macroeconomics summary

7/31/2019 Macroeconomics Summary

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Macroeconomics EBC1018 SummaryAuthor: Ferdinand Kraemer

CHAPTER 1

Output: Level of production of the economy as a whole

Unemployment rate: proportion of workers in the economy who are not employedand are looking for a job

Inflation rate: Rate at which the average price of the goods in the economy isincreasing over time.

Recession: period of negative growth

CHAPTER 2

Aggregate OutputMeasure of aggregate output: gross domestic product GDP

- GDP is the value of the final goods and services produced in the economyduring a given period (production side)

- GDP is the sum of value added in the economy during a given period(Production side)

- GDP is the sum of incomes in the economy during a given period (Incomeside).

Nominal GDP, $Y(t): Sum of the quantities of final goods produced x their currentprice.

- Increases over timeo

production of most goods increases over timeo The prices of most goods also increases over time.

Real GDP, Y(t): Sum of the quantities of final goods x constant prices

GDP growth:(Y(t) Y(t-1)) / Y(t-1)

Expansions: periods of positive GDP growth

Recession: periods of negative GDP growth

Unemployment rateLabor force: Sum of those employed and those unemployed.

L = N + U(L = labor force; N = employed; U = Unemployed)


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Unemployment rate: ratio of the number of people who are unemployed to thenumber of people in the labor force.

u = U/L

Discourage workers: People without jobs that have given up looking for a job.

Participation rate: ratio of the labor force to the total population of working age.

Unemployment and OutputOkuns Law: Relation between unemployment and GDP growth

- High output growth is typically associated with decrease in the unemploymentrate.

- Low output growth is typically associated with increase in the unemploymentrate.

Why are we interested in unemployment?

a. Where does the economy stand and what growth rate is desirable?b. Is the economy operating above or below its normal level of activity?c. Has social consequences.d. Direct effects on the welfare of the unemployed.

Inflation: sustained rise in the general level of prices price level.

Inflation rate: rate at which the price level increases.

Deflation: sustained decline in the price level.

To define price level: GDP deflator and consumer price index (CPI)

GDP deflator: P(t) = nominal GDP(t) / Real GDP(t) = $Y(t) / Y(t)

Rate of inflation: (P(t) P(t-1)) / P(t-1)

CPI: measures the average price of consumption, or the cost of living.

Inflation and UnemploymentPhillips Curve: Negative relation between inflation and the unemployment rate.

- High Unemployment => increase in inflation- Low unemployment => decrease in inflation

Why care about inflation?a. During periods of inflation, not all prices and wages rise proportionally, which

affects income distribution.b. Inflation leads to other distortions (Verzerrungen) Inflation affects income distribution, creates distortions and increases

uncertainty.

CHAPTER 3 The Goods Market

3.1 The Composition of GDP- Consumption, C: goods and services purchases by consumers

- Investment, I: sum ofnon-residential investment (purchase by firms) andresidential investment (purchase by people).


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- Government spending: purchase of goods and services by the government.- Net export, X IM: Difference between Imports, IM, and Exports, X.

Trade surplus: Exports > ImportsTrade deficit: Exports < Imports

Inventory investment: difference between products sold and produced in a givenyear.

3.2 Demand for GoodsTotal demand for goods, Z:

Z = C + I + G + X IM

Assumptions:- All firms produce the same product.- All firms are willing to supply the good at a given price P.- Economy is closed

Z = C + I + G

Consumption, C: depends on disposable income

Disposable income: Income that remains once consumers have received transfersfrom the government and paid their taxes. Y(d) = Y T

Consumption: C = C (Y(d))+

C = c0 + c1Y(d)

(c1 = propensity to consume; c0 = what people would consume if their disposableincome would be 0.)

C = c0 + c1(Y T)Consumption, C, is a function of income, Y, and taxes, T.

Endogenous variable: variable, which depend on other variables in the model.

Exogenous variable: Variable, which is takes as given.

Investment, I exogenous variable

Government Spending, G exogenous variable

3.3 The Determination of Equilibrium Output

Demand Function: Z = C+I+G => Z = c0+c1(Y-T) + I + G

Equilibrium in the goods market: production = demandY = Z

Y = c0 + c1(Y-T) + I + G


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Autonomous spending: c0 + I + G c1T - does not depend on output.

Multiplier: 1 / (1 c1) always greater than 1 due to propensity to consume.

Demand increases => Production increases => Income IncreasesResult: Increase in output that is larger than the initial shift in demand, by a factorequal to the multiplier.

3.4 Investment equals SavingsKeynesian model: The general theory of employment, interest and Money.

Private Saving: Disposable income their consumption:S = Y(D) C=> S = Y T - C

Investment: I = S + (T G)

a. If Taxes exceed government spending => Budget surplusb. If Taxes are less than government spending => Budget deficit.

