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Summary Macroeconomics
Chapter 1&2
Macroeconomics→ study of the aggregate behavior and performance of an economy.
GDP (Gross Domestic Product) →- goods and services for final uses produced within a
specific period (normally per year)
- varies substantially across countries and time
-comparable across countries
-captures the nation’s output and income
Three important indicators:
1. Real GDP
2. Growth rate of GDP
3. Real GDP per capita
Labor and Capital are the two main factors of production, or inputs.
Inflation→ the rate of change of the average level of prices.
The inflation rate is usually procyclical, rises in periods of high growth and declines in periods
of slow growth.
The unemployment rate is usually countercyclical, it moves against the cyclical behavior of
output, falling when output is growing rapidly and rising when output is growing more slowly
or falling.
Recession→ decrease in real GDP
Depression→ severe recession
Flow variable: quantity measured per unit of time
(GDP)
Stock variable: quantity measured at a given point
in time (wealth)
GNI: Gross national income
= GDP + income received from abroad – payments to
residents of other countries
Nominal GDP is computed using the actual selling price
Real GDP is computed using the price of a given base
year
Prices are kept fixed so that real GDP varies only if the
physical quantity sold changes
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One important measure of price level changes: GDP
deflator:
GDP deflator=Pt=(Nominal GDPt)/(real GDPt)
Definitions:
Y: GDP/Output/Income
C: Consumption
S: savings of the private sector
I: Investment ( = goods for future use)
T: Net taxes = taxes – transfers (pensions, allowances…)
G: Government purchases
X: Exports
Z: Imports (NX: Net Exports = X – Z)
Closed economy→ Y = C + I + G
Open economy→ Y=C+I+G+X-Z
(S - I) + (T - G) = (X - Z)
(Private sector)+(Government)=(Rest of the world)
The Balance of Payments
I. Current Account
a. Goods and Services
1. Goods
2. Services
b. International Income
1. Wages & Compensation
2. Investment Income
c. Current Transfers
II. Capital & Financial Account
a. Capital Account
b. Financial Account
1. Direct Investment
2. Portfolio Investment
3. Other Investment
4. Reserve Assets (Official
Account)
c. Errors and Omissions
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Chapter 3
Four main reasons economies grow:
1.Capital accumulation
2.Population growth
3.Technological progress
4.Other factors: institutions, education
(endogenous growth models, Chapter 4)
5 stylized facts about economic growth:
Intensive form = production function / L
Fact 1: Output per capita (Y/L) and capital intensity
(K/L) keep increasing
ongoing technological progress continuously increases
labor productivity→ Y/L increases with rate a because A increases
→ Steady state: K/AL = constant → K/L increases if A increases
Fact 2: The capital output ratio (K/Y) is roughly
constant
Steady state: K and Y both increase both at rate a+n
Fact 3: Hourly wages keep rising
Workers are paid according to their marginal product. So
if labor productivity increases because A increases → w increases
Fact 4: The rate of return to capital is constant
Productivity of K stays constant, technological progress
increases only efficiency of labor → profit rate of K is
constant
Fact 5: The relative shares of GDP going to labor and
capital are constant
K and L receive income respective to their contribution to
GDP. If their relative contribution stays constant → income
shares are constant
The steady state is the long run equilibrium of the economy.
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The interaction between the depreciation line and the savings function is the steady state
point.
Steady state: characterized by a balanced growth path:
In the steady state each variable of the model is growing
at a constant rate (trend)
In reality:
We are never exactly at the steady state, but we
permanently move around it.
Steady state growth rate: long-run average growth rate
An economy not at the steady state will move to it.
Two forces influence the capital stock
1. Investment
2. Depreciation
At a given saving rate: the further away the economy is
from the steady state, the faster it grows (if before
below the steady state)
An increase in the saving rate has an effect on the level
of GDP per capita
It does NOT have an effect on the growth rate of GDP
per capita.
Because of diminishing returns: as soon as sf(k) meets dep
line→ growth rate of y= 0
Notice also that saving more leads to a reduction in
consumption levels.
Golden rule:
The steady state value of the capital-ratio, k*, maximizes consumption when the marginal
product of capital is equal to the depreciation rate.
Marginal productivity of capital = depreciation rate
What if we are at a steady state that is not the Golden
Rule steady state?
This means that the saving rate is too high or too low which
leads to high or to low steady state value of k.
Two possible scenarios:
-The capital/labor ratio is too high: dynamic inefficiency (too much saving, less consumption)
-The capital/labor ratio is too low: dynamic efficiency (too much consumption, less savings)
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Golden rule with population growth:
Consumption is maximum when marginal product of capital – depreciation is equal to the
rate of population rate.
