Macroeconomics Revision Notes: 1) Demand Side of The Economy

Macroeconomics Revision Notes
1) Demand side of the economy
National Accounts can be calculated via 3 methods:

1. Expenditure method: y = C + I + G + (X – M)
2. Value Added method: y = value of output sold – costs of raw materials & intermediate goods
3. Income method: y = salaries of workers + profits of the owners of capital
Measurement error means the three methods may yield different figures.
IS Curve- combinations of the interest rate and output at which aggregate spending = output
AD in the private sector is affected by:
1. Expectations about the future
2. Extent of credit constraints- borrowing by households and SMEs is often restricted by banks
due to information problems. Changes in house prices also affect the amount of collateral
on which to secure loans.
3. The interest rate- when interest rates increase, the demand for houses and consumer
durables goes down as consumers postpone consumption in order to reap the benefits from
saving. Firms will also reduce spending plans on new capital.
e.g. Pessimistic expectations would shift the IS

leftwards. If the central bank (CB) lowered the
interest rate, the economy would move along the
IS from A to B. If the government launched a
major expenditure programme, the IS would shift
rightwards.
Note- the larger the multiplier, the large the shift
and the flatter the IS since a given interest rate
cut has a larger effect on output.
In a closed economy yD = C + I + G
Keynesian Consumption function C = c0 + c1 (1 – t) y
Where c0 is autonomous consumption and c1 is marginal propensity to consume.
The Multiplier
AD= c0 + c1 (1 – t) y + I + G
To the left of the 45° line, demand > supply. An
increase in G shifts AD upwards by ΔG. Now, AD > y.
As the government increases its purchases and
stocks decline, output must rise until there is a new
good market equilibrium.
By substituting y = yD into AD, we can define output
in only exogenous variables.
y = c0 + c1 (1 – t) y + I + G
y - c1 (1 – t) y = c0 + I + G
1
y= (c0 + I + G)
1−c 1 (1 – t)
1
Δy= ΔG
1−c 1 (1 – t)
1 |Macroeconomics Revision Notes

Paradox of thrift- encouragement to save more will
not help an economy to exit recession since there is
no mechanism through which higher saving
translates into higher investment.
Consumption smoothing- desire to have a stable

path of consumption, through borrowing and saving.
Permanent Income Hypothesis (PIH)

Individuals choose how much to consume by
allocating their resources across their lifetime.
1+ p E
Euler equation: Ct = C
1+r t +1
When r < p, consumption falls over time.
r E
PIH Consumption function: Ct = φ
1+ r t
The amount consumed each period is equal to the annuity value of expected lifetime wealth.
Anticipated changes in Y have no effect on consumption because they are already accounted for.
Unanticipated changes do have an effect because they alter future lifetime wealth. A permanent
change will have a larger effect, and the multiplier will be greater than 1. For credit constrained and
impatient households, the multiplier will be larger than 1 even for temporary income shocks.
Criticisms of PIH
- Excess sensitivity to anticipated changes in income counters PIH predictions. Studies have also
found that consumption over-responds to temporary income shocks.
-Credit constraints prevent consumption smoothing as individuals cannot borrow.
-Impatience- shown as a higher discount rate for the short run than for the long run. Impatient
households fail to reduce current consumption upon receipt of news, meaning consumption falls
dramatically when income actually falls.
-Uncertainty about future employment or health means households may save more in early life.
Investment function: I = a0 – a1r

1
IS curve: y = (c + (a0 – a1r) + G)
1−c 1 (1 – t) 0
y = k(c0 + (a0 – a1r) + G)

y = k(c0 + a0 + G) –k a1r
y = A – ar
where k is the multiplier. A rise in c1 (MPC) or a fall in t will increase the multiplier, making the IS
flatter.
The IS curve would shift rightwards as a result of a house price boom (where home equity loans are
available), better access to credit, increases in expected lifetime wealth. IS would shift leftwards due
to increased uncertainty.
Tobin’s q theory of investment- compares expected benefits and costs of investing in an increase of
the capital stock
MB
q=
MC
The optimal amount of investment is where q = 1 and MB = MC.
Firms should invest more if price increases, the interest rate decreases, marginal productivity of
capital increases or the rate of depreciation decreases.
Average Q model
market value of firm
Q=
replacement cost of capital
Firms should invest more if the firm’s market value rises relative to the replacement cost (which will
increase if the interest rate and the depreciation rate rise).
Firms may not be able to invest as much if they are credit constrained.
2) Supply Side of the economy
Efficiency wage setting- employers set the wage above the level at which a worker would take the job
in order to motivate workers and reduce worker turnover.
The utility from working and receiving a

wage must be greater than x. Excess of
efficiency wage over the opportunity cost
of working must increase as
unemployment falls.
At some point, the labour supply curve
becomes vertical when the tendency of
workers to enter the labour force due to a
wage rise is offset by a fall in the hours of
work by those already working. The labour
supply curve may be backward bending if
the income effect (negative) outweighs
the substitution effect (positive).
WS curve- pins down the unemployment

rate consistent with constant inflation and
sets wages.
PS curve- assumes labour is the only input
and productivity is constant.
At the intersection of WS and PS, the real
wage secures sufficient labour for
production to be profitable.
Employers set the nominal wage in order

to achieve their desired real wage on the WS curve, so must make assumptions about the consumer
Price Level (PL). Firms set their prices making assumptions about the nominal wage to achieve the PS
real wage on the PS curve.
unemployed
Unemployment rate =
employed +unemployed (labour force )
A rise in the unemployment benefit will shift the WS curve upwards, which will increase equilibrium
unemployment. Equilibrium unemployment will also increase if the PS shifts downwards. A decrease
in the extent of competition in the goods market (higher mark up over unit labour costs) will shift the
PS downwards.
Nominal rigidities- when nominal wages and prices do not adjust immediately to fluctuations in AD.
There are two extreme cases – fixed price and flex price.
Nominal rigidities can be caused by wages being changed at intervals e.g. annual wage review.
Wage stickiness during the recession may be explained by firms’ concern that wage cuts could
reduce worker effort or cause their most productive workers to quit, whereas layoffs could target
the least productive workers.
Price stickiness occurs when firms are afraid that raising prices will reduce their competitiveness.
Implicit contracts with customers also deter price hikes when demand rises but allow them when
costs rise.
Prices respond to changes in AD with a lag.
e.g An investment boom has no effect on
WS or PS but raises employment in the short
run. At the next wage round, wage setters
will set a nominal wage increase to take the
real wage up to the point on the WS with
higher employment. Afterwards, firms
increase their prices as their costs have
increased.
Union wage setting- unions can use their bargaining power to set wages above the efficiency wage
(upward shift in the WS). If unions exercise bargaining restraint, unemployment will be lower
(downward shift in the WS).
NAIRU- non-accelerating inflation rate of unemployment- the unemployment rate at which inflation
is constant.
Stagflation- high unemployment and high inflation.
Wage-setting equation:
(nominal terms) W = PE B(N, ZW)
WS
W P E B(N , Z W )
(real terms) W = E = E
= B(N, ZW)
P P
Where B is a positive function of the level of employment and Z W are wage-push factors
(institutional, policy, structural and shock variables).
The WS is non-linear since as involuntary unemployment approaches zero, the cost of job loss
approaches zero and the wage that has to be paid to elicit effort goes towards infinity.
The WS will shift downwards when unemployment benefits/ their duration decreases, when the
disutility of work decreases, and when unions have less legal protection, are weaker and exercise
bargaining restraint.
Price-setting equation: WPS = λF( μ, ZP)

At the labour market equilibrium, WWS = WPS
Perfect Competition model- when firms are price and wage takers.
W
P = MC =
MPL
W
= MPL
P
Imperfect Competition model- when firms set prices to maximise profits.
Price-setting equation: P = 1+ ( 1
n−1 )( MPL
W
)=( 1+ μ) ( MPL
W
)
Price-setting real wage:
W
=
1
P 1+ μ ( )
MPL = (1−μ)MPL
The excess of the real wage on the labour demand curve above that on the PS is the supernormal
profits/worker.
If firms set prices to deliver a specific profit margin, output per worker= real profits + real
w
wages/worker: λ = μ λ +
P
W
Price-setting real-wage equation: WPS = =λ (1−μ)
P
W W
Tax wedge – difference between real consumption wage and real product wage: W = =
P c P (1+ t)
Employers care about the real product wage as this is the full cost of labour including taxes divided
by the product price. The PS shifts upwards when the tax wedge or mark-up decreases, and when
productivity rises.
Imperfectly competitive firms maximise profit and make supernormal profits when P>MC. In general,
a shift in demand alters the profit-maximising price but there is a trade-off between costs and
benefits. Price responds only to changes in labour costs and since productivity is constant, only
changes in nominal wages.
W
P = (1+ μ)
λ
Okun’s law- labour hoarding- when output rises, workers on the payroll but not fully utilised will be
used meaning that employment may not initially rise. A 1% change in output growth above trend
increases unemployment by less than 0.5%.
WS curve (linear form): WWS (yt) = (W/P)WS = B + α (yt- ye) + ZW

Wage inflation: (ΔW/W)t ≈ (ΔP/P)t-1 + α ¿ yt- ye)
Price inflation: (ΔP/P)t ≈ (ΔW/W)t – (Δ λ / λ )t
Substitute wage inflation into price inflation where productivity is constant to yield a Phillips
Curve: (ΔP/P)t ¿(ΔP/P)t-1 + α ¿ yt- ye)
Adaptive Expectations Phillips Curve: π t =π t−1 +α ( y t− y e )
E
Adaptive inflation expectations: π t =π t −1
The PC curve will be steeper if the WS is steeper. Each PC shows a feasible set of output and inflation
pairs for a given rate of lagged inflation.

An investment boom shifts the IS to the right,
leading to a rise in output and employment. At
the next wage round, wage setters respond by
increasing wages. Firms’ labour costs rise,
leading to price inflation. At the next wage
round, wage setters will negotiate a further
wage increase to account for the inflation and a
new PC will be drawn.
3) The 3 equations model

IS curve (forward-looking), Phillips Curve
(backward-looking) and Monetary Rule
(forward-looking)
Inflation targeting- the government gives

responsibility to the CB to stabilise the economy
by adopting a specific target for the annual rate
of inflation.
In response to a surge in inflation, the CB would raise the interest rate to lower interest-sensitive
spending and to lower AD and output.
When there is a large negative demand shock, the CB can cut the nominal interest rate to 0 without
succeeding in reviving AD due to the problem of the zero lower bound (deflation trap).
Disinflation- reducing the level of inflation, via a costly procedure involving high unemployment.

Permanent demand shock
A consumption boom is shown by a
rightward shift of the IS curve and an
increase in output and employment
from A to B. At the first wage-setting
round, wage and price inflation will
increase above target inflation due to
the shock. Firms will raise their prices
to protect their profit margins. Higher
inflation is now embedded in the
expectations of wage-setters, so at
the next wage round, the PC is higher
at 3%. Given this forecast, the CB
chooses its best response- point C on
the MR. This interest rate will
dampen AD and lower inflation and
expected inflation, shifting the PC
down to 2.5%. The CB chooses point
D on the MR and will lower the
interest rate. The CB will continue to
guide the economy along the MR by
reducing the interest rate as inflation
returns to the target rate. The
process finishes at point Z at a higher
interest rate.
Monetary rule- shows the output gap of the CB in response to any economic shock. It is the path
along which the CB seeks to guide the economy back to its target inflation.
(yt – ye) = -αβ ( π t – π T)
Deriving the MR
1. Define the CB’s loss function of being away from target inflation and equilibrium output
2. Define the Phillips curve as a constraint on the supply side
3. Derive the best response MR
4. Use the IS to implement this choice.
Loss function L = (yt – ye)2 + β ( π t – π T)2

β > 1 means greater weight is placed on deviations in inflation than in employment.
Philips Curve-
shows all output and inflation combinations from which the CB can choose for a given level of

expected inflation.
The Taylor Rule- the interest rate that the CB should choose to implement its chosen output gap.
The Taylor Principle- the CB must adjust the nominal interest rate to achieve a particular real interest
rate on the IS.
Dynamic IS curve: yt = At – art-1
Inflation shock
When there is an inflation shock, the bliss point is unobtainable. The CB has to choose between y e
along with higher inflation at B and π T along with lower output at C. The CB can minimise its loss by
choosing point D where PC is tangential to and IC closest to the bliss point.
An inflation shock causes an exogenous shift upwards of the PC. The CB will choose the new position
on the PC on the MR to minimise its loss function. As inflation is above target, the CB will have to
reduce output by increasing the interest rate to squeeze inflation out. Output dampens and inflation
starts to fall. The CB gradually reduces r until back at the original equilibrium.
Temporary positive demand shock
Period 0: IS shifts to IS1 for one period only. The economy

shifts from A to B. The rise in output leads to inflation
above target. The CB forecasts PC will move to π 0 in the
next period so it will choose point C on the MR and set
the interest rate to r0 using the original IS curve.
Period 1: the economy moves to C. The higher interest

rate reduces output. The CB forecasts PC will move to π 1
in the next period so it will choose point D on the MR and
set the interest rate to r1.