Equilibrium in the goods market:IS RELATIONInvestmentfor saving

CHAPTER 4: Financial Markets

Currency: Coins and bills, which can be used for transaction

Checkable deposits: bank deposits, which can be used for transaction

Income: what one earns from working + what is received in interests and dividends. Flow since it is mostly expressed per unit of time.

Savings: part of after-tax income that is not spent. Flow

0 1

1

1

1Y c I G c T

c


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Wealth: value ofones financial assets all financial liabilities. Stock variable, since it is the value of wealth at a specific moment in time.

Investment: purchase of new capital goods (machines, plants, buildings)

Financialinvestment: purchase of financial assets (shares, stocks etc.)

4.1 The Demand for Money

Money: can be used for transaction, pays no interest

Bonds: positive interest rate, i, but cannot be used for transaction.How much bonds and how much money?

1. The level of transaction2. Interest rate on bonds

Demand for money: M^d = $Y L(i)

4.2 The Determination of the Interest rateTwo suppliers for money:

1. Checkable deposits: Banks2. Currency: Central bank

Equilibrium in financial markets: Demand = SupplyM^s = M^d

M^s = $Y L(i) Interest rate, i, much be such that $Y, people are willing to hold an amount of

money = existing money supply.

Equilibrium in money market: LM Relationliquidity and money

Effects on changes in nominal income or in the money stock on the equilibriuminterest rate, i:


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a. Increase in nominal income => increase in interest rateb. Increase in money supply => decrease in interest rate

Monetary Policy and Open Market Operations

Central bank: changes money supply by buying or selling bonds in the bondsmarket.

- Expansionary operations: central bank buys bonds and pays for them- Contractionary operations: central bank sells bonds and removes money.

Interest rate on bond: i = $100 - $P(B) / $P(B)($P(B) = price of the bond today)

The higher the price of the bond, the lower the interest rate.

Liquidity trap: people are willing to hold more money at the same interest rate.

4.3 The Determination of the Interest rateWhat Banks do?Financial Intermediaries: institutions that receive funds from people and firms, anduse these funds to buy bonds or stocks, or to make loans to firms and people.

The Supply and Demand for Central Bank Money by Banks- The demand for central bank money = demand for currency + demand for

reserves by banks.

- Supply of central bank money is under control of central bank- Equilibrium interest rate: demand and supply for central bank money are

equal.

The Demand for Money M^d = $Y L(i)-

How much money to hold in currency and how much in checkable deposits?CU^d = cM^d and D^d = (1-c)M^d

(CU^d = demand for currency; D^d demand for deposits; c = proportion of moneypeople wants to hold in currency; 1-c = proportion people wants to hold in deposits)

The demand for Reserves


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Demand for checkable deposits => demand for reserves by banks

R = D(R = demand for reserves;= reserve ratio; D = dollar amount of checkable deposits

owed by the bank)

Combination of demand for deposits, D^d, and demand for reserves by banks, R:R^d = (1-c) M^d

The Demand for Central Bank money

H^d = demand for central bank money

H^d = CU^d + R^d H^d = cM^d + (1-c) M^d H^d = c + (1-c) $Y L(i)

The Determination of the Interest RateEquilibrium: Supply of central bank money, H, = demand for money for central bank,H^d

H = H^dor

H = c + (1-c) $Y L(i)

Increase in central bank money => decrease in interest rate & vice versa.

Federal funds market: market for bank reserves

CHAPTER 5 Goods and Financial Markets: The IS LMModel

5.1 The Goods Market and the IS relation- Equilibrium in goods market: Production = Demand for goods Y = Z- Equilibrium condition: Y = C (Y T) + I + G- Consumption and disposable income was linear

Investment, Sales, and the Interest Rate


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Investment depends on two factors:1. Level of sales: increasing sales may lead to the need for investing2. The interest rate: height of the interest rate influences firms decision on

investment.

I = I (Y, i)(+,-)

The Determination of OutputY = C(Y T) + I(Y,i) + G

Production = demand for goods => expanded IS relation

- Increase in output => increase in income => increase in disposable income=> increase in consumption

- Increase in output => increase in investment

Deriving the IS CurveWhat happens if the interest rate changes to the demand curve?

1. Increase in interest rate => decreasesdemand for goods => decrease in equilibriumlevel of output.

2. Equilibrium in the goods market implies:a. Increase in interest rate =>

decrease in output. IS curve is downward sloping

Shifts of the IS CurveWhat happens with a change in either Taxes orGovernment Spending with the IS Curve?

Taxes increases => disposable income decreases => decrease in consumption =>decrease in demand for goods => decrease in equilibrium output.

IS curve shifts to the left.