MPK – dep. = rate of pop. rate
AL: “effective labor”
Golden rule with technological progress:
The steady state value of the capital effective labor ratio maximizes consumption when
MPK – depreciation is equal to both the growth of technological progress and population
growth.
MPK – dep. = rate of pop. + technological progress
Chapter 4
A country’s output per capita in the steady state is affected by:
- Savings rate, s
- Population growth, n
- Level of technology, A
If s, n and A are similar across countries → convergence to the
same steady state should occur → same Y/L
Convergence hypothesis:
Basic idea: If a country starts out with a low level of k (below
the steady state) capital accumulation should occur faster
than in advanced economies (closer or at the steady state).
Conditional convergence:
Basic idea: countries with different production functions will
converge to different steady states, characterized by different
levels of capital and output per (effective) labor.
Human capital: stock of knowledge, competencies, experience etc that determine the
productive ability of the labor force.
Streets, public transports, internet contribute to output, KG.
Y = AF (K L H KG) → new aggregate production function
Solow growth model:
→ assumed decreasing marginal product of capital.
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Endogenous growth model:
- Constant marginal product of capital
Imagine that technological improvement in capital races along just fast
enough to offset the diminishing marginal productivity of capital.
i.e. Technological progress shifts the production function outward
faster then we can go to the new steady state.
- Slope of production function always exceeds the capital
widening line
→ No steady state capital stock possible → K/L and Y/L never
stop growing!
Externalities: Effect of an individual’s activity on the
productivity of the economy without the individual feeling
these effects himself.
Chapter 5
Unemployment rate = number of unemployed workers
divided by the labour force
Labour force=individuals working + individuals actively
looking for a job
Real wage: the ratio of the nominal wage workers receive
and the price level: nominal wage/p
(p: index of the cost of living (price level))
Substitution effect→ more labor
→ If I can consume more for every hour I work, I give up more easily an
extra hour of leisure, higher incentive to work
Income effect→ less labor
→ For the same amount of work as before I get more consumption. If I
reduce my work time, I will still earn as much as before.
1. Both consumption and leisure are normal goods → if
income rises so will (the workers’ optimally chosen levels
of) consumption and leisure
2. Substitution effect dominates → labour supply is always
upward sloping, thus if wage rises workers offer more
labour
Aggregate supply: measure in person-hours, i.e. total number
of hours supplied by all workers in the economy during the
same period
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Labor demand:
Highest profit : when MPL = real wage
MPL > w: it pays to hire more L
MPL < w: it does not pay to hire more L
What happens to the demand curve after a change in
labor productivity (increase in technological progress,
increase in capital stock…)?
→ If labor becomes more productive: upward shift
→ If labor becomes less productive: downward shift
Involuntary unemployment: individuals belonging to the
labor force who seek for paid labor but cannot find it
Structural unemployment→ when the prevailing wage w is higher than the equilibrium wage
Wage rigidity: failure of the wage to adjust until equilibrium is reached
Equilibrium: point of tangency between labor demand
and union indifference curve
Paying higher wages to increase productivity of workers
and give them incentives to do a good job
1.Higher wages →better nutrition and better health
→Important in poor countries (India, many African countries)
2.Reduce labor turn-over →lower cost of job training & hiring
3.Self-selection of workers →Attracting the best workers
4.Reduction of moral hazard →If the productivity of workers
cannot be observed higher wages increase incentives to
work (getting fired becomes costly)
The equilibrium rate of unemployment is the rate of unemployment toward which the
economy gravitates in the long run (steady state)
(Also called natural rate of unemployment)
Equilibrium unemployment rate = when inflow and outflow
out of unemployment are equal: fU=sL
U= Frictional unemployment ( different jobs require different kind of workers) + structural
unemployment (not enough work places for the supply)
U = S / (S+F)
S= unemployed
F= re-employed
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Chapter 6
Money facilitates our life because it is…
1. A store of value: I can keep my money today and be sure I can get something for the
same value tomorrow
2. Unit of account: makes all prices easily comparable
We count everything in € and can thus easily say X is cheaper than Y
3. A medium of exchange: I don’t have to find somebody who wants to buy my X and sells Y.
Two types of money:
1. Fiat money.
Ex. the paper currency whe use. The money we use doesn’t have a value on it’s own.
2. Commodity money.
Ex. gold, cigarettes. These have an intrinsic value. These products have an own value.
Money supply: the quantity of money in circulation
Regulated by:
In Europe: European Central Bank (ECB)
In the US: Federal Bank of Reserve (FED)
Nominal exchange rate: the price of one money in terms of another
Real exchange rate: what money can actually buy in two countries that are being compared
The neutrality principle says that in the long run a change in the money supply will only lead
to a change in nominal variables but not in the real economy.