Period 2: the economy moves to D. Output increases and inflation falls. The process continues until
the economy is back at point Z with ye, π T and rs on the old IS curve.
Permanent positive demand shock
Period 0: IS shifts to IS1 permanently. The economy shifts

from A to B. The rise in output leads to inflation above
target. The CB forecasts PC will move to π 0 in the next
period so it will choose point C on the MR and set the
interest rate to r0 on the new IS curve.
Period 1: the economy moves to C. The higher interest

rate reduces output. The CB forecasts PC will move to π 1
in the next period so it will choose point D on the MR and
Period 2: the economy moves to D. Output increases and

inflation falls. The process continues until the economy is
back at point Z with ye, π T and rs on the new IS curve..
Deflation- when a nominal interest rate close to 0 is combined with deflation this implies a positive
real interest rate which may be too high to stimulate private sector demand. Continued weak
demand will make inflation more negative and push the real interest up. Deflation increases real
debt burdens.
Zero lower bound- min r≥ - π e

From the Fisher equation: r = i - π e , we can see that if the real interest rate needed to achieve the
CB’s chosen output gap on the MR is e.g. 0.75% and expected inflation is -1%, a nominal interest rate
of -0.25% would be required.
Permanent negative demand shock →

Deflation trap
Period 0: IS shifts to IS1 permanently. The

economy shifts from A to B. The fall in
output leads to inflation below target.
The CB forecasts PC will move to π 0 in
the next period. It would like to locate at
C1 back on the MR but this would require
r01, an interest rate below the min. real
interest rate than can be achieved which
is - π 0.

Period 1: the lower interest rate boosts output and the economy moves to C. The level of output is
still far below the CB’s best response level, so inflation falls further and the CB forecasts PC will move
to π 1 in the next period. The CB would like to locate at D 1 back on the MR but this would require r 11,
an interest rate below the min. real interest rate than can be achieved which is - π 1.
Period 2: the economy moves to D. Output decreases and inflation falls, leading to a deflation trap
where inflation becomes more negative each period, which increases the minimum real interest rate
that the CB can achieve.
To escape the deflation trap, the IS could be shifted to the right or more positive inflation
expectations could be created since this would shift down the min r line.
Permanent positive supply shock

Period 0: The economy moves from A to B (where output
is at its original level but inflation is lower). The CB
predicts a permanent supply shock so shifts MR to MR 1.
The CB forecasts PC will shift down to π 0 and would like
to locate at C on MR1 so lowers the interest rate to r0.
Period 1: the lower interest rate increases output. The

economy moves to C. The CB forecasts PC will move to π 1
in the next period so it will choose point D on MR 1 and
Period 2: the economy moves to D. Output falls and

inflation increases. The process continues until the
economy is back at point Z with target inflation and
higher output ye1, and lower interest rate rs1..
4) Expectations
Risk- when we can assign probabilities to known outcomes. Note that inaccurate probabilities still
may be assigned to outcomes e.g. underestimated probability of a US-wide fall in house prices.
Uncertainty- when it is impossible to assign probabilities to known outcomes and there may be
unknown outcomes too e.g. the financial crisis was an uncertain event.
E
Standard Phillips Curve π t =π t + α ( y t − y e )
Rational Expectations - agents in the model use all available information to forecast and therefore do
not make systematic errors. When agents have rational expectations, they know inflation in period t
because they can work it out from shocks that have occurred up to and including period t-1. Only an
unpredictable inflation shock within period t itself, ∈t , could render their calculation inaccurate.
e
Rational Expectations Phillips Curve π t =π t + α ( y t − y e ) +∈t
Adaptive Expectations-Rules of thumb such as adaptive expectations may provide a better

description of private sector agents’ behaviour. For example, in the 3-equation model, wage-setters
form inflation expectations in an adaptive manner and so do make systematic errors because

inflation turns out higher than expected every period. Workers respond to their forecasting errors
and update their expectations based on inflation last period.
Adaptive Expectations Phillips Curve(IAPC) π t =π t−1 +α ( y t − y e )
Under Rational Expectations

The economy starts at A where inflation is above the new target. The CB would like to move to Z to
minimise its loss function. This implies a new MR curve, MR 1. The economy will jump immediately
from A to Z, without the cost of a rise in unemployment. SEE MATTEO’S NOTES:
Under Adaptive Expectations

The announcement of the new target leads to the CB tightening monetary policy by raising the
interest rate to move the economy to B. It would take a further x-1 periods of active adjustment of
the interest rate to get to Z and for the PC to shift. This results in unemployment above equilibrium.
5) Money banking and the Financial Crisis
Lending rate- mark-up on the policy rate and is the interest rate relevant for households and firms.
The mark-up covers the costs of providing bank account facilities and assessing credit worthiness.
Banks might increase the mark-up if there is a shock to the banking system which makes loans seem
riskier. An unexpected rise in the lending rate for an unchanged policy rate leads to a contraction of
AD along the IS, leading to a recession. An inflation-targeting CB would forecast a reduction in
inflation below target. It would then find its desired position on the MR curve, work out the
corresponding lending rate and lower the policy rate.
Policy rate- the rate at which the CB lends to financial institutions and pays on reserves. The short-
term interbank lending rate will never fall below the policy rate as no bank has an incentive to lend
money to another bank at a rate lower than the rate they receive by keeping money as reserves.
Mark-up: r = (1 + μ B ¿ rp
Banks’ profits depend on the expected return on their loans, the rate they pay for borrowing in the
money market and the opportunity cost of holding bank capital. In maximising their expected rate of
return, they take into account credit risk. The riskier the loans, the higher the margin of r above r p. A
lower risk tolerance requires a higher mark-up. The banks’ equity/capital cushion is the difference
between the value of its assets and its liabilities. A lower capital cushion implies less credit risk can
be taken on, so a higher margin will be chosen. A bank with greater market power may also set a
higher mark-up.
Narrow money- M0- high-powered money, notes and coins and reserve balances of banks held at the
CB (the most liquid forms of money).
Broad money- CB money and commercial bank money, including holdings of notes and coins and
sterling-denominated ‘retail’ deposits with UK monetary financial institutions.
Reserves provide banks with liquidity to settle balances with other banks and to pay customers who
want to withdraw deposits. They do not hold excessive reserves since they give fewer returns than
loans. The stock of commercial bank money in the economy is measured by the size of current
accounts.
Bond- financial instrument sold by an institution wishing to borrow e.g. a government of firm to an
investor willing to lend. Bonds can be sold along.
coupon
Bond yield i =
price
Where the coupon is a fixed payment made to the bondholder forever. The price is the price at
which the bond currently trades on the bond market. The price and interest rate are inversely
related. A higher interest rate makes bonds more attractive relative to holding deposits.
MD
Demand for money =f ( y , i , Φ) where i = r + π e
P
The demand for money depends positively on output and negatively on the nominal interest rate
and is shifted by Φ (structural changes in the financial sector such as confidence, innovation in
payments technology and wider availability of financial instruments).
In the 3-equations model, a policy rate of r P is chosen by the CB so the banking system provides
credit to the private sector to implement their spending plans shown by the IS curve at r=r s and y=ye.
For the interest rate to remain unchanged there must be equilibrium between the demand and
supply of money. The amount of money in the economy is a result of banks’ and the private sector’s
response to the CB’s interest rate decision. The CB effectively controls the interest rate as long as it
accurately predicts the mark-up applied by commercial banks.
Credit constraints and collateral
Moral hazard means borrowers have a lower incentive to guard against default when their own
funds are not at stake.
Asymmetric information means banks cannot observe your future expected earning capacity. If
banks charge a higher interest rate to cover risk, individuals with stronger prospects would self-
select away from the bank credit. This leaves weaker applicants to dominate the pool seeking credit.
Banks respond by rationing credit through adverse selection.
Secured loans are those with an asset as a guarantee which may be claimed by the creditor if not
repaid.
Fractional reserve system- banks hold only a fraction of deposits in liquid form.
Liquidity risk- risk that a fractional reserve system has inadequate reserves to meet demand by
depositors to withdraw their money. A banking panic occurs when bank deposit holders suddenly
demand that banks convert their debt claims into cash. To protect from this, CBs provide insurance
in the form of a back-stop provision of CB money,
Insolvency- occurs when the value of a bank’s assets is less than the value of what it owes. If not
bailed out by the government, it will go out of business.
Note- a solvency problem for a small number of banks can quickly become widespread liquidity
problem because no bank will be sure whether it is sage to borrow from another.

 The CB acts as a lender of last resort to the banking system.
 The government/taxpayer is responsible for the solvency of the banking system.
 The CB acts as a lender of last resort to the government. e.g. when a government bails out
banks, it builds up sovereign debt and private sector holders of government bonds lose
confidence in the government’s ability to service their debt so sell the bonds, leading to a drop
in their price and a rise in the interest rate. It increases the cost of government borrowing,
further increasing the risk of default. The CB will step in to buy government bonds.
Investment boom
An increase in business sentiment boosts I and IS shifts rightwards. Firms borrow from banks to
finance the extra investment. Output and income increases as a result of higher investment spending
and saving also goes up. Households can either deposit in the banking system (earning no interest
but safe and ideal for transactions purposes), or buy government bonds (cannot be used for
payment and the price of the bond may decrease when the interest rate increases) or purchase bank
shares (the most illiquid and riskiest option). New deposits in banks will not fully fund the lending so
banks will borrow the remainder from the money market. Concerned that the boom will increase
inflation, the CB will announce a new, higher policy rate. This increases the cost of borrowing for
banks so they will increase their lending rate and this will choke off demand for loans from the
private sector. The CB continues to adjust its policy rate until the economy gradually returns to
target inflation.
The Monetary Sector

The CB sets r0 = r 0 in QI which determines the level of
interbank rates on which banks determine their loan
rates by a series of risk-related mark-ups. r L = r0 + m
In QII, banks supply a volume of new loans as
determined by credit-worthy clients at rate r L. Ls, the
loan supply curve, denotes flows. LD, the loan demand
curve, is downward sloping since a change in the official
rate alters the rate of growth of money and credit.
Demand for loans is a positive function of π and output
growth and a negative function of the loan rate. QIII
represents the banks’ balance sheet constraint. The L=D line passes through the origin at 45°. In QIV,
the DR line shows demand for reserves and its angle is determined by the reserve ratio. The DR line
rotates with changes in banks’ desire for liquidity.
Inflation Shock
Start with an official rate r0 giving a loan
rate rL and lending L0 and a monetary
expansion of D0. The inflation shock
increases nominal income pushing the
loan demand curve to LDI. Without policy
intervention, loans and deposits would
grow more rapidly; however, an
inflation targeting CB will raise the
policy rate from r0 to r0I and the market
rate increases from rL to rLI if the markup

is kept constant. The demand for new loans reduces to L I, the rate of monetary expansion falls and
banks’ requirements for new reserves is reduced. In QIV, the higher interest rate reduces output
from A to C. As inflation begins to fall, the CB reduces the official rate, which eventually returns to r 0
and market rates begin a return to r L. The loan demand curve shifts to the left, reflecting the lower
nominal income. Eventually Ls=LD converges to the original position, producing Y * and π T.
Credit crunch
Banks built up a large portfolio of

lending to ‘subprime’ borrowers. A
downturn in the US housing
market calls the value of this
lending into question. The
securitisation of these loans
obscures their ownership and the
distribution of associated risk. The
extent of risk is also unknown
because many of the CDOs
(collateralised debt obligations) are
never traded. Hence the market for
CDOs collapses, banks cannot
securitise further loans and face a liquidity problem, and are unwilling to lend to each other since
they don’t know the risk exposure of the counterparty. The market rate premium over the official
rate jumps significantly.
In QII, banks restrict lending to Ls. total lending is 0-L0, of which the securitised fraction is L1- L0. The
rate of interest charged by banks is a markup on LIBOR. The conventional relationship between
LIBOR and the official rate collapses, the markup is now m’ and the cost of loans rises to r’. Banks
need fewer additional reserves to mean loands i.e. R 1. Banks want to increase liquidity so the DR
rotates clockwise. The restricted flow and increased cost of credit is deflationary, threatening to
push up the IS, down the SRPC to D, which increases the output gap to Y*-Y 1. The policy maker is on
an inferior indifferent curve and will seek to move to A, by restoring the flow of new credit to L 0 and
reducing the cost to the level intended by policy.
Asset price bubbles

These are undesirable as they distort resource allocation
and can cause financial instability.
The 45° line shows price stability between the two periods.
PDE- price dynamic equation shows the relationship
between price this period and next.
For an s-shaped PDE, Pt+1 = f(Pt; At) where At is a variable that
shifts the whole curve.
A shock to the housing market means agents expect a lower

price AI so the PDE shifts downwards. Some people sell
houses and the new equilibrium is at B. As more and more
people believe the price will fall, PDE shifts down again until
a tipping point is reached where PDE(A II) is tangential to the 45° line. The middle equilibrium has
disappeared and the economy is pulled towards the low price equilibrium at C.

A process of self-fulfilling price expectations can only operate in the market for durable goods.
When a bubble is formed, the PDE has a slope greater than 45°.
NB-
bubbles are hard to identify, often only appearing in hindsight. Central banks have admitted that
their pre-recession regulatory frameworks overlooked systemic risk in the banking system. They
tried to rectify this by focusing more on macro-prudential regulations to mitigate spillovers when a
bubble does burst.
The financial accelerator- a positive feedback process through which a change in the price of an asset
affects the macroeconomy.
e.g. a positive shock to house prices relaxes credit constraints (dependent on the value of a
household’s collateral) and households borrow more, shifting the IS curve. Some of this borrowing is
used for consumption, some is used to buy more housing which further increases the demand for
and the price for housing, creating an upwards trend. The business cycle is amplified because
spending is stimulated by previously credit-constrained people.
The housing feedback process- house price booms typically precede systemic banking crises. Pre-
crisis asset price booms are associated with substantial expansions in credit.
The house-price feedback can be set into motion by an exogenous rise in the price of housing or by a
change in bank regulation e.g. a rise in loan-to-value ratio leads to a rise in the demand for
mortgages. A LTV ratio greater than 100% means receiving a loan greater than the value of the
property without providing any down-payment.
Compare a city with ample space for expansion to a city with binding constraints. As the demand for
housing increases in 2 consecutive periods in both cities, prices will rise due to perfectly inelastic
supply in the short run. However, in the first city, supply will respond in the long run and prices will
fall back down as more houses are built. If there is no supply response, prices will not back down and
this forms a bubble.
Plain Vanilla Financial Crisis

1. When a property bubble bursts, the net worth of households falls and some households
cannot service their mortgage.
2. Foreclosure- houses are repossessed by the bank and sold at a loss.
3. The net worth of banks falls due to losses incurred on mortgage loans.
4. Banks may become insolvent if the shrinkage of asset value wipes out its capital
cushion.