General:a. Any factor that, for a given interest rate, DECREASES the equilibrium level of

output => IS curve shifts to the LEFTb. Any factor that, for a given interest rate, INCREASES the equilibrium level of

output => IS curve shifts to the RIGHT

5.2 Financial Markets and the LM RelationM^d = $Y L(i)

-


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Real Money, Real Income and the interest rateM / P = YL(i)

-

Equilibrium condition: Real money supply = Real money demand LM RELATION

Deriving the LM CurveReal money supply is vertical line M/P. For a given level of real income, Y, moneydemand is a decreasing function of the interest rate => downwards sloping M^d

Increase in income => demand for money increases => M^d shifts to the right =>higher interest rate.

Equilibrium in financial markets implies that for a given money stock, the

interest rate is an increasing function of the level of income => LM CURVE

Shifts of the LM CurveChanges in M/P will shift the LM curve.

- Increases in the money supply, M^s, shift the LM curve down- Decreases in the money supply, M^s, shift the LM curve up.

5.3 Putting the IS and LM Relation togetherIS relation: Y = C(Y T) + I (Y,i) + GLM relation: M / P = YL(i)

1. Equilibrium in the goods market: Increase in interest rate => decrease in

output (IS curve)2. Equilibrium in financial market: Increase in output => increase in interest

rate (LM curve)


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Fiscal consolidation / Fiscal contradiction: change in fiscal policy wheregovernment decides to REDUCE the budget deficit.

- Increasing taxes, while keeping government spending constant

Fiscal Expansion: change in fiscal policy where government decides to INCREASEthe budget deficit.

- Decreasing taxes, or increasing government spending.

Steps to answer what is the effect of the policy:1. How much affects the goods and financial markets equilibrium relations2. Characterize the effect of theses shifts on the intersection of the IS and LM

curve.3. Describe the effects in words.

Monetary expansion: INCREASE in money supply

Monetary contradiction: DECREASE in money supply.

5.4. Using a policy mix

CHAPTER 7 The Medium run

7.1 A tour of the labor market- Population working age: potentially available people for employment.- Labor force: sum of people. Either working or looking for a job.- Out of labor force: neither working or looking for a job- Participation rate: ratio of the labor force to the population working age

- Unemployment rate: ratio of the unemployed to the labor force.

Shift of IS Shifts of LM Movement in Y Movement in iIncrease in taxes left None Down DownDecrease in taxes right None Up Up

Increase in spending right None Up UpDecrease in spending left None Down DownIncrease in money (MONETARY) none Down Up DownDecrease in money (MONETARY) None Up Down Up


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The large Flows of workersQuits: Workers leaving their jobs for a better alternative

Layoffs: changes in employment levels across firms

Flows in and out the labor force: number f people that move in and out from thelabor force.

Non-employment rate: ratio of population minus employment to population.

During periods of high unemployment: probability of losing a job increases, andthe probability of a job decreases.

7.2 Wage DeterminationWages can be set in many ways:

1. Collective bargaining: bargaining between firms and unions.2. By employers

3. By bargaining between employer and individual employees.

Workers are paid above the reservation wage: wage that would make themindifferent between working or becoming unemployed.Labor-market conditions: The lower the unemployment rate, the higher the wages.

BargainingBargaining power depends on:

1. How costly it would be for a firm to replace the worker, was he to leave thefirm.

2. How hard it would be for the worker to find another job, was he leave the firm.=> depends on labor market conditions.

Efficiency WagesWhy would then firms be willing to pay more than the reservation wage?Efficiency wages theories: links the productivity or the efficiency of workers to thewage they are paid.

lower unemployment => higher wages

Wages, Prices and UnemploymentW = Pê F(u,z)

(-,+)(Pê = expected price level; u = unemployment rate; z = other variables that may

affect the outcome of wage setting.)

The expected price levelWorkers and firms care about real wages, not nominal wages.

- Workers care about how much they can buy with their wages, not how many they receive.

- Firms care about the nominal wages they pay in relation to the price ofoutput they sell.

increase in Pê => increase in wage decrease in Pê => decrease in wage

Decreasing the unemployment rate => increase in wages. (vice versa)


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The other factors- The height of unemployment insurance- Increase in minimum wage- Increase in employment protection increase in z => increase in W

7.3 Price DeterminationProduction function: relation between the inputs used and the quantity of outputproduced, and on the price of the inputs.

Y = AN(Y = Output; A = labor productivity; N = Employment)

Labor productivity output per worker - is constant and equal to A.

Assumption: A = 1Y = N

one more unit of output = cost of one more employee.P = (1 + ) W

(= Markup of the price over the costs)

The higher the degree of competition, the lower the mark up and viceversa.

= f(PMR)(+)

(PMR = product market regulation)

7.4 The Natural Rate of Unemployment

The Wage setting (WS) relation:W/P = F(u,z)

(-,+)(W/P = real wage)

Graph of WS: always downward sloping with W/P on the Y-axis and u in the X-Axis

The Price Setting (PS) relation:W/P = 1/(1 + )

Price setting decisions determine the real wage paid by firms. An Increase in themark up => increase in their price given the wage => to a decrease in real wage.


