria models in unit 8 but does not use an S-curve. The growth accounting equation from section 4 is used again here with the same definitions for technological progress and growth rates of capital and labour.
Key concept: Exogenous vs endogenous growth
Students should understand what is meant by exogenous and endogenous growth. In this model, exogenous growth occurs through learning by doing and from others. Endogenous growth occurs through investment (according to a simple investment rule).
(Sections 9.9 – 9.12)
Section 9 is a case study of Botswana and Tanzania and applies the growth dynamics model from section 8. Section 10 is a case study of Bangladesh and Pakistan. Section 11 examines the global income distribution. Section 12 explored environmental sustainability and asks what would be required to transition to green energy sources such that economic growth can be de-coupled from carbon emissions.
Key concept: Country case studies
examining two pairs of countries which are similar in some ways but have seen very different growth trajectories.
Key concept: Global income distribution
rather than comparing average income between countries, this section looks at the global income distribution, with data from 1950 on the 10th to the 90th percentile. This data is very rich and contains a lot of insights within in. The text helps contextualize this data.
https://www.gapminder.org/tools/#$model$markers$mountain$data$filter$dimensions$geo$/$or@$geo$/$in@=africa&=americas&=asia&=europe&=gha&=rwa&=deu&=ind&=usa;;;;;;;;&encoding$color$data$constant=_default;&scale$type:null&domain:null&zoomed:null;;;;&billy$encoding$selected$data$;;;;;;&chart-type=mountain&url=v2Key concept: Sustainable economic growth
students should be able to differentiate between the idea of “degrowth” and the approach of “green growth”. This section discusses what would be involved in an energy transition whereby economic growth is decoupled from harmful emissions of carbon. The potential roles of relative prices, taxation, regulation, institutions and social movements are discussed.
Conceptual prerequisites:
Required Building blocks:
Building blocks in this unit:
(Section 10.2)
This section explains the characteristics of the government and its role in society. Students who have studied the microeconomics volume will be familiar with the government’s role in addressing market failures (Unit 10), and with the concepts of Pareto efficiency and fairness for evaluating outcomes (Units 4 and 5). Instructors can refer to Sections 4.5, 5.3, and 5.12 of The Economy: Microeconomics for an overview of these concepts.
Key concept: Government
Students should understand the difference between the government and private economic actors (the government has coercive power, authority to collect taxes, and obligations to advance and protect civil/human rights e.g. providing public goods and merit goods). Section 10.2 outlines four ways for governments to pursue their objectives: incentives, regulation, persuasion/information, public provision.
https://obr.uk/forecasts-in-depth/brief-guides-and-explainers/public-finances/). Identify the purpose of each spending category listed in the budget (e.g. national defense = public good provision). Instructors can ask students to compare across countries – for example, what are the 3 largest spending categories? (Instructors can refer to Figure 12.10 of Economy, Society, and Public Policy for examples of spending categories and cross-country comparisons: https://books.core-econ.org/espp/book/text/12.html#127-spending-by-democratic-governments-priorities-of-a-nation)https://www.ft.com/content/e6b9fd0e-593c-11df-adc3-00144feab49a) about how the financial crisis changed consensus in the US on the role of the government as an economic actor. Instructors can ask students to compare the article’s findings with those in other countries or events (such as after the COVID-19 pandemic).https://www.economist.com/open-future/2019/05/09/the-role-of-the-state-in-creating-economic-value). Questions: How do Mariana Mazzucato’s ideas challenge conventional views about the role of government and public policy? To what extent do you agree with Mariana Mazzucato’s ideas about the role of government?(Section 10.3-10.6)
Section 10.3 describes the key characteristics of democracy. Section 10.4 covers the median voter model, which outlines conditions under which the Nash equilibrium of both parties (in a two-party system) is to offer very similar, ‘middle-of-the-road’ political platforms. Section 10.5 presents data showing the advance of democracy and its recent stalling (Figure 10.7). Section 10.6 shows descriptive data on the correlation between democracy and policy outcomes (inequality, working hours, size of government).
