MACROECNOMICS 1

-Stylized facts, business cycles and growth

Introduction to macroeconomics, growth and business cycles, macroeconomic variables and measurement,
business cycle patterns.

-Brief history of economic thought

Classical economics

Classical monetary theory

 V = PY/M  Md = PY/V
 V is determined by:
o Institutional arrangements
o Technological arrangements
 Assumption Velocity is constant in the S/R & Y constant at the L/R  An M  leads to a
proportional P .
 Interest rates do not play a role; money is only held for transactions which are determined by natural
nominal output (PY) and institutions (V).

 FAALSE, then appears Keynes…

Liquidity Preference Theory (Keynes)

 Three motives for holding money:
1. Transaction motive: Similar to classical view (money as a medium of exchange Md /PY)
2. Precautionary motive: Money is held to prepare for unexpected shocks (these future expenses
are assumed to be proportional to income: Md /PY).
3. Speculative motive: Money is held as a store of wealth.
 If interest rates are low today, expected interest rates are high:
o Rate of return on bonds decreases
o Demand for bonds decreases
o Demand for money increases
 A rise in the interest rates encourages people to hold less money (decrease in Md), thus the turnover
of the money must be higher.

Keynesian economics
Neoclassical-keynesian synthesis

DGSE debate

Model used in policy institutions

The simplest of all models of DGSE (lecture 2)

Assimilated to: Real Business Capital without financial system

 Hypothesis: 
 Perfect Competition (w = MgProductivity)
 P = 1, N = 1, logarithmic utlity (σ = 1), full depreciation (𝛿 = 1)
 technology --> AR(1) model
 No financial system

Goal of derivation: demonstrate that an exogenous shock of productivity in the economy in period t has
persistence in the economy in period t+1 due to capital accumulation and investment.

Derivation steps:
1. Set up lagrangian
2. Max lagrangian by Ct, t and kt+1 (Kt was determined in period t-1)
3. Use FOCS to get Euler equation (Marginal Utility of Today’s Consumption = Marginal Utility of
Tomorrow’s Consumption which expresses consumption of today in terms of consumption of
tomorrow)
4. Get It/Ct as a function of It+1/Ct+1 and then as a function of ONLY constants
5. Get It as a function Yt and get tomorrow’s capital as a function of today’s ouput (using Kt+1 = It)
6. Plug tomorrow’s capital in tomorrow’s output equation
7. Analyse it in equilibrium; growth = 0.

Conclusions:
 Endogenous variables of the model = K, C, N but N = 1
o A productivity shock in t increases Consumption and Investment and Output, which then
increases tomorrow’s capital and thus increases tomorrow’s output.
o Variables in equilibrium are functions of previous level of K and previous exogenous
productivity shock
o In this simple version:
 Investment is a constant fraction of Y (kt+1 = constant*Yt)
 Consumption is the other constant fraction of Y (Ct = (1-constant)*Yt)
 Production will evolve depending on the values of K
 When shock is white noise, only generates persistence in 1 period.
 In RBM with capital, we have intrinsic persistence that come from the productivity shock and is
transmitted through capital accumulation.
 Yt = parameter*zt  autocorrelation of yt equals the autocorrelation of the productivity shock

-Lucas critique and microfoundations

Lucas Critique
 Changes in economic policy (fiscal policy, monetary policy) will affect the behaviour of the private
agents (households, firms)
 The timing and the time profile of the economic policy are relevant.
o Timing: new policy today or tomorrow.
o Time profile: persistence of the policy (transitory versus permanent change in economic
policy)
  changes in policy may change expectations about future values of important variables, and that these
changes in expectations may change the coefficients of reduced-form relationships. This type of
problem can limit the usefulness for policy analysis of reduced-form econometric models based on
historical data.
 How to test for the Lucas critique?
o The setup: take advantage of the cross–equation restrictions to evaluate the empirical
relevance of this critique.
o Identify a shift in (fiscal and/or monetary) policy. Then investigate if some behavioral
equations (consumption, investment, labor demand/supply, money demand) display
instability (will not be the same) when policy changes.
The Solow Model

