Microecomomics
 study of individual decisions
e.g. choices made by firms regarding quantity and price
consumer choices (amount of a good to be consumed)
labour supply (how much time on individual work?)
Macroeconomics
 Is the study of broad aggregates
 It’s the study of aggregate behavior within an economy
Main variables of interest:




Total output
Employment / unemployment
A measure of the general price level
Balance of payments
 Records a country’s transactions with the rest of the world
- We want to define measures of each of the variables
- Understand the determinants
- Understand how they interact
 Looking for a role for government policy in affecting these variables
Blanchard:
Short run (few years)
 Output is determined by demand
Medium run (10 years or so)
 Output is determined by the level of technology /
capital stock
Long run (40-50 years)
 Output is determined by investment in technology /
capital
Number unemployed
Unemployment rate =
labour force
4 levels of interest
1.
2.
3.
4.
Output ( National income accounts)
Unemployment
Price level
Balance of payment
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Output:
 is a measure of the total value of goods and services produced in an
economy within a year
The measure of output we use is called Gross Domestic Product (GDP)
Measured in 3 ways:
1. The value of final goods produced in a year
GDP is the value of the final goods and services produced in the
economy during a given period.
 A final good is a good that is destined for final
consumption.
 An intermediate good is a good used in the production of
another good.
2. The sum of value added in a given year
GDP is the sum of value added in the economy during a given
period.
 Value added equals the value of a firm’s production minus
the value of the intermediate goods it uses in production.
3. The sum of incomes in a economy during a given year
Example 1: Calculating GDP


Firm 1 produces steel using labour and machines
Firm 2 produces cars using steel, labour and machines
Revenue
Costs
-Wages
Profits
Firm 1
€100
€80
€20
Revenue
Costs
-Wages
-Steel
Profits
Firm 2
€210
€70
€100
€40
What is the value of GDP according to the three different methods of
calculating GDP?
1. Final goods approach
GDP = €210 (we have one final good, cars, the value of which is € 210)
We don’t include the value of steel production to avoid double counting
The value of the steel is included in the cost of the cars.
If the two firms joined, then the only revenue that would appear would be
for the cars. The transaction involving steel would take place internally.
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International Trade:
Exports: are goods produced domestically, but consumed abroad
 Exports are wanted as final goods regardless how they are used
Imports: produced abroad, consumed domestically
 Imports are subtracted from final sales
e.g.
Car sales
Chrysler
Toyota
Final sales
- Imports
GDP
€
1000
500
1500
500
1000
Indirect Taxes (value added tax (VAT))
GDP is measured at market prices
I.e. the prices paid for goods and serviced ( including VAT)
Example 1A: Allowing for VAT



Firm 1 produces steel using labour and machines
Firm 2 produces cars using steel, labour and machines
The steel producer charges 10% VAT and the car producer 20% VAT
Revenue
Costs
-Wages
Profits
Firm 1
€100
Firm 2
€210
Revenue
Costs
-Wages
-Steel
Profits
€80
€20
€70
€100
€40
What is the value of GDP according to the three different methods of
calculating GDP?
GDP = 210 + 42 (0,2*210) =€252
2. Value added approach
Value added = value of products – value of intermediates
Firm I: 100 (-0)
= 100
Firm II: 210 (-100)
= 110
GDP = € 210
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Basic Prices:
is the amount receivable by the producer minus any tax
on products (e.g. VAT)
Purchaser’s Price: is the price the purchaser actually pays for the
product (including Vat, etc.)
- Final consumers always pay a Vat
- When a producer buys an intermediate good, VAT is deductible
GDP can be written:
Total gross value added + taxes on products – subsidies on products
Value added
Firm I :
Firm II:
Total gross value added
€100
€110
€210 ( at basic prices)
Taxes on products
Steel sales
Car sales
- Intermediate purchases
Taxes on products
€10
€42
€-10
=€42
(car firm pays €10 in VAT)
(Purchasers of cars pay €42 in VAT)
(car firm can claim back the €10 paid
for steal, since intermediate
purchases are VAT deductible)
After intermediates have been paid for a firms revenue will be used to
pay:
- Workers (wages)
- Capital (profits, dividends)
- Factories (rent/land)
- Indirect taxes (VAT)
3. Incomes in a given year
Incomes:
Wages
Profits
GDP =
€150
€60
€210
Example 1A:
Incomes:
Wages
Profits
Indirect taxes
GDP =
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€60
€42
€252
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Net Domestic Product (NDP)
Accounts for depreciation1
Each year part of a country’s assets will be used up
(capital assets2 = machines, factories)
NDP = GDP – consumption of fixed capital
Note: Doesn’t take account of national resources that are used up in
production
National Income (Gross National Product (GNP))
GDP – total value of goods and services produced in our economy in a
year
GDP doesn’t account for income earned abroad (e.g. residents owning
foreign firms, or commuting abroad to work)
GDP doesn’t account for income earned by non residents in the domestic
economy
Define “ the balance of primary incomes of the rest of the world”
= Sum of primary incomes paid from residents to non-residents
- Sum of primary incomes paid from non-residents to residents
(primary incomes = profits, wages,…)
Example 1B: Calculating National Income




Firm 1 produces steel using labour and machines
Firm 2 produces cars using steel, labour and machines
The owners of the steel company are non-resident
Resident workers cross the border each day to work, earning €50
Revenue
Costs
-Wages
Profits
Firm 1
€100
€80
€20
Revenue
Costs
-Wages
-Steel
Profits
Firm 2
€210
€70
€100
€40
What is the value of National Income (previously GNP)?
Balance of primary incomes of the rest of the world (RoW)
= €20 - €50 = -€30
National Income = GDP – Balance of the primary incomes of the RoW
€210 - €-30 =€240
1
2
Wertminderung, Entwertung
Anlagevermögen
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Ireland :
Inward Foreign investment
 Many firms owned by non-residents
National Income is much lower than GDP
i.e. The amount of goods produced in Ireland is “high” but a lot of the
profits of the firms goes to non-residents
Net National Income (Net national product)
= National income – consumption of fixed capital
Nominal GDP
is the sum of the quantities of final goods produced times their current
price.
Year
2007
Car production
10
2008
12
Price
1000
=10*1000=€10.000
1200
=12*1200=€14.400
Nominal GDP can increase because
- Price increases
- Production increases
Often we are more interested in actual production rather than the value of
production.
Real GDP


diminutives the impact of increasing prices, allowing us
to concentrate on the actual numbers of goods produced
is constructed as the sum of the quantities of final goods
times constant (rather than current) prices.
Example 2A: Nominal and Real GDP
Year
1999
2000
2001


Quantity of
Cars
10
12
13
Price of Cars
Nominal GDP
€20,000
€24,000
€26,000
€200,000
€288,000
€338,000
Real GDP (in
2000 €)
€240,000
€288,000
€312,000
Nominal GDP is calculated as quantity in year t multiplied by price in
year t
Real GDP is calculated as quantity in year t multiplied by the price in
the base year (i.e. in year 2000)
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Nominal GDP
1999
10*20.000
2000
12*24.000
2001
13*26.000
200.000
288.000
338.000
Growth rate of GDP
=
GDPt
GDP
Year 2000
Year 2001
GDP
t-1
t-1
288000  200000
= 0,44 (44%)
200000
388000  288000
=0,1736 (17,36%)
288000
Real GDP
- Choose a base year (e.g. 2000)
- Use the price level in 2000 to calculate GDP in all years
1999
2000
2001
10*24.000
12*24.000
13*24.000
240.000
288.000
312.000
Real GDP growth
Year 2000
288000  240000
= 0,2 (20%)
240000
Year 2001
312000  288000
=0,083 (8,3%)
288000
e.g. Base year 2001
1999
2000
2001
10*26.000
12*26.000
13*26.000
260.000
312.000
338.000
Real GDP growth
Year 2000
312000  260000
= 0,2 (20%)
260000
338000  312000
=0,083 (8,3%)
312000
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With only one good we could use the number of goods produced as an
indicator of real GDP
In the base year Real GDP = Nominal GDP
When GDP growth > 0
- We have an “expansion” (the number of goods being produced is
increasing)
When GDP growth < 0
- We have a recession (the number of goods being produced is
falling)
We tend to see an upswing in GDP growth followed by a downswing
Business Cycles
Example 2B: Nominal and Real GDP
2000
Quantity
10
4
1000
Cars
Computers
Oranges
2001
Price (€)
2000
1000
1
Quantity
12
6
1000
Price (€)
3000
500
1
- Nominal GDP in the two years is calculated as,
Nominal GDP (€)
2000
2001
Cars
12  3,000  36,000
10  2,000  20,000
Computers
Oranges
4  1,000  4,000
1,000  1  1,000
6  500  3,000
25,000
40,000
Total
1,000  1  1,000
- Real GDP (base year = 2000) is calculated as,
Nominal GDP (€)
2000
2001
Cars
12  2,000  24,000
10  2,000  20,000
Computers
Oranges
4  1,000  4,000
1,000  1  1,000
6  1,000  6,000
25,000
31,000
Total
1,000 1  1,000
Yt  P Q  P Q  ...  P Q
A
0
A
t
B
0
B
t
N
0
N
t
-
i.e.
-
The percentage increase in real GDP is:
(31,000 – 25,000) / 25,000 = 0.24 (24%)
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- Real GDP (base year = 2001) is calculated as,
Nominal GDP (€)
2000
2001
Cars
12  3,000  36,000
10  3,000  30,000
4  500  2,000
1,000  1  1,000
Computers
Oranges
6  500  3,000
1,000  1  1,000
Total
33,000
40,000
- The percentage increase in real GDP is:
(40,000 – 33,000) / 33,000 = 0.2121 (21.21%)
When there is more than one good….
Real GDP is defined as the weighted overage of the output of all final
goods.
The weights we use are the relative prices. If a good costs twice as much
as another, it counts twice as much in our calculation of GDP
Nominal GDP Growth
GDPt  Pt AQtA  Pt B QtB  ...  Pt N QtN
Again, nominal GDP can increase because of increases in Price and
Quantity
Real GDP
GDPt  P0AQtA  P0B QtB  ...  P0N QtN
(0 = Base year)
When changing the base year we again find that the level of Real GDO
changes (as in the one good case), but now the growth rates of real GDP
also change. To get around this problem is to form a “chain index”
Chain index : construct Real GDP from 2000 and 2001 using both 2000
and 2001 as the base year, and take the average growth rate.
Why is GDP important
GDP per capital =
GDP
Population
USA =$35000
AUT =$30000
Togo =$80