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Equilibrium Real Wages and UnemploymentReal wage price setting = real wage setting

Wage setting: W/P = F(u,z)Price setting: W/P = 1/(1+)

Equilibrium unemployment rate:F(u,z) = 1/(1+ )

(-,+)

Natural rate of unemployment: Equilibrium unemployment rate

The position of the wage-setting and price-setting curves, and thus the natural rate ofunemployment depend on z and .

Situation 1: Increase inunemployment benefits => increase inz => increases in wages => shift ofwage setting curve => natural level ofunemployment increases.


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Situation 2: Enforcement ofcompetition law => Increase in =>decrease in real wages => shift ofprice setting curve => natural level ofunemployment increases.

(Higher unemployment is required tomake the workers accept the lowerwages)

From Unemployment to EmploymentNatural Level of employment: level of employment that prevails whenunemployment is equal to natural level.

u = U/L = L-N/L = 1 (N/L)(u = unemployment rate; U = unemployment; L = Labor force, N = Employment)

N(n) = L(1-u(n))

From Employment to OutputNatural Level of output: level of output when employment is equal to natural level.

Y(n) = N(n) = L(1 u(n))

natural level of output: Unemployment rate, the real wage chosen in wagesetting(left) = real wage implied by the price setting (right)

CHAPTER 8 Putting all Market together: The AS AD Model

Wage and Price determination in the labor market.

8.1 Aggregate Supply (AS)Aggregate supply relation: Captures the effect of output on the price level.

1. W = P^e F(u,z)(-,+)

2. P = (1 + )W

AS relation: gives us a relation between price level, output level and expected pricelevel => relation between PS and WS.

Step 1: eliminate nominal wage between 1. und 2.P = P^e(1 + ) F (u,z)


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price level, P, depends on expected price level, Pê, and on theunemployment rate, u.

Step 2: Replace the unemployment rate by its expression in terms of output.u = 1 (Y/L)

For a given labor force, L, the higher is output => lower is unemployment rate

AS Relation: P = Pê(1+ ) F(1 (Y/L),z) price level depends on expected price level, Pê, and on the level of output,Y,

and the constants, t and L.

Properties of the AS relation:1. An increase in output => increase in the price level

a. Increase in output => increase in employmentb. Increase in employment => decrease in unemploymentc. Decrease in unemployment => increase in nominal wagesd. Increase in nominal wages => increase in price level

2. An increase in expected price level => increase in the actual price level

a. If wag setters expect higher price level => higher nominal wageb. Increase in nominal wage => increase in price level.

AS Curve:

Properties:1. AS curve is upward sloping (increase in output => increase in price level)

2. AS curve goes through point A, where Y = Y(N); P = Pê3. Increase in the expected price level, P e, shifts the AS curve up (vice versa)

8.2 Aggregate Demand (AD)

Aggregate Demand Relation: captures the effect of the price level on output and isderived from the equilibrium conditions in the goods and financial markets.

Goods market: IS: Y = C(Y-T) + I(Y,i) + GIS: Output = Demand for goods.

Financial market: LM: M/P = Y L(i)LM: Supply of money = demand for money


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Situation:- IS LM relation is drawn. Equilibrium

of financial (LM) and goods (IS) market atpoint A.

- Increase in price => decreases thereal money stock (M/P) => increase in interestrate

A => A; i => i; Y => Y Increase in price Level => decrease in

output

Any other variable than the price levelthat shifts the IS or LM curve also shifts the AD relation.

AD Relation: Y = Y(M/P, G, T)(+ , + , -)

An increase in price level, P, => decrease in real money stock, M/P => decrease inoutput

8.3 Equilibrium in the Short Run and in the Medium Run

AS Relation: P = P^e (1 + ) F 1 (Y/L),z AD Relation: Y = Y(M/P, G, T)

Equilibrium in the Short Run- AS curve, drawn for given value

of P^e => upward slopingo The higher the level of

output, the higher theprice

- AD Curve, drawn for givenvalues of M, G and T =>downward sloping

o The higher the price level,the lower the output

Equilibrium:a. Labor market (AS curve) in

equilibrium comes fromintersection of the curves

b. Goods and financial markets (AS curve) in equilibrium come fromintersection of the curves.


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From the short run to the medium run

Situation:- Output is higher than the natural output.- Price level is higher in the short run than expected.

o Price setters revise upwards their expectation. Pê => Pê next period the AS curve will shift upwards from AS to AS

Y > Y(n) => P > Pê => increase Pê => increase W => increase P =>

decrease M/P => increase u => decrease Y

Moves up until Y(n) is reached again.