In the long run: Prices grow at the same rate as money supply
higher M →higher P
The neutrality principle states that real GDP is unaffected by changes in the money supply,
therefore any change in M must be matched one-for-one by a change in prices
Cambridge equation: M = kPY
rewrite →
M/P = kY (real money demand)
M= demand for money
K= the amount of cash held by residents as a proportion of income
PY= nominal GDP
(Purchasing power: M/P)
Money growth=inflation + real GDP growth
If P increases, more money is needed to carry out the same transaction
If Y increases, more money is needed to carry out the resulting larger number of transactions
Why doesn’t an increase in money supply lead to an
increase in real GDP?
The growth rate of real GDP depends on growth in the factors of production and on
technological progress
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The fact that M supply does NOT affect Y, while Y DOES affect M demand is also known as
dichotomy principle
Inflation = Money growth – real GDP growth
Common misperception: inflation reduces real wages
This is true only in the short run, when nominal wages are fixed by contracts.
In the long run, the real wage is determined by labor supply and the marginal product of
labor, not the price level or inflation rate.
Appreciation (increase in the exchange rate): means an increase in the value of a currency in
terms of foreign currencies
→ I get more of the foreign currency for 1 unit of my currency
Depreciation (decrease in the exchange rate):
→I get less of the foreign currency for 1 unit of my currency
Real exchange rate = S
P = domestic price level, expressed in domestic currency
P* = price level in the foreign country, expressed in foreign
currency
The real exchange rate can appreciate (σ↑) for 2 reasons:
1. When the nominal exchange rate S appreciates (S↑)
2. When inflation at home (ΔP) is higher than inflation abroad
(Δ P*)
-domestic goods become relatively expensive →CA↓(X↓, Z↑)
Depreciation of σ:
1. When S depreciates
2. When Δ P*> Δ P
-domestic goods become relatively cheap →CA↑(X↑, Z↓)
The Law of One Price posits that the same good should trade at the same price everywhere
when prices are expressed in the same currency
1 € must have the same purchasing power in every country. Real exchange rate equals 1!
In the long run, countries with a high inflation rate see their currencies depreciate
P↑→ S↓ →in order to equalize again SP and P*
That means if the monetary authority changes the supply of money, the exchange rate will
offset any change in competitiveness driven by the monetary policy
M↓ →P↓→ my goods become cheaper for the foreign consumer, but quickly S↑
→In the long run: σ is constant
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Relative PPP:
→states that in the long run the movement in the nominal exchange rate between two
countries reflects the evolution of the inflation rates of two countries.
→Real exchange rate stays constant over time
The rate of change in the real exchange rate →
Suppose that domestic money supply is more expansionary at home than abroad.
Inflation at home will be higher than abroad
Hence, if S remains fixed for the moment, then σ appreciates
Chapter 7
Budget constraint in present discounted value terms:
=
Present discounted value of consumption = present discounted value of income
= wealth derived from income
Rational expectation hypothesis:
given the available information, individuals make on average correct forecasts
(no systematic errors)
In the aggregate: Saving = investment
Present value of an investment:
V=
If V >0 then the investment of K is profitable, because return is greater than r
Indeed: V>0 →F(K) > K(1+r): total future output should give you a higher return than leaving
the money on your bank account
If the investment has a positive present value, then it must increase wealth by V
Intertemporal budget constraint of government:
=
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=
(Individual)
=
(Government)
Combining the private and public budget(if rG=r):
=
If rG=r, the consolidated budget constraint tells us that the household can only consume the
output that is not used for public spending: we thus see here a substitution between private
and public consumption.
Ricardian Equivalence Proposition
→ states that the taxation pattern (i.e. whether the government runs or not a deficit in
period 1) does not affect the consumption possibilities of households
→What matters is only the amount of public spending and not how it is financed, namely
which of T1 or T2 is highest!
Fails when:
… there are different interest rates for households and government
… individuals do not live long enough to fully incorporate the government budget constraint
Also: new agents (ex. immigrants) who enter at future dates will pay taxes thus breaking the
link between the budget constraint of presently living generations and future government
revenues
… there are distortionary taxation: individuals change their behavior (for example their labor
supply) in response to a change in taxes
… there are restrictions on borrowing: credit rationing affecting households
i.e. they are not allowed to borrow or they can borrow up to a limited
extent
If the government can borrow at a better rate than private individuals (i.e. rG<r): running a
primary deficit→ increases the resources available to private sector
→ i.e., by decreasing taxes today (and increasing therefore the primary deficit) the
government increases the consumption possibilities of households because the government
can borrow at a better rate as compared to individuals!
