Macroeconomics Theory

First Part

Measuring the economy

1) GDP – Measures production and income
A) Nominal GDP VS Real GDP (computing)
B) Growth Theory (Address RGDP going up over time) vs Business Cycle (Address the
cyclical fluctuations in RGDP in the long-run trend)
2) Employment/ Unemployment – Measures how much labor used/ unused
a) Labor force (employment & unemployment)
b) Unemployment rate = (# of number unemployed/ labor force ) * 100
3) Price Level – Measures the level of prices in the economy
a) GDP Deflator = (Nominal GDP/ Real GDP) * 100
- a measure of price inflation/deflation with respect to a specific base year
- A measure of the level of prices of all new products such as final goods and services
in an economy in a year.
b) CPI (Consumer price index) =
(price of basket of goods and services/ price of basket in base year) * 100
- A measure of the overall cost of the goods and services bought by a typical
consumer
- National Income Accounting Identity : Y= C+I+G+NX (C & I move in same direction-
Procyclical and I much more volatile than consumption )

Business Cycle?
1) What is it?
2) How do we measure it?
3) What happens during the business cycle?

What happens during a recession?

1) Movement of variables (pro-cyclical? Counter-cyclical?)
2) Lead-lag patterns
Results when recession:

Real GDP declines

Consumption & Investment Declines (durables and residential sector)
Real Wage declines
Inflation & Interest rate Rising before recession and falls sharply
during recession
Unemployment Rate Goes up and declines slowly
Model of Aggregate Demand: IS-LM
1) Consumption Theory – based on consumer optimization
a) Consumer’s problem: U(c1,c2)=u(c1)+bu(c2)
b) Solving the maximization problem:
1) Tangency Condition
2) Intertemporal budget constraint (ITBC)
3) Consumption Function (allocates consumption evenly over two periods:
consumption smoothing)
4) Saving Function
c) Permanent Income Hypothesis (Consumption depends almost on permanent income)
- Keyne vs Friedman
d) Random Walk Hypothesis (non-rational behavior, no access to credit markets,
liquidity constraints=limited borrowing)
e) Aggregate consumption function: C= C(Y-T, r, CS)
F) Endowment economics
2) Investment Theory – Based on firm optimization
a) Properties of capital
b) User cost equation of capital
c) Investment Function: I= I (SP,r) * Tobin’s q (value of a unit of capital in place relative
to its purchase price q= mpk/(r+sigma)
d) Time-varying price of capital
e) Stock Prices – Fundamental stock price
3) Government Spending – ad hoc and exogenous
a) IS-LM model (supply of saving & demand for saving: Investment) -Graph
interpretation
4) Money Market – the central bank
a) Demand for real money balances: (m/p)^d=L(Y,MT,r)
b) Supply of real money balances –
- Money supply is adjusted via open-market operations (purchasing/sale of bonds in
bond markets)
- Central bank buys bond (money supply goes up) and sells bond (money supply goes
down)
- R=reserve ratio, I/R=money multiplier
- Three standard methods of affecting money supply:
1) open-market ops
2) reserve ratio
3) Discount rate

Models of Aggregate Supply

1) Classical assumptions and long-run aggregate supply- output is independent of prices
2) Keynesian assumptions and short-run aggregate supply – higher prices require higher
output to clear labor market
 Labor Demand
1) Labor Demand (firm’s profit max problem)
- Production function: Y=AK^a*N^(1-a), MPn = (1-a)AK^a*N^-a
- L^d=(u,A,K)
Labor supply
- Two effects of wages on individual labor supply (income and substitution effect)
- Intensive margin: employed people working more or less (low elasticity)
- Extensive margin: people entering or leaving the labor force (high elasticity)
- W/P=Z*P^e/P
Aggregate supply curve = equilibrium in the labor market given z,p^e,A,K,u
- In the long run = p^e=p
- No effect on labor supply, employment, production (vertical)
- SRAS & LRAS, Philips curve (pi and unemployment)
- Oil prices increase
– LRAS AND SRAS AND TOTAL PRODUCTION FALL & NATURAL RATE OF UNEMPLOY RISE

Business Cycle Model: bringing together AS & AD

1) The joint Determination of price, output, interest rates, and employment
2) Comparative statics (What happens if?)
3) Assessing the prediction of the model
4) Using the model to understand what drives the business cycle