Business cycle- fluctuations of the economy from recession to boom to recession, driven by demand
and supply shocks and policy changes.
Financial cycles- fluctuations in key financial variables (not GDP) such as credit and house prices.
In financial upswings, house prices rise more rapidly than over the long run and banks extend more
credit. Banks and households extend their borrowing.
In financial downswings, household and banks reduce their debt levels (deleveraging). Banks try to
rebuild their capacity to absorb losses by setting a higher interest rate above the policy rate and by
making fewer loans. Public sector debt increases because of government bailouts of banks.
Stylized facts about the financial cycle:

1. Banks play a key role through lending and borrowing behaviour.
2. Housing sector is procyclical and the purchase of housing if often financed by borrowing
from banks.
3. The inter-relationship between banks and housing is central. The peak of a financial cycle is
often followed by a collapse in house prices and a banking crisis.
The zero lower bound (ZLB)

Combining the Fisher equation i = rp + π e with the fact that nominal interest rates cannot fall below
0, we find the minimum real interest rate that the CB can set is min r≥- π e
US house prices began to fall in mid 2006 as the

result of the rise in interest rates triggered by oil
price inflation in 2005. Falling house prices then
triggered a sub-prime crisis. The credit crunch
began in the autumn on 2007.
1. The fall in house prices reduced

consumption and investment, reducing AD
and shifting IS to ISI.
2. The CB forecasts inflation will fall and
chooses a low real interest rate and to
locate at point C on the MR.
3. Even when the nominal interest rate is cut
to zero, monetary policy is unable to attain
C (the dashed part of ISI). The highest
attainable level of output is point D.
In 2008, the situation was even worse and

unusually large interest rates above the policy
rate emerged. As interest rates in major
advanced economies were slashed near to 0,
policy makers feared a deflation trap of falling
prices, rising real interest rates and contracting
output. If asset prices are also falling, the real
burden of debt increases and assets used as security/debt collateral loses value. This financial
accelerator shifts the IS further to the left. Heightened uncertainty steeps the IS, making
investment less interest-rate sensitive.
Policy intervention
During the Great Depression, contractionary monetary and fiscal policy reinforced the downward
spiral of demand. The US President also increased protectionism, inducing retaliation from the US’
main trading partners- leading to a decline in world trade.
During the Financial Crisis, in 2008-9, expansionary monetary and fiscal policies were adopted to
avoid a repeat of the above: governments introduced fiscal stimulus packages and CBs slashed
interest rates. This response addressed the liquidity problem (money markets didn’t seize up e.g.
BofE made $10bn of reserves available for 3 month loans to banks and the ECB injected €95bn credit
into the interbank market), bank solvency problems (failing banks were saved to prevent contagion
e.g. the US Treasury’s $700bn bailout plan) and stabilisation of AD and expectations. Support for the
financial system came in 3 main forms: 1) taking ownership stakes in banks in exchange for providing
capital, 2) nationalisation e.g. the UK nationalised Northern Rock and RBS, 3) Toxic asset purchases.
Conventional monetary policy was restricted by the ZLB on nominal interest rate so monetary policy
makers had to turn to unconventional policies to stimulate demand.
e.g. Quantitative Easing- when the CB creates new or high-powered money to buy financial assets
with the aim of supporting asset prices and bringing down long-term interest rates, to boost AD
through consumption and investment. By buying government bonds, the CB raises demand for them,
pushing up their price and lowering the interest rate. When the banking system is failing in lending
to the real economy, boosting demand for financial assets makes it easier for firms to sell corporate
bonds to finance their investment.

The Yield Curve- relationship between the
nominal interest rate of the bond and its time to
maturity. Bonds can be short term or long term.
The yield curve slopes upwards because investors
demand a premium over short-term interest
rates to hold long-term bonds due to higher
uncertainty in the long run.
In response to a negative demand shock, the CB

reduces the SR interest rate, shifting YC to YC I.
The LR interest rate falls to iLI. If the shock is
sufficiently large, the CB will reduce the SR rate to
0 but this may still be insufficient to stabilise the
economy.
The CB could undertake QE and buy government bonds in secondary markets, increasing their
price and reducing their interest rate. This pivots the YC to YC II and reduces the LR interest rate
to iLII.
Fiscal policy
The MR can be reinterpreted as the PR (policy rule) to include fiscal policy as an instrument.
1. The 1st fiscal channel was to allow automatic stabilisers to operate and accept the
associated increase in the deficit. This limited the leftward shift of the IS in response to
the negative AD shock.
2. Governments in both emerging and developed countries also used discretionary policy
(the gap between the current budget deficit and the impact of automatic stabilisers)
[G(yt) – T(yt)] – a(ye-yt). A budget deficit that persists at equilibrium output is
discretionary: structural/cyclically adjusted budget deficit.
e.g. the UK cut VAT from 17.5% to 15%, many European countries introduced car
scrappage schemes. Note that the stimulus package relative to GDP was smaller in the
UK compared the US and Germany due to the cost of bailouts.
3. The fiscal response was coordinated across countries in order to internalise positive
externalities of the stimulus packages. This recognised that a proportion of any stimulus
would leak abroad through imports, benefitting trading partners without them incurring
any fiscal cost.
4. Note that countries with high government debt e.g. Ireland were severely restricted in
their ability to implement stabilisation through fiscal policy.
Fiscal policy is more effective when:

1. Monetary policy supports expansionary fiscal policy by preventing interest rates from
rising.
2. The rise in government spending is temporary since this directly raises demand for g/s.
Even in the case of a balanced budget spending increase (i.e. taxes also increase), AD will
rise since taxation does not affect the first round of the multiplier process.
3. Temporary tax cuts occur and there are credit-constrained households in the economy.
Note- if the government borrows to fund extra spending, households might anticipate higher
taxation in the future and increase their saving, which will dampen the multiplier. Howeve,
this does not extinguish the positive effect on AD in the first round.
Austerity post-crisis- tighter fiscal policy aimed at reducing the debt to GDP ratio. Fiscal stimulus was
followed by discretionary contractionary fiscal policy in the UK in 2009-10.

-In a balance sheet recession following a financial crisis, banks, borrower households and
government posses more debt than their target levels. This dampens AD. Furthermore, with many
countries in the same position, demand is reduced by spillovers through trade links of similar
contractionary policies abroad.
-Although the IMF revised upwards its estimates of the size of the multiplier due to the ZLB, extent
of slack and synchronised fiscal consolidation across countries, households increased their saving to
get back to their target wealth, so the multiplier was dampened.
-When the economy is depressed, fiscal stimulus is likely to self-financing when even a small amount
of hysteresis (where high cyclical unemployment has permanent negative effects and raises
equilibrium unemployment) occurs.
-Pressure to shift from fiscal stimulus to austerity comes from the deterioration in government
finances. But evidence shows it is inappropriate to tighten fiscal policy too early. In an economy with
spare resources, saving more reduces output and AD, leaving aggregate saving unchanged but
output lower (paradox of thrift).
-The effect of austerity depends on ‘state and time dependency’ i.e. whether other countries are in
recession and their policies too.
-Evidence from previous financial crises suggests governments should be pro-active owners of banks
they bail out in order to shorten the crisis. Initially government debt will increase but the subsequent
fiscal deficits would be smaller.
-Forebearance- ignoring failure of customers to service and repay loans. If non-performing loans are
not identified and removed, banks’ ability to make new loans is impaired (zombie banks). If firms
unable of servicing their loans are allowed to survive (zombie firms), productivity growth is
depressed.
6) The Wide World Part
In an open economy when shocks occur, the CB attempts to stabilise the economy, whereas
foreign exchange traders attempt to profit by selling and buying government bonds to take
advantage of differences in interest rates (arbitrage). However, the extent of international
capital market integration makes these opportunities short-lived.
Home’s nominal exchange rate

no . of units of home currency
e=
one unit of foreign currency
An increase in e means $1 can buy more £s, so the £ has depreciated/weakened.
Home’s real exchange rate- measure of price competitiveness

price of foreign goods∈h ome currency P∗e
Q= =
price of h ome goods P
An increase in Q means the price of home goods has fallen relative to the price of foreign
goods. This depreciation makes home exports more attractive to foreigners and discourages
import demand by domestic consumers. An increase in net exports will boost AD.
Two stabilisation channels
Say a shock pushes inflation above target:
- INTEREST RATE CHANNEL: The CB will increase the interest rate to depress next
period’s level of output and lower inflation.
- EXCHANGE RATE CHANNEL: in an open economy, a negative output gap is also
required. Forex traders spot an arbitrage opportunity due to the higher interest rate
(higher return on UK bonds). A rush out of $ into £ occurs, causing the £ to

appreciate, increasing (reducing) the price of UK exports (foreign imports). The UK
economy loses competitiveness and AD is depressed.
- Consequently, the CB can raise the interest rate by less than would be the case in a
closed economy to achieve the same NOG.
Inflation shock
The CB raises the interest rate to reduce output and dampen inflation. UIP states that home’s
ER will appreciate due to higher demand for the £. Appreciation depresses demand through
net exports. Thus the dampening of demand needed to get the economy back on the MR
occurs through both the interest and exchange rate channel.
3 equations model in an open economy

1. IS Curve- households, firms and governments spend on imported goods as well as
home goods. Some additional demand from higher income leaks abroad, so the
multiplier is lower the higher the marginal propensity to import. A lower multiplier
makes the IS steeper since a fall in the interest rate is associated with a smaller
increase in output. An improvement in home’s competitiveness (depreciation of Q)
boosts export demand and dampens import demand.
A depreciation of Q shifts the IS rightwards, an appreciation shifts it leftwards.
2. Phillips Curve- households use domestic inflation in their wage-setting calculations.

The equilibrium rate of unemployment only shifts as a result of supply side shifts in
the WS or PS curve.
3. Monetary Rule- open economy has no effect on policy maker’s preferences.
Capital market openness- when there is global capital mobility, trade in international financial
markets dominate the Forex market. We assume perfect international capital mobility- home
residents can buy/sell foreign bonds at the fixed world interest rate, i*, in unlimited
quantities at low transaction costs. We also assume the home country is small and cannot
affect i* and that households can only hold bonds and/or money. There is perfect
substitutability between home and foreign bonds in terms of risk (but different returns).
Uncovered Interest Parity Condition (UIP)- The difference is expected return on
home/foreign bonds depends on: 1) any expected difference in interest r22ates 2) view about
the likely development of the ER over the same time horizon. NB- households are forward-
looking in terms of their savings but workers are backward-looking in terms of their wage
negotiations.
e.g. Assume the interest rate in the UK is greater

than that in the US by 2.5%. The £ will appreciate by
2.5% so that the expected return on UK and US
bonds is identical. Over the course of the year,
American investors holding UK bonds loses 2.5% as
the £ depreciates back to its normal level.
NB- for an unexpected interest rate announcement,
over 60% of traders said markets react in less than
10 seconds, most of the rest said in less than a
minute. Arbitrage opportunities are exhausted
extremely quickly. UIP states that the ER will jump
immediately in response.

E
¿ e t+1 −e t E
UIP= i t −i = ¿ log e t +1−log e t
et
Interest gain/loss from holding £ bonds rather than $ bonds = loss from expected
depreciation/appreciation of £ against $
We assume the expected ER returns to its previous value after one period.
A: i= i* and ER expectations are fulfilled

B: i> i* so home’s ER will immediately appreciate so that its expected depreciation over the
year is equal to the interest rate differential.
Each UIP curve has a -45° slope and goes through (loge E,, i*). A change in home’s interest rate
causes a movement along the UIP. For a given expected ER, any change in i* shifts the UIP.
For any given i*, any change in expected ER shifts the UIP.
Suppose a fall in i* for one period.

UIP shifts to UIPI and the economy
moves from A to B due to an
immediate appreciation of the
home currency. At the end of the
period, i* reverts to its initial level
and UIP shifts back inwards.
If the home CB immediately
follows the interest rate move by
the foreign CB the ER will not
change and the economy would
shift from A to C. At the end of the
period, if home again follows the
interest rate move of the foreign
CB the move is from C to A with no
change in the ER.
If traders expect a depreciated home ER, UIP will shift rightwards. With i=i*, this causes an
immediate depreciation of the actual ER to its new expected value.
Medium-run equilibrium
In a closed economy, the MR eq. is when inflation is constant and there is equilibrium on the
supply-side.
In an open economy, the real ER plays a part. The medium run model applies whatever the ER
regime. It will only affect the dynamics of adjustments to shocks, the available policy
instruments and how MR inflation rate is determined.
The ERU curve- combinations of real ER and

output at which WS real wage= PS real wage,
where inflation is constant.
ERU : y = ye(ZW, ZP)
q is the log of the real ER.
ZW = supply side factors that shift WS e.g.
labour market regulations, unemployment
benefits, trade unions
ZP = supply side factors that shift PS e.g. tax
rate, level of technology, labour productivity

A rise in unionization shifts WS upwards and the ERU shifts leftwards.
The AD curve
Open economy AD: y t =A t −ar t −1+ bqt −q
AD responds negatively to r and positively to a depreciation in q, both with one period lag.
Incorporate financial integration
¿ E
UIP: i t −i =log e t +1−log e t
¿ E
RUIP:r t −r =q t +1−q t
In medium run equilibrium, we require the real ER to be constant, r= r*.

