Birks – Mankiw Chapter 32 – a note on models and assumptions
Mankiw, N. G. (2015) Principles of economics (7th ed.) Ch.32
Principles of macroeconomics (7th ed.) Ch.19
Mason, OH: South-Western Cengage Learning
A note on models and assumptions
It is important that you familiarise yourselves with the economics approach to models.
Every model is based on assumptions. These are very important. They set the structure of the analysis. Commonly assumptions are spelled out in relation to each model. However, sometimes “standard” assumptions are unstated. Mankiw tends to hide his assumptions in the body of the text. It is worth highlighting the words “model” and “assumption” or “assume” whenever they appear. Also, note that anything not mentioned is either assumed to be constant or assumed not to affect the variables included in the model.
Mankiw also has a tendency to present a finding that is specific to a model as if he has explained a real world phenomenon. See the first paragraph of Chapter 20 Section 2a for several examples of this. The model is not the world, the map is not the territory.
Assumptions may not be realistic, but any subsequent analysis should follow logically from them. When using analysis to try to understand the real world, it is important to be aware of the limitations caused by the assumptions and the choice of relationships included in models. While they may help us to understand some aspects of the world, they leave out many things which may also be important. This is inevitable in any analysis, whether in economics or elsewhere. I tend to consider models as analogies which may give some insights into real world, but which generally need additional thought (Keynes, talked of reserves, qualifications and adjustments).
An open economy macroeconomic model
In the first main section of the chapter Mankiw sets out the basic structure for the two markets that he will include in his model. In this commentary you can see how to draw on the text to identify key components of a model.
You will also get some pointers as to how to identify limitations in a model. These are in square brackets and inset. They include more advanced material, so you can ignore them if you wish.
The basic structure is set out in the introduction and in Section 1.
From the introduction:
- Real GDP given and equal to full employment real GDP, determined by real factors (classical dichotomy, Ch.30 subsection 1e)
- The price level is given, where S and D of money are equal (Ch.30 Figure 1)
The model includes
(a) a market for loanable funds and
(b) a market for foreign-currency exchange
(a) market for loanable funds
Assume the financial system consists of only 1 market, the market for loanable funds
“Definition” loanable funds: the domestically generated flow of resources available for capital accumulation
In subsection 1a: “As we learned” QS and QD depend on the real interest rate. This is an assumption.
[i.e. “as we learned” according to our earlier model. Note the model for a closed economy in Chapter 26 subsection 3a. Note also the four bullet points in Chapter 31 subsection 1b including three other determinants of net capital outflow which are assumed constant here. In practice, capital movements are also likely to depend on expectations about the future.]
The assumed relationships are then described: “A higher real interest rate encourages people to save and, therefore, raises the quantity of loanable funds supplied. A high interest rate also makes borrowing to finance capital projects more costly; thus, it discourages investment and reduces the quantity of loanable funds demanded.”
[As an aside, we can look deeper into the 1st sentence. First, there is an assumption that real interest rates in overseas markets are constant, as are political risk and government policies (bullet points in Chapter 31). This is part of a broad ceteris paribus assumption. Second, the next paragraph describes a more complex relationship than covered in Mankiw. You may wish to skip it.
A higher interest rate reduces the price of future consumption relative to current consumption. There is therefore likely to be a “substitution effect”, whereby people reduce current consumption and save more, so as to increase future consumption. Economists refer to two effects from a change in a price (or relative prices), an income effect and a substitution effect. Both of these could arise from an interest rate change. The income effect is the result of the price change altering the overall real income. A fall in the price of a good increases real income, permitting increased purchases of all goods. Similarly, an interest rate rise, by increasing future income from a given level of saving, can enable people to increase both current and future consumption. A higher interest rate could therefore result in lower saving. Mankiw ignores this, and his assumption results in an upward sloping supply curve for loanable funds. ]
Note that demand for loanable funds is the sum of demands for funds for domestic and overseas investment.
(b) market for foreign-currency exchange
Assume supply is from net capital outflow, buying foreign currency.
Assume demand is from net exports, giving net overseas demand for your currency.
Subsection 1b, “As we saw in the previous chapter, the real exchange rate is the relative price of domestic and foreign goods, and therefore is a key determinant of net exports.” It is suggested that a rise in the real exchange rate results in increased imports and reduced exports, so, according to the description here, net exports fall. This gives a downward sloping demand curve in figure 2.
[We can question this assumption. Note that the changes that we can expect in exports and imports are quantity changes. It is not certain whether total spending on exports and imports will rise or fall. This depends on the extent to which quantity changes in response to a price change. For example, if the price of petrol rises from $2.00 to $2.50 per litre and your demand falls from 20 litres to 18 litres, your demand has fallen, but your spending has increased from $40 to $45. Consequently the stated quantity changes in exports and imports do not necessarily result in the specified change in net exports, which is a value measure. If a rise in the real exchange rate results in a rise in net exports, Mankiw’s demand curve could be upward sloping. Given his vertical supply curve, this would result in an unstable equilibrium, with an exchange rate above equilibrium resulting in excess demand and further upward movement in the exchange rate.]
Figure 2 assumes net capital outflow. There could be net capital inflow.
Note also in subsection 1b, “the supply curve is vertical because the quantity of dollars supplied for net capital outflow does not depend on the real exchange rate. (As discussed earlier, net capital outflow depends on the real interest rate. When discussing the market for foreign currency exchange, we take the real interest rate and net capital outflow as given.)”
[Note the assumptions being made here, fixed real interest rate, fixed net capital outflow, and, implicitly, no exchange rate risk, among other things (once again, a ceteris paribus assumption).]
Note, in all these models, if a variable is not mentioned it is assumed either to be constant or not a determinant of the values of the variables which are included.
Commentary by Stuart Birks, 8 September 2014