These numbers are often used as a measure of the “standard of living”
- i.e. Somebody in the USA is x-times better off than somebody in
Togo
Differenced in price levels across countries cannot account for such
massive differences
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

Some GDP figures adjust for price differences
”Purchasing Power Parity (PPP) adjusted GDP”
GDP growth is used as an indicator of how well an economy is
performing
For most of the course we assume no imports or exports
 a closed economy
Balance of Payments
 records a country’s transactions with the rest of the world
Current account
records all payments to and from the rest of the world
1) Exports: payments received for goods sold abroad
2) Imports: payments made to the rest of the world for goods
consumed domestically
3) Trade balance: difference between exports and imports
Trade deficit: Imports > Exports
Trade surplus: Exports > Imports
4) Investment Income received: Includes dividends3on foreign shares,
yields and bonds, etc
5) Investment Income paid: Dividends, yields, etc. paid to the rest of
the world from the domestic economy
6) Net Investment Income : is the difference between 4) and 5)
7) Net transfers received: Aid received – Aid given
Current account balance: 3)+6)+7)
Current account balance < 0  current account deficit
Current account balance > 0  current account surplus
If a country is running a deficit it means that it had to borrow money
e.g. if a country imports more than it exports, then it has to borrow to
pay for the excess of imports over exports
The capital account explains how this can be done. The capital account
calculates the difference between the increase in foreign holdings of
3
Dividenden
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domestic assets and the increase in holdings of foreign assets by
domestic residents
Net increase in foreign holdings
The U.S. has a current account deficit mainly because
Imports > Exports
It must borrow to pay for the excess of imports over exports.
To do this it issues government bonds which non-residents purchase,
providing the domestic economy with foreign currency to pay for
imports.
The current and capital accounts should balance
i.e. current account deficit = capital account surplus
Statistical discrepancy: takes the two accounts add up
Overall, the balance of payment should be Zero.
Balance of Payments (BoP) disequilibrium is when one of the accounts
has a very large deficit.
Unemployment Rate
 ratio of the number of people unemployed to the labour force
u
unemployment rate
L=N
=
Number of people employed
+U
U
Number of people unemployed
L
labour force
Number of people unemployed
What determines if somebody is unemployed?


They don’t have a job
But they must be actively looking for a job
People who are not actively looking for a job would not be included in the
labour force
Examples:
 Parent staying at home with children
 Student
 Retired
 People with handicaps unable to work
 Discouraged workers : People who would like a job, but have not been
able to find one and so leave the labour force
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 Participation rate : is the ratio of the labour force to the total population
of working age. If the number of discouraged
workers are high, then the participation rate will be
low.
Why do we care about unemployment?
Okun’s law  There is an inverse relationship between the unemployment
rate and the output growth.
Change in
unemployment
rate
Okun’s law
Ut – Ut-1
Output growth
So, the unemployment rate tells us something about how the economy is
performing
A country is not utilising it’s full recources
 unemployed labour could be used to produce goods
Probles of unemployed an unemployment:






Benefits?




The unemployed have lower incomes
“Psychological suffering”
Higher crime level
Lower tax revenue
More government benefits paid out  Government’s budget
deficit worsens
Unemployment hurts different sectors of society
disproportionately
 Low skill workers
 Workers for particular sectors ( e.g. mining)
Increased leisure time
Maybe some psychological benefits
Increased search time may increase the chance of finding a
relatively high – paid job or one more suitable to the
talents
Possibility to retrain / reskill
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
Allows an economy to shift production from declining
sectors
e.g. The closing of the coalmines in the UK increased
unemployment amongst (ex) miners and in mining regions.
But, since then the regions have been rejuvenated4
(particularly IT, retail parks ) and unemployment has
fallen.
Inflation rate
We need to form an average price level
 avergae price level of all goods produced / consumed
Inflation rate gives the growth rate of this (average) price level. Inflation
is a sustained rise in the average or general price level.
Deflation is a sustained decrease in the average price level.
Measurment of Infaltion
GDP deflator
Pt=
Nominal GDPt
Real GDPt
Why is this measure of average price?
If nominal GDP increases, but real GDP stays the same, then all of that
increase is due to increasing price
Remember: In the base year nominal GDP = real GDP



So the GDP deflator will equal one in the base year
The level of the GDP deflator is meaningless
But the rate of change gives the rate at which prices are
growing
Let GDP deflatort = Pt
Then
t 
( Pt  Pt 1
Pt 1
Is the inflation and gives the rate of growth of prices
4
verjüngt
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Paasche Index:
Pt * Qt  Pt * Qt
B
P0 * Qt  P0 * Qt
B
A
A
A
A
B
B
Consumer Price Index (CPI)
The price of output is not necessarily relevant for consumer in a country
Why not?


Because some output is consumed by governments and
firms not consumers
Some products produced domestically are exported (not
consumed domestically)
The CPI looks at an average basket of goods consumed by a
representative consumer
To construct:
 Form a average basket of goods
 The cost of that basket is calculated in year “0”base year
(P0A*Q0A+P0B*Q0B….)
 The cost of that basket is calculated in
year t=1,2…(PtA*Q0A+PtB*Q0B….)
 Construct the consumer price index
CPI=
PtA*Q0A+PtB*Q0B
P0A*Q0A+P0B*Q0B
 in the base year Pt=1

The rate of change
t 
( Pt  Pt 1
gives the infaltion rate (Laspeyres Index)
Pt 1
Figure 2-4
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




1979 oil crisis
Inflation according to the CPI increased
The US is a big importer and consumer of oil, so the price increase in
oil increased the general price level.
Since the US doesn’t produce a great deal of oil the GDP deflator will
not be effected directly by the oil price increase
But the price increase affected the deflator indirectly by increasing the
cost of transportation and the cost of inputs
Why is inflation important?
Inflation
rate
U (Unemployment rate)
There is a neg. relationship between inflation and unemployment (inflation
is related to unemployment, unemployment is related to output growth)
Inflation distorts relative prices
- e.g. through the tax system
Income below €2000 is not taxed
Income above € 2000 is taxed at 30%
Initially a person earns € 3000
 He is taxed at 30% on 1000 of his income i.e. 1000*0,3=€300
(10 % of his income)
Now assume all prices double ( including wages) so his income is € 6000
 He pays tax of €1200 (i.e. 0,3*4000); Now he pays 20% of his income
in tax (12000/6000=0,)
So, he is worse off, he can buy fewer goods an services
A way round this is to increase the tax bonds in response to inflation
-e.g. Income below €4000 is not taxed
Income above €4000 is taxed at 30%
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Inflation redistributes Income
Some incomes are expressed in nominal terms.
e.g. the basic pension is €X per week.  These incomes don’t increase
with inflation. So if prices rise, but income don’t people on fixed nominal
incomes can buy fewer goods. (Indexation of wage contracts)
Inflation creates uncertainty
- Inflation erodes5 the value of money ( money gets smaller and
smaller)
- So inflation provides uncertainty to firms who invest. Who will not
be able to predict the future value of their investment
National Accounting Identities
Assume:
- closed economy ( no international trade)
- no government ( no taxes, no government spending)
- Final sales will be given by
- Consumption (C) an Investment (I) GDP = C+I
GDP will equal wages and profits
These incomes can either be consumed or sold. (S)
GDP = C + Savings
 S= I saving must equal investment in a closed economy with no
government
Now allow for a government sector
Government receives taxes from households
T = level of taxes ( Government buys goods and services)
G = government spending
Then :
GDP = C+I+G
GDP = C+S+T
So: I = S private saving +(T-G)
Now introduce trade:
government +public savings
GDP = C+I+G+X
exports
–Q
imports
GDP = S+C+T
So (S-I)+(T-G) = (x-Q)
5
erode = zerfressen, zernagen
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GDP = C+I+G+X-Q
Current account balance (CA)
CA= (X-Q) + net payment of primary incomes + net transfer received
GNI (Gross national Income) = GDP – balance of primary income of the Rest of
the World
Gross national income Income received by domestic residents
Balance of … = Income received by the RoW form residents
- Income received by residents form RoW
Balance of primary Income received by residents=
Incomes of residents – Income received by the RoW
So we can rewrite GNI as
GNI = GDP + balance of primary incomes of residents received from RoW
Now define :
Gross National Disposable Income (GNDI)
GNDI = GDI – current transfers
(taxes on income, wealth, social benefits etc.)
playacts to non residents + current transfers by residents from non
residents
GNDI = GDI – balance of current transfers of the RoW
Rewriting:
GNDI + GDI + balance of current transfer to residents
GNDI= GDP – balance of primary incomes of the RoW – balance of current
transfers of residents
GNDI is used for C,S,T
GNDI = C+S+Z
(S-I)+(T-G) = CA
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Introduction and National Income Accounting:
Question 1
In Economics, GDP per capita is often used as a measure of the welfare of
an economy. Discuss its advantages and disadvantages.
GDP is used as a population measure of welfare standard of living.
1995 ( real GDP, PPP $)
Austria
$
21375
USA
$
27330
Ethiopia
$
446
These figures adjusted for differences in prices across countries
Disadvantages
Advantages

GDP doesn’t include
bartering6
(exchange a good for a good)


GDP doesn’t include self
production
(e.g. production of good for
consumption7. Do it yourself,
staying at home to care for
children)
GDP doesn’t include money
earned abroad (GNI does)
GDP doesn’t include the
black economy ( some
attempts have been made)
Infrastructure / existing
housing
Quality of life (e.g. weather,
crime levels, political rights,
freedom of speech; hours
worked vs. leisure time)
Income distribution ( weather
income is evenly spread trough
an economy)
Negative externalities
( pollution; not “valuable”
production; cost of clean up;
health care etc. not taken
account of)
Doesn’t account for
depreciation (Net domestic
product does. But doesn’t
account for the depreciation of
national resources and the
environment)








6
7
Figures are easily
available
(makes them comparable
both across countries and
aver time)
Single value for standard
of living
bater = Tauschhandel
Consumption = Verbrauch , Konsum, Absatz
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Chapter 3
The goods market
Determines Output
Supply – Demand Model
Short-run (1-2 years)
 The determinants of output
Assumptions:
- supply responds to demand ( Output)
We can therefore ignore supply; it always equals the value of
demand
- price level is fixed
This is relaxed when we consider the medium run
Who demands goods?
- households consumer
- Firms
- Non-residents
- Government
Government spending
Includes:
- Defense spending
- Roads
- Street lightning
Excludes:
- Pensions
- Unemployment benefits
- Interest on national debt
Government spending would’ve been 31 % with these expenditures
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Consumption:
A good purchased today to be used today
Investment:
A good purchased today for use in the future
Non residential Investment:
Includes the purchase of a new machine or factory (usually by firms)
Residential investment: Involves the purchase of houses ( usually by
households)
We subtract imports from GDP, since this is domestic income spent on
goods produced abroad. We add exports when calculating GDP.
Assumption:
 Inventory Investment is Zero.
Define Aggregate demand
Z  C  I  G  X  IM
We make the assumption that we have a closed economy  X=IM=0
Z  C I  G
Determinants of the components of demand
Consumption