∴ Medium run AD: y= A−a r ¿ +bq
AD is upward-sloping in ER-output space. A more depreciated ER is associated with a higher
output.
The AD-ERU model

Equilibrium occurs at intersection
of AD with ERU where r= r*, y=ye,
q= q and there is constant
inflation.
In a closed economy, there is a
new stabilising real interest rate at
the MR eq. following a permanent
demand or supply shock.
In an open economy, the real
interest rate is pinned down by the
world interest rate in MR eq (r=r*)
and therefore the real ER varies in
response to demand supply
shocks.
Positive supply shock: PS shifts up,
ERU shifts right, real ER
depreciates to q I and eq output ↑.
Positive demand shock: AD shifts right, real ER appreciates to q I and output is unchanged.
Stabilisation under flexible exchange rates

RX Curve- determines the CB’s best interest rate response taking into account the reaction of
the foreign exchange market. It goes through the intersection of r* and y e and shifts when
either of the changes. We assume the CB continues to target domestic inflation. Its slope
reflects the interest and exchange rate sensitivity of the AD, the CB’s preferences and the
slopes of the PCs. It is flatter than the IS and the flatter the IS and the higher b is, the flatter
RX is. It is flatter the steeper the MR.
b ¿ 1
RX: y1 – ye = - (a + ¿(r 0−r ) where λ=
1−λ 1+ α 2 β
An increase in a means that interest-rate sensitive expenditure responds more to changes in
the interest rate and that the IS is flatter. This reduces the interest and exchange rate
responses and a larger share of the output gap is accounted for by the interest rate
component. This makes RX flatter.

An increase in b means AD is more sensitive to changes in the real ER. This lowers the initial
interest rate chosen by the CB and the associated appreciation and increases the share of the
output gap accounted for by the ER component. This makes RX flatter.
A decrease inα or β makes MR steeper. This means a lower (1- λ ) and a slower rate of decline
of the output gaps on the path to equilibrium. This makes RX flatter.
The CB minimises its loss function close to its inflation target of π T:

L = (yt – ye)2 + β ( π t – π T)2
This is subject to the supply side constraint, the AE Phillips Curve: π t =π t−1 +α ( y t− y e )
This produces the monetary rule: (yt – ye) = -αβ ( π t – π T)
This is implemented through the CB’s choice of r using the open economy IS and accounting
for the reaction of the forward-looking Forex market: y t =A t −ar t −1+ bqt −1
The open economy IS is steeper due to a smaller multiplier due to marginal propensity to
import. It shifts in response to changes in Q and y*. A depreciation of home’s real ER or a rise
in y* shifts it rightwards.
Instead of adjusting back to equilibrium along the IS as in a closed economy, the CB adjusts
along a flatter ‘interest-rate-exchange rate’ curve called the RX. Smaller interest rate changes
are needed because the exchange rate channel is in operation.
Comparing Closed & Open economies to an Inflation Shock
CLOSED ECONOMY
Period 0- Start at A, the CB’s
bliss point. An inflation shock shifts
PC upwards, moving the economy to
B. The CB forecasts PC in the next
period at PC ( π E1= π 0). It would like
to locate at C, back on the MR so
they set the interest rate to r 0.
π 0, ye, r0
Period 1-the higher interest rate

dampens investment and AD,
reducing output to C. The CB
forecasts PC in the next period at PC
( π E2= π 1). It would like to locate at D,
back on the MR so they reduce the
interest rate to r1.
π 1, y1, r1
Period 2+- the economy moves to D

as the lower interest rate stimulates
demand and output increases.
Inflation falls to π 2. The same process
repeats itself until the economy
moves down the MR to equilibrium
at Z, where π T, ye, rs.
OPEN ECONOMY

Period 0- Start at A. An inflation shock shifts PC upwards, moving the economy to B. The CB
forecasts PC in the next period at PC ( π E1= π 0) and would like to locate at C, back on the MR.
The Forex market forsees that the CB will keep interest rates above r* for a number of
periods to squeeze out inflation. UIP implies this will cause an immediate appreciation of the
home’s currency so that it can depreciate for the whole period during which there is a
positive interest rate differential between home and foreign bonds. The CB sets the interest
rate at r0 (on the MR and RX) taking into account this appreciation.
π 0, ye, r0, q0
Period 1-the higher interest rate dampens investment and the appreciated ER reduces net
exports, both reducing output to C. The CB forecasts PC in the next period at PC ( π E2= π 1). It
would like to locate at D, back on the MR. The CB foresees that a depreciation in the ER will
follow any reduction in the interest rate. They therefore reduce the interest rate to r 1 and the
ER depreciates to q1 (point D on the RX)
π 1, y1, r1, q1
Period 2+- the economy moves to D as the lower interest rate and depreciated ER stimulate
demand and output increases to y2. Inflation falls to π 2. The IS shifts right due to the
appreciation in the ER. The economy travels down the RX (which is flatter than the IS). The
same process repeats itself until the IS gradually shifts back to the right and the economy
moves down the RX and MR to equilibrium at Z, as the CB slowly adjusts the interest rate
from r1 to r* and the ER depreciates from q1 to q .
π T, ye, r*,q .
NB- the position of the AD and ERU are unaffected by the shock. For the entire process, the
economy is to the left of the ERU (so there is downward pressure on inflation) and AD (since
r>r*).
Summary
-the initial interest rate hike to r0 in response to the inflation shock is greater in the closed
economy.
-the IS shifts in each period in the open economy but remains fixed in the closed economy
because the open economy IS includes net exports which are affected by changes in ER. In
contrast, a change in the real interest rate causes movements along the IS.
-the closed economy moves along the IS back to eq, showing the interest rate the CB must set
to achieve their desired output gap on the MR. The open economy moves along a flatter RX
curve back to eq, which takes into account the exchange rate channel.
Demand and Supply Shocks

The CB manages the adjustment to these shocks only if the economy does not respond
quickly enough to prevent inflation shock consequences. It takes one period for the decisions
of the CB and the Forex market to affect the real economy.
PERMANENT NEGATIVE DEMAND SHOCK
Period 0- Start at A, the CB’s bliss point. A negative demand shock shifts IS to IS (A I,q ). Output
falls to y0, inflation falls to π 0 and the economy moves from A to B. The CB forecasts the PC
will move to ( π E1= π 0). It would like to locate at C, back on the MR so they reduce the interest
rate to r0. The Forex market forsees that r<r* so there is an immediate depreciation of home
currency, so that it can then appreciate afterwards for the whole period.

π 0, y0, r0,q
Period 1- The lower interest rate boosts

investment and the depreciated ER
increases net exports. The economy
moves to C with y1 and π 1. The IS shifts
rightwards to IS(AI,q0) due to the
depreciation, but further to the right
than the original. The adjustment from
C to Z will take a number of periods-
the IS gradually moves up the RX and
MR as the CB slowly adjusts the
interest rate up from ro to r* and the ER
appreciates from q0 to q I.
π T, ye, r*,q I
In the new medium run equilibrium,

the IS is indexed by a lower
autonomous demand and a
depreciated ER. The bottom panel
shows a leftward shift of the AD. The
initial depreciation was greater than
the equilibrium depreciation. This is
called real exchange rate overshooting-
phenomenon of nominal and real
exchange rate jumping by more than
the equilibrium adjustment in response
to shocks.
Note- point C is not on the new AD since r<r* and on the AD r=r*.
For a supply shock, the ERU, MR and PC shifts. The RX will shift to intersect the new
equilibrium output level and r*.
For an inflation shock, there is no change in the equilibrium real ER, so all of the initial jump
from q to q0 is overshooting.
For a permanent demand shock, the new equilibrium real ER is depreciated but initially the
depreciation overshoots this equilibrium.
The theory of overshooting was developed by Dornbusch in the 1960s to explain the volatility
of ERs. Overshooting exists because of:
-internationally integrated financial markets
-rational expectations in the Forex market
-sluggish adjustment of wages and prices in the economy, requiring the CB to keep the
interest rate above or below r* until inflation returns to target.
When r>r*, q must jump relative to its expected value. Overshooting will be greater when
shocks are larger. Initial jump = equilibrium change + ER overshooting
Thatcher’s Medium-Term Financial Strategy

In 1979, Thatcher introduced anti-inflationary monetary policy to reduce the growth of
money supply. With no overshooting, a 10% reduction in money supply produces a 10%
reduction in prices and output would remain unchanged. However, announcing a lower

money supply growth rate did not produce an immediate fall in inflation. In anticipation of
high interest rates to push up unemployment and squeeze inflation out of the system, the £
appreciated. Unemployment rose as a consequence and a fall in inflation ensued.
Nominal ER behaviour
¿
P e
Q=
P
Q is a measure of price competitiveness where a higher Q is a real depreciation and an
improvement in competitiveness for home. This improves the trade balance through next
exports.
NB- Volume effect- quantities of exports/imports changing
Relative price/terms of trade effect- a given volume of imports will be more expensive and
hence worsen the trade balance.
Marshall-Lerner Condition- as long as the sum of price elasticity of demand for exports and
imports exceeds one, a depreciation will improve the balance of trade (the volume effect
outweighs the TOT effect).
J-curve effect- in the immediate short run when contracts are already in place, the volume
effect is minimal but the TOT effect operates fully. Therefore in the short run, a real
depreciation typically depresses the trade balance.
Rational expectations in the Forex market are oriented towards producing the jump in the
nominal ER that is implied by solving the model. Since P* is exogenous to the small open
economy and P and Q are pinned down by the inflation shock and the best response PR, e is
just a residual.
The nominal ER depreciates more rapidly than the real ER along the path to the medium run
equilibrium. The initial nominal appreciation in period 0 is less than the real appreciation
because part of the required real appreciation takes place through the initial inflation shock.
X +M
Trade openness is measured by the sum of exports and imports as a % of GDP: ( )
GDP
The Balance of Payments records transactions between the home country and the rest of the
world. It sums to zero.
The trade balance records receipts from export sales- payments for imported goods and
services: BT = X –M
The current account consists of the trade balance plus net interest and profit receipts.
The capital & financial account records changes in the stock of various types of foreign assets
owned by home residents, home assets owned by overseas residents and changes in official
parts of the capital account.
BP = (X – M) + net interest receipts + (private net K inflows – change in official foreign ERs)
Current account Capital account

BP = (BT + INT) + (F –ΔR) = 0
A trade surplus means the home economy is increasing its wealth. A current account surplus
is a source of foreign exchange, which must be used to purchase foreign assets or to increase

foreign exchange reserves. NB- running a trade deficit may still mean a country is fast-
growing with highly profitable investment opportunities- borrowing from abroad allows these
to be taken advantage of. However, a trade deficit may also reflect weak competitiveness and
high levels of private/gvmt consumption.
Following a depreciation of the home currency, there will be a trade surplus. The increase in
output is equal to the multiplier times by the boost to net exports caused by the depreciation.
In a flexible ER regime, there is no government intervention so ΔR = 0. In a fixed ER regime,

the nominal ER is fixed at a certain level. If the CB purchases foreign exchange, ΔR > 0 and if it
sells foreign exchange, ΔR<0. A CB would buy foreign exchange to increase the supply of
home currency if excess demand for home currency was causing pressure for it to appreciate.
Revaluation-intervention for an upward change in the currency’s value.
Devaluation- deliberate downward adjustment in an ER, reducing the currency’s value.
Supply side
When wage-setting behaviour is defined by real wages (including imports), the ERU is
downward-sloping. Therefore, shifts in AD can also lead to new medium run equilibrium with
constant inflation. E.g. a positive AD shock leads to lower unemployment and an appreciated
ER. This is because the lower real cost of imports, due to appreciation, allows real wages to
rise.
The BT curve shows the trade balance explicitly and is upward sloping. Above the BT line,
there is a trade surplus and below the BT, there is a trade deficit. The BT is always flatter than
the AD.
Open economy AD= (C + I + G) + BT

Assuming X is exogenous and M depends only on the level of domestic output or income…
y = yD = c0 + c1(1-t)y + I(r) + G + X – my
1
= ¿)
1−c 1 ( 1−t ) + m
1 1
= <
1−c 1 ( 1−t ) + m 1−c 1 ( 1−t )
= Open economy multiplier < closed economy multiplier

Pricing Rules for Exports
Home-cost pricing- basing prices on domestic costs
World pricing- basing prices on those of similar products produced abroad
Relative Unit Labour Costs- an alternative measure of the real ER
foeign unit labour costs expressed ∈home currency ULC∗e
RULC = =
home unit labour costs ULC
Higher home costs reduce home competitiveness. This is a real appreciation.
Law of one price

The common currency price of a traded good is identical in different countries. For any good j
that is traded, Pj = P*je
International trade should equalise prices for the same good in different countries since as
long as transport costs are not too high, profits can be made by transporting a good from
location where the price is low to where it is high (arbitrage).
If the law of one price holds for all goods and the same basket of goods is consumed in
different countries, this basket will have the same common currency price anywhere=
Absolute Purchasing Power Parity…. Pj = P*je → P = Pe →Q = 1.
This implies the real ER always equals 1. Under perfect competition, there will be no
supernormal profits. Hence neither price nor can cost competitiveness vary.
NB- transport costs, trade barriers and including non-traded g/s in the basket and differences
in consumer tastes across countries interfere with the law of one price.
Export price = Px = P = (1 + μ) * ULC
Import price = Pm = P*e
7) Monetary Policy
Classical dichotomy- identifying different factors that pin down the real (output and
employment) and nominal (price level, inflation rate) sides of the economy. In a perfectly
competitive economy, prices and wages adjust immediately to keep the economy at
equilibrium output.
In the early 1970s following the collapse of Bretton Woods, monetary policy was back on the
agenda. The Bundesbank established a value close to 1 for the coefficient on the inflation
target in the Phillips Curve.
In a model economy with rational expectations, fully flexible wages and prices, announcing a
lower inflation target leads to an immediate fall in inflation to the target without cost. Thus
announcing a lower target for money growth would also reduce inflation at no
unemployment cost. Once we abandon these perfect assumptions, tighter monetary policy
works through raising the real interest rate and creating a NOG. Problems arise when the
relationship between inflation and the targeted monetary aggregate is unreliable.
The failed Thatcher experiment – from 1979, Thatcher tried to reduce inflation and
unemployment by setting ‘intermediate financial targets’- fixed targets for the growth rate of
the money supply and public sector borrowing for every 4 years as part of the Medium Term
Financial Strategy. However, disinflation brought about large unemployment and there were
large shifts in the demand for money. The government’s use of the growth of broad money,
M3, as an anchor for inflation failed because the relationship between M0 and M3 was not
stable over time.