Bob Lucas criterion

a) Identify a shock in the real world and figure out how the economy responds
b) Apply the same shock to the model and see what response the model predicts
c) The predicted response of the model is close to the real world, we have confidence in
model
Limitations
- Hard to identify shocks in the real world
- Even if you match response to one shock, it may fail to match other shocks
EX)
Identified shock: Monetary policy
- We use test of monetary neutrality
Identified shock: Government spending WWII
Model: P,Y increases, consumption ambiguous, I drops via crowding out, r increases
Data: P,Y increases, Consumption drops a little, I drops a lot, r increases

Possible sources of Recessions: 1) diminished expectation 2) The Fed did it

Traditional and modern business cycle facts:

- R,c,I= procyclical
- Residential investment is leading variable
 - Employment and real wages are pro cyclical
- Unemployment is counter-cyclical
- Prices move very little in short-run, but pro-cyclical overall. (Tradition view of
business cycle facts)
- Prices lead the business cycle and are counter-cyclical (modern view of business
cycle facts)
Second Part

What can policy-makers do about the business cycle?

1) Countercyclical policy in general
Demand tools for macroecon policy making
- Fiscal Policy (Government spending and borrowing and taxes)
- Monetary policy (Central banks, the money supply and interest rates)
Supply side tools
- Competition policy (the use of regulations to affect competitiveness of industries)
- Incentives (the use of taxes/subsidies to alter incentives and behavior)
- Employment benefits/costs
Economics of complete collapse
Theory (why might an economy fail to stabilize itself?)
- Counter-cyclical policy (Fiscal and monetary policy makers can stabilize prices and
output in response to shocks to AD by shifting AD in opposite direction
Difficulties of counter cyclical policy
1)Times lags
-information, Decision, Impact lags (policy action destabilizing if policy action affects the
economy after the economy has already adjusted to the initial shock)
2) Unobservable variables (variables that affect equilibrium when Y=Y^n and U=U^n)
3) The difficulty of forecasting the future
4) Quantitative uncertainty about policy responses
5) Supply-side shocks and stagflation
Why not use Fiscal policy
- Decision lags long
- Political incentives sometimes clash with optimal economic policy
Solution: Automatic stabilizers (policies automatically raise spending or lower taxes when
output is low, vice versa)
Ex) unemployment benefits, progressive income taxes, Medicaid, food stamps
- These policies tend to raise the reservation wage (z) and push the natural level of
output down
- Economy booming : tax revenues rise and government expenditures fall (budget
balance is increasing – procyclical )
- Zero deficit policy – taxes rise and cut spending when economy is doing poorly
- Spending exceeds revenues, government runs a deficit (financed by issuing
government bonds which are repaid with interest) so periods of high deficits are
followed by periods of high interest payments (one of the costs of deficits)
- Tax revenues coming from individual income taxes
 - Social security and medicare or Medicaid account for growing government
expenditures
Supply-side policies
- with this policy, policy-makers face a trade-off: lower inflation vs higher output
Solution: supply side policies designed to shift AS curve to the right
Ex) Deregulation, lower costs to hiring or firing workers, cutting corporate income taxes, cut
income taxes, lower unemployment benefits
- Lowering income tax rates raises tax revenues (Laffer curve)
- above some point of tax rate, decreasing tax rate will increase tax revenue and
below some point of tax rate, decreasing tax rate will decrease tax revenue
Country- cyclical monetary policy
Why monetary policy is the primary economic stabilization tool?
1) Zero decision lags
2) Limited political influence
3) Inflation is primarily a monetary phenomenon
Quantity equation
- MV = PY, m= money supply, V= velocity of money, P= price level, Y= quantity
produced
- In the long run, gm = pi (the growth of money is equal to inflation)
Challenges for monetary policy makers
1) Information and impact lags
- Monetarism: info and impact lags are too severe for monetary policy to serve as
useful stabilization mechanism, then the optimal policy is constant money growth
rate
2) Short term vs long-term interest rates
- Central banks target short-term interest rates, but the interest rates that affect
consumers and investors are long-term interest rates.
- Long term interest rate = ½ (r1+r1e)
- Current long-term interest rates depend on expectations of future short-term
interest rates
- Differences between current short-term and long-term interest rates reflect the
market’s expectation of future short-term interest rates (inverted yield curve)
3) Nominal vs Real interest rates
- Central banks directly affect nominal interest rates, but the interest rates that
should matter for consumers and investors are real interest rates
- Fisher equation – rt=it-Et*pi(t+1) – real interest rate = nominal interest rate –
inflation rate (shows relationship between real and nominal interest rate under
inflation)
4) Time-inconsistency problem
- Policies that determined to be optimal yesterday is not optimal today.
- Solutions:
1) central bank independence (lowering political pressures to push UE rates down by
inflating economy)
2) Conservative central bankers (appoint central bankers who don’t like inflation)
 3) Rules vs discretion
- Force central bank to follow a specific rule for setting interest rates
- Taylor rule matches closely the historical interest rate decisions made by the fed,
useful way to compare monetary policy decisions across time or across regions.