Income: The higher the income, the more that you would expect
people to consume
Price: The (general) price level. But we’ve made the assumption that
prices are fixed
Taxes: The more people are taxed, the less of their income they have
left and so the fewer goods they by
Interest rate: a higher interest rate increases savings and may
reduce consumption
Wealth: The sum of past savings. Individuals with grater wealth may
consume mare
Expectations / Consumer confidence: If confidence is low, people
may consume less.
Macroeconomics
WS 0708
Foster
20
Disposable Income : Income left after taxes have been paid and
transfers received.
YD = Y(Gross income)-T(the level of taxes paid – transfers received)
We assume that consumption is determined by income, and disposable
income in particular.
Consider the following specification
C  c0  c1YD
C  c0  c1 (Y  T )
C0, C1 are parameters
C0>0
0<C1<1
C0: Autonomous Consumption
The value of consumption when YD is Zero.
The consumption level consists with subsistence living.
How to live with an YD of Zero:
- Saving (dissaving)
- Friends and family
- Take out a loan, but banks may not be willing to give you a loan.
C1: Marginal propensity to consume (MPC)
This is the additional amount you would consume if your disposable
income (YD) increased by € 1
e.g. C1 = 0,6
Then if YD increased by € 1  0,6*€1= 60 cents
Investment : I = Ī Ī>0
C  c0  c1YD
 This is found when we solve the model ( endogenous)
Ī: we know this value before we solve the model (exogenous)
Y Government
 c0 Yc1(YSpending
c0Tc)1(GYI =TG)  I  G >0
Macroeconomics
WS 0708
Foster
21
Z  C I  G
C  c0  c1 (Y  T )
I=Ī
These 4 equations
define aggregate
demand
 c1 (Y  T ) GI = G
Substituting the value of C,I and G in Z gives:
Z
Y Cc0 0+Cc11(Y-T)
(Y  T+) Ī I+ 
G
ZY
C
0 c+ C1cY –C
(Y 1T T+)Ī +I
G
0
1
Equilibrium in the goods market implies that aggregate demand (Z) equals
aggregate supply (Output)
The Equilibrium condition is Y(final goods)=Z
i.e. Output (Y) = aggregate demand (Z)
Setting Y= Z gives:
Y
Y Cc0 0+Cc11Y(Y–C1TT+
) Ī I+
G
Y C1cY0 Cc01 (–YC1TT+
) Ī I+
Y-
G
subtract C1Y from both sides
Y (Y1- C
1T
c01)cC10(Y–CT
)+
 ĪI +G
1
Y
[c  I  G  c1T ]
1  c1 0
 Equilibrium level of output
- The equation gives an expression for the equilibrium level of output
- The equation shows that government can affect Output through G
and T
1
- The term 0
called “ autonomous spending “
1
i.e. they don’t depend on Y
1
[c  I  G  c T ]
1 c
1
- The term
is
the multiplier (not money market
Y
[ccalled
0  I  G  c1 T ]
multiplier)
1  c1
Y
Macroeconomics
WS 0708
Foster
22
The multiplier tells us by how much Y will increase if autonomous
spending increase by 1 unit.
Y
1
[c>10  I  G  c1T ]
1  c1
So a € 1 increase in G has a bigger than €1 impact on Y
Example:
- G increase by € 1
- C1 = 0,6
Y= 1/(1-0,6) *G
Y= 2,5 *1
Y= 2,5
i.e.
- If G increases by €1, Y will increase by € 2,5
- If G increases by €1, Z (Z=C+I+G) increase by €1
- Since supply responds to demand, Output will also increase by €1
- The in crease in Y increases consumption
- Consumption increases by 0,6*1 = 60 cents
- The increase in C increases demand (Z) by 60 cents
- The increase in Z leads to an increase in Y of 60 cents (since supply
responds to demand)
- The increase in Y of 60 cents increases consumption
- Consumption increases by :
C1*C1*1
= 0,6²*1
= 0,36*1
Y=G (1+c1+c1²+c1³+…+C1n)
this is called geometric series, the sum of
Y
which is given by
Macroeconomics
1
[cthe
I  G  c1T ]
0 multiplier
1  c1
WS 0708
Foster
23
1
Paradox of Thrift (savings):
- countries that save a lot tend to have high levels of output (or output
growth)
But:
Assume people to decide save more/consume less -> C0 falls.
1)
2)
From S = -C0 + (1+C1)*(Y-T) a decrease in Co implies higher
savings.
A decrease in C0 leads to a decrease in Y.
The decrease in Y will lead to a decrease in S.
- It seems that the decrease in C0 can either increase or decrease S.
- But from I = S + (T-G) it must be that S in unchanged (since T, G
and I are unchanged).
Any attempt to increase S has the effect of reducing Y and leaving S
unchanged.
But this is a model of the short-run. In the long-run attends to increase
S will increase investment and long-run output.
Demand:
Z  C I  G
C  c0  c1 (Y  T )
I
=
Ī
(Y  T ) GI =
G
Equilibrium :
1
Y
[c  I  G  c1T ]
1  c1 0
Y= Equilibrium Output
1
Y
[c=0 The
 I multiplier
 G  c1T ]
1  c1
1
Y
[c  I  G  c1T ]
1  c1 0
Macroeconomics
= Autonomous spending
WS 0708
Foster
24
Role of Government in affecting Output
1) Taxes= Total tax revenue – Total transfer payment
2) Government spending
Government spending
1) Government spending increases
2) Aggregate demand (Z) increases
3) Output (Y) increases since Output responds to
demand
4) Consumption increases since Output has increased
Since C1 < 1 the increases in Consumption get smaller and smaller
Overall:
Y
ΔY (change in Output) =
1
[c*0 Δ GI (change
 G in Government
c1T ] spending)
1  c1
Taxes:
1)
2)
3)
4)
5)
6)
A decrease in taxes
Disposable Income (Y-T) increases
The increase in YD increases Consumption
Increased C increases Z (Demand)
Increased Z increases Y (Output)
Increased Y increases C
 Not all of the increase in YD is consumed, some -C1 is saved
 Only C1 * ΔYD is consumed
Y
So, ΔY =
1 * -C1 ΔT
[c0  I  G  c1T ]
1  c1
So, an equal (but opposite) change in T (to G) will have a smaller impact
on Y.
 Taxes are less “effective” than changes in government spending
Y
1
[c0  I  G  c1T ]
1  c1
- Changes in I will have a similar impact on Y as a change in G, as
will change in C0
- Changes in C1 (marginal propensity to consume) will also effect Y.
Macroeconomics
WS 0708
Foster
25
Forecast error= actual GDP – predicted GDP
A forecast error is the difference between the actual value of GDP and the
value that had been forecast by economists one quarter earlier.
Table 1
GDP, Consumption, and Forecast Errors, 1990-1991
Quarter
1990:2
(1)
Change in
Real GDP
19
1990:3
1990:4
1991:1
1991:2
29
63
31
27
(2)
Forecast Error
for GDP
17
(3)
(4)
Forecast
Index of Consumer
Error for c0 Confidence
23
105
57
88
27
47
1
37
30
8
90
61
65
77
“-17”;”-57”  GDP was less than predicted
Much of this error was due to an error in C0.
Reason:
- Consumer confidence fell drastically
The first Iraq war was lead to lower confidence, people
thought oil prices may rise, there may be a recession etc.
 Autonomous consumption fell which lead to a fall in
Output
C  c0  c1 (Y  T )
C = C0+C1Y-C1T
C0>0
0<C1<1
Macroeconomics
WS 0708
Foster
26
c0  c1 (Y C0-C
T1)T+Ī+
IG
C0-C1T +Ī
C0-C1T
Y Intercept
c0  c1 (=Y C0-C
T1)T+Ī+
IG
Slope = C1
ZZ=Z=C+I+G
Macroeconomics
WS 0708
Foster
27
Equilibrium Y=Z
Everywhere along the 45° line Y equals Z. Where ZZ intersects the 45°
line we have a equilibrium Output Y
 “Keynesion Cross”
An increase in G shifts the ZZ curve up, and increases equilibrium Output
(Income). The increase in Z is smaller that the increase in Y.
 This is the multiplier effect
Changes in C0 and Ī will have a similar impact to a change in G.
A decrease in T will increase Y.
An increase in C1?
e.g C1 increases from 0,6 to
0,7
Intercept shifts down slope
increases (gets steeper)
Macroeconomics
WS 0708
Foster
28
Another way of defining equilibrium:
S  YD  C
Or
S YTC
Equilibrium in the goods market
Y  C I  G
Subtract T and C
Y T C  I  G T
Replace Y-T-C in S= Y-T-C
S  I  G T
Or
I  S  ( T  G)
(1)
S= private savings ; (T-G) = public saving
In S= Y-T-C replace C with C= C0-C1(Y-T)
S=Y-T- C0-C1(Y-T)
S=- C0+(1-C1)*(Y-T)
(2)
 saving function (analogous to the
consumption function)
Substitute (2) into (1)
I= - C0+(1-C1)*(Y-T) +(T-G)
Solving for Y gives
Y
1
[c0  I  G  c1T ]
1  c1
Macroeconomics
WS 0708
Foster
29
Financial Market
- Determine equilibrium interest rate i
- Many financial assets:
money
savings accounts
shares
Government bonds (bills)
We assume their exists only money ( make purchases) and Government
bonds (earn interest)
- Currency: Notes and coins
- Checkable deposits: Bank accounts on which you can write checks
(These earn no interest)
We need to consider money market and bond market
Tinberg’s Rule
If we have 2 markets and one is in equilibrium then the other market is
also.
Money supply: given by the central bank
Money demand: individuals share their wealth between money and bonds
Wealth: financial assets – financial liabilities ( e.g. remaining mortgage)
What determines money demand?
- rate of return on bonds (i.e. interest rate: A higher interest rate
makes the return n bonds higher increasing bond demand and
reducing money demand
- The level of transaction: The higher the level of transaction, the
higher will be money demand.
Assumption:
A person’s level of transaction is proportional to their income.
Aggregating over individuals money demand depends on:
1) interest rate
2) Nominal GDP $Y
Real output = Y
Macroeconomics
WS 0708
Foster
30
Define a money demand function:
(-)
M d  $YL(i )
Md = Money demand
$ Y = nominal income
L(i) = function of the interest rate
This is downward sloping a higher i leads to increased bond demand and
reduced money demand
Remember : wealth = Md + Bd (demand for bonds)
An increase in $Y shifts the Md
function to the right
$Y increasestransactions increase
 money demand increases
Md
= L(i)
$Y
 There should be a negative relation between these.
Md
$Y
has declined rapidly since the 60’s or
$Y
M
has increased rapidly
since 60’s.
$Y
M
$Y = level of transactions; M = velocity of money
Macroeconomics
WS 0708
Foster
31
For a given M the level of transaction has increased i.e. money must be
changing hands more quickly. The reason for this is mainly credit cards
and other financial innovations.
When paying wth a credit card you don’t pay with money. You only need
money at the end of the month when the bill comes.
Average money holdings fall i.e. the same number of transactions can
be made with less money.
Equilibrium I:
- Money consists of notes and coins ( currency)
- Notes and coins issued by the central bank
- Let M be the amount of money issued by the central bank Ms = M
(in this example!!)
LM  Liquidity Money
M= $Y L(i) central bank determines M
An increase in M (government policy  monetary policy)
Expansionary  M
Contractionary  M
- Increase in M leads to an excess money supply at the initial
interest rate
- The return to equilibrium money demand must increase. A increase
in the interest rate will achieve this, but would decrease the
demand for bonds
Macroeconomics
WS 0708
Foster
32
An increase in $Y
An increase in Y will increase
i. For a given I, an increase in
money will increase the level
of transactions an increase
Md.
Md>Ms (excess demand for
money)
To return to equilibrium
money demand was to fall. A
higher interest rate will
achieve this.
 I  Bonds more attractive
  Bd   Md
Central bank sells bonds
 People buy the bonds
 Pay the central bank using notes and coins.
 This reduces the amount of notes and coins hold; and therefore the
money supply.
Central bank buys bonds
 Pays people for these with notes and coins
 This increases people’s holdings of money and the money supply.
The bond promises payment of $ 100 in one year
- you pay $PB for a bond today.
- your rate of return is
$100  $ PB
i
$ PB
e.g. $PB =$95
$PB =$90
i=0,053 (5,3%)
i=0,111 (11,1%)
There is an relationship between bond prices and i. Back to OMO (Open
market operation)
Open-market operations, which take place in the “open market” for
bonds, are the standard method central banks use to change the money
stock in modern economies.
Macroeconomics
WS 0708
Foster
33
Expansionary OMO
- central bank buys bonds in the bond market
- Increases bond demand
- This increases the price of bonds
- The higher bond price implies a lower interest rate
Equilibrium II
Introduce high street banks now money consists of notes and coins and
checkable deposits
- Banks take in deposits
- Banks buy government bonds with these deposits
- Only a part of the deposits are used for purchasing bonds
- The rest are kept as reserves
- For the US, banks would keep 10% of deposits as reserves,
investing 90 % in bonds
Notes and coins issued by the central bank are demanded by
- individuals (currency) Demand for Currency : CU 
- banks (for reserves) Demand for checkable deposits:
d
cM d
D d  (1  c) M d
People hold a given function of their money as currency and the remaining
function as deposits.
Md= CUd+Dd
Demand for reserves:
Bank hold a fraction of deposits or reserves
US example: Rd=0,1 D
Two sources of demand for notes and coins
Rd=D
=Anteil
CUd and Rd
Demand for central bank money:
H d  CU d  R d
Hd = cMd+D
Hd = cMd+(1-c)Md
Hd = [c+(1-c)]Md
H d  [c   (1  c)]$YL(i )
supply of high powered money  determined by the central bank
Macroeconomics
WS 0708
Foster
34
Hs=H
Equilibrium
H  [c   (1  c)]$YL(i )
Chapter 4: Financial Markets: (Money vs. bonds -> earn interest)
 Equilibrium interest rate
Equilibrium in money markets:
M d  $YL(i )
Nominal Income:
(Proxy for level of
transaction)
interest rate
1) Money supply consists only of notes and coins.
Ms = M
Equilibrium: Ms = Md
Macroeconomics
WS 0708
Foster
35
Money Supply = Money demand
M  $YL(i )
2) Equilibrium
Money consists of notes, coins and checkable deposits.
Hs = supply of notes and coins
High powered money,
monetary base
Hs Individuals who wish to hold currency,
Banks that wish to hold reserves.
HD = CuD + RD
Demand for highpowered money
Demand for reserves.
Demand for
currency
Demand for currency:
CU d  cM d
0<C<1
Demand for checkable deposits:
D d  (1  c) M d
RD = θDD 0 < θ < 1 (US banks have a θ of at least 0-1)
Equilibrium: Hs = HD let Hs = H
H d  cM d   (1  c) M d  [c   (1  c)] M d
H d  [c   (1  c)]$YL(i )
Macroeconomics
WS 0708
Foster
36
If C=1 (people only demand currency)
Hs = $YL(i) as Equilibrium
If C=0 then H = θ$YL(i)
And if θ=0,1 H=0,1 $YL(i)
So, the overall demand for money is 10 times bigger than the supply of
notes and coins.
The overall supply of money is equal to central bank money times the
money multiplier:
H  [c   (1  c)]$YL(i )
Then:
1
H  $YL(i )
[c   (1  c)]
Supply of money = Demand for money
1
H  $YL(i )
[c   (1  c)] = Money market multiplier > 1
It tells us by how much an increase in central bank money, H, will
increase the overall money supply.
Macroeconomics
WS 0708
Foster
37
The central bank controls H, but doesn’t control the overall money supply.
[But C and θ are farley stable, so it has indirect control].
Example:
- People only hold checkable deposits (C=0)
- Ratio of reserves in deposits: R/D = θ = 0,1
Stage 1:
The central bank buys € 100 of bonds off seller 1 ie seller 1 receives €100.
He deposits these into his bank, Bank 1.
1) supply of high powered money has increased by €100
2) Bank 1 has €100 more in deposit
Stage 2:
Bank 1 keeps €10 in reserve.
Bank 1 invests the remaining, €90 are invested in bonds.
Seller 2 sells the bonds to bank 1, receiving €90
Seller 2 deposits €90 in Bank 2.
Stage 3:
Bank 2 keeps 90*0,1 = €9 as reserves
Bank 2 invests the money, the remaining €81 in bonds, purchasing them
from Seller 3.
And so on ….
So, the increase in H of €100 has a much bigger impact on the overall
money supply, which increased by:
100 + 90 + 81 + …..
or
100*(1+0,9+0,9²+0,9³+….) = 100 * 1/ θ
1
H = 1/
$YL
(i ) C=0
θ when
[c   (1  c)]
Equals money
multiplier since
C=0
θ = 0,1 -> (1/0,1)=10
Overall increase in money supply = 100*10 = 1000
Macroeconomics
WS 0708
Foster
38
1
Goods Market:
Z  C I  G
C  c0  c1 (Y  T )
(Y 
I=Ī
T ) G I= G
Y=Z
Y
1
[c0  I  G  c1T ]
1  c1
Financial Market:
M d  $YL(i )
Ms = MD Money supply = Money demand
Ms = M
M  $YL(i )
What determines investment?
-
interest rate
the higher the interest rate, the lower the level of investment
The price of the investment good
The level of sales/output
Expectations of future sales
Government subsidies/incentives
The price of labour (wages)
 If wages are high, firm may hire fewer workers and invest in
capital goods/machines.
 If workers are needed to operate machines, higher wages
may discourage investment.
We assume that investment depends upon i and Y.
I –> I
Y –> I
I = I(Y,i)
Macroeconomics
WS 0708
Foster
39
ZY= C(Y-T)
c  c (Y+I(Y,i)
T )  I+
0
1
G
Equilibrium condition:
YY=c0C(Y-T)
 c1 (Y +
 TI(Y,i)
)  I +G
Now, a more specific functionel form:
I = 0 + 1Y + 2i
Now
Z=C+I+G
= C0 + C1(Y-T) + 0 + 1Y + 2i + G
Z = (C1 + 1)Y + C0 – C1T + 0 - 2i + G
Setting Y=Z
Y = (C1 + 1)Y + C0 – C1T + 0 - 2i + G
(1 - C1 - 1)Y = C0 – C1T + 0 - 2i + G
Y* = 1/(1 - C1 - 1) * [C0 – C1T + 0 - 2i + G]
IS-Model:
Assumption:
0<C1+1<1
with i = i0, demand is given
by Z0 and equilibrium by
Y0*.
Now let i increase to i1.
This lowers investment,
which lowers demand Z1.
So the ZZ line shifts down,
this lowers equilibrium
output.
i  I  Z  Y
Y  C1, I  Z  Y and
so on.
Macroeconomics
WS 0708
Foster
40
B
The IS-Curve gives the combination of i and Y at which goods market in
equilibrium.
Points off the curve are pints of non-equilibrium.
Compare A and B:
Point B has a higher interest rate -> Z
Supply at A equals demand ZB = Y0
Since ZB < ZA it must be that Y > ZB
Macroeconomics
WS 0708
Foster
41
What causes the IS to shift?
Example: Taxes increase T
The IS Curve shifts left.
Any changes in C0, 0, T
and G that lowers demand
will shift the IS curve left.
Obviously, changes in C0,
0, T and G that increase
demand will shift the IS
curve right.
LM-Curve:
M  $YL(i )
Divide both sides by the price level P.
P
nominal GDP
real GDP
real GDP 
nominal GDP
P
Macroeconomics
M
 YL(i )
P
WS 0708
Foster
42
Equilibrium is at i0, with output at Y0.
Now, assume that output increases to Y1 (Y1 > Y0)
Money demand curve shifts up (higher income leads to more transactions,
which means that people need more money).
Y -> transaction -> 
MD
P
MD
must fall -> i must increase -> this makes
P
MD
bonds more attractive ->  BD, 
.
P
To get back to equilibrium,
What shift the LM-Curve?
An increase in M
M  rightward shift of