Monetarism- view that the quantity of money has a major influence on economic activity and
the price level and that monetary policy is best achieved through targeting the growth rate of
money supply. Often associated with Thatcher and now discredited.
Active rule-based policy- frequent adjustments to the interest rate in order to achieve the
CB’s inflation objective at least cost.
Central bank preferences-

Loss function: L = (yt – ye)2 + β ( π t – π T)2
PC: π t =π t−1 +α ( y t− y e )
MR: (yt – ye) = -αβ ( π t – π T)
β captures the CB’s degree of inflation aversion. If β >1, more importance is attached to
being away from the inflation target than to being away from equilibrium output. This results
in a flatter MR. Any inflation shock that shifts the PC upwards implies that for the CB to get
back on the MR, a larger output reduction and cut in inflation is needed.
Moreover, the higher α , the steeper the PCs such that any given cut in output has a greater
effect in reducing inflation. This makes the MR flatter too.
Sacrifice ratio- the % point rise in unemployment needed for a 1% point reduction in inflation
during a disinflationary episode.
Taylor Rule- expresses the best response interest rate the CB should choose to achieve its
objectives.
r0 – rs = 0.5 ( π 0 – π T ) + 0.5 (y0 – ye)
Deriving the Taylor Rule

PC: π 1=π 0 +α ( y 1− y e )
MR: (y1 – ye) = -αβ ( π 1 – π T)
IS: y1 – ye = -a (r0 – rs)
Substitute the PC into the MR for π 1:

1
π 0 +α ( y 1− y e ) - π T = - (y1 – ye)
αβ
1
π 0- π T= - (α +¿ ) (y1 – ye)
αβ
Substitute the IS into (y1- ye):

1
r0 – r s = 1 ( π 0- π T)
a( α + )
αβ
r0 – rs = 0.5 ( π 0- π T) if a= α =β=1
Taylor principle- the nominal interest rate has to be raised sufficiently to push up the real
interest rate. The coefficient of the inflation gap must >1 for monetary policy to be stabilising.
As β increases (i.e. more inflation averse), the interest rate must be higher.
As α increases (i.e. steeper PC, flatter MR), the interest rate response is smaller.
As a increases (i.e. flatter IS), the interest rate response is smaller.
The impact of interest rates on output can take up to one year and on inflation up to 2 years.
Quantitative easing- unconventional monetary policy, useful when conventional policies are
constrained by the ZLB; CBs create CB money to buy financial assets.e.g. gvmt bonds in the UK

and mortgage-backed securities in the US. QE aims to affect long term interest rates set in
financial markets, which alter the term structure of interest rates and flatten the yield curve.
See further notes from Chapter 13 on Quantitative Easing
8) Fiscal Policy
1. Income distribution: tax and transfer systems to redistribute income.

2. Resource allocation: subsidies to particular industries which need encouragement and taxes on
those where consumption should be discouraged.
3. Public goods: non-excludable and non-rivalrous goods that are often underprovided by the
market.
Discretionary fiscal policy

1
Δy= ΔG = kΔG where k>1 since 0<c1 & t<1
1−c 1 (1−t )
Deep recession
A negative demand shock shifts IS leftwards and pushes output below eq. Inflation falls below
target and the government must increases spending to shift the economy back on to the PR.
From point C, the policy maker gradually eases the fiscal stimulus to guide the economy back
to A. In the new medium run eq. the real interest rate remains unchanged at r s so interest-
sensitive private spending is at its pre-recession level. The new medium run eq. has higher
government spending and lower private spending. Once the negative demand shock begins to
recede, the policy maker reverses the fiscal stimulus to maintain the medium run eq.
Over-ambitious output target

The government introduces expansionary fiscal policy and increases output to y H, shifting the
IS to ISI to point B and shifting the PR to PR I. The new inflation target is π T. Point B is not a

medium run eq. since workers’ inflation expectations are not fulfilled. Expectations are
backward-looking so the PC shifts up in the new period. The government responds by
reversing the fiscal expansion in order to get to point C on the PR. At C, output is still above
eq. so there is upward pressure on inflation and the PC shifts upwards again. The process
continues until the economy reaches point D, the new medium run eq, where output is back
to ye but inflation has risen. The government is worse off than if it had stayed at A.
Note- under rational expectations, the economy moves directly to D.
This economy has spare capacity- the government can boost AD and output which enhances
welfare. However in an economy with eq. output where the CB keeps the real interest rate
unchanged, the economy experiences an inflation bias and higher government debt.
Balanced budget multiplier- when the government increases taxation by enough to finance
increased expenditure so that there is no deficit at the short run equilibrium. This means the
government can still increase AD without the need for debt financing, which is valuable
during recessions when it is unadvisable to increase the deficit.
yD= c0 + c1(y-T) + (a0 –a1r) +G
Δy = ΔG + c1ΔG + c1(c1 ΔG) +… + -c1 ΔT – c1(c1 ΔT)- …
Δy = Δ G
∆y
=1
∆G
The balanced budget multiplier hinges on the fact that gvmt spending on g/s generates extra
output and income whereas the increase in taxation redistributes spending power from
taxpayers to those who provide g/s. If these two groups have the same mpc, the BBM=1
because aggregate consumption is unchanged.
Across 44 countries, it was found that the multiplier was larger in developed than developing
countries, larger in closed than open economies (due to import leakages), zero in economies
under a flexible ER regime but relatively large in countries with fixed ERs and negative in high-
debt countries. A number of studies also found the multiplier to be larger during recessions.
Automatic stabilisers to some extent insulate the economy from shocks to AD. The inbuilt
dampening of shocks means that the budget deficit rises when activity falls and declines
when activity rises.
Taxes related to the level of income reduce the size of the multiplier and dampen the impact
on AD of a demand shock. Transfers increase as the level of output falls too, reducing the size
of the SR multiplier.
Cyclically adjusted budget deficit- that which prevails given existing tax and transfer
commitments if the economy was operating at eq. output. It indicates whether fiscal policy is
expansionary or contractionary.
Cyclically adjusted /structural budget deficit / discretionary fiscal impulse=
budget deficit – automatic stabilisers
G(ye) – T(ye) = [G(yt) – T(yt)] – a (ye – yt)
This is the primary budget deficit as it excludes interest payments on outstanding government
debt.
During a recession, automatic stabilisers increase gvmt expenditure on transfers and

decreases tax revenue, pushing up the actual deficit. If these two effects cancel out, the
change in the deficit simply reflects the automatic stabilisers and there is no discretionary
fiscal impact on AD and the cyclically adjusted deficit is 0. However, a deficit of G(ye) – T(ye)>0
implies an expansionary fiscal impulse and a surplus implies a contractionary impact on AD.

If discretionary fiscal policy is used to stimulate return to eq. after recession, there will be a
larger debt stock and the government will eventually have to reduce it with discretionary
fiscal tightening when output is above eq.
The actual primary budget balance has been in deficit for the majority of 1970-2010 but has
worsened during and after recessions. The cyclically adjusted budget balance was also in
deficit in recessions too, showing the UK gvmt undertook fiscal stimulus. The gvmt also ran
expansionary fiscal policy in the years of growth leading up to the crisis, suggesting it ran a
potentially destabilising pro-cyclical fiscal policy.
Countries with larger government sectors tend to have larger automatic stabilisers, and hence
undertake less discretionary policy.
Government’s Budget identity

The gvmt can finance expenditure through selling new bonds, taxation or printing money.
Gt + itBt-1 = Tt + ΔBt + ΔMt
Gvmt expenditure + interest = tax revenue + new bonds + new money
ΔM is a last resort and a state of extreme political dysfunction. It increases the growth rate of
money supply and if maintained can lead to hyperinflation. This is not a viable option when
the CB is independent.
Debt dynamics
G + iBt-1 = T + ΔB
government expenditure + interest = tax revenue + new bonds
Stock of gvmt debt= stock of gvmt bonds that have been sold to the private sector in the past.
Δ B = (G - T) + iBt-1
Change in debt = primary deficit + debt interest = actual budget deficit
B t−1
Debt ratio: bt =
P t yt
budget deficit ∆ B G−T iBt −1
Budget deficit to GDP ratio: = = +
GDP Py Py Py
primary deficit G−T

Primary deficit to GDP ratio: =d=
GDP Py
B = bPy
∆ B ≈ Py ∆ b+ by ∆ P+ bP ∆ y
∆ B b ∆ Py b ∆ yP ∆ bPy
= + +
Py Py Py Py
π
=b +b y+γ ∆ b where is the growth rate of prices and γ is the growth rate of output
π
Using Fisher r = i – π
∆ b=d +¿ y)b = d + (r – γ y)b
There are 4 key determinants of the growth of the debt to GDP ratio:
1) primary deficit ratio, d 2) real interest rate, r
3) growth of real GDP, γ y 4) existing ratio of gvmt debt to GDP, b
CASE 1: UNSTABLE: r > γ y (interest rate exceeds growth rate so the interest payments on existing
debt are rising faster than GDP hence servicing the debt pushes up the debt burden). The phase line
is upward-sloping.

CASE 2: STABLE: r < γ y (interest rate is below the growth rate, the growth of the economy is
sufficient to reduce the impact of interest payments on the debt burden). The phase line is
downward-sloping.
Now there is a switch between r < γ y to r > γ y and the economy moves from point A to B and
the debt ratio begins to rise w/o limit unless the interest or growth rate changes. If the
government immediately tightens fiscal policy so that the primary deficit is replaced by a
primary surplus (requiring a dramatic cut in government spending and/or rise in taxation) the
economy would move from A to C.
Sovereign default risk

A positive default risk alters the debt dynamics since the risk premium, p, is added to the risk-
free real interest rate.
r = r risk− free + p
∆ b=d +¿ y)b

Cost of high and rising government debt
In advanced economies, often the real interest rate on government bonds is risk-free i.e. well
below the real rate of return on fixed investment. When r > γ y, a substantial primary surplus
may be required to stop the debt ratio rising further and an even larger primary surplus is
required to reduce the debt burden, requiring painful spending cuts or unpopular tax
increases.
A high level of debt that is rising w/o limit may cause concern that the government will
default on its debt. The government will face a higher interest rate on borrowing to
incorporate for the premium of default risk, p. This worsens the debt burden and dampens
investment.
If r > γ y,a primary budget deficit is consistent with a stable debt ratio. However, the higher the
debt ratio, the more vulnerable the government will be if the relationship between r and γ y
switches: it would have to undertake greater fiscal tightening to stem the rise in the debt
ratio and the risk premium may also rise.
The government’s intertemporal budget identity can also be interpreted as its solvency
constraint and as the requirement for the absence of a default risk on its debt.
Assume b>0 and Δb≤0
Since Δb = d + (r – γ y)b for Δb≤0
−d
b≤
r −γ y
Existing debt Primary surplus /GDP
≤
GDP (r −γ y)
For long run sustainability, when r > y , there must be a LR primary surplus if the debt ratio is
to be constant.
Reinhart & Rogoff found that periods with gvmt debt to GDP ratios in excess of 90% were
associated with 1% lower growth P.A. They claim high debt causes low growth whereas
others say it is the other way round- that slow growth causes debt to build up.
Can fiscal consolidation be expansionary?