In the medium run: Output = natural level of output

8.4 The Effects of a Monetary ExpansionThe dynamics of AdjustmentAD: Y = Y(M/P, G, T)

Expansionary monetary policy: increase in the level of nominal money.


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Situation:- Short Run: Increase in nominal money, M => increase real money, M/P =>

shift of the AD curve to the right => increase in Outputincrease M => Increase M/P => increase Y

- Medium run: price expectation => Shift up of the AS curve => natural levelof output.

If M/P is unchanged, it MUST be that M and P has changed in the same proportion!!!

The Neutrality of moneySummary of monetary policy:

1. Short run: monetary expansion => increase in output => decrease in interestrate => increase in price level.

2. Medium run: Increase in nominal money => increase in price level,BUT DOESNT AFFECT THE OUTPUT!!!

Monetary policy cannot sustain higher output forever.

7.5 Decrease in the Budget DeficitGovernment decides to reduce its budget deficit by decreasing government spendingfrom G to G, while taxes are unchanged.

Situation:- Short run: G => G=> shift of the AD Curve to the left =>output is lower- Medium run: Y = Y(n)

Budget Deficits, Output, and InvestmentSummary of fiscal policy:

1. Short run: budget reduction => decrease in output => decrease in

investment2. Medium Run: Output returns to natural level of output AND INTEREST

RATE IS LOWER!

Short Run Medium Run

Output Interest rate Price level Output Interest rate Price level

Monetary Increase Decrease Increases No change No change Increases

Expansion (Small)

Deficit Decrease Decrease Decreases No change Decreases Decreases

Reduction (Small)

Increase in Decrease Increase Increases Decreases Increase IncreasesOil price


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CHAPTER 9 The natural Rate of Unemployment and thePhillips Curve

9.1 Inflation, Expected Inflation, and unemployment

Wage setting relation: W = PêF(u,z)AS: P = Pê (1 + ) F(u,z)

F(u,z) = e^- u + zThis captures the notion that the higher unemployment rate, the lower the wage, andthe higher z. captures the strength of the effect of unemployment on the wage.

P = Pê (1 + ) e^- u + z (9.1)= ê + ( + z) - u (9.2)

(= inflation; e = expected inflation)

Inflation: given last years price level, a higher price level this period implies a higherrate of increase in the price level from last period to this period.

IMPORTANT EFFECTS:a. An increase in expected inflation, ê => increase in actual inflation, .- 9.1:increase in expected price level => increase in actual price level

o increase in expected inflation => increase in inflationb. Given expected inflation, ê, an increase in the markup or an increase

in the factors that affect wage determination an increase in z - =>increase in inflation, .

- 9.1:given expected Pê, increase in markup or z => increase in P- 9.2:given expected ê, increase in markup or z => increase in

c. Given expected inflation, ê, increase in unemployment rate =>decrease in inflation, .

- 9.1:given expected Pê, increase in unemployment rate => lower nominalwage => lower price level.

o Given expected inflation, ê, increase in unemployment rate =>decrease in inflation, .

Use time indexes: (t) = (t)ê + ( + z) - u(t) (9.3)

8.2 The Phillips curveAssumption: (t)ê = 0

(t) = ( + z) - u(t)

Phillips Curve: Negative relation between unemployment and inflation


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Given Pê, lower unemployment => higher nominal wages =>higher price level.

Wage price spiral:- Low unemployment rate => higher nominal wages

-higher nominal wages => higher prices => price level increases

- higher price level => workers ask for higher nominal wages- higher nominal wages => increase in price => price level increases- higher price level => workers ask for higher nominal wages

Mutations:1970: negative relation between unemployment and inflation broke down.original Phillips Curve: (t)ê = (t-1)

(= captures the effect of lastyears inflation rate, (t-1), on thisyears expectedinflation rate, (t)ê)

New Phillips Curve: (t) = (t-1) + ( + z) - u(t)

The higher the value of, the more lastyears inflation leads to workers and firms torevise their expectations of what inflation will be this year.

- When = 0: Original Phillips Curve: (t) = ( + z) - u(t)- When > 0: inflation rate depends on unemployment rate and last years

inflation: (t) = + (t-1) ( + z) - u(t)- When = 1: relation becomes: (t) - (t-1) = ( + z) - u(t) When = 1; u affects not only inflation rate, but the change in inflation:

High unemployment => decreasing inflationLow unemployment => increasing inflation

Back to the natural rate of unemploymentNatural rate of unemployment: unemployment rate is such that the actual pricelevel = expected price level.Natural rate of unemployment: unemployment rate such that the actual inflationrate = to the expected inflation rate.

Natural Rate of unemployment: u(n) = + z the higher the markup or the other factors that affect wage setting, z, the

higher the natural rate of unemployment

(t) - (t-1) = - u(t) u(n)

IMPORTANT:


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- Change in inflation depends on the difference between actual and the naturalrate of unemployment.