MS
P
M
-> money supply > money demand
P
Money demand must increase to restore equilibrium.
A decrease in i will achieve this -> i = Bd, Md
The point i1, Y0 is a point of equilibrium so an increase in M shifts LM
Curve right.
Macroeconomics
WS 0708
Foster
43
IS-LM Curve
IS-Curve
Y  C(Y  T )  I (Y , i )  G
Anything that increases Z will shift
the IS-Curve right (G;T)
LM Curve
M
 YL(i )
P
M
= real money supply ; YL(i)=real money demand
P
An increase in M will shift LM curve to the
right
Macroeconomics
WS 0708
Foster
44
Overall equilibrium
IS-Curve:
TY0C
CZYC; I=Z
The ZZ curve shift down
LM-Curve:
Since T doesn’t appear in this
equation the LM-Curve will be
unaffected
Equilibrium: where the new IS
Curve intersects LM 0
(In the 45° diagram, the
decrease in I increases I, which
shifts the ZZ line up)
Outcome lower Y, lower i
Macroeconomics
WS 0708
Foster
45
Determinants of demand
 T ;  Y;  i
C= C0 + C1 (Y-T)  (due to T and Y)
I  = 0+1 Y - 2 i 
YI, but  i I ?
G= (remains the same)
Explanation /Description of results
 TYCZ
ZZY (Output responds to demand)
YC,IZ…..multiplier effect
Money Market
MD
MD
Ytransactions
to return to equilibrium
must increase.
P
P
MD
A decrease in I will achieve this  i return on bonds   Bd,