Primary Deficit = amount of non-interest expenditures exceeding revenues (G1-T1<0)
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Chapter 8
Irrespective of when the income increases in period 1 or period 2: The chosen consumption
pattern will stay the same→ consumption smoothing
Permanent increase in income: proportional increase in period 1 and 2
The life cycle theory of consumption:
Basic idea: The Life cycle hypothesis implies that saving varies systematically over a person’s
lifetime but consumption stays constant Income fluctuates a lot over lifetime (student, first
job, better job, retirement) but saving and borrowing allow to smooth consumption over the
years.
John Maynard Keynes:
Consumption is linked to current disposable income (Y - T). People save a fraction of their
income and spend the rest (that’s also what we assume in the Solow growth model)
Investment decision is an intertemporal decision.
Y=F(K)
Gain: K : MPK = F’(K)
Costs: (1+r)
Profits are highest when:
F'(K) = MPK =(1+r)
Marginal productivity of K = marginal cost of K
Investment
→Brings K to its desired level
→If K is at the desired level: I replaces depreciation
→We have then a negative relation between I and r: I=I(r)
→If r increases, optimal K is lower, so I is lower
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Chapter 9
Money is the stock of assets that can be readily used to make transactions.
M1:
currency: banknotes and coins (C)
+ demand deposits by commercial banks (D)
Only this can be used for daily transactions
M2:
M1
+ savings deposits by commercial banks
M3:
M2
+ larger, fixed term deposits + accounts at non-bank institutions
Monetary institutions create money:
1. Central bank
2. Commercial banks
Central bank (CB) = public agency with legal mandate to control money and credit conditions
Provides the currency in circulation (C)
Holds bank reserves of commercial banks (R)
Key instrument of CB to control money creation of commercial banks
C + R = M0 or monetary base (money created by CB)
Commercial banks = financial intermediaries, bring borrowers and lender together (public or
private)
-Hold demand deposits (D)
-Grant loans (L)
Creation of money by granting loans
Money supply = currency + deposits
M=C+D
Basic idea: Banks can use the deposits they get to give out new loans and create thus new
deposits →D↑.
Fractional-reserve banking →banks hold only a fraction of deposits as reserves and use the
rest to make loans.
100% reserve banking → banks hold all deposits as reserves
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D= (1/rr)*x
rr= reserve rate
R = rr*D
R= Total amount of reserves
Reserve multiplier →D=(1/rr)*R
→banks cannot expand money creation beyond a multiple of existing reserves
M0=currency in circulation (C)+ commercial bank reserves (R)
M0= C + R
M1= C + D → M1 = C + 1/rr *R
1.Money supply M1 is proportional to M0.
2.The lower rr →the higher M1
3.If people replace their bank deposits by currency →decrease in money supply (M1)
Central Bank controls the money supply by:
1. Reserve requirements: reserve ratio
rr ↑↓→ M1 ↓
2. Open-market operations: purchases and sales of securities (ex.: government bonds)
FED buys bonds from the public →pays with $ →M0↑→M1↑
FED sells bonds to the public →get paid with $ →M0↓→M1↓
3. Interbank rate: the i CB charges when lending to banks
i ↓→reserves become cheaper→Demand for loans ↑→M0↑→M1↑
CB has never total control on M1
Money demand = M = kPY
Cost of holding money = nominal interest rate i
So money demand should be = M=k(i)PY
Increase in Y ↑Shift to the right of M
If central bank keeps M0 constant →interest rate will go up
CB has to options to determine the equilibrium
1. CB fixes the interest rate → must provide as much M0s as demanded at that rate
2. CB fixes M0s → let money demand determine the interest rate
Both options lead to the same M0s and i.
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Objectives of the CB:
1. Price stability
2. Employment and growth
Conflict of the two goals:
Higher M →higher inflation in the long run
Higher M →higher growth and employment in the short run
Two main instruments:
1. Interest rate
2. Supply of reserves → M1
Taylors rule:
i = i* + a(π- π*) + b
𝒀−𝒀∗
𝒀∗
i* = natural nominal interest rate, the rate CB would want if both π and Y are stabilized at
their desired levels.