Assumptions:
 Perfect competition & P = 1
 No technology
 Process function w/ constant returns to scale allow as to normalize N = 1, i.e. the size of the economy
as measured by the number of workers does not affect relationship K/N.
 Y=C+I
 C = (1 – s)Y where s is exogenous
 Cobb-Douglas capital accumulation function (Kt+1 = Kt(1 – 𝛿) + It)
 Production process dependent on both factors of production

Derivation goal: What is the effect of the saving rate on Y, C? Is it consistent with Kaldor facts?
Derivation step:
1. Take eq. of Capital accumulation and express it in terms of s and delta using the assumptions and the
equation of the production process.
2. Add technological progress and thus Kt+1 eq:

3. Find golden saving rule that max consumption

(REVISE NOTES)
4. Find the balance growth path of capital:

Conclusions:
Outuput
 Countries w/ higher saving rates will tend to be richer, ceteris paribus. These countries have more
capita per worker and thus are therefore able to produce more output per worker.
 s determines the LEVEL of output per worker in the long run but has NO effect on the long-run
growth rate of output per worker, which equals to 0.
 An increase in the saving rate will lead to a higher growth of output per worker for some time, but
NOT forever.
Consumption
 An increase in the saving rate, increases output per worker differently than consumption per worker.
o Economy with s = 0  K = 0, Y = 0, C = 0
o Economy with s = 0  people save all income, Y and K but C = 0.
Kaldor Effects (After adding technological progress)
 If gtz = gz, the steady state of the solow model is consistent with the Kaldor effects.
  Capital per worker at cte rate gk=gz (with the ass. that labor supply constant)
 Output per worker at cte rate gy=gz
 Capital-output rate is constant: K/Y = s/ (gz + 𝛿)
 Share of capital and labor in national income are constant K/z, Y/K and Y/z are constant. 
rate of returns to capital and labor are constant.
Endogeneity of saving rate

Neoclassical growth model

Assumptions:
 Perfect competition
 N = 1, P = 1, logarithmic utility
 Y=C+I
 C = (1 – s)Y where s is exogenous
 Cobb-Douglas capital accumulation function (Kt+1 = Kt(1 – 𝛿) + It)
 Production process dependent on both factors of production
 Technology process
 Microfoundations in It=sYt  Firms and households decide on their optimal level of savings in
response to the economic environment they are exposed to.

Derivation goal: This time we will max the model both from the equilibrium perspective (households and
firms max their utility) and from the social planner perspective.

Derivation Steps:
Competitive Equilibrium
1. Households max their utility restricted to BC
a. Intratemporal BC (oferta de treball)  Unt + Uctwt = 0
b. Intertemporal BC (Euler eq)  MgUt = MgUt+1
2. Firms max production function st. w=zt*MgProdN r=zt*MgProdK
3. Good markets (Yt = Ct + It) to Kt+1 equation
4. Labor mkt  equal labor demand and labor supply
5. Asset mkt  Bt = 0
6. Substituim n=1 a l’equació de producció per torbar Y. (i això ho podem utilitzar per trobar ct + it) Si
volem trobar r, partint de l’equació euler, apliquem l’equilibri al mercat de béns i aïllem r.
Social Planner
7. Set up lagrangian
8. Max lagrangian by Ct, Kt+1 and t
 Find golden rule of capital and golden rule of savings (max consumption in all periods)
Conclusions:
 Now the balanced growth path is a function of the model’s underlying parameter: production
structure (alpha and delta), time preferences (beta) and the exogenous growth rate of technology.
(Because the saving rate is endogenous!! If we substitute s by the endogenous saving rate we get k as
a function of these parameters).
 Saving rate is not anymore ad hoc and reacts to changes in the economy’s parameters alpha, delta,
beta as well as to the exogenous growth rate of technological progress.
o This is exactly what the Lucas critique was about!
 Special case of full depreciation (delta = 1): s = B(1-a)gz/(1+gz) -> high s when:
 o High patience (preference for future)
o High marginal productivity of capital
o High growth rate of technological progress
 We are able to introduce shock (technological shocks) and analyse the reaction of the
savings/investment shocks.
 Comparing saving rate & golden saving rate: Realized saving rate in steady state is smaller than GR
saving rate  Do people not save enough? It comes from time-preference