P
Back to the Goods Market
iIZY
C,I ….. (so the multiplier effect is smaller)
Monetary policy
Increase in the Money supply (M)
Expansionary monetary policy
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IS Curve
Y= C(Y-T) + (Y, 1)+G
M doesn’t appear in this equation, so it won’t affect the IS curve
LM Curve
M
 YL(i )
P
An increase in M shifts the money supply curve to the right the
Equilibrium interest rate falls (for a given output level)LM Curve shifts
richt. Equilibrium will be where LM, intersects IS0 here Output has
increased (Y0* to Y1*) and the interest rate has fallen (i0* to i1*)
Components of demand
 Y; i  ; M 
C (because Y YD )
I (because Y and I )
G (unchanged)
Explanation
Open Market Operation
 central banks buys bonds, paying for them with notes and coins, this
increases the amount of money in circulation (M)
Financial Markets
MD
 excess supply of money money demand must increase to
P
return to equilibrium money demand will increase if I fallslowers return
on bondslowers bond demand, increases money demand
M 
Goods Market
 i ;  I Z Y
YC, I ZY etc…..
Back to Financial Markets
Ymoney demandto return back to equilibrium money demand must
fall. This is achieved by a higher interest rate  Bd and Md
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US Recession (2001)
- Decrease in
investment (is
Curve left)
- Taxes fell (T)
- Government
spending
increases (G) (IS
Curve right)
- Federal reserve
increased in
money supply
(decreased i) (LM
Curve right)
So, the recession was much less severe due to the policy response (M,
T, G)
- can consider more than one policy simultaneously
- The model can explain real world events
- Policy is important: The government can affect output in the
short run
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Medium – run
- We relax the assumption that prices are fixed
Increase in demand
Increase in production
Increase in employment
Decrease in unemployment
Increase in wages
Firm’s costs increase
Firm’s charge higher prices
wage-price spiral
If prices rise, real wages fall
workers demand higher wages
higher wages increase costs and prices further
Labour market
 equilibrium unemployment rate (natural rate of unemployment)
real wages
From the labour market we derive the Aggregate Supply curve. The
Aggregate demand curve is derived from IS-LM model
The noninstitutional civilian population are the number of people
potentially available for civilian employment.
The civilian labor force is the sum of those either working or looking for
work.
Those who are neither working nor looking for work are out of the labor
force.
The participation rate is the ratio of the labor force to the
noninstitutional civilian population.
The unemployment rate is the ratio of the unemployed to the labor
force.
Discouraged8 workers:
- people that have left the labour force
u
unemployment rate
L=N
=
Number of people employed
US, 1998
8
+U
U
Number of people unemployed
L
labour force
Number of people unemployed
u=4,5%
entmutigt
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Unemployment rate for 16-19 year olds = 16,2& (similarly
unemployment tends to be higher for immigrants, the elderly,
uneducated,…)
Average Monthly Flows Between
Employment, Unemployment,
and Nonparticipation in the
United States, 1994-1999
(1) The flows of workers in and out
of employment are large (2) The
flows in and out of unemployment
are large in relation to the number of
unemployed (3) There are also large
flows in and out of the labor force,
much of them directly to and from
employment
From the CPS data we
conclude that:
- The flows of workers in and out of employment are large.
Separations consist of:
Quits, or workers leaving their jobs for a better alternative,
and
Layoffs, which come from changes in employment levels
across firms.
- The flows in and out of unemployment are large in relation to
the number of unemployed.
The average duration of unemployment is about three
months.
- There are large flows in and out of the labor force, much of
them directly to and from employment.
Discouraged workers are classified as “out of the labor
force,” but they may take a job if they find it.
The nonemployment rate is the ratio of population minus
employment to population.
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Higher unemployment is associated with
 The chance that an unemployed worker will find a job
diminishes.
 Employed workers are at a higher risk of losing their jobs
ZY Firms need fewer workers
They can adjust employment:
1) Can lay – off workers
employed workers have a greater chance of losing their jobs.
2) Stop hiring (employment will fall as people retire and leave for
other reasons)
Unemployed have less chances of finding a new job
Wage determination
- collective bargaining9 (bargaining between trade unions and
firms)
- Employee has bargaining power to determine wages (high
skill level’s or innate10 ability, e.g. actors)
- Employer has the bargaining power to dictate the wages
Common forces at work in the determination of wages include:
 A tendency for the wage to exceed the reservation
wage, or the wage that make them indifferent between
working or becoming unemployed.
 Dependency of wages on labor market conditions.
In unemployment is high wages tend to be lower (and vice versa)
Two models explain these facts.
Bargaining Power:
- Ability a workers has to raise the wages above the reservation
wage
- How costly it is to replace the worker. Everybody can work for
e.g. Mc’Donalds  easy to replace
- People that are skilled are more difficult to replace
- How easy it is for the worker to find another jobthis will
depend on market conditions
- If unemployment is low then workers will have more
bargaining power
9
aushandeln, feilschen, schachern
angeborene
10
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In 1914, Henry Ford decided his company would pay all qualified
employees a minimum of $5 a day for an 8-hour day. While the
effects support efficiency wage theories, Ford probably had other
objectives as well for raising his employee’s wage.
Table 1
Annual Turnover and Layoff Rates (%) at Ford,
1913-1915
1913
1914
1915
Turnover Rate
Layoff Rate
370
54
16
62
7
0.1
Efficiency wages (e.g. Henry Ford)
 Paying the reservation wage people are indifferent between
being unemployed and working
 Paying a higher wage creates some kind of “bond” between
firm and workerlowers worker turnover .By keeping
workers in the firm, over time they become better at their
job and more productive
Again more skilled workers will be paid higher wages because
commitment11 and moral tends to be more important for these
professions
Developing countries
 Paying a higher wage can improve shelter, diet health etc.
 Workers will be at work moremore productive
11
Bindung, Hingabe
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Market conditions
Lower unemployment makes it more attractive to quit
to counteract this problem firms will pay higher efficiency wages
W  P e F (u, z)
(  , )
The aggregate nominal wage, W, depends on three factors:
 The expected price level, Pe
 The unemployment rate, u
 A catchall variable, z, that catches all other variables that
may affect the outcome of wage setting.
Expected Price level (Pe)
People don’t know actual price level in the future when sign a
contract
 People must make an expectation of the price in order to
have an idea about a suitable wage
Unemployment rate:
Also affecting the aggregate wage is the unemployment rate u.
If we think of wages as being determined by bargaining, then higher
unemployment weakens workers bargaining power, forcing them to
accept lower wages. Higher unemployment also allows firms to pay
lower wages and still keep workers willing to work.
Z-Anything else that affects wages:
 Unemployment insurance: implies that reservation wages
are higherfirms must offer higher wages to encourage
workers to work
 Minimum wage: this will also obviously raise wages
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Wages equation
W  P e F (u, z)
(  , )
Assume that P = Pe
(we argue next week that price expectations won’t be systematically
wrong)
W=PF (u,z)
W/P=F (u,z)
wage setting equation
Price determination
Prices depend on costs
Costs depend on the nature of the production function
Y= F ( Kcapital, Atechnology Nemployment)
Assumption:
- no capital
- technology doesn’t change (A=1)
Then = Y= N
Output equals the level of employment
To increase output by 1 unit, employment increases by 1 unit
The cost of employing one more worker = W i.e. Marginal cost = W
Perfectly competitive firm
P= MCmarginal cost (=MRmarginal revenue)
P=W
We assume imperfect competition and that firms charge a mark –
up12 over costs:
P=(1+Mmark-UP)W
12
Price equation
Handelsspanne
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e.g
M=0,055%
P=1,05W
P=(1+M)W % by W
(P/W)=(1+M)
W
1

P (1  M )
invert both sides
Price setting equation
In equilibrium the real wage from WS must be the same as that
from PS.
F(u,z)=
1
(1  M )
Un=natural rate of unemployment
(W/P) determined
solely13 by the PSCurve
13
ausschließlich
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Examples:
W
 F ( u, z )
P
(WS)
W
1

P (1  M )
(PS)
increase the value of ZWS shifts out
Unemployment Benefits
and the Natural Rate of
Unemployment
An increase in
unemployment benefits
leads to an increase in the
natural rate of
unemployment.
Equilibrium rate of
unemployed increases
Increases in benefits:
increase in wages (So
W
increases), but prices will also increase
P
(i.e. of W, P will still be (1+M)*W, so P will increase )
real wages unaffected
e.g.
W=10; M=0,1
P=1,1*10 =11
W 10

P 11
Now: W=20;M=0,1
P=20*1,1=22
W 20 10


The same
P 22 11
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Examples
- more stringent14 antitrust legislation15
(lower monopoly power)
W
 F ( u, z )
P
(WS)
W
1

