Macroeconomics & Monetary Economics

Module 7 in the curriculum. Starting point: newspaper-level-plus knowledge from years of FT and Economist reading --- solid intuition for how central banks, fiscal policy, and business cycles interact, but lacking the formal models that make those intuitions precise. Planning to work through MIT OCW 14.02 alongside this module.

Why this module matters

Macro is the backdrop against which all financial markets operate. Interest rates, inflation, exchange rates, fiscal deficits --- these are not exogenous forces but outputs of models with specific assumptions and policy levers. Understanding those models transforms macro from “reading the news” to “having a framework for what the news means.”

Learning roadmap

Core ideas to internalize

IS-LM: the workhorse

The IS curve represents goods market equilibrium (investment = saving):

$Y=C(Y-T)+I(r)+G$

The LM curve represents money market equilibrium:

$\frac{M}{P}=L(Y,r)$

Their intersection gives equilibrium output $Y^{\ast }$ and interest rate $r^{\ast }$. The model’s power is in comparative statics: fiscal expansion shifts IS right (higher $Y$, higher $r$); monetary expansion shifts LM right (higher $Y$, lower $r$). Its limitation: it treats the price level as fixed, which is why we need AD/AS to discuss inflation.

The money creation process

Banks do not lend out deposits --- they create deposits when they lend. A loan creates a matching deposit on the liability side. The money multiplier $m=1/\text{rr}$ (where rr is the reserve ratio) is a simplification: in practice, money creation is constrained by capital requirements, risk appetite, and demand for credit, not just reserves. Post-2008 QE made this abundantly clear --- reserves exploded but lending did not.

Monetary policy at the zero lower bound

When $r\approx 0$, conventional monetary policy loses traction (the liquidity trap). Central banks then resort to:

• Quantitative easing (QE): purchasing long-term bonds to compress term premia and push investors into riskier assets
• Forward guidance: committing to keep rates low to anchor expectations
• Negative rates: charging banks for excess reserves (ECB, BOJ experiments)

The effectiveness of each is debated. QE clearly affects asset prices; its transmission to the real economy is less certain.

The impossible trinity

A country cannot simultaneously maintain all three of:

1. Free capital flows
2. Fixed exchange rate
3. Independent monetary policy

You must give up one. The US gives up (2). China restricts (1). The Eurozone members give up (3). Currency crises (ERM 1992, Asian 1997, Argentine 2001) typically result from trying to hold all three.

Debt sustainability

Government debt is sustainable when the debt-to-GDP ratio stabilizes. The key condition:

$\Delta \left(\frac{D}{Y}\right)\approx (r-g)\frac{D}{Y}+\text{primary deficit}$

When the interest rate $r$ exceeds the growth rate $g$, the government must run primary surpluses to stabilize debt. When $g>r$ (as in much of 2010—2021), deficits are more sustainable. This simple equation is the foundation of every sovereign debt debate.

Prerequisites

• Statistics --- time series basics, regression for empirical macro
• Probability Theory --- for stochastic macro models

Key references

• Blanchard --- Macroeconomics (the standard textbook)
• MIT OCW 14.02 --- Principles of Macroeconomics (primary course companion)
• Mankiw --- Macroeconomics (alternative textbook)
• Minsky --- Stabilizing an Unstable Economy (for Unit 7.6)
• Obstfeld & Rogoff --- Foundations of International Macroeconomics (for Unit 7.7)