→ a and b: weights of the respective objectives
CB increases i if → π
> π* or Y > Y*
CB decreases i if→ π < π* or Y < Y*
If CB wants to reduce reserves:
Reducing the loans granted to commercial banks
The central bank lends to commercial banks on a very short term base (one week to 10 days)
If they want to reduce the volume of reserves they just decide not to renew some of these
loans
They ask commercial banks to deposit collateral in the form of very safe assets in order to get
their loan
Hence, commercial banks must pay back the central bank in exchange for their collateral
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Chapter 10
Income influences demand
for money
Goods
Market
Money Market
Interest rates affect
Aggregate demand
Real exchange rates
Affect aggregate
Demand
Foreign
exchange market
Interest rates influence
the exchange rate
Classics →long run
→Prices are flexible
→Aggregate supply (K, L, A) determines income
→Prices adjust →aggregate demand = aggregate supply
Keynes →short run
→Assumption of sticky prices
→Aggregate demand determines output of firms
→Prices cannot adjust →aggregate demand can differ from supply →supply adjusts to
demand
AD curve: Relation between quantity of output demanded and the aggregate price level
Y = C + I + G + PCA
Y= Aggregate supply
C+I+G+PCA = Aggregate demand
Aggregate supply
→Total volume of goods and services brought to the market by
producers at a given price level
Aggregate demand
→Sum of consumption, investment, government purchases of
goods and services plus net exports of goods and services
→PCA: primary current account=net exports of goods and services (X-Z)
Actual expenditure = desired expenditure
Y = DD
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Keynesian demand multiplier:
1
1 − 𝑐(1 − 𝑧)
The multiplier is bigger…
…the bigger c, the share of my income that I consume
…the lower z, the share of my consumption that I spend on imports
IS-curve
→graphs all combinations of i and Y that result in goods market equilibrium
→actual output = planned expenditure (desired demand)
→downward sloping
ENDOGENOUS variables: those determined by the model.
→hint: those on the axes of the graph →move on the curve
→Example IS curve: Y and i
EXOGENOUS variables: all predetermined variables that
affect the endogenous variables
→hint: NOT on the axes of the graph but in the equation that determines the curve →shift
the curve
→Example IS curve: Ω, T, q, G, Y* (overbar variables)
“More” →outward shift, “Less” →inward shift
→Real exchange rate depreciation →outward sift
Right of IS: excess supply
Left of IS: excess demand
TR curve
→represents the equilibrium in the money market
i.e. the combinations of the interest rate i and the income level Y
where money demand equals money supply
→Prices are fixed
→Upward sloping
→CB sets the interest rate →money supply endogenous
→Interest rate set according to the Taylor rule to ensure
price stability (inflation targeting)
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Short run → prices are fixed→ inflation =0
Taylor rule (SR):
i = i* + b
For the TR curve to shift→ If change in:
→ the target for Y or for π
→ or the natural interest rate
→ or change in π
𝑌−𝑌∗
𝑌∗
Positive demand shock: increase in demand → IS shifts to the right
Example: IS curve shifts because of an increase in G
Goods market (Keynesian cross):
→ Desired demand(C+I+G+PCA) increases → supply of goods
will follow
→ Total production rises and thus income rises also: Y↑
→ Multiplier effect: A-C (the new equilbrium would be C)
Money market:
→ Increase in Y leads to a higher money demand for a given i
→ Taylor rule tells CB how to set the interest rate in case that Y
is above the trend value (here the case!) → expansionary
monetary policy
→ CB will increase money supply and i (depending on b) → i ↑
(A → B)
Expansionary monetary policy shock: decrease in the
natural interest rate → TR shifts to the right
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Chapter 11
The Mundell-Fleming Model→ Extension of the IS-TR model for the open economy with
internationally integrated financial markets→ Key variable: exchange rate
Assuptions: sticky prices
Small open economy→ influenced by changes in the world but does not
influence the world.
Interest rate parity condition→ If international capital markets are perfectly integrated, the
rate of return (in the same currency) on assets sharing the same risk profile should be
identical.
Domestic interest rate = International interest rate
Impossible Trinity:
- Fixed exchange rate
- Independent monetary policy
- Free capital movements
A country can have two of the above, but never 3.
The behavior of the economy change when internationally integrated.
Fixed exchange rate
→ CB stands ready to buy and sell their currencies at a fixed price
→ CB intervenes when there is an excess supply or demand of the
currency at the fixed exchange rate
→ Ex: Denmark → Euro, China → US Dollar
Flexible exchange rate
→ Central banks allow the exchange rate to adjust to equate the supply
and demand for foreign currency
→ The British pound floats freely against both the US dollar and the
Euro
→ The fluctuations can be very large
→ Reminder: increase in the exchange rate = appreciation → my goods become more
expensive
Flexible exchange rates and perfect capital mobility
i = i*
→ If i > i* → capital inflow, S increases
→ σ increases→ IS shifts left
→ If i < i* → capital outflow, S decreases
→ σ decreases → IS shifts right
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Real demand disturbances
IS shifts following an increase in the demand for domestic goods →IS shifts right
→Y increases →higher money demand →pressure on I increases
→Higher i leads to exchange rate appreciation (capital inflow)
→Appreciation decreases demand for our exports, Y ↓ →IS shifts back
→Appreciation of S continues as long as i > i* and until IS back to initial level.