In 1983-6 Denmark and 1987-9 Ireland, fiscal consolidation ran alongside expansions in C, I
and GDP. If the economy is already in fiscal stress, the interest rate will be higher due to the
risk premium and the gvmt borrowing costs will diverge from the risk-free rate. Households
may lower their estimates of their wealth and feel uncertainty about the future, which
generally depress C and I. A credible fiscal consolidation therefore may reduce uncertainty,
restore optimism and increase C and I.
Moreover, composition rather than size alone of fiscal consolidation may determine its SR
impact. E.g. government cuts on consumption (rather than investment or raising taxes) may
signal more serious fiscal reform and have a stronger effect on private sector expectations.
Fiscal consolidation is typically contractionary, but less so in countries with high perceived
default risk and it is likely to benefit GDP in the LR.
Ricardian Equivalence (PIH)- any increase in the gvmt deficit will be analysed by households
for its consequences for their permanent income.
∞
y t +i ∞
Ct +i
Households’ intertemporal budget constraint: ∑ i =∑ i
i=0 (1+ r) i=0 (1+ r)
1+ ρ
The solution to the max. problem is the Euler equation: Ct = C
1+ r t+i
Introducing a government with a balanced budget each period (G = T) and assuming gvmt
spending does not provide utility to households or affect future income…

∞
y t +i−T t +i ∞
Ct +i
Households’ intertemporal budget constraint with gvmt: ∑ i =∑ i
i=0 (1+r ) i=0 (1+ r)
Households continue to maximise utility and smooth out consumption. The only difference is
a lower level of consumption due to taxes reduces permanent income.
If we assume the government reduces tax to 0 and finances spending through borrowing.
They have to raise taxes in the next period to pay interest (rB). Disposable income is y e-T in
each period i.e. ye in period 1, ye- rB in period 1, ye -2rB in period 2. If households want to
consume the same amount in each period, they need to save B in each period, in effect
buying the bond the gvmt has sold.
The permanent consumption of households is the same whether gvmt spending is financed
by taxes or borrowing.
Ricardian equivalence depends on:

-absence of credit constraints on households
-interest rate and time horizon faced by households and the gvmt being the same
-households having children and incorporating their utility into their consumption behaviour.
∴ changes in fiscal policy are only partly offset by changes in private sector savings.
Temp tax cut: In the RE-PIH framework, temporary tax cuts entail a tax increase later.
Because the tax cut is saved, consumption and AD do not change. Hence attempts to
stimulate the economy via a temporary tax cut is completely ineffective.
Temp rise in gvmt spending financed by borrowing: higher gvmt spending in period 0 reduces
permanent income for households who will reduce consumption in every period. Since the
impact of higher G on households’ budget constraint is spread across all periods, the fall in C
must be less than the rise in G i.e. a positive boost to AD occurs in period 0. NB- the increase
in gvmt spending is partially offset by lower consumption, so the multiplier is less than 1.
Compare to Keynesian consumption: multiplier> 1 when there is a temp rise in gvmt spending
financed by borrowing and multiplier = 1 when there is a balanced budget fiscal expansion.
Deficit bias- tendency for budget deficits to rise in recessions, but not to fall during booms.
This leads to a preference for financing gvmt spending through borrowing rather than
taxation.
Causes of deficit bias:

-Over ambitious output target- when the gvmt seeks to achieve unemployment below the eq
rate, there is inflation bias and higher gvmt debt.
- Uncertainty about growth forecasts- the gvmt may make optimistic growth forecasts,
producing higher estimates for tax revenue. The gvmt may hence adopt tax and spending
plans that raise the debt level if the growth rate is lower than expected.
-Intergenerational conflict- current voters may take insufficient account of the future burden
that will arise e.g. from an ageing population.
Variation across countries

-Preferences for public goods- Scandinavian countries run tighter fiscal policies than Greece
and Italy due to a higher provision of public goods. The idea is that current generations pass
on the cost of public spending to the next.
-Common pool problems and budgetary processes- countries with proportional
representation, and more coalitions, may face different pressures than majoritarian-system

countries. Public spending projects/tax cust may favour particular groups in the economy and
ministers may fail to fully internalise the costs to the current and future budget. Proportional
representation systems are more likely to lead to fragmented gvmts with overspending
problems.
How to tackle deficit bias

1) Fiscal rules- guidelines for fiscal policy make sure it is sustainable e.g. numerical limits for
fiscal aggregates.
Optimal fiscal policy rule- PFPR- Prudent Fiscal Policy Rule- set the share of tax in GDP to a
constant level equal to the permanent level required to satisfy the constraint:
(T/y) = (T/y)P ≥ (G/y)P + (rP – YyP)b where p is the long run value
-Any permanent increase in G should be financed by a rise in T e.g. pensions
-Any temp increase in G should be financed through borrowing e.g. transfers in a recession
-Any major gvmt infrastructure spending should be financed through borrowing
-Borrowing should be allowed to rise if the interest rate is confidently known to be temp.
higher than its permanent value or if growth is depressed relative to its LR value.
-G must be reduced below its permanent level in upswings.
-Tax revenue should be smoothed over time by borrowing and saving. The gvmt’s optimal tax
share only changes when there is a permanent change to the gvmt’s intertemporal budget
constraint. Temp or unforeseen fluctuations in G are dealt with solely by changes in
borrowing.
Stability and Growth Pact
-budget deficit to GDP ratio < 3%
-gvmt debt to GDP ratio < 60%
-cyclically adjusted budget balances must be close to balance or in surplus (i.e. fiscal policy
cannot be used for long term infrastructure projects).
2) Fiscal Policy Councils-independent ‘fiscal watchdog’ to ensure fiscal policy is sustainable

over the long run. They provide independent forecasts of the evolution of public finances and
call for the gvmt to account for unsustainable plans. Many new FPCs have been set up or re-
emerged after 2007 due to the success of independent inflation-targeting CBs, insufficient
fiscal rules, and the introduction of unpopular austerity packages.
9) Real Business Cycles
- RBC models view aggregate economic variables as the outcomes of decisions made by
individual rational agents acting to maximise their utility subject to production
possibilities and resource constraints.
- Production technology is assumed to be subject to temporary productivity shifts or
technological changes which provide the underlying source of variation. These
exogenous shifts in technology are known with certainty to all agents.
- RBC theory embraces the classical dichotomy- that real and nominal variables can be
analysed separately.
- The real wage is procyclical in RBC- during recessions, the price of leisure relative to
goods, the real wage, falls so individuals rationally increase their leisure and decrease
their consumption of goods.

- RBC theorists have developed a method of ‘calibration’ - ‘a strategy for finding
numerical values for the parameters of artificial economies’ and involves a ‘symbiotic
relationship between theory and measurement’.
Robinson Crusoe
- All individuals are alike; hence imagine Robinson Crusoe- a representative agent.
- Crusoe’s choice problem is to maximise his lifetime utility (a function of their
expected consumption and leisure) subject to production technology and resource
constraints and hence choose how to allocate his hours between work and leisure.
- In the absence of productivity disturbances, Crusoe’s optimal choice of consumption,
work effort and investment will converge to constant or steady state values.
- Given a temporary positive productivity shock, Crusoe will be encouraged to
substitute current for future work and current consumption for leisure. Wealth is
higher and reduces current and future work effort. The substitution effect dominates
however so that current work effort rises hence the effects of the shock show up in
higher output, consumption and leisure in the future.
- Given the productivity shock is more permanent, wealth is raised more significantly
so Crusoe’s incentive to increase investment is reduced and his incentive to increase
current consumption would increase. There will also be less incentive to work harder
today because the wealth effect is stronger and the intertemporal substitution effect
is reduced.
- There are no market failures in this economy so Crusoe’s response to productivity
shifts is optimal and the economy is always Pareto-efficient. Any other allocation, or
government attempts to stabilise employment, is hence welfare reducing and will
impede the invisible hand.
Criticism of RBC theory

- Technological improvements are gradual over tome rather than sudden shocks.
- RBC assumes employment fluctuations are either inexistent or fully voluntary and that
individuals are willing to reallocate leisure over time.
- It is unlikely that individuals are so responsive to intertemporal relative prices. Only small
changes in hours worked have been observed in reality.
- RBC requires there to be only a few sectors and large disturbances since too many
independent sectoral shocks, with labour mobile between sectors, would average the effect
out to 0 (the law of large numbers).
- The idea of recessions being periods of technological regress. As Mankiw (1989)
notes, ‘recessions are important events; they receive widespread attention from the
policy-makers and the media. There is, however, no discussion of declines in the
available technology. If society suffered some important adverse technological shock
we would be aware of it.’
- RBC sidesteps the aggregation
problems inherent in
macroeconomic analysis by using a
representative agent whose choices
are assumed to coincide with the
aggregate choices of millions of
heterogeneous individuals. Such
models therefore avoid the
problems associated with
asymmetric information, exchange
and coordination.
Positive technology shock

RAD and RAS curves are relabelled as Cd and Ys respectively. The initial equilibrium position is
at point a in all four quadrants of Figure 6.6. The shock shifts the Ys curve from Ys1 to Ys2 in
quadrant (d) and the production function up from AF(K,L) to A*F(K,L) in quadrant (b). A
favourable technology shock increases the marginal productivity of labour, thereby shifting
the labour demand curve (DL) to the right in quadrant (a); that is, from DL1 to DL2.
However, the labour supply curve also shifts from SL1 to SL2 in quadrant (a), this decrease in
labour supply being a rational intertemporal response to the fall in the real interest rate (from
r1 to r2). The new equilibrium taking into account all of these effects is given by point b. Thus a
favourable technology shock increases real output (from Y1 to Y2), lowers the real rate of
interest (from r1 to r2), increases labour productivity and the real wage (from (W/P)1 to
(W/P)2). That is, the real wage and labour productivity are procyclical, as the stylized facts
suggest.
Increase in Government Spending

The initial equilibrium position is at point a. An
increase in government purchases shifts the real
aggregate demand curve from Cd1 to Cd2. In this
case real output increases (from Y1 to Y2), the real
rate of interest rises (from r1 to r2) and the real
wage falls (from (W/P)1 to (W/P)2) in response to
an increase in labour supply, with the labour
supply curve shifting from SL1 to SL2 in quadrant
(a). The new equilibrium taking into account all of
these effects is given by point b. In the old
classical model aggregate supply is perfectly
inelastic and an increase in government
purchases has no effect on real output. In
contrast, in REBCT, an increase in government
purchases leads to an increase in real output
because the induced rise in the real rate of
interest encourages an increase in labour supply, thereby increasing employment and real
output.
10) New Keynesian Economics Microfoundations
Keynes’ theories came under attack in the 1970s when they failed to explain the stagflation of
the 1970s. Keynesian economics had to be modified to account for the influence of supply
side shocks and was criticised for its inadequate microfoundations and adaptive rather than
rational expectations.
Main Keynesian propositions

- Unregulated market economies will experience unemployment at equilibrium
- Business cycles are caused by disturbances to AD
- Monetary policy may be ineffective in very deep recessions
- Government intervention in the form of stabilisation theory can improve macro
stability and welfare.
-In both old and new Keynesian economics, the failure of prices and wages to change quickly
enough to clear markets implies demand and supply shocks will have substantial real effects
on output and employment. New Keynesians (NKs) attempt to provide microfoundations to
explain these phenomena. New classical theorists also saw the need for microfoundations but
RBC theorists saw these in light of perfect competition, perfect information, zero transaction
costs and a complete set of markets.

-There is no unified view of NKs on the role of fiscal policy, however, greater weight is placed
on the stabilising role of monetary policy (hence why NK is sometimes referred to as New
Monetarist economics).
-NK developments were distinctly non-empirical in the 1980s.
Assumptions of NK economics
- Violation of the classical dichotomy
- Money non-neutrality
- Rational expectations
- Involuntary unemployment
- Real market imperfection: imperfect competition (monopolistic price-making firms),
incomplete markets, heterogenous labour, asymmetric information, agents
concerned with fairness, possibility of coordination failure.
Nominal rigidities- price and wage inertia (slow adjustment) following a disturbance.
Nominal wage rigidity- The Fischer Model

Long term wage contracts may generate significant wage rigidity. The real wage is
countercyclical since AS is a decreasing function of real wage.
An unexpected nominal demand shock shifts AD

inwards. Prices are flexible but nominal wages
are temporarily rigid at W0. The economy moves
to B and output falls. With flexible wages and
prices, SRAS will shift outwards to re-establish
output at point C. However, long term wage
contracts prevent this flexibility. Monetary
authorities instead expand the monetary supply
to shift AD outwards.
Note- different countries have varying degrees of

contract duration. Staggered contracts mean
nominal wages exhibit more inertia in the face of shocks than synchronised renegotiations.
Although long-term wage contracts increase instability, they are advantageous since frequent
negotiations are costly in time and research needed on the structure of wage relativities and
key variable forecasts. There is also potential for negotiations to break down and for
strikes/costly disruptions to occur. ‘Jumping’ wages to the new equilibrium isn’t optimal
follow a shock because if other firms do not do so, it may see increased turnover.
Nominal price rigidity

Nominal wage contracting was soon criticised for the countercyclical nature of the real wage
when evidence shows it is mildly procyclical.
PAYM insight (Rotemberg, 1987) - in imperfect competition, the presence of even small costs
to price adjustment generates considerable aggregate nominal price rigidity. The private cost
of nominal rigidities to the individual firm is much smaller than the macro consequences of
such rigidities.
Menu costs- barriers to price adjustment e.g. physical costs

of resetting prices, expensive management time from
negotiation of purchase and sale contracts.

There is no incentive for a profit-maximising firm to reduce price if z (menu cost) > B-A
(increase in profit). The flatter the MC, the smaller the menu costs need to be to keep the
price unchanged. Society would be better off if firms cut their prices but the private incentives
to do so are absent. If the presence of menu costs causes nominal price rigidity, shocks to AD
cause large fluctuations in output and welfare. If all nominal prices were instantaneously
flexible, a purely nominal shock would leave the real equilibrium of an economy unchanged.
Real wage rigidity

In NK models, an equilibrium real wage can emerge that is different to the market-clearing
real wage. Real wage rigidity can generate involuntary unemployment. 3 explanations:
1. Implicit contract models- firms provide insurance against variable income in the face
of shocks by providing a constant real wage which helps smooth workers’
consumption.
2. Efficiency wage models- it is not in a firm’s interest
E to lower real wages because worker productivity
ff and the real wage are interdependent. Wage
Effort
eor M cutting would lower productivity and raise costs.
functi
*t Profit maximising firms will offer an efficiency
on
wage of w*, where the elasticity of effort with
w Rea respect to wage is unity, to minimise labour costs
Wage
cost Effort * Effort l per efficiency unit of labour. Up to point M,
increases in the real wage elicit a more than
per elasticit elasticit wag proportionate increase in worker effort. The firm
y>1 y<1 e
efficien
w should hire labour up to the point where MP = w*.
cy
* unit
/ w Rea
e * l
* wag If at this point, aggregate
e demand for labour
<aggregate supply for
labour or if w*> market-clearing wage,
there will be involuntarily
unemployment. If there is a negative shock to
demand for labour, involuntarily
unemployment will increase since w* stays the same.
Efficiency wage theory has several explanations:

A. In developing countries, higher wages increase wellbeing and labour
efficiency through better nutrition.
B. Adverse selection- firms send signals to the labour market in the form of a
higher wage offer. If workers’ abilities are closely connected to the
reservation wage, higher wage offers will attract the most productive
applicants. Even if there is excess supply of labour, firms will not lower wages
as the most productive workers will quit voluntarily.