Key concept: Political institution
These are the ‘rules of the game’ that determine who has power and how it is exercised in a society.
Democracy: A type of political institution with three characteristics – rule of law, civil liberties, and elections that are inclusive, decisive, and fair). Instructors should emphasise that democracy is a spectrum; for example, many countries have historically had elections that were only open to select groups in society. There are also many varieties of democracy, as each country has different electoral systems and voting rules.
https://freedomhouse.org/country/scores) – Ask students to explore: What criteria does the Freedom House use to construct these measures, and how does your country rank? Pick a country – which aspects of democracy does it do well/not so well in?https://www.economist.com/the-americas/1997/10/23/the-varieties-of-democracy) Questions: For each of the Latin American countries mentioned in the article, how closely does their electoral system correspond to the definition of democracy used in the unit (3 criteria)? Instructors can ask students to find recent information about the countries mentioned to determine the extent to which the political situation has changed since the article was written (1997).https://www.ft.com/content/354d2e78-f419-11db-88aa-000b5df10621). Instructors can ask students to find more recent examples to support/refute the arguments in the article.https://www.ft.com/content/43ea5f04-5d4c-11e6-bb77-a121aa8abd95) about how the advance of democracy has arguably stagnated in the 21st century. Instructors could ask students to find more recent examples (after 2016) to support or refute the article’s arguments.https://www.economist.com/international/2015/11/26/the-road-less-travelled). Questions: To what extent are the case studies in the article consistent with the model in the unit? Based on the case studies discussed in the article, what factors contribute to a successful transition from dictatorship to democracy?https://www.economist.com/finance-and-economics/2019/06/13/how-compatible-are-democracy-and-capitalism) about the historical relationship between capitalism and democracy, and whether this relationship is likely to continue. Questions: To what extent is the relationship between capitalism and democracy stable? What factors determine the stability of the relationship between capitalism and democracy?https://www.economist.com/finance-and-economics/2018/07/21/as-inequality-grows-so-does-the-political-influence-of-the-rich), which discusses research findings on the relationship between democracy and inequality. Questions: To what extent are economic outcomes in the US driven by special interests? (Students can make comparisons with other countries.) Explain how inequality can affect the democratic system and policies chosen by a country.https://www.economist.com/free-exchange/2013/03/27/autocracy-or-democracy) about the relationship between political regime and economic growth in East Asian countries. Questions: From the information in the article, what lessons can we learn about the types of political systems that help economic growth? Discuss the role of political systems in helping economic growth. Why is it difficult to make broad statements about the type of political system countries should adopt?Key concept: Median voter model
This model aims to explain the policies that political parties adopt when competing in democratic elections. Students should be able to explain what happens to the Nash equilibrium when the model’s assumptions are relaxed.
https://www.economist.com/special-report/2018/07/12/should-the-party-move-to-the-left-or-to-the-centre), which analyses the policy platforms chosen by the Democrat party in recent US elections (up to 2018). Questions: How well does the basic median voter model represent the situation that political parties in the US face? Discuss the challenges that political parties face with determining what voters actually want.https://www.ft.com/content/1188eefe-dd0a-11e4-975c-00144feab7de), which discusses Hotelling’s model on spatial competition, and how it maps (imperfectly) to democratic politics.https://www.economist.com/international/2017/02/04/millennials-across-the-rich-world-are-failing-to-vote) – Instructors could ask students to find more recent data to determine whether this trend still holds after the article’s publication year (2017). Questions: Use the median voter model to analyse the consequences of millennials choosing not to vote. What are the main reasons why young people choose not to vote, and how could they be encouraged to vote? (Instructors can also have a quick poll in lecture asking students whether they vote or not, and have a think-pair-share discussion on the reasons why/why not.)(Section 10.7-10.10)
These sections introduce a model of political rent-seeking that uses the same constrained choice framework as that of the price-setting firm in Unit 7 of the microeconomics volume.