→Back in point A: all markets are again in equilibrium, same Y and i
→BUT: higher G and lower PCA compared to initial situation, higher S
Expansionary monetary policy
→CB aims at a natural interest rate < i* →TR shifts to the right
→CB wants to put more money into circulation: requires lower i
→i <i* →capital outflow →decrease in demand for my currency
→Decrease in exchange rate (depreciation) →my goods become relatively cheaper
→Net exports increase
→Increase in exports leads to an increase in Y →IS shifts right
→Higher Y →higher money demand
→IS curve shifts out until i = i* and money market is back in
equilibrium
→IS, TR and IFM back in equilibrium: same i but higher Y due to
higher PCA, exchange rate has depreciated.
Beggar-Thy-Neighbor policy → Monetary expansion only shifts demand from one country
to another, doesn’t increase the total demand for goods.
Fixed exchange rate regime: central bank commits to maintain a fixed relative price for the
domestic currency vis a vis a foreign one.
Monetary policies are useless if the exchange rate is fixed →To prevent the depreciation, CB
needs to sell foreign currency to buy domestic currency →by buying domestic money, CB
takes the money out of circulation→ So TR-curve shifts back (left)
Fixed exchange rate regime: an increase in government expenditure is effective in increasing
output.
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Chapter 12
Aggregate supply curve →describes for each given price level the quantity of output firms
are willing to supply.
Keynes
→Sticky Prices →Short run
→Demand drives output →Quantities adjust
Neoclassics
→Flexible prices →Long run
→Supply drives demand →Prices adjust
Phillips curve:
negative relation between unemployment and inflation
trade-off : a decrease in unemployment increases inflation
Okun’s law:
Negative correlation between the change in the unemployment rate and the change in real
GDP.
Some problems regarding the Phillips curve:
- Neutrality principle: Nominal variables have no impact on real variables in the long
run.
- Inflation in the long run is determined by the growth in money supply and not by Y or
U.
- In the long run both the supply curve and the Phillips curve should be vertical.
- Problem 1: the initial version of the Phillips curve did not incorporate inflation
expectations
- Problem 2: it did not take into account other production costs (only labor costs)
Price setting:
Perfect competition: price takers (P = MC)
Imperfect competition (product differentiation) → market
power → price setters: mark-up pricing
𝑊𝐿
P = (1+Ɵ) 𝑌
MC =
𝑊𝐿
𝑌
Real average labor costs = labor share of output
Unions want to maximize the real wages→ but they can only negotiate about the nominal
wages→ so they need to make anticipations about the future price changes.
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Final labor share depends on the bargaining power of the unions:
𝑌
W = (1+y) sl*𝐿 𝑃𝑒
y = mark-up, representing the bargaining power of unions (depending on business cycle at
the moment of negotiations)
sl* = normal labor share
Pe = price expectations
𝑊𝐿
Firms :
P = (1+Ɵ)
Unions:
W = (1+y) sl*𝐿 𝑃𝑒
Together:
𝑌
𝑌
P = (1+Ɵ) (1+y) sl*𝑃𝑒
Firms: Employers set prices as a mark-up on wage cost
Unions: The wage equation set prices as a mark-up on expected price level
The current price level depends
→on the battle for mark-ups: (1+Ɵ) (1+y)
→the expected price level: Pe
Thus: inflation (rate of increase in prices) is determined by the change in the mark-ups and
the change in expected prices (expected inflation)
ΔƟ
Δy
𝞹 = (1+Ɵ) + (1+y) + πe
𝞹= 𝞹* - b(U-U*)
Phillips curve:
𝞹*= underlying inflation = 𝞹e
- b(U-gap) =
𝛥Ɵ
(1+Ɵ)
+
𝛥𝑦
(1+𝑦)
Underlying inflation has two components:
→Backward looking component (πt-1)
→Forward looking component (long run inflation rate)
Important non-labor costs
→Change in the price of raw material (oil shocks)
→Depreciation (increasing the price of imported inputs)
→Productivity shocks, taxes
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In case of unexpected increase in production costs: firms raise prices above the expected
level.
Phillips curve with supply shocks:
𝞹= 𝞹* - b(U-U*)+s
Long run
→Expectations on supply shocks are zero
→Actual inflation must be equal to the underlying inflation
𝞹= 𝞹* and s=0 → U=U*
Phillips curve must be vertical in the lon run
No permanent trade-off is possible between inflation and
unemployment
Inflation is higher than the expected (underlying) inflation. Therefore real wages are lower
→more workers are hired and unemployment is below the natural rate→ in the short run a
trade-off is possible.
However in the next period the underlying inflation will adjust→ the Phillips curve will shift.