C. Labour turnover- workers will be less willing to quit if their wage is above the
going rate. This will thus reduce costly labour turnover.
D. Shirking- the threat of dismissal if a worker is shirking is not efficient if
workers can find a new job at the same wage rate. But if the wage rate is
higher, there is an incentive not to shirk since there is a real cost to being
fired. If monitoring intensity decreases and/or the unemployment benefit
increases, the wage needed to deter shirking increases and the equilibrium
rate of involuntary unemployment increases.
E. Fairness- feelings about equity/fairness act as a deterrent to firms to offer too
low wages. Worker productivity is a discretionary variable and changes
according to working conditions, and is a positive function of their morale.
Fairness of the wage is measured by comparing similar workers. Workers who
feel unfairly trated will reduce their effort. e.g. Henry Ford paid $5 instead of
$2.34 and saw a 75% reduction in asbsenteeism, a 87% reduction in turnover
and a 30% increase in productivity.
3. Insider-outsider models- insiders are the current employees and outsiders are the
unemployed workers.
Insiders partially determine wage and employment decisions and there is no
assumption that wages affect productivity. Insider power results from turnover costs
and their ability to cooperate or harass new workers if they feel threatened by
outsider. They may refuse to train them or make life at work unpleasant, raising the
disutility of work so outsiders’ reservation wage rises, making it less attractive for
firms to employ them.
NK Business Cycle Theory

Aggregate disturbances can arise from supply or demand side shocks. Frictions and
imperfections in the economy amplify these shocks, resulting in large fluctuations in real
output and employment.
(a) Importance of nominal rigidities

(b) Destabilising impact of wage and price
flexibility.
Negative AD shock
Menu costs and real rigidities make the PL rigid
at P0, moving the economy from E0 to E1. The
decline in output reduces the effective demand
for labour. With prices and real wages rigid,
firms move off DL and operate instead along
NKL1. At the rigid real wage, firms would like to
hire L0 workers but have no market for the extra
output they would produce, creating an increase
in involuntary unemployment. Eventually
downward pressure on prices and wages moves
the economy from E1 to E2 but this takes time.

NKs advocate measures that push AD back to E 0. The failure to cut prices even though this
would benefit all firms is a coordination failure.
Another branch of NK economics suggests that employment would still be very unstable if
wages and prices were flexible. Greenwald and Stiglitz (1993) say that financial market
imperfections constrain firms from access to equity finance, meaning they can only partially
diversify out of the risks they face. Depending more on debt makes them vulnerable to
bankruptcy. During a recession, when marginal bankruptcy risk increases, risk-averse equity-
constrained firms prefer to reduce output at each price because the uncertainties of price
flexibility are much greater. Any change in a firm’s net worth or in risk perception will have a
negative impact on their output and shifts AS to the left.
Credit market imperfections also lead risk-averse lenders to respond to recessions by shifting
their portfolio towards safer activities, raising the real costs of intermediation. The credit
squeeze can convert a recession into a depression as many equity-constrained borrowers find
credit expensive or difficult to obtain, leading to bankruptcy. Since high interest rates increase
the probability of default, risk-averse financial institutions often credit-ration.
NAIRU- non-accelerating inflation rate of unemployment.

The natural rate of unemployment is market-clearing whereas NAIRU generates consistency
between the target real wage and the feasible real wage determined by productivity and the
size of the firm’s mark-up. NAIRU is determined by the balance of power between workers
and firms- imperfect competition in the labour and product markets. In the 1980s, several
explanations emerged as to why NAIRU was increasing:
-specific policy changes reduceD labour market flexibility
- AD does influence NAIRU- Hysteresis theories- the natural rate depends on the history of the
equilibrium rate i.e. prolonged periods of abnormally high/low economic activity shift NAIRU.
a) Duration theories- where Ut > UNt, structural unemployment is exacerbated due to a human
capital depreciation experienced by the unemployed.
b) Insider-outsider theories- the unemployed are unable to price their wage back into jobs
due to insider power.
The ‘Great Slump’ of the 80s can be explained by 5 OECD-wide real shocks to business
profitability and workers’ incentives:
1. Reduced expectations of productivity growth, increasing the effective cost of capital
2. Increase in expected real interest rate
3. Increase in services from workers’ private assets
4. Increase in social entitlements due to expansion of welfare state
5. OPEC oil price shocks in 1973 and 1979
The New Keynesian Phillips Curve

Assume that only a fraction α of all firms may adjust prices each period. Firms that may
change prices are determined by chance. Each period all firms have the same probability α of
being selected, independently of whether their prices were adjusted for the last time one or
several years ago. As a result, 1 - α per cent of all firms have not adjusted prices for at least
one period. (1 - α )2 per cent have not modified prices for at least two periods.
e ¿
NKPC: π=π +1 + λ (Y −Y )

Today’s inflation, and thus the position of the curve in π−¿ Y space, depends on the rate of
inflation expected for the next period rather than on the rate of inflation that had been
expected for today. This may appear a minor technicality, but it endows the NKPC with new
properties compared to the conventional SAS curve. The intuition behind the appearance of
expected future inflation in the NKPC is that if a firm adjusts prices today, it cannot be certain
whether it will have an opportunity to readjust tomorrow. Therefore, it sets today’s prices
also in anticipation of price movements to come in the future.
The NKPC has been criticised for not accounting for real world inflation inertia and for the fact
that disinflations generate booms.
Stylized facts
-NK analysis is consistent with the procyclical nature of employment, consumption,
investment, government expenditure and productivity.
-Non-neutrality of money is consistent with money being procyclical.
-Inflation is procyclical and lagging.
- The real wage is acyclical or mildly procyclical if the efficiency wage is sensitive to the rate of
unemployment.
Policy implications
-Policy effectiveness is re-established because markets do not clear instantaneously. There is
potential for corrective demand management policies even if prices are flexible.
-Because of uncertainty, NKs do not support fixed-rule approaches to monetary policy.
- Institutional reforms to reduce insider power e.g. softening job security legislation to reduce
turnover costs
-Policies to enfranchise outsiders e.g. human capital training, improved labour mobility
New Neoclassical synthesis- fusion of new classical and NK economics

1) intertemporal optimisation
2) rational expectations
3) imperfection competition in the goods, labour and credit markets
4) costly price adjustment in macro models
Conclusions about monetary policy

1) monetary policy has persistent effects on real variables due to gradual price adjustment
2) little LR trade- off between real and nominal variable
3) inflation has significant welfare costs
4) take into account policy credibility
Criticisms of NK economics
- Lack of empirical work
- Unrelated theories
- Doubt about how small menu costs can account for major contractions in output and
employment.
- Continued acceptance of the IS-LM model

11) Complexity Economics
Complexity portrays the economy as process-dependent, organic and always evolving. There
is no underlying assumption of stability or instability, since a Complex system “endogenously
does not tend asymptotically to a fixed point, a limit cycle, or an explosion Economic agents
continually adjust their market moves, buying decisions, prices and forecasts to the situation
these moves/decisions/prices/forecasts together create. Human agents react with strategy
and foresight but considering outcomes that might result as a consequence of their
behaviour.
Conventional economics studies consistent patterns that require no further reaction e.g. general
equilibrium theory, game theory (choices consistent with other agents’ moves), rational
expectations economics (forecasts consistent with outcomes forecasts and expectations create).
Complexity economics, on the other hand, works at a more out-of-equilibrium level. If we allow for
positive feedback effects (firms gain advantage as their market share increases) or increasing returns
(as opposed to DR in conventional economics), the culmination of random events helps to select the
outcome randomly. It helps us understand market instability, the emergence of monopolies and the
persistence of poverty.
This dynamic approach tends towards a belief that governments should avoid coercing a desire
outcome and keeping strict hands-off and instead seek to push the system gently towards favoured
structures that can grow and emerge naturally.
If we focus on the formation of structures rather than their given existence, prediction in the
economy is dealt differently. The conventional approach of rational expectations assumes agents can
deduce what model will work in advance and everyone knows how to use this model.
e.g. El Farol, bar in Santa Fe- deciding whether to go based on expectations of attendance.
If you predict more than 60 people will go, you avoid the crowds and stay home. If fewer than 60 go,
you will go to the bar. However, predictions of how many people will attend depends on other
people’s predictions of how many will attend i.e. infinite regress, an ill-defined problem. Moreover, if
everyone believes most will go, no one will go, invalidating the belief.
If as agents visits the bar, they act inductively, each week they will act on their currently most
accurate model. The mean attendance will quickly converge to 60. The predictors self-organise into
an equilibrium ecology where 40% of them on average forecast above 60 and 60% forecast below
60.
In financial markets, rational expectations do not account for unexpected price bubbles and crashes
and price volatility. Under complexity, we assume investors must discover expectations rather than
deduce them. If parameters are set so that agents update hypotheses slowly, the diversity of
expectations quickly collapses into homogenous rational ones since if a majority of investors believe
something close to rational expectations forecast, the resulting prices will validate it. However, if the
rate of updating hypotheses is increased, the market undergoes a phase transition into a complex
regime and displays several of the anomalies observed in real markets.
Emergence
CE believes that, rather than being the result of exogenous shocks to an economy, business
cycles are instead an ‘emergent’ phenomenon created endogenously by the economic
system. This is in effect a direct counter to the standard assumption that the macroeconomy
is simply the aggregation of the choices of one RA. Through interactions between agents,
patterns and regularities emerge at the level of the macro level.

Learning
The RE hypothesis assumes that agents at all times use all available information efficiently,
and the information available represents the true nature of the economy. However, since it is
difficult to describe a learning process, any changes in the information set occur
instantaneously (Sargent 1993). This means that RE models exhibit global knowledge
properties, so that any change in expectations or any new innovations affects all sectors in
the economy at the same time, which is implausible (see chapter 3). CE believes that its
agents are not behaviourally independent and that the behaviour and beliefs of agents can
affect the actions and beliefs of their neighbours (Samuelson 2006; Kirman 1993). Not only
this, but some complex models have dropped the assumption of consistency, and instead of
having perfectly rational agents they have boundedly rational agents.
Carroll assumes that agents can be ‘infected’ with news, either from a single common news
outlet or from another agent they come into contact with. Having constructed an infection
model with heterogeneous agents and compared to real data about inflationary expectations,
the model does “an excellent job of explaining the dynamics of aggregate expectations”
(Carroll 2006 p. 26). A running theme of CE is that social interactions between agents have a
much more important role in determining the spread of ideas and expectations than standard
theory assumes.
Multiple Equilibria
In the Arrow-Debreu model (1954), consumers and producers are drawn towards the point of
GE in a process which is dynamically simple. This is because the preferences and production
functions of all agents are linear and concave. In contrast, in complex systems there may be
multiple points of attraction, both stable and unstable and their effects on agents may
produce complex and chaotic dynamics. Preferences and production processes may not be
concave but convex, allowing for increasing returns (Bak et al. 1993; Durlauf 1993). In this
complex ‘rugged landscape’, it is possible that a sudden change can occur when “a previously
stable equilibria becomes unstable, setting the system adrift while it searches for a new
equilibrium”. The most important implication of these complex dynamics is that “there is little
if any evidence that economic data converge to stationary states, to steady growth or to
periodic cycles” (Day 1994 p. 7).
Macroeconomics has been hesitant to embrace the existence of multiple equilibria because
of the analytical complexity they add to even the simplest macroeconomic models; however,
CE’s extensive use of computer simulation technology. The most important implication of
these three themes in CE is that the economy is not inherently stable. The economy moves
between points of equilibrium, some stable and some unstable. It can be disturbed by
exogenous shocks, such as an unexpected spike in oil prices, or by a shock created
endogenously from the system itself. The economy becomes an adaptive system in which
time and the initial conditions are important considerations.
The vital role played by the connections and interactions between agents means that the
macroeconomic problem cannot be described purely as an aggregated micro problem. Most
standard business cycle models do not bother trying to integrate depressions and financial
crashes, labelling them as ‘outliers’.
12) Economic Growth

Tangible terms: increase in output (GDP) from one period to another/ increase in productive
capacity. Welfare terms: slackening of budget constraints/ advancements in education/
greater per capita income and life expectancy (Hans Gosling).