P (1  M )
(PS)
M= measure of monopoly power
will reduce the value of M
If M falls, then the PS Curve will shift upwards
This increases the real wages and reduces the natural rate of
unemployment
14
15
streng, strikt
Anti-Trust Gesetzgebung
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Aggregate Supply and Demand
- Equilibrium rate of unemployment = Natural rate of unemployment
(Un)
- Real Wages (W/P)
Two equations defining labor market equilibrium
1)
W= PeF(u,z)
W= nominal wage;
Pe= Expected price level;
u= unemployment rate
z= other stuff (unemployment benefits)
2)
P=(1+M)W
Assume P= Pe
W= PF (u,Z)
(W/P)=F(u,z)
(W/P)= 1/(1+m)
wage setting
price setting
Aggregate Supply
Captures the impact of Output an the price level
1) W= PeF(u,z)
2) P=(1+M)W
Substituting 1) into 2)
P=PeF(u,z)*(1+M)
A higher u implies a lower price level
u= (U/L)=1-(N/L)
Y=N
u= 1-(Y/L)
replace u we have
P=PeF(1-(Y/L), z)*(1+M)
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- The relationship between Y and P is positive
- An increase in Pe leads to an increase in P
PeWcostsP
Why a positive relationship between Y and P?
GZY
YNU (and u)
The lower unemployment rate implies higher nominal wages (bargaining
power, efficiency wages)
Yn is the natural level of Output
The level of Output produced when u=un, derived under the assumption
that P=Pe
When Y=Yn it must be that P = Pe (i.e the AS curve goes through this
point, similarly , if Y >Yn, it must be that P>Pe (and vice versa)
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Aggregate Demand
Reflects the impact of price upon output
Based on IS-LM
Y=C(Y-T)+I(Y,i)+G
(M/P)=YL(i)
IS-Curve
LM Curve
Consider an increase in P
- shifts the (M/P)s function to the left
- this shifts the LM Curve left
 The interest rate increases and Output falls
 So an increase in price (P0 to P1) leads to a lower Output level (Yo to
Y1)
 AD is downward sloping
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What factors shift the AD Curve?
M increases
(M/P) increases
LM Curve shifts
right. We have a
higher Output
T increases
Y0CZY
IS Curve shifts
left, for a given
Price (P0) Output is
lower
 AD shifts left
Y=Y(
M
,T,G)
P
shifts the AD Curve right
Obviously other coefficients will affect the position of the Ad Curve
(e.g. C0, C1,…)
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To sum up:
AS Relation P  P

AD Relation Y  Y 

e
Y 

(1   ) F  1  , z

L 
M

, G, T 

P
In the short-run there is no reason why Y0* is equal to Yn.
Why? Because equilibrium Output is determined also by the position of the
AD Curve, which is influenced by government policy
What happens over time?
This depends upon how Price expectations are formed
Rational expectations
- expectations based upon all available information
Adaptive expectations
- expectations based upon past levels of the variable of interest
Pte = Pt-1
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What happens in period t+1?
Pt+1e = Pt
As Curve goes through the point Pt+1e and Yn=Y
What happens in period t+2?
Pt+2e = Pt+1
As Curve goes through the point P = Pt+2e, Y=Yn
AS Curve shifts right
Output increases and price level falls further
As Curve shifts because of differences in the expected and actual price.
As Curve will continue to shift until it intersects the AD Curve at Y0
Since when Y=Yn, it must be that P = Pe
At this point there is no “incentive” for the AS to shift further
Medium –run equilibrium
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Aggregate Supply – Aggregate Demand Questions
1) For each of the following changes, state which curve or curves are
affected initially (IS,LM,AS and AD) and in which direction they will initially
shift
a) Increase in government spending G
IS-LM model
GIS Curve right
Y, i
AD-AD Model
GZ
AD Curve shifts right
Y, P
IS-LM Model
M
P

P
LM Curve shifts left
Y, i
Short run equilibrium:
Y, P; i, C(Y)
I ? (Y, i)
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b) Increase in the nominal money supply M
IS-LM Model
M
M
P
LM shifts right
Y, i
AS-AD Model
M
Y=Y( ,T,G)
P
AD Curve shifts right
iIZ
Y, P
IS-LM Model
M
P

P
LM Curve shifts left
Short-run equilibrium
Y, P, i, C(Y), I (Y, i)
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c)Increase in price of oil
Supply side shock
Y 

elation Pt  Pt-1 (1   ) F  1  , z

L 
e
We can model the change in oil price by assuming that M increases
P=(1+M)*W
Firms increase their mark-up over wage costs to pay for the higher price
oil.
An increase in u will shift PS down – Natural rate of unemployment
increases  Natural level of Output decreases.
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Remember: AS Curve goes through the point Y=Yn, and P = Pe
Period 1 (initial change)
P1e= P0
The AS Curve will go
through the point P=P0,
Y=Yn1
Hence it must shift left
 Y, P
IS-LM
M
 LM Curve
P
shifts left
P
Short-run equilibrium
Y, P, i, C (Y),
I (Y, i)
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2) Using the As-AD model, describe the effects of the following shocks on
the IS,LM,AS and AD curves in both the short-run and the medium-run.
Describe the impact on Output, The interest rate and the Price level in
both the short-run and the medium run. Assume that initially the economy
was at the natural of Output.
a) A reduction in the money supply M
Period 1
M

P
Shifts the LM Curve left
Y, i
IS-LM: M
AS-AD: i IZ
Shifts the AD-Curve left
M

P
Shifts the LM-Curve right
IS-LM: P
Short-run: Y, P, i, C,
I
Period 2
P2e= P1
AS Curve goes through the
point P= Pe, Y=Yn
So AS must shift right going
through P= P2e, Y=Yn Y(
from Y2 to Y3)
P
M
IS-LM: P

P
Shifts the LM-Curve right
This process will continue in
periods 3,4. At some point
AS will intersect AD at Yn
(here Y=Yn and P= Pe). The
fall in price level continues
to shift the LM Curve right.
- In the medium-run LM returns to LM0
M
is unchanged
P
Medium-run:
Output and interest rate are at initial levels  C, I back at initial levels,
only the price level has fallen “Neutrality of money”
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b) An increase in Taxes T
Period 1
IS-LM: IS Curve will
shift down Y, i
AS-AD: AD will shift
down P, Y
M

P
Shifts the LM-Curve
right
IS-LM: P
Short-run equilibrium
Y, P, i, C, I ?
Period 2
P2e= P1
AS Curve shifts right
going through the
point P= Pe, Y=Yn
So, Y increases To Y3
and P falls to P2
M
LM shifts
P
right  i 
P
This process
continues….
In the medium – run
AS intersects AD and
Yn  P
M
in the medium-run; LM will intersect IS at Yn  i 
P
Equilibrium:
Y = Yn, i , P
C
I( i)
 Increases long-run growth
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d)Increase in unemployment benefits
- supply side policiy
Can be represented by an increase in Z
- WS shifts upUn increases Yn decreases
Period 1
As curve shifts left going
through P= P1e
, Y=Yn.
M
P
 LM Curve
P
shifts left  Y, P, i
Period 2
P2e= P1
AS Curve shifts right
going through the point
P= P2e, Y=Yn.
M
 Y, P
 LM
P
Curve left  Y, P, i
This continues as long
as P > Pe
In the medium-run AS
intersects AD at Yn1
M
P
 LM Curve
P
intersects at Yn1
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Supply side policies can affect Output in the medium-run
e.g.
- Decrease unemployment benefits
- Decrease minimum wage
- Increase Y in the medium-run
Any policy that increases the working of the labour market should increase
Y in the medium-run
e.g.
- Increase training/skills that
- Increase labour mobility
Decreasing union power would decrease Z in
W
 F ( u, z )
P
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The Labour Market Questions:
1) How do the following policies affect the equilibrium real wages and
unemployment level;
a. An increase in the mark-up by firms
same as by question 1 c ( if oil prices, non-wage costs
increase, firms must charge higher mark-up over wages to
cover these costs)
1
 in Mark up 
 PS Curve shifts down
1  Markup
 Real wages will fall
 Increase in Un; decrease in Yn
b. A reduction in unemployment benefits
Can be represented by a decrease in Z ->wages hould be
lower with lower unemployment benefits
i.e. the reservation wage should fall ; people earn less by
being unemployed. Can be represented by a townward shift in
WS
 Un falls
 Real wages are unaffected
c. See 1 a. W increases, but this increases costs and therefore
W
prices increase. Overall
is unaffected
P
d. The imposition of a minimum wage
Represented by an increase in Z (i.e. it should increase
nominal wages)
 WS Curve shifts upward
 Un increases
 Real wage is unaffected
2) Suppose that the firms’mark up over costs is 5% and the wage
setting equation is W = P(1-u) where u is the unemployment rate.
a. What is the real wage as determined by the price setting
equation?
W
1

 0,9528
P 1  0,05
b. What is the natural rate of unemployment?
PS=WS
0,9528=1-u
u=1-0,9528=0,04762=4,8%
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c. Suppose that the mark-up over costs increases to 10%. What
happens to the natural rate. Explain the logic behind your
answer.
W
1

 0,9091
P 1  0,1
0,9091 =1-u
W
u=0,09=9% Increase in Mark-up increases Un. If
fewer
P
people will want to work e.g. the new real wage will be
belower the reservation wage for some people
unemployment rate increases
Phillips Curve
- refers to the negative relationship between inflation and the
unemployment rate
- Trade off for governments high unemployment’s and low inflation
or, low unemployment and high inflation
e.g. If u was too high governments would increase Z, which would
increase Output Y and decrease u.
lower unemployment would push wages up  higher costs= higher prices
(inflation)
If inflation was too high the government would do the opposite
“stop-go” policies
worked well in the 1950’s and 1960’s. Relationship broke down during the
1970’s – high unemployment and high inflation (Stagflation)
Aggregate Supply
Pt=Pte (1+M) F(u,z)
Specify a form for F
F (u, z)  1   u  z
P  P e (1  )(1   u+ z)
t 
( Pt  Pt 1
we can obtain expressions for inflation
Pt 1
   e  (   z)   u
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Original Phillips Curve
For much of the 20th century inflation was approximately zero
e
So,  t  0 therefore
t
t
  (   z)   u
Original Phillips Curve
Wage-price spiral
low unemployment
higher prices
higher nominal
wages
higher costs
To maintain real wages, nominal wages must rise in response to higher
prices
Why did the relationship brake down in the 1970’s ?
1) Oil prices increased (1973,1978)
u increases 
Phillips Curve shifts out
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2) From the 1960’s inflation was consistently positive. So, the assumption
e
that  t  0 no longer held.
 t e   t 1
Pre – 1970    0
After 1970    0
Shortly after 1970    1
 t e   t 1
So,  t   t 1  (   z )  u 
 t   t 1  (   z)  ut
Change in inflation
So there is now a relationship between u and the change in inflation
- modified
Phillips
Curve
- Expectations augmented
- Acceleration16
Natural rate of unemployment
- No natural rate of unemployment in the original Phillips Curve
- With the modified Phillips Curve the natural rate of u will be the
e
rate at which  t   t
 t   t 1  (   z)  ut
Un 0 
16