- The natural rate of unemployment is the rate of unemployment required tokeep the inflation constant.

9.3 The Phillips Curve and the Natural Rate of Unemployment in Europe

What explains European Unemployment?- Generous system of unemployment insurance- High degree of employment protection- Minimum wages- Bargaining rules

High Inflation and the Phillips CurveWage indexation: provision that automatically increases wages in line with inflation

CHAPTER 10 Inflation, Activity, And Nominal Money Growth

9.1 Output, Unemployment and InflationThree relations between output, unemployment and inflation:

1. Okuns law: Output growth affects unemployment2. Phillips curve: Unemployment affects inflation3. Aggregate demand relation: inflation and money growth affect output

growth

Okuns LawAssumptions:

- if output and employment move together, a 1% increase in output => 1%increase in employment rate

-If movements in employment rate reflect movements in unemployment.

u(t) u(t-1) = -g(yt) (10.1)(U(t): unemployment rate in year t; u(t-1): unemployment rate in year t-1; g(yt): rate of

output from year t-1 to year t.)

Change in unemployment rate = negative growth rate of output.

Okuns law:


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Okuns law: u(t) u(t-1) = -0.4(G(yt) 3%) (10.2)

Differences:9.1 and 9.2 gives negative relation between change in unemployment and outputgrowth but with differences:

- Annual output growth has to be at least 3% to prevent unemployment

rate from rising.o To maintain a constant unemployment rate, output growth must be

equal to the sum of labor force growth and labor productivity growth.o Natural output growth: rate of output growth needed to maintain a

constant level of unemployment.- The coefficient on the right side of equation (10.2) is -0.4 compared to -

1.0 in equation (19.1)o Firms adjust employment less than one for one in response to

deviations of output.o An increase in the employment rate does not lead to a one for one

decrease in the unemployment rate.

Okuns Law: u(t) u(t-1) = - (G(yt) G(y)) (9.3)

(: effect of output growth above normal on the change in the unemployment rate;G(y): normal growth rate of an economy)

Output growth above normal leads to a decrease of unemployment rate Output growth below normal leads to an increase of unemployment rate.

G(yt) > G(y) => u(t) < u(t-1) & G(yt) < G(y) => u(t) > u(t-1)

The Phillips Curve(t) - (t-1) = - u(t) u(n)

u(t) < u(n) => (t) > (t-1) & u(t) > u(n) => (t) < (t-1)

Aggregate demand relation

Y = Y M(t)/P(t), G(t), T(t)

Focus only on real money stock, M/P, and output, Y.Y(t) = (M(t)/P(t)

(= positive parameter) Equation shows that the demand for goods and thus output, is simply

proportional to the real money stock. Relation between price level, Growth rates of output and money.

Mechanism of IS /LM model.- Increase in real money stock => decrease in the interest rate- Decrease in interest rate => increase in the demand for goods => increase

in output.

Relation between growth rates of output, money and price level:G(yt) = G(mt) - (t)

(G(yt): growth rate of output;(t): growth rate of the price level => inflation; G(mt)growth rate of nominal money)


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G(mt) > (t) => G(yt) > 0 & G(mt) < (t) => G(yt) < 0

Summary:Phillips curve: negative relation between unemployment rate & inflation

(t) - (t-1) = - u(t) u(n) u(t) < u(n) => (t) > (t-1) u(t) > u(n) => (t) < (t-1)

Okuns law: negative relation between output growth & unemploymentu(t) u(t-1) = - (G(yt) G(y))

G(yt) > G(y) => u(t) < u(t-1) G(yt) < G(y) => u(t) > u(t-1)

AD Relation: Relation between growth rates of output, money and pricelevel.

G(yt) = G(mt) - (t) G(mt) > (t) => G(yt) > 0 G(mt) < (t) => G(yt) < 0

10.2 The effects of money growthWhat do the three equations imply for the effects of nominal money growth on output,unemployment rate and inflation?

Medium run- In the medium run: unemployment rate must be constant:

o u(t) = u(t-1) Okuns law: G(yt) = G(y) In the medium run: output must grow at its normal rate of

growth-

nominal money growth = G(m) & output growth equal to G(y)o In the medium run: G(y) = G(m) - => = G(y) G(m)

Inflation = nominal money growth nominal output Inflation = adjusted nominal money growth In the medium run: inflation equals adjusted nominal

money growth- medium rung: inflation constant => inflation this year = inflation last year

o Phillips curve: u(t) = u(n) In the medium run: unemployment rate must be equal to

the natural rate of unemployment.

Short run:

Assumption: Economy is in the medium run equilibrium:- unemployment = natural rate- Output growth = normal output growth- Inflation rate = adjusted nominal money growth.