-Policy analysis in basic macro model

Keynesian assumptions

IS-LM model & multipliers

AS-AD in SR and LR

Demand-side and Supply-side policies

-IS – LM – BP model

 How the equilibrium will adjust under fixed exchange rate? What about flexible exchange rate?
What are endogenous and exogenous variables in each case?
 What does NX depend on? What makes it shifts and what are its endogenous and exogenous
variables?
 What is the Marshall-Lerner condition? Does always hold?
 When would we encounter crowding out effect from interest rates/investment?
 When does the BP curve shift? What does the BP slope show? When does it gets flatten?
 How do fiscal policy multipliers change in this model? Who causes this crowding out effect?
 When is fiscal policy effective and monetary policy? Can you compare the different regimes and
open close?
 Explain the impossible trinity.
 With sterilization we also have changes in reserves inducing changes in domestic credit in order to
offset the reserve flows. Sterilized intervention is the action by a CB to offset the effect of a foreign
exchange intervention, on the domestic money supply, by using the open market operations.

-Optimal Currency Areas

Criteria
1. International factor mobility: High internal mobility and low external mobility of labour and capital
2. Degree of openness: High proportion of tradables (exports and imports) in overall production
3. Product diversification: High degree of diversification of exports
4. Financial integration: High ratio of gross capital in- and outflows over GDP
5. Structural similarity in order to not be hit by asymmetric shocks
6. Policy integration: High degree of coordination of economic policies (surrender of monetary and
fiscal sovereignty to supranational entity)
7. Inflation rates: Similar levels of rates of inflation of countries participating in the currency area
Symmetric shocks
 Exogenous negative shock demand  IS shifts left 
Low Y, Low i  Net exports fall, outflows of FI.
 Depreciation of currency  BP curve shifts down and IS
shifts right
o Flexible exchange rate with the rest of the world
accommodates negative shock
o CB can also do a monetary expansion to fully offset
the effects of the neg. shock

Asymmetric Shocks
 Adverse external demand shock that hits only one of the
countries in the monetary union.  IS shift left  Low Y,
low i.  Net exports fall and outflows of FI
 Interest rate is fixed (needs to increase to the previous level,
so M decreases)  LM curve shifts to the left.
 Economy contracts even more! And the IS’ also contracts
even more to the automatic stabilizers.
 Most likely, the monetary authority will not react with
expansionary monetary policy as only one country is
concerned.
 Why does money supply fall when country in monetary union is hit by an asymmetric demand
shock?
o Negative demand shock means that IS curve shifts downLower interest rates in country A
lead to capital outflows to other countries in the union B e.g. lower interest rates in Greece
lead to capital flowing to Germany and exchange rate does not change because we assume
country is small relative to rest of unionCapital outflows lead to ∆RA < 0* so domestic
money supply fallsFall in money supply makes demand shock even worse