Z


Set  t   t 1  0  (   z )  u 
 Un  (   Z )
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 t   t 1  Un  ut
 t   t 1   (Un  ut )
or
 t   t 1  ut  ut
 t   t 1   (ut  ut )
if ut >Un   t   t 1 …inflation falling
if ut<Un   t   t 1 … inflation is rising
if ut = Un   t   t 1 … inflation is rising
Un is sometimes called Non-accelarating inlation rate of unemployment
(NAIRU)
Intexation:
When inflation is very high and volatile17 , people will not want to base
expectations on  t 1
W
- They could be very wrong and
could be particularly low
P
- One way around this to index labour contracts . Here wages
automatically adjust to changes in inflation
Example:
2 contracts
1) proportion 1-λ are standard labour contracts
e
i.e. nominal wages based on expected inflation  t   t 1
2) proportion λ are indexed contracts
i.e. nominal wages increase in line with inflation
 t   t 1   (ut  u n )
 t  [(1   ) t 1   t ]   (ut  un)
a proportion 1- λ
17
proportion λ
schwankend
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 t  (1   ) t 1   t   (ut  un)
 (ut  u n )
(1   ) t   t 1 
1 
 (ut  u n )
 t   t 1  
1 
0  (1   )  1
 (ut  u n )

 (ut  u n )
1 
So, inflation responds more to unemployment with intexed labour
contracts than without.
Intuition
No intexed contracts: lower unemployment  WcostsP (inflation)
With intexed contracts: uWcostsP (inflation)
For people on intexed contracts the inflation in period t will lead to a
further increase in W, costs and prices.
 So, overall the impact of lower u on inflation will be higher in this case.
Consider the links between Output, inflation and unemployment
M
- Aggregate demand ( Y and
)
P
- Phillips Curve (  and u)
- Okun’s law ( Y and u)
Aggragate demand:
Y= Y(
M
, G, T)
P
M
(>0)
P
 in M   i in I  in Z
we want a relationship between Output and the money supply
Y=
gyt  gmt  t
Output growth equals nominal money growth minus inflation
Phillips Curve  t   t 1   (ut  u n ) = 1 un=6%
if ut >Un   …inflation falling
if ut<Un   … inflation is rising
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Okun’s law
Gives a relationship between Output growth and the unemployment rate
ut-ut-1=-0,4(gy-3%)
- There is a negative relationship between Output growth and the
change in unemployment
3% if in a particular year gyt<3%; ut-ut-1>0  unemployment rate will
increase if gyt<3%
 So, a county can produce more still unemployment may still rise.
1) Population growth (1,7%)
Output has to increase to give new entrants to the labour force jobs.
if gyt<1,7% unemployment will increase
2) Productivity growth (1,3%)
Each worker becomes more productive over time so, if Output were
constant over time we would need 1,3% fewer workers per year due to
productivity growth
 To maintain constant unemployment output must increase by 1,3% per
year
3% normal growth rate for U.S
-0,4
if gyt<4% ut-ut-1=-0,4
An Output growth rate 1% in excess of 3% decrease in unemployment
rate by only 0,4%
Why?
1) Firms may not adjust employment one for one to change in Output
 Some workers are needed regardless of the level of Output
 Firms may not lay off workers when output falls as they don’t
want to loose skills and money invested in the worker
2) Participation rate = proportion of working age population in the
labour force; when Output growth is high participation increases
 So some few jobs will be taken by people not previously in the
labour forceThese new jobs will not affect the reported
unemployment rate
ut-ut-1=-3(gyt- gy)
coefficient
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ut-ut-1=-3(gyt- gy)
gyt  gmt  t
growth rate of money
What happens if the central bank / government lowers the growth of
the nominal money supply?
g  gmt  t
gytin gmt willtlower gyt  gmt  t
1) For a given  , a decrease
yt
Decrease in money supply
2) A decrease in
increase
in u (i.e. u -u
gyt implies
gmt an

t
t
t
t-1>0)
3) An increase in ut will decrease  t
ut  uutu 1  ( gg 
( gyt  g y )
 gg)  
 ( g  g )
  ( gyt  g y )
 ut  1 g  g  ( gyt  g y )
Assume the government maintains lower money growth ( gm )
- Medium-run: unemployment rate is constant ut=ut-1 from Okun’s law it
must
yt = y mt
t
t
t  1 be that
yt
ytSince
y
and
gm are constant in the medium-run, so must  t (From
AD)
From the Phillips Curve setting  t   t 1 it must be that ut=un in the
medium-run  t must be lower since gm is lower.
i.e.
yt
mt
t
Phillips Curve:  t   t 1   (ut  u n )
Government wants to reduce inflation (i.e. disinflation)
Left hand side of Phillips Curve has to be negative
 ut-un>0 i.e. the unemployment rate has to rise
The additional unemployment is the same regardless of the speed of
disinflation
Define: point year of excess
unemployment = difference between the actual and the natural rate of
unemployment of 1% for one year
e.g. If un = 6,5% an actual ut of 9% for four years
The number of point years = (9-6,5)*4=10
1. year: need an unemployment rate of 10% above un for one year
i.e. (16,5-6,5)*1=10
10.years: need an unemployment rate of 7,5 for 10 years
i.e. (7,5-6,5)*10=10
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Example:
- Inflation to fall from 14% to 4%
- In 5 years (2% per year)
- un =6,5%
- =1
- 3=0,4
- gy=3%
Show what happens to gyt,  t , ut and gmt

u
gy
gm
0
14
6,5
3
17
1
12
8,5
-2
10
2
10
8,5
3
13
3
8
8,5
3
11
4
6
8,5
3
9
5
4
8,5
3
7
6
4
6,5
8
12
gyt  gmt  t
gmt=gyt+  t
17=3+14
Period 1:
1) Use the Phillips Curve to solve for ut
 t   t 1  1(ut  u n )
12%  14%  u1  6,5
2) Use Okun’s law to solve for gyt
ut-ut-1=-0,4(gyt-3%)
8,5-6,5=-0,4gyt+0,4*3
3) gmt=gyt+  t
gmt =-2+12=10
To reduce inflation, u must be above un. To increase ut we need a
recession (gyt<0) in order to create a recession the growth of money must
fall, in order to lower demand.
To reduce inflation in years 2,3,4,5 unemployment must remain above un.
To maintain
t constant
t  u1t, gyt must return
yt to
y
u u
  ( g  g )
Once  t is constant, ut must return to un we need an expansion
gmZgy
 Monetary policy affects only prices (i.e. inflation)
Short-run: G, T, MY
Medium-run: G,T(affect compasition of demand),M NO IMACT on Y
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Only supply-side policies effective in the medium-run
- lower unemployment benefits
- lower minimum wage
- improved training / education
Phillip’s Curve Questions
1. Suppose that the Phillips curve is given by:
 t   te  0.1  2ut
where,
 te   t 1
Also, suppose that

is initially equal to zero.
 =0
a. What is the natural rate of unemployment?
Defined when
 t   te
 t   te1  0
0 = 0.1  2u t
2ut = 0,1
0,1
ut 
 0,05  5%
2
Suppose that the rate of unemployment is initially equal to the natural
rate. In year t the authorities decide to bring the unemployment rate
down to 3% and hold it there forever.
b. Determine the rate of inflation in years t, t+1, t+2, t+10, t+15.
t:
 t  0  0,1  (2 * 0,03)
 t  0,04  4%
t+1:
 t 1  0  0,1  (2 * 0,03)
 t 1  0,04  4%
Inflation will be 4% for all t.
c. Now suppose that in year t+5
increase like this?

increases from 0 to 1. Why might

 became positive during the 1970s.
 because inflation was consistently positive.
 People expected a positive rate of inflation (i.e.
By the mid 70s
   t 1
 > 0)
 was equal to 1.
e
t
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What is the effect on un?
Again set
 t   te   t 1
 t   t 1  0,1  2ut
 te   t 1
 t   t 1  0,1  2ut
0  0,1  2ut
So, un 
0,1
 0,05  5%
2
U/P
1/(1+)
d. Suppose that the government is still determined to keep u at 3%
forever. What will the inflation rate be in years t+5, t+10 and t+15?
 increases to 1
 t 5   t 4  0,1  2ut 5
In t+5
From part b)
 t 4  0,04
 t 5  0,03
 t 5  0,04  0,1  (2 * 0,03)
 t 5  0,08 ( by 4%)
t+6:
 t 6   t 5  0,1  2ut 6
 t 6  0,08  0,1  (2 * 0,03)
 t 6  0,12 ( by 4%)
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

In t+5 people are expecting inflation of 4%.
To encourage the unemployed nominal wages must increases by
more than 4%.
W
and reduce unemployement.
P
Consequence:  W   costs   P  Inflation rate increases.
This will increase
To increase W, Government must increase demand.
 M   i   Z   Y   W   u
2. Suppose that the Phillips curve is given by:
 t   te  0.1  2ut
e
where,  t   t 1
Suppose that inflation in year t-1 is zero. In year t, the authorities
decide to keep the unemployment rate at 4% forever.
a. Compute the rate of inflation for years t, t+1, t+2 and t+3.
t:
t+1:
 t  0  0,1  (2 * 0,04)
 t  0,02  2%
 t 1  0,02  0,1  (2 * 0,04)
 t 1  0,04  4%
 t 3  0,06  6%
t+4:  t  4  0,08  8%
t+3:
Indexed labour contracts
 wages respond automatically to an increase in inflation.
 If  t increases – Wt also increase.
In standard contrasts inflation will only be accounted for with a lag.
Eg: if  t = 5%, workers will demand 5% higher wages in period t+1 to
compensate.
 te   t 1
 t   te  0.1  2ut
 te  0.5 t 1  0,5 t
So,
 t  [0.5 t 1  0,5 t ]  0.1  2ut
0,5 t  0.5 t 1  0.1  2ut * 2
 t   t 1  0.2  4ut
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b. Now suppose that half the workers have indexed labour contracts.
What is the new equation for the Phillips curve? Compute the rate of
inflation for years t, t+1, t+2 and t+3.
 t  0  0,2  (4 * 0,04)
 t  0,04  4%
 t 1  0,04  0,2  (4 * 0,04)
t+1:
 t  0,08  8%
t:
c. What is the effect of indexation on the relation between