Central Bank: Decrease nominal money growth- Aggregate demand function: lower money growth => lower real money

growth => decrease in output.- Okuns law: Output growth below normal => increase in unemployment- Phillips curve: increase in unemployment => decrease inflation

10.3 Disinflation(t) - (t-1) = - u(t) u(n)

Disinflation: decrease in inflation


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- Can only be obtained by cost of higher unemployment.o left side of equation to be negative,o (u(t) u(n)) must be positive.

Unemployment level > natural level.

Point of excess unemployment: difference between actual and naturalunemployment rates of 1% point of one year.

Sacrifice Ratio: number of point years of excess unemployment needed to achievea decrease in inflation by 1%

Point-years of excess unemployment / decrease in inflation

Nominal rigidities and contractsNominal rigidities: in modern economies, many wages and prices are set innominal terms for some time and are not readjusted where there is a change inpolicy.

Disinflation: period of high unemploymentFaster disinflation: smaller sacrifice ratioSacrifice ratios are smaller in countries with shorter wage contracts.

CHAPTER 11 The facts of growth

11.1 Measuring the standard of livingThe reason we care about growth is that we care about the standard of living.

output per person

a. What matters for peoples welfare is their consumption rather than theirincome.

i. Consumption per personb. differences in productivity

i. Output per worker

11.4 Thinking about growth: A primerThe aggregate production function:

Y = F (K,N)(Y = aggregate output; K = capital; N = Labor)

State of technology: How much output can be produced for given quantities ofcapital and labor?

Returns to scale:- Constant returns to scale: if the scale of operation is double, the output will

also double.o 2Y = F(2K,2N)

- Decreasing returns to capital: increase in capital lead to smaller andsmaller increase in output.

- Decreasing returns to labor: increase in labor lead to smaller and smallerincrease in output.

Output per worker and capital per workerY/N = F(K/N; 1)

Output per worker depends on capital per worker


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Sources of growth- Increase in output per worker (Y/N) can come from increase in capital per

worker (K/N)- Increase in output per worker can also come from improvements in the state

of technology that shift the production function, F, and lead to more outputper worker given capital per worker.

Growth comes from capital accumulation and from technological progress.

CHAPTER 12 Saving, Capital Accumulation and Output

12.1 Interactions between Output and Capital

-Amount of capital determines the amount of output being produced

- Amount of output determines the amount of saving and investment, and sothe amount of capital being accumulated

The Effects of Capital and OutputAggregate production function with constant returns to scale:

Y/N = F(K/N; 1)

Y/N = f(K/N)

Assumptions:

1. Size of population, the participation rate, and the unemployment rate are allconstant => Employment is also constant.2. There is no technological progress =>production function does not change

over time.

Y(t)/N = f K(t)/N higher capital => higher output

The Effects of Output on Capital AccumulationTo derive second relation between output and capital accumulation, we use twosteps:

- Step 1: Output and Investment

o Assumptions:a. economy is closed => I = S + (T-G)


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b. We ignore taxes and government spending => I = Sc. private saving is proportionally to income => S = sY

=> I(t) = sY(t) Investment is proportional to output: the higher the output => the higher

the saving rate => the higher the investment.

- Step 2: Investment and Capital Accumulation=> K(t+1) = (1 - ) K(t) I(t)

Combination of the output and investment & investment & capitalaccumulation

relation from output to capital accumulation

In words: Change in capital per worker = saving per worker minus depreciation.

12.2 The Implications of Alternative saving ratesDynamics of capital and output

1. Y(t)/N = fK(t)/N

2.

K(t+1)/N K(t) / N = sf(K(t)/N) - x (K(t) / N)

Change in capital from year t Investment - Depreciationto year t + 1 during year t during year t

Description:- Investment per worker (first term on the right). Level of capital per worker

this year determines output per worker this year=> K(t)/N => f(K(t)/N => sf(K(t)/n)

- Depreciation per worker (second term on the right). Capital stock determinesthe amount of depreciation per worker this year.=> K(t)/N => (K(t)/N)

Conclusion:

-If investment per worker > depreciation per worker => change in capital perworker > 0 =>capital per worker increases

- If investment per worker < depreciation per worker => change in capital perworker < 0 => capital per worker decreases.

K

N

K

Ns

Y

N

K

N

t t t t

1

K

N

K

Ns

Y

N

K

N

t t t t

1


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Steady State Capital and OutputLong runSteady state: State in which output per worker and capital per worker are no longerchanging

Sf(K*/N) = (K*/N)

In words: Steady state value of capital per worker: amount of saving per worker (left)= depreciation of capital per worker (right)

Y*/N = f(K*/N)

The saving rate and OutputWhat are the effects of the saving rate on the growth rate of output per worker?