Key concept: Political rent
The ‘reward for being in power’. Political rent is the difference between the net benefit (monetary or otherwise) that an individual receives as a result of their political position, and the net benefit from their next best alternative (what they would receive in the absence of a privileged political position).
Political rent-seeking model (isorents, duration curves): Figure 10.13 summarises the model. Students should understand how political competition changes the slope of the duration curve and the political elite’s preferred choice. If students have studied Unit 7 of the microeconomics volume, instructors can draw analogies to the price-setting firm’s decision (isorents and isoprofits, duration curves and demand curves). Figure 10.18 outlines the parallels between political competition and economic competition. If students have studied Unit 3 of the microeconomics volume, instructors can use the concepts of income and substitution effects to analyse the impact of changes in the duration curve.
https://www.ft.com/content/5fe10fea-cd13-11e7-b781-794ce08b24dc), which discusses how a monopoly government without accountability can inflict severe damage to the economy.https://www.economist.com/finance-and-economics/2018/10/04/bought-and-paid-for) about how the close relationships between business and politics can be harmful for market competition. Questions: Use the model in the unit to illustrate the potential consequences of lobbying on the political system. Discuss the consequences of strong links between firms and politicians.(Section 10.11-10.14)
These sections outline various reasons why governments may fail to address societal problems. Sections 10.11-10.12 describe three different concepts of feasibility (economic, political, administrative) that must be satisfied for policies to be implemented and have the intended effect. Section 10.13 explains the conflicts of interest arising from the principal-agent relationship between citizens and elected leaders. Section 10.14 concludes the unit with some examples of government successes (climate change, inequality, education).
Key concept: Economic feasibility; Political feasibility; Administrative feasibility
Students should know the difference between these concepts. Economically feasible (policy must work – be economically sound and a Nash equilibrium); politically feasible (people in power must want the policy to be implemented – no lobbying by special interests); administratively feasible (government must have the capacity to implement the policy).
https://books.core-econ.org/espp/book/text/12.html#how-economists-learn-from-data-administrative-infeasibility-an-application-from-nigeria) discusses the findings of this paper: Imran Rasul and Daniel Rogger. 2016. ‘Management of bureaucrats and public service delivery: Evidence from the Nigerian civil service’. The Economic Journal 128 (608): pp. 413–46.https://tinyco.re/15357399https://tinyco.re/3513621https://www.ft.com/content/dbb420c0-3069-11df-bc4a-00144feabdc0) about special interests in the US. Instructors may want to supplement this discussion with recent examples for the US or other countries.https://www.economist.com/europe/2012/08/25/the-boat-tax-war). Questions: Evaluate the effectiveness of Italy’s boat tax policy. What policy might be more effective in raising tax revenue? Discuss the unintended consequences of Italy’s boat tax policy. What constraints does the government face with implementing this tax policy?https://books.core-econ.org/doing-economics/book/text/12-01.htmlhttps://books.core-econ.org/espp/book/text/03.html#39-unintended-consequences-of-a-redistributive-taxhttps://books.core-econ.org/espp/book/text/12.html#1213-free-tuition-in-higher-education-can-it-be-fair-to-non-students) evaluates 5 different ways to finance higher education, ranging from fully private to fully government-funded. Instructors can present this content in lecture or run an in-class debate on which measures they think governments should use.https://www.ft.com/content/867b430e-8132-11e8-8e67-1e1a0846c475. Instructors can ask students to find examples from other countries.https://www.ft.com/content/a00a3312-5913-11e8-806a-808d194ffb75. For a longer assignment, instructors can ask students to write a similar article comparing two different countries.Key concept: Principal-agent relationship
In this context, the citizens are the principals and the government is the agent. Democracies can address the principal-agent problem by giving elected leaders political rents and holding them accountable (with the threat of replacement). Section 10.13 explains why not all citizens have equal say in a democracy (for example, wealthier citizens have more power to influence policy).
https://books.core-econ.org/insights/government-debt-and-wealth/07-conflicts-of-interest.html