and u?
Indexation increases the impact of unemployment on inflation.
Why?
No Indexation:
 u   W   costs   P   inf lation  this effects  e next year.
With indexation:
 u   W   costs   P   inf lation
 inf lation   W in the current period  Further increases in costs P
and  in the current period.
3. The estimated Okun’s law equation for the US is given by:
ut  ut 1  0.4( g yt  3%)
a. What growth rate of output leads to an increase in the unemployment
rate of 1% per year? How can the unemployment rate increase even
though the growth rate of output is positive?
ut  ut 1  0,01
0,01  0.4( g yt  0,03)
0,01  0.4 g yt  0,12
g yt 
0,002
 0,005
0,4
Output growth of 0.5%.
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Why?
1) labour force growth
Output must increase in order to provide Jos for newcomers to
the workforce.
2) Productivity growth
Workers became mor productive over time
If productivity growth exceeds output growth we need fewer
workers to produce the output and unemployment will increase.
b. What rate of output growth do we need to decrease unemployment by
two percentage points over the next four years?
A reduction of 2% implies 4 years of a 0.5% reduction.
u t  ut 1  0,05
0,005  0.4 g yt  0,12
g yt 
0,017
 0,0425
0,4
we need 4 years of output growth of 4,25%.
4. Suppose that the economy can be described by the following three
equations:
Okun’s Law
u t  u t 1  0.4( g yt  3%)
 t   t 1  (u t  5%)
g yt  g mt   t
Phillips Curve
Aggregate Demand
a. What is the natural rate of unemployment for this economy?
From the phillip’s curve
Set  t   te   t 1 (i.e.  te   t 1 and   1)
0  ut  0,05
i.e. u n  0,05 (5%)
b. What rate of output growth do we need to decrease unemployment by
two percentage points over the next four years?
ut  0,05  t  0,08   t 1
From AD g yt  g mt  0,08
Substitute in Okun’s law
ut  ut 1  0.4(( g mt  0,08)  0,03)
setting u t  u t 1  u n
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0  0.4 g mt  0,32  0,0012
0.4 g mt  0,044
g mt 
0,044
 0,11
0,4
g yt  g mt   t
g yt  0,11  0,08
g yt  0,03  equal to the normal growth rate
c. Suppose that conditions are as in (b), when, in year t, the authorities
use monetary policy to reduce the inflation rate to 4% in year t and
keep it there. What must happen to the unemployment rate and
output growth in years t, t+1 and t+2? What money growth rate in
years t, t+1 and t+2 will accomplish this goal?
t-1
t
t+1
t+2

u
8%
5%
4%
9%
4%
5%
4%
5%
gy
3%
-7%
13%
3%
gm
11%
-3%
17%
7%
t:
From Phillip’s Curve
t+1
From Phillip’s Curve
0,04  0,08  (ut  0,05)
0,04  0,04  (ut 1  0,05)
 0,04  ut  0,05
0  ut 1  0,05
ut  0,05  0,04
ut 1  0,05  5%
 t   t 1  (ut  5%)
 t 1   t  (ut 1  5%)
ut  0,09  9%
From Okun’s Law
From Okun’s Law
0,09  0,05  0.4( g yt  0,03)
0,05  0,09  0.4( g yt 1  0,03)
0,04  0.4 g yt  0,012
 0,04  0.4 g yt 1  0,012
g yt  0,07  7%
g yt 1  0,13  13%
g yt  g mt   t
g yt 1  g mt 1   t 1
 0,07  g mt  0,04
0,13  g mt 1  0,04
g mt  0,03  3%
g mt 1  0,17  17%
ut  ut 1  0.4( g yt  3%)
Macroeconomics
ut 1  ut  0.4( g yt 1  3%)
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IS relation in the open economy
Demand for domestic goods
Z C I  G IM/ X
exports
Imports: the
part of demand
that falls on
foreign goods.
:
real exchange rate
so we divide by

Multiplyling IM by
domestic goods.
in order to express foreign good in domestic terms.
1

express the price of foreign goods in terms of
What are the determinants of the components of demand?
We still assume:
C = C0 + C1Y0 = C0 + C1*(Y-T)
I=I(Y,i)
GG
Imports:
- Income (Y)
The higher the level of income, the higher is demand. Some of that
demand will be on domestic goods and some imports.
-
Real exchange rate ()
The higher the price of foreign goods, the lower the demand for
imports and the higher demand for domestic goods.
IM  IM (Y ,  )
(  , )
If
 increases, domestic goods are relatively more expensive.
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Exports:
- Foreign income (Y*)
The higher is foreign income the more foreigners demand. Some of
this demand will fall on domestic goods (i.e: exports).
-
Real exchange rate ()
If  increases, domestic goods are relatively more expensive. So the
fewer domestic goods will be demanded by foreigners.
X  X (Y * ,  )
(  , )
Z  C (Y , T )  I (Y , i)  G  X (Y *,  ) 
IM (Y ,  )

Equilibrium: Y=Z
Can be determined using the 45° diagram.
DD: Z = C + I + G (closed economy)
Now subtract imports:
AA: Z = C + I + G -
IM

AA will be flatter than DD since imports increase with Y.
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Now add exports:
ZZ: Z = C + I + G + X -
IM

ZZ will be parallel to AA since exports don’t expand in Y.
 Demand function will be flatter in the open economy  Multiplier lower.
Trade balance:
Net exports
NX  X (Y  , ) IM (Y , )/
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where DD = ZZ; NX = 0
The output level at which NX = 0 is called YTB (TB= trade balance)
Net exports of a decreasing function of Y (ie: Imports increases as Y
increases)
Example:
→ Expensionary fiscal policy (G ↑)
- Result is standard
G ↑  Z ↑  ZZ shift up
 increase in equilibrium output
Differences:
1) we have a trade deficit
Y ↑  IM ↑  NX 
2) Multiplier is lower in the open economy
(slope of demand function is lower).
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Closed economy:
Z ↑  ↑ in domestic demand → Multiplier effect
Open economy:
↑ in domestic demand
Z↑
↑ demand for imports
Not all of the increased demand falls on domestic goods.
Im ports
 90%
GOI
So 90% of any increase in demand falls on imports.
Increase in foreign demand (G* ↑)
G* ↑  Z* ↑  Y* ↑
DD: C + I + G
ZZ: C + I + G + X -
IM

X ↑
Represented by a shift up of ZZ (X ↑  Z ↑  Y ↑  Multiplier effect)
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New equilibrium: Y’
Y ↑  IM ↑
For a given Y, exports are now higher
ie: by Δ X
 NX line will shift upwards
The new trade balance will be where DD intersects ZZ.
Result:
NX > 0 (X >
IM

)
Exports must increase by more than imports
Nominal exchange rate
Domestic price
EP
 *
P
Foreign price
Prices are fixed.
Monetary policy:
 M ↑   i (ie:  BD, ↑ MD)
 Return on domestic bond 
 Domestic bonds less attractive.
 Demand for domestic currency   Price for domestic currency 
 Domestic currency depreciates (E )


 (if P, P* fixed)
Domestic goods are relatively cheaper.
NX  X (Y  , ) IM (Y , )/
1) Increases exports

2) 
  domestic goods cheaper  exports increase
  foreign goods more expensive  imports will fall
3) Each unit of imports will cost more  imports will rise.
1) and 2) improve the trade balance.
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2) will make the trade balance worse.
For the trade balance to improve we require that the effect of 1)+2) is
bigger than that of 3).
 Empirially this is the case.
A depreciation leads to an increase in NX.  Marshall-Lerner-Condition.
IS relation in the open economy
Demand for domestic goods
Z C I  G IM/ X
exports
Imports: the
part of demand
that falls on
foreign goods.
:
real exchange rate
so we divide by

Multiplyling IM by
domestic goods.
in order to express foreign good in domestic terms.
1

express the price of foreign goods in terms of
What are the determinants of the components of demand?
We still assume:
C = C0 + C1Y0 = C0 + C1*(Y-T)
I=I(Y,i)
GG
Imports:
- Income (Y)
The higher the level of income, the higher is demand. Some of that
demand will be on domestic goods and some imports.
Real exchange rate ()
The higher the price of foreign goods, the lower the demand for
imports and the higher demand for domestic goods.
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IM  IM (Y ,  )
(  , )
If
 increases, domestic goods are relatively more expensive.
Exports:
- Foreign income (Y*)
The higher is foreign income the more foreigners demand. Some of
this demand will fall on domestic goods (i.e: exports).
-
Real exchange rate ()
If  increases, domestic goods are relatively more expensive. So the
fewer domestic goods will be demanded by foreigners.
X  X (Y * ,  )
(  , )
Z  C (Y , T )  I (Y , i)  G  X (Y *,  ) 
IM (Y ,  )

Equilibrium: Y=Z
Can be determined using the 45° diagram.
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DD: Z = C + I + G (closed economy)
Now subtract imports:
AA: Z = C + I + G -
IM

AA will be flatter than DD since imports increase with Y.
Now add exports:
ZZ: Z = C + I + G + X -
IM

ZZ will be parallel to AA since exports don’t expand in Y.
 Demand function will be flatter in the open economy  Multiplier lower.
Trade balance:
Net exports
NX  X (Y  , ) IM (Y , )/
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where DD = ZZ; NX = 0
The output level at which NX = 0 is called YTB (TB= trade balance)
Net exports of a decreasing function of Y (ie: Imports increases as Y
increases)
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Example:
→ Expensionary fiscal policy (G ↑)
- Result is standard
G ↑  Z ↑  ZZ shift up
 increase in equilibrium output
Differences:
3) we have a trade deficit
Y ↑  IM ↑  NX 
4) Multiplier is lower in the open economy
(slope of demand function is lower).
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Closed economy:
Z ↑  ↑ in domestic demand → Multiplier effect
Open economy:
↑ in domestic demand
Z↑
↑ demand for imports
Not all of the increased demand falls on domestic goods.
Im ports
 90%
GOI
So 90% of any increase in demand falls on imports.
Increase in foreign demand (G* ↑)
G* ↑  Z* ↑  Y* ↑
DD: C + I + G
ZZ: C + I + G + X -
IM

X ↑
Represented by a shift up of ZZ (X ↑  Z ↑  Y ↑  Multiplier effect)
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 t  (   z )   ut
New equilibrium: Y’
Y ↑  IM ↑
For a given Y, exports are now higher
ie: by Δ X
 NX line will shift upwards
The new trade balance will be where DD intersects ZZ.
Result:
NX > 0 (X >
IM

)
Exports must increase by more than imports
Nominal exchange rate
Domestic price
EP
 *
P
Foreign price
Prices are fixed.
Monetary policy:
 M ↑   i (ie:  BD, ↑ MD)
 Return on domestic bond 
 Domestic bonds less attractive.
 Demand for domestic currency   Price for domestic currency 
 Domestic currency depreciates (E )


 (if P, P* fixed)
Domestic goods are relatively cheaper.
NX  X (Y  , ) IM (Y , )/
4) Increases exports

5) 
  domestic goods cheaper  exports increase
  foreign goods more expensive  imports will fall
6) Each unit of imports will cost more  imports will rise.
3) and 2) improve the trade balance.
4) will make the trade balance worse.
For the trade balance to improve we require that the effect of 1)+2) is
bigger than that of 3).
 Empirially this is the case.
A depreciation leads to an increase in NX.  Marshall-Lerner-Condition.
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