1. Saving rate has no effect on the long run growth rate of output per worker,which is equal to 0.

2. The saving rate determines the level of output per worker in the long runa. Countries with higher saving rate, will achieve higher output per

worker in the long run. (Graph1)3. An increase in the saving rate => higher growth of output per worker for some

time, but not forever. (Graph 2)

Graph 1:


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(+ , + )

- Increase in capital per worker => increase in output per worker- Increase in average level of skills => increase in output per worker

Human Capital, Physical Capital and OutputHow does the introduction of human capital change the analysis of the previoussection?

- Physical capital:o An Increase in the saving rate => increases steady state physical

capital per worker =>output per worker- Human capital:

o Increase in how much society saves in form of human capital =>increases steady state human capital per worker => increase inoutput.

Endogenous Growth

Models of endogenous growth: Models that generate steady growth even withouttechnological progress.

CHAPTER 13 Technological Progress and Growth

13.1 Technological Progress and the Rate of GrowthWhat will the rate of output be in an economy in which there is both capitalaccumulation and technological progress?

Technological Progress and the Production functionDimensions:

-

Larger quantities of output for given quantities of capital and labor- Better products- New products- Larger variety of products

State of technology: How much output can be produced from given amounts ofcapital and labor at any time.

Production function: F = (K, AN)( + , + )

(K = Capital; A = technological progress, N = labor)

-Technological progress reduces the number of worker needed to achieve agiven amount of output

- Technological progress increases AN (amount of effective labor in economy)

Interactions between Output and Capital


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1. Output per effective worker increases with capital per effective worker but at adecreasing rate.

2. Investment = Private saving I = sYa. Investment per effective worker:

I/AN = sf(K/AN)3. What level of investment per effective worker is needed to maintain a given

level of capital per effective worker?a. An increases over time => to keep ratio K/AN constant => K has

to increase at the same rate.

i. = depreciation rateii. g(A) rate of technological progressiii. g(N) rate of population growth

1. Ratio of employment to population stays constant=> AN = g(A) + g(N)

I =+ g(A) + g(N)x K

An amount ofK is needed just to keep the capital stock constant. Anadditional amount (g(A) + g(N)) x K is needed to ensure that the capital stockincreases at the same rate as effective labor.

To obtain the amount of investment per unit of effective worker needed to keep aconstant level of capital per unit of effective worker.

In words: The change in the stock of capital per unit of effective worker given bythe difference between the two terms on the left is equal to saving per unit ofeffective worker given by the first term on the right minus the depreciation perunit of effective worker given by the second term on the right.

Steady state (capital per effective worker doesnt change) value of capital perunit of effective worker:

In words: the Steady state value of capital per unit of effective labor is such that theamount of saving (left) is exactly enough to cover the depreciation of the existingcapital stock (right).

See figure: (Red Line with slope g(A) + g(N))


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The Effects of the saving rate

Changes in the saving rate do not affect the steady-state growth rate, but changes inthe saving rate do increase the steady-state level of output per effective worker.

Increase in saving rate => shift of investment relation up => K/AN(0) => K/AN(1) &Y/AN(0) => Y/AN(1)

Output against time:1. Economy is on balanced growth path AA: Output is growing at rate g(A) +

g(N) slope of AA is equal to g(A) + g(N).2. Saving rate increases in at time t =>output grows faster for some period of

time.3. Output ends up at higher level but with same growth rate g(A) + g(N).4. New steady state: economy grows at same rate, but on higher growth path,

BB with slope g(A) + g(N)


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13.2 The Determinants of Technological Progress

What determines the rate of technological progress?Technological progress in modern economies is the result of research anddevelopment (R&D) activities.

Level of R&D spending depends on:1. Fertility (Fruchtbarkeit) of the research process: How spending on R&D

translates into new ideas and new products.2. Appropriability (Anwendbarkeit) of research results: The extent to which

firms benefit from the results of their own R&D.

The Fertility of the Research Process

The fertility of research depends: on the successful interaction between basicresearch and applied research and development.

Basic research: search for general principles and results.

Applied research and development: the application of the results to specific usesand the development of new products.

The Appropriability of Research Results

Patent: right to exclude anyone else from the production or use of the new productfor some time.

13.3 The Facts of Growth Revisited

Capital Accumulation versus Technological Progress in Rich Countries

High growth rate of output per worker over some period of time can comefrom:- High rate of technological progress under balanced growth- Adjustment of capital per effective worker, K/AN, to a higher level.

If high growth rate reflects high balanced growth: Output per workershould be growing at a rate equalto the rate of technological progress.

If high growth rate reflects instead the adjustment to a higher level ofcapital per effective worker: this adjustment should be reflected in a growthrate of output per worker that exceedsthe rate of technological progress.

Technological frontier: Advanced countries, which need to develop new ideas, newprogresses and new products.

Technological catch-up: Countries, which has to catch up to the developedcountries by imitating the ideas.

macroeconomics summary

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