Full dollarization
 When you adopt another country's currency (e.g. USD) as legal tender. This strategy is often pursued
by very small countries.
 Examples of economies dollarized to euro: Andorra, Monaco, Vatican City
 Differences with monetary unions:
o No seignorage revenue.
o Easier exit.
o Autonomous exchange rate and monetary policy is completely given up.
o Since the dollarizing economy does not have any influence on monetary policy and is
negligible in size to the anchor economy, credible inflation stabilization is imported.
o Lender of last resort lending and the like is even more unlikely than in a monetary union.
 Terminology:
o Original sin: Inability of a country to borrow in its own currency (on international markets).
It describes the phenomenon that emerging markets cannot borrow abroad in their local
currency i.e. their debt is all denominated in foreign currencies.
 This can both cause and exacerbate financial crises because if your currency devalues,
your real debt burden will become very high. So you are faced with a choice of either trying
 to bolster currency by raising interest rates/reducing the money supply even if you are in a
recession, or letting currency depreciate and jump in debt burden which could lead to default.
o Debt intolerance: The perception of what is a sustainable external debt ratio differs among
industrialized countries and EMEs. In other words, debt crises appear to happen in
developing countries at levels of debt that would be normal in developed countries e.g. often
below 60% of GNP.  This appears to happen because sovereign debt is seen as much more
risky in developing countries and so interest payments are much higher which leads to more
defaults.
o Liability dollarization: Gross debt is denominated in foreign currency.
o Currency mismatch: Significant difference between assets and liabilities that are held in
foreign currencies.
o Currency substitution: Use of a foreign currency for transactions! also called payments
dollarization.
 Devaluations are usually thought to be "good" for the
economy because they make your exports cheaper on the
international market which will boost aggregate demand.
 However, you can also get contractionary devaluations if
e.g. your economy depends on imports (because they will
get more expensive) or if e.g. lots of your debt is
denominated in foreign currency (because your real debt
burden will jump up)

 Characteristics of a currency crises in emerging markets:

o "Sudden stops" i.e. large reductions in capital inflows which could be due to loss of confidence
because of e.g. political shock
o Lower confidence means that interest rates on government bonds skyrocket
o Currency devalues if CB doesn't have enough foreign currency reserves to maintain a peg. This
can be exacerbated by speculative currency attacks.
o High inflation due to higher import prices
o Currency crises occasionally coincide with large GDP contractions, but also there can be
"Phoenix miracles" in which countries recover quickly and without credit
-Policy Trilemma and fixed exchange rates

Consumption/Saving

Styled Facts
 Lower volatility than GDP  smooth consumption
 2/3 of GDP is consumption

Euler equation: For CRRA utilities:

There are two opposing forces that affect the inter-temporal choice of the agent
 the higher is the interest rate, the more attractive is to save.
 the stronger the degree of time preference – the lower the B – the less attractive is c2. p measures the
weight the consumer attaches to the future compared to the present.
 o p = 0  equal increases on c1 and c2 have the same impact on total utility
o p > 0  (1/1+p) < 1  Increases in consumption in t1 gives higher utility, consumer requires
1+p units of c2 to compensate for a reduction in one unit of c1. B(1+R) < 1  c1 > c2
o p = r  perfect consumption smoothing  his impatience is offset by the interest rate in his
savings. (c1 = c2)
 The IC represents the combi of C1 and C2 that provide the same level of utility. The fact that has a
negative slope and CONVEX means that compared to unbalanced consumption path, the consumer
prefers a more balance path.
 What happens if (Y1 + Y2/(1+r))  ?
o Represents a pure income effect and leads to increase in C1 and C2
o The effect on borrowing or lending depends on the timing of the rise in income
o Transitory and permanent changes produce different effects

 What happens if r increases?

o SE: the higher interest rate lowers the cost of consumption in the second period and makes
saving more attractive.
o IE: (depends if you are borrower or lender)
 Borrowers: reduces the feasible consumption levels  high interest payments
 Lenders: raises the wealth of lenders  receive higher interest payments
 With Logarithmic preferences, the savings rates does NOT depend on the interest rate, because
the IE and SE cancel out against each other.  c1*/x = 1/ 1 + B
-Life Cycle Hypothesis (LCH)
 Agents typically borrow when they are young (education, housing) and save during prime age and
dissave during retirement.
 At different stages of their life, agents or households therefore act at different sides of the credit
market.
Permanent Income Hypothesis
 Consumption in t is not determined by the income in t but by all income in his life time.
 Consumption only determined by Permanent income
 ≠ between permanent and current income = transitionary income
 Although the time pattern of income is not important to consumption, it is critical to saving.
 Thus saving is high when income is high relative to its average—that is, when transitory income is
high. Similarly, when current income is less than permanent income, sav- ing is negative. Thus the
individual uses saving and borrowing to smooth the path of consumption. This is the key idea of the
permanent-income hypothesis of Modigliani and Brumberg (1954) and Friedman (1957).
 Saving is driven by preferences between present and future consumption and information about
future consumption prospects.
 it is often asserted that poor individuals save a smaller fraction of their incomes than the wealthy
do because their incomes are little above the level needed to provide a minimal standard of living.
But this claim overlooks the fact that individuals who have trouble obtaining even a low standard of
living today may also have trouble obtaining that standard in the future. Thus their saving is likely
to be determined by the time pattern of their income, just as it is for the wealthy.