Phillips curve:
Okun’s law:
AS curve:
𝞹= 𝞹* - b(U-U*)+s
(U-U*) = -h(
𝑌−𝑌∗
𝑌∗
)
𝒀−𝒀∗
)+s
𝒀∗
𝞹= 𝞹* + a(
In the short run→ AS increases → 𝞹 increases → Y increases
In the long run→ the AS curve is vertical
The short run AS curve shifts when:
→The underlying inflation changes
→The natural unemployment rate changes
→The trend GDP changes
→Supply shocks (temporary or permanent)
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Chapter 13
Distinction between nominal and real interest rates:
Lender: prefers low inflation
Borrower: prefers high inflation
Rt = it – 𝞹t
(t=period)
Long term –
AD curve → horizontal
AS curve → vertical
AD slopes downward:
When inflation rises, the central bank raises the (real) interest rate, reducing the demand for
goods & services.
AD curve shifts in response to changes in:
• the inflation target (↑→shifts AD to the right)
• demand shocks (ε = changes in G, T, wealth, …) (↑ in demand → shift to the right)
Fluctuations caused by supply shocks
Supply shock (s > 0)
AS shifts upward, π rises
CB responds to higher π by raising the (real) interest rate, output falls.
Supply shock is over (s = 0) but AS does not return to its initial position due to higher inflation
expectations. As πt decreases, underlying inflation decreases →AS shifts downward →Y rises.
Positive demand shock until t = 4 (ε > 0)
AD shifts to the right
Y and π increases.
Higher inflation in t raises inflation expectations for t + 1
AS shifts up. Y decreases and π increases even more.
Fluctuations caused by demand shocks
Higher inflation in previous period raises inflation expectations
AS curve continues to shift up. Y decreases and π increases.
AS is higher due to higher π in preceding period, but demand shock ends AD returns to its
initial position.
Next periods:
AS gradually shifts down as π and fall, the economy gradually recovers until reaching the
original LR-equilibrium.
Increasing government expenditure has only an effect on output in the short run, NO impact
in the long run.
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Economy will always come back to it’s natural output level
Either: AD curve shifts back (e.g. fiscal policy not sustainable) →back to natural level of Y
(Option 1) →business cycle!
Or: change in underlying inflation leads to upward shift of AS-curve →
decrease in output and increase in inflation →back to natural level of
Y (but with higher inflation in the long run, i.e. CB accepts higher π in
the long run = higher inflation target) (Option 2)
Fluctuations caused by monetary policies
Target inflation rate = 2%, initial equilibrium: point A
CB lowers inflation target to = 1%, raises i and r to reduce π.
AD shifts left
Y decreases and π decreases.
New eq. : point B
The fall in πt reduces inflation expectations because expected inflation is lower than actual
inflation →AS shifts down
→Y increases , π decreases
Subsequent periods:
This process continues until output returns to its natural rate and inflation reaches its target.
Chapter 16
Reminder: in a small & open economy and flexible exchange rates, fiscal policy is
NOT or only little effective, under fixed exchange rates it is monetary policy that is
ineffective.
Stagflation: both unemployment and inflation increase.
Supply & demand shock policies, 3 main options:
1. Expansionary→ AD curve shifts to the right. Unemployment is solved but there is a
higher inflation.
2. Contractionary→ AD curve shifts to the left. Inflation is solved but there is a higher
unemployment.
3. The CB can announce credibility that inflation will be at its target level→ Aim: stop
the underlying inflation from increasing to allow a swift return to the initial AS curve
and initial equilibrium.
Rational expectations: Underlying π = long run inflation → AS shifts directly
Adaptive expectations: Underlying π = previous year’s observed inflation→ AS shifts slowly.
Keynesians: Prices are sticky
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Adjustment of prices and wages takes time→ nominal rigidities, long term contracts
Backward-looking component dominates →wage indexation
Consequence: short run AS curve shifts only slowly
Government intervention is desirable…
→ (fiscal policy under fixed exchange rates, monetary policy under flexible exchange rates,
both in closed or big and open economy)
…rather than wait for underlying inflation to adjust enough to get back to the trend.
Neoclassics: Prices are flexible
Fast adjustment of prices and wages
Foward-looking component dominates
Consequences: short run AS curve shifts quickly back to the equilibrium on the LAS
(anticipations adjust quickly)
If underlying π adjusts fast (AS shifts quickly down to AS‘), actual π drops quickly.
That means: people understand the relationship between actual and underlying inflation.
This adaptation of expectations if negative demand shock is believed to be long-term
(rational expectations).