Great Depression, Japan’s lost decade, and the great recession

Depression- extended period of economic stagnation/decline that exceeds in depth and length
the typical business cycle
Depression Theory
1) Depression is caused by a huge negative shock to AD (recover somehow in the future)
2) Adjustment mechanism of the economy fails (economy keeps shrinking)
3) Nominal and real interest rate (effect of higher expected inflation on saving market and
IS curve,r=I,pi^e)
4) Natural adjustment mechanism of model can fail : Deflationary spiral
- Falling prices can cause expected inflation to fall
- Lower expected inflation raises real interest rates
- High interest rates lower investment and consumption
- This shifts AD down, causing prices and output to fall further
- The economy is no longer stable
Solutions:
- shift AD out using expansionary monetary and fiscal policy
- Raise inflationary expectations to lower real interest rates

Liquidity Trap
- Describes a situation when expansionary monetary policy becomes powerless
- The increase in money falls into a liquidity trap – people are willing to hold more
money at the same nominal interest rate
- The central bank can increase liquidity but the additional money is willingly held by
financial investors at zero interest rate
The US Great Depression
Sources of the Great Depression: 1) decline in residential investment 2) stock market crash
Amplification of the shocks:
1) Tight fiscal policy (eliminating budget deficits so government lower spending and raise
taxes during the depression)
2) Bank failures (leads to further reduction in investment and banks increasing reserves-
reduced money multiplier and the money supply)
3) Monetary policy failure (fed failed to increase the money supply enough to raise real
money balances)
4) Deflationary spiral (leads to high real interest rates and declines in investment)
5) Liquidity trap (large increases in real money balances had little effect on interest rates)

What may have ended the Great depression:

 1. Federal deposit insurance corporation (insured people’s bank deposits, stopped bank
runs)
2. National Industrial recovery act (asked industries to establish minimum wages in
exchange for orderly competition
3. Regime change
- election of Roosevelt have raised consumer and firm sentiment
- new fed chairman emphasized raising inflation and inflationary expectations
- leaving gold standard, devaluation of US dollar, led to a rise in exports and higher
prices from imports gdp
Sources of Japanese Slowdown
2 primary shocks: 1) real estate bubble popped 2) stock market bubble popped
- CS and SP fall – leading to recession in the early 1990s
- Unemployment rate rises and inflation has been falling
- Twin Problems (liquidity trap and deflation) – The bank of japan cut the nominal
interest rate, but slowly and the effect of low growth made inflation turn to
deflation. So the real interest rate was higher than the nominal interest rate
- Japanese government cut taxes and raised government spending over time.
(moderate the depth of slump), but it is now running large deficits and faces a huge
debt.
- East European transition (privatization of state-owned companies, companies free to
set prices, elimination of production subsidies)

1) Hyperinflation
Why do governments keep printing more money?
To finance spending – 1) collect taxes, issue debt, print money
The use of printing money to finance spending is known as seignorage (Inflation tax)
Government issue bonds that are sold to the central bank. The central bank buys these with
printed money. This money is used to finance spending
- Seignorage= growth rate of money * real money balances
- An increase in money growth raises inflation and causes people to reduce holdings
of money
- An increase in money growth raises initially raises seignorage. But as people start
reducing real money balances, seignorage falls
- To finance deficits by printing, governments must keep increasing money growth,
which cause inflation and hyperinflation eventually.
How hyperinflations end
Stabilizing programs
1) Fiscal reform:
- Reductions in government spending
- Suspension/elimination of interest payments on debt
- Tax reform: substituting for the inflation tax
2) Monetary reform
- Eliminate monetization of debt (prohibition against buying gvt bonds)
 - Monetary peg (government sets fixed exchange rate for its currency with a foreign
currency)
3) Income policies
- Wage and income controls

-Stabilization programs are costly and frequently fail

How Hyperinflations end

-peg to a foreign currency
-central bank independency
-external enforcement and foreign assistance
-sequencing and political support

Definitions, short answers, consumption, aggregate demand and supply, lectures from others