Budget constraint (no interest rates in this case):

Lagrangian (BG is binding since MgU > 0)
 Individual divides his lifetime resources equally among each period
of life

If individual has gain a temporary income at t Z  permanent income

raises by Z/T  Impact in current consumption is small.

But savings are high when income is high relative to its average (transitionary income is high). As well as
savings are negative when current income is lower than average income.
 Compensating changes in Y1 and Y2 leave the c1* and c2* unchanges but lead to changes in Savings!

a) Keynesian consumption function: Ct = a + bYt  “the amount of

aggregate consumption mainly depends on the amount of
aggregate income” & this relationship is fairly stable. (higher Y
 higher S)
b) Within a country over time, aggregate consumption is essentially
proportional to aggregate income.
 Over time, almost all the variation in aggregate income reflects long-run
growth (Perm.) thus the estimated coefficient is close to 1.
c) Slope of estimated consumption is similar for whites and blacks
& ≠ intercepts. Permanent-income hypothesis predicts
determinant of b is the relative variation in permanent income
and transitionary income.  An increase in current income is
associated with an increase in consumption ONLY to the
extent that it reflects an increase in permanent income.
 Blacks have lower averages, so when they see a high income, is mostly
going to be transitionary income. Since they have lower average permanent
income, they are going to consume less than they current income. But for
whites, since it is as likely to find a high or lower income than their current
income  whites with this current income on average they consume their income.

Random walk consumption

Utility: and BC:

Since we have (below) and

BC satisfied with equality:

 Each period, expected next-period consumption equals current consumption. Changes in consumption are
unpredictable.
where et is a variable whose expectation in t-1 was 0.
Change in consumption et only depends on change in household's estimation of lifetime resources i.e. due to
unanticipated change in lifetime resources.

Interest rates and savings

Discussion/application: precautionary savings and global imbalances

Investment

Tobin’s Q model of investment

lumpiness of investment

Discussion/application: paradox of thrift and secular stagnation

Financial markets

Bank runs (Diamond-Dybvig)

Discussion/application: recent financial crisis and the run on repos

How is it done? {{c12::Changing the short-end of the yield curve}}

 Target inflation is decided by {{c11::the Government.}} 

 If rate is at 5% and CB wants to increase it, {{c13::he supplies liquidity overnight.}} Then,
{{c13::the interest rate goes down}}, the borrowing cost for the consumers goes {{c13::down}},
consumption {{c13::increases}} and the CPI goes {{c13::up}}. 
-Things to remember when doing exercises

 When comparing different equilibriums with new adjustments. Try to isolate the same multiplier or
the same left hand side of an equation to see whether the new one is bigger or smaller.
 If you want to see the slope of the curve, isolate the variable on the Y axis and look at the coefficient
in front of the variable of X axis. To understand the number, go back to where the “parameters”
belong in the other equations.
 To find AD, find equilibrium between IS=LM and then the equation for Y is your AD. If you solve
for P, you can have the slope. To find out where is positive or negative, take the derivative!
-Financial Markets
 What is a repo, and a certificate of deposit?
 Why financial intermediation?
o Transaction costs: economies of scale
o Asymmetric info: monitoring technology of financial intermediaries
o Pooling of risk
 What happens when investors are not-risk averse in the Diamond-Dybvig? Is the optimal insurance
contract optimal as well?
 You need to find delta ---

Questions
 How to know when should I do the total derivative or the partial derivative?
 Ex b) of PS4 ex1 last steps before assuming x = R^1-sigma ¿?¿? What do you do with your sigma.
 What is the interest rate channel? That is commented when they say that paradox of thrift is more
plausible when we have a zero-rate-bound?