Keynesians
→Sticky prices lead to a dominating backward-looking component
→slow adjustment
→We can be for a long time off the LAS curve
→Demand policies help to get back on track
Neoclassics
→Foward-looking component dominates →fast adjustment
→We should always come back quickly to the LAS curve
→We will never be far away from the equilibrium
→No room for demand policies
Two ways to explain business cycles:
1. Deterministic view of business cycles
→Today’s situation depends mechanically on the economic
history
→Problems of the deterministic model:
- Generates regular business cycles, reproducing themselves
2. Stochastic view of business cycles
→Economy is hit regularly by random shocks → the economic
system leads to the propagation of the shock → over time:
back to equilibrium → new shock…
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Economic policy is characterized by a series of `lags’
→Recognition lag
→Decision lag
→Implementation lag
→Effectiveness lag
→ it is possible that a policy that was meant to be
countercyclical actually reinforces the cycle.
Current financial crisis: AD shifted left
→Fed and ECB: increase in money supply → AD shifts right
→US government: decrease in taxes →AD shifts right
Electoral business cycles
→Expansionary policy just before and restritive policy
after the election
Partisan business cycles
→Different political parties follow different economic policies
→When there is a change in the party of power: change in the policy
Empirical evidence: stronger for electoral cycles, much less so for partisan cycles
Chapter 17
Public goods: goods that are non-rival and non-excludable.
Governments try to stabilize the economy
→Output and employment smoothing
→ Consumption and tax smoothing
The budget consists of two components
→Component depending on the business cycle (cyclical)
→Component depending on the government’s policy (structural)
FP = given budget law
→Slope of FP is positive
→taxes increase with output and transfers fall with output
Expansionary fiscal
policy: lowers budget surplus for any given level of output (shift down)
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Public debt
Total budget deficit = (G – T) + rB
Debt stabilization (ΔB = 0) : (T-G)=rB →(T-G)/Y=r(B/Y)
Change in debt ratio over GDP growth in (B/Y)= ΔB/B – ΔY/Y =(G-T)/B + r - g
→ Δ (B/Y)=(G-T)/Y+(r-g)B/Y
If Δ(B/Y)=0 → (T-G)/Y=(r-g)B/Y
Additional revenue of the government: Seigniorage →Money that is created is worth more
than it costs to produce it.
The government can finance its deficit by printing new money.
→The government creates inflation by issuing money
→With inflation: it is even easier to maintain the debt/GDP ratio stable over time.
Stabilizing public debt:
Short-run: three possible approaches:
1. Cut the deficit by increasing taxes/reducing public expenditure
→Virtuous road, but costly!
2. Printing money and taxing holders of nominal assets (works if government bonds are
long-term and not linked to inflation).
→Effective only if inflation is not anticipated →risk of hyperinflation!
→Less likely with independent central bank
→Worked nicely for the U.K in the 19th century; not anymore
3. Default on debt
→Advantage: reduce expenditures today
→Disadvantage: it gets harder to borrower in the future
Medium and long run:
1. Interest rate relief (r)
→Higher default risk →higher interest rate →higher default risk (self-fulfilling prophecy)
→ESM (before EFSM and EFSF): offers governments in need to borrow at lower rates in
exchange for structural reforms (Greece, Portugal, Ireland)
2. Economic growth (g)
→Increase growth rate to increase GDP →lower debt/GDP ratio
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Chapter 14
Stocks (=shares)
“A claim on a part of the profits or earnings of a firm after operating costs and interest have
been paid”
Bonds
“Recognition of debt by the borrower along with a schedule of payments concerning both
interest and principal”
Option 1: bond with 2-years maturity (Long term bond)
Option 2: two consecutive bonds with one year maturity each
The interest rate on a LT bond = average of the short term interest rate that people expect
to occur over the life of the LT bond.
No-profit rule→ Equivalent financial operations carry the same interest rate.
If all stays the same, loans with longer maturity are characterized by higher interest rate
1. Due to impatience
2. Longer maturity implies more uncertainty (Most people are risk averse)
Stocks (= shares): riskier than bonds, but higher yield possible
Stock price :
q=
𝑑𝑡+𝑞 𝑒 𝑡+1
1+𝑖
This is the so called fundamental value of an asset→ present value of expected dividends
A market is efficient if prices fully reflect all available information.
Speculative bubbles
→Overly optimistic expectations
→Asset prices raise as long as people believe that they will raise
Credit driven bubbles
→Driven by credits: more credits →buy more assets →asset prices increase →higher asset
prices make loans easier because higher collateral or more capital →upward spiral
→Asset prices are well above their fundamental value
→When bubble burst →difficult to pay back credits and lenders reduce supply of credit
→prices decline →downward spiral
The bubble of the subprime:
→Asset prices rose following growth in credit
→Endangered the health of financial institutions and put into danger the whole financial
system → Dire consequences for the whole (world) economy
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