Benefits: reduction in poverty rate and increased life expectancy. Costs: income inequality,
negative externalities of carbon emissions from increased output.
Short- & Medium-Run Model

Growth models ignore inflation by conducting analysis in real terms. In the short run model,
there is no mechanism through which higher planned savings can translate into higher
investment, thus output and AD fall. In the medium run model, the rise in saving leads to a
NOG and lower forecast inflation, so the CB cuts the interest rate, shifting the investment
function upwards and leading to a medium-run equilibrium.
Growth concepts
y t +1− y t ∆ y
Annual growth rate in discrete time: γy= = ≈ log ⁡( y t +1)−log ⁡( y t )
yt y
dy
Annual growth rate in continuous time: ẏ dt
g y= =
y y
Rule of 70: how long it takes for GDP/capita to double at a constant growth rate
70
doubling time =
% growth rate
The Solow Model

→ focus on the role of capital accumulation and increases in the savings rate
→ technology as an exogenous variable
Y = AF (K, N)
The slope of the production function is MPK. MPK and MPL are positive and diminishing. The
production function exhibits constant returns to scale in capital and effective labour. Assume
no population or technology growth. The model treats other potential sources of differences
in real incomes are either exogenous and not explained by the model or absent altogether.
Depreciation is the reduction of the value of K stock over time due to age/wear and tear. We
assume δ proportion of K depreciates each period so that an amount δ K of savings is invested
to keep K stock constant.
We drop the assumption that savings are automatically invested. If the savings rate increases,
the CB will see that higher output is possible at a higher K/L ratio and reduce the interest rate
to stimulate investment. This prevents output from declining as in the paradox of thrift and

output and K will increase. A permanent increase in the savings rate produces a temporary
increase in the growth rate of output per worker i.e. it has a level effect, not a growth effect.
Intensive form: Y = AK α N 1−α

Y A Kα N
=
N N N∝
y = Ak α where A is TFP and 0<α <1 is capital’s share of income

Output per worker depends on capital per worker and total factor productivity.
d [ A kα ] α−1
MPK= = Aα k APK = y/k
dk
Whenever there are diminishing returns, APK >MPK.
dN
Growth rate of labour: Ṅ dt i.e. the labour force grows exponentially
n= =
N N
Change in K stock: K̇=I −δK
Assuming no borrowing from abroad is possible and that S=I and I=Sy…
α 1−α
K̇=I −δK =sY −δK =s AK N −δK Growth rate of capital stock:
K̇ sY
g K= = −δ =sAPK −δ
K K
Steady State Balanced Growth- when output and capital grow at the same rate i.e. the
capital-output ratio is constant, v*. At k*, both K and N grow at the same rate,n.
gy = g k = n
sY
−δ =n
The K/L ratio, k*, will also be constant: gk =
K
Harrod-Domar Formula: v* =
Y
=
y( ) ()
K ¿ k ¿
=
s
n+δ
The capital-output ratio in the steady state is
higher, the higher the savings rate and the

lower the labour force growth rate and
depreciation.
If k<k*, k̇ is positive and if k>k*, k̇ is negative
and if k=k*, k̇ =0. Regardless of where k

starts, it converges to k* and remains there, where the growth rate is balanced- each variable
of the model is growing at a constant rate. On the balanced growth path, the growth rate of
output per worker is determined solely by the rate of technological progress.
Intensive Form
K̇=sAK α N 1−α −δK
α−1 α −1
K̇ k̇
=sAk −δ =sAk −(n+δ)Fundamental Solow Equation of motion:
K k
α
k̇ =sAk −(n+δ)k
Steady state level of output/capita: y* = A(k ¿ )∝
Steady state level of consumption/capita: c* = A(k ¿ )∝- s A(k ¿ )∝
∝
At equilibrium, k̇ =0 ∴ s A ( k ¿ ) =¿ k*( n+ δ )
( )
1
As 1−∝
Steady state capital-labour ratio: k* =
δ+n
( )
1 ∝
¿ ∝ s
Steady state output per capita: y* = A ( k ) =A 1−∝ 1−∝
δ +n
Golden Rule Savings Rate- the saving rate that maximises welfare
Consumption per worker is maximised at k* GR at which the tangent to the production function
has the same gradient as the line (n+δ )k.
Golden rule condition: fI(k) = n+δ = r + δ → r = n

An increase in savings above the golden rule rate reduces consumption per worker and
welfare.
Reduction in the savings rate
A downward shift in the sy curve

leads to lower capital per worker
in the steady state. The shock
can also be demonstrated by a
downward shift of the gk curve.
The growth rate of capital and
output drops. As the economy
converges to the new steady
state at k*1, gk and gy rise back to
the steady state values of n, to
point B.
Convergence
Absolute convergence- poor countries will grow faster than rich countries and eventually
catch up to their per capita GDP through capital deepening.

e.g. the savings rate in a poor country is below that in a rich country and the poor country has
a lower capital-labour ratio and lower output per capita. In steady state both economies are
growing such that gk= gy=n=0. An increase in the savings rate in the poor country will lead to
positive growth of capital per worker. It will converge from its low output per capita level to
that of the rich country, taking advantage of high MPL at low levels of initial capital intensity.
Moreover, if there are lags in the diffusion of knowledge, income differences can arise, which
will tend to shrink as poorer countries gain access to the best available technologies.
Conditional convergence- countries converge to their own steady states and more similar
economies have steady states closer to one another.
We assume poor and rich countries have different production functions. It is distance away
from your own steady state which dictates the speed of output per capita growth. Countries
with similar steady states will converge but fundamentally different economies will not. There
was evidence of this in the “golden age”- 1950-1973 in OECD countries but convergence is
much slower than the model predicts.
One explanation for lack of convergence is that education increases MPL for all given levels of
physical capital and labour, which increases productivity in richer countries. In the Cobb-
Douglas production function, this appears as h: Y = AK α (hN ¿ ¿1−α
( ) ( )
1 α 1 α
1−α s s
Steady state output per capita: y* = (h A ¿ ¿ 1−α 1−α
= h[ A 1−α 1−α
¿
n+ δ n+δ
This predicts that countries with better education will have higher levels of output per capita
in steady state. This model focuses on broad capital
accumulation (incl. human capital).
Technological progress-increases the productivity of

labour by a constant rate of x% P.A. (labour-
augmenting)
NB- only faster technological growth can raise the
growth rate (not just the level) of SoL.

Growth accounting
Ẏ Ȧ + K̇ Ṅ
Y=A K N
α 1−α
= α +(1−α )
Y A K N
g y =g TFP +α g K + ( 1−α ) n
Solow Residual: g y −α g K −( 1−α )n

= (g¿¿ y−n)−α g K + αn ¿
= g y −α g K
Endogenous Growth Theories

The Romer Model (1990)
→ Growth is driven by endogenous technological change which arises from intentional
investment decisions made by profit-maximizing agents.
→ Main conclusions: the stock of human capital determines the rate of growth, too little
capital is devoted to research in equilibrium and a large population is not sufficient to
generate growth
Ideas are non-rivalrous but the excludability property of patents allows firms in imperfect
competition to earn supernormal profits for a limited period of time. The developer charges
a price above marginal cost and resultant profits
provide incentives for R&D.
Endogenous growth models require production

functions with constant returns to a factor that can be
accumulated. Steady state occurs where the sY line
coincides with the δ k line and here the capital stock will
remain at a constant level. An increase in the savings
rate causes the capital stock and output to grow
without limit.
Nyt = no. of workers in final goods market

NRt = no. of workers in R&D
At = ideas
α
Y t =K t ¿
n R
Ȧt =c A t N t
Ideas accumulate proportionally to the no. of workers in the R&D sector and is related to the
current stock of ideas. As long as n>0, there are positive spillovers from the existing stock of
ideas/blueprints- “standing on the shoulders of giants”. If n=1, there are constant returns to
accumulation of ideas →endogenous growth. A permanent increase in the growth rate of
productivity can be achieved by increasing the number of workers in the R&D sector.
Equilibrium will occur where consumers’ optimization intersects producers optimization.

Growth rates are all equal at equilibrium:
From before
And H=Hy+Ha.

Solving optimization and applying the constraint that human capital is split between research
sector and final output sector we get:
Therefore growth equals:
Implications
- If interest cost is higher on initial investment, less human capital will be allocated to
research – growth rate is lower.
- Higher research productivity increases growth.
- Increase in human capital devoted to research will increase growth rate as A will
increase faster.
- Economies that are fully integrated into international markets will have access to
more human capital. A will increase faster and so does economic growth.
- When individuals are less patient (discount rate p) is higher, fewer workers engage in
R&D so growth is lower.
- Better substitutability between designs reduces growth. Patent holders have less
power so each additional design contributes less to output and R&D becomes less
attractive.
- Increase in size of population raises long run growth (assuming increase in population
expands the size of the market an inventor can reach, increasing the returns on R&D)
Learning by Doing- Arrow (1962)

→As individuals produce goods, they think of ways of improving the production process.
When learning-by-doing is the source of technological progress, the rate of knowledge
accumulation depends on how much new knowledge is generated by conventional economic
activity. This can be modelled by saying the stock of knowledge is a function of the stock of
capital.
Lucas Human Capital Model (1988)

→Human capital accumulation raises the productivity of both labour and physical capital.
Assumptions:
- A closed system
- Constant population growth
- N workers
- Technology A is constant
- Constant returns to scale
- Human capital level of h ranges from 0 to infinity
- u is the proportion of non-leisure time devoted to current production
- 1 - u is the proportion devoted to human capital accumulation
- Internal and external effect
Human capital accumulation path:

 h = (1 – u) h
 gh = 1 – u
Production function:
 Y = AK α(uhL)
Marginal product of human capital:
 MPK = αAK α-1(uhL) 1-α
Growth rate:
 gMPK = gA + (α- 1)gk + (1 -α)(gh + gL)

Since α- 1 < 0, MPK falls as K grows.
But since gh = 1 - u, MPK grows even when K grows.
The higher the productivity of training, the higher the increase in the marginal product labour
and the higher the future wage rate. This increases the incentives for training and there will
be higher growth in the economy. The lower the rate of ‘impatience’ (the less weight
consumers place on present compared to future consumption), the more likely workers will
be willing to train and forsake consumption in the present. This would also lead to a higher
rate of economic growth.
The Barro Infrastructure Growth Model (1990)

→ the rate of change in growth with respect to government spending. Maximizing the
differential of this function gives the optimum rate of government spending.
- Based on a modified Romer AK model

- Barro’s contribution is the inclusion of government spending y = Ak 1-aGa
- Government can only spend as much as it taxes. This is taken as a proportion of
income per capital, G=Ty (where T is between zero and one.
- This gives y = Ak1-a(Ty)a
- Assuming away depreciation of capital (𝛿=0), capital has the linear law of motion
- This can then be used to find a function for optimal taxation
- See lecture notes for intermediate calculation steps
- If growth is
exogenously dependent on government spending, this can be a useful policy tool.
This gives a shape similar to the Laffer Curve, suggesting that there is an optimal rate of
taxation and that the growth rate achieved by further increase in taxation is
counterproductive for growth.
13) Consumption and Investment
Consumption
An individual’s consumption in a given period is determined not by income that period, but by
income over his or her entire lifetime- permanent income. The right-hand side is permanent
income, and the difference between current and permanent income is transitory income.
( )
T
1
C t= A + ∑ Y for all t
T 0 T=1 t
Consider the effect of a windfall gain of amount Z in the first period of life. Although this
windfall raises current income by Z, it raises permanent income by only Z/T. Thus if the
individual’s horizon is fairly long, the windfall’s impact on current consumption is small. One

implication is that a temporary tax cut may have little impact on consumption. 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 (when transitory income is high). Similarly,
when current income is less than permanent income, saving is negative. Thus saving and
borrowing smoothes the path of consumption.
Saving is future consumption. As long as the individual doesn’t value saving in itself, decisions
about the division of income between consumption and saving is driven by preferences
between present and future consumption and info about future consumption prospects.
Although an increase in the interest rate reduces the ratio of 1 st-period to 2nd-period
consumption, it does not necessarily reduce 1 st-period consumption and thereby raises
saving. The complication is that the change in the interest rate has not only a substitution
effect, but also an income effect. Specifically, if the individual is a net saver, the increase in
the interest rate allows him to attain a higher path of consumption than before.
Summary of permanent-income hypothesis:

There is considerable agreement on the broad factors that must be present: a high degree of
impatience (from either a high discount rate or time inconsistency with a perpetually high
weight on current consumption); some force preventing consumption from running far ahead
of income (either liquidity constraints or rules of thumb that stress the importance of
avoiding debt); and a precautionary-saving motive.
Investment
The combination of firms’ investment demand and households’ saving determines how much
output is invested; as a result, investment demand is important to standards of living over the
long run. Moreover, investment is highly volatile and important to short-run fluctuations.
Baseline model
Firms face a perfectly elastic supply of capital goods and can adjust their capital stocks
costlessly. This model provides little actual insight since it implies that discrete changes in the
economic environment produce infinite rates of investment or disinvestment.
In reality, the firm forgoes the interest it would receive if it sold the capital and saved the
proceeds. This has a real cost of r (t)pK (t) per unit time, where r (t) is the real interest rate.
Second, the capital is depreciating. This has a cost of δpK (t) per unit time, where δ is the
depreciation rate. And third, the price of the capital may be changing. This increases the cost
of using the capital if the price is falling (since the firm obtains less if it waits to sell the
capital) and decreases the cost if the price is rising. This has a cost of − p˙K (t) per unit time.
The model does not identify any mechanism through which expectations affect investment
demand. The model implies that firms equate the current marginal revenue product of capital
with its current user cost, without regard to what they expect future marginal revenue
products or user costs to be. Yet in practice, expectations about demand and costs are central
to investment decisions: firms expand (contract) their capital stocks when they expect sales
to grow (fall) and the cost of capital to be low (high).
The q theory model of investment

The model’s key assumption is that firms face costs of adjusting their capital stocks.
Internal adjustment costs arise when firms face direct costs of changing their capital stocks,
e.g. costs of installing the new capital and training workers to operate the new machines
External adjustment costs arise when each firm, as in our baseline model, faces a perfectly
elastic supply of capital, but where the price of capital goods relative to other goods adjusts

so that firms do not wish to invest or disinvest at infinite rates. When the supply of capital is
not perfectly elastic, a discrete change that increases firms’ desired capital stocks bids up the
price of K goods. The result is that the rental price of capital does not change discontinuously
but begins to adjust, and that investment increases but does not become infinite.
The ratio of the market value to the replacement cost of capital is known as Tobin’s q. Our
analysis implies that what is relevant to investment is marginal q—the ratio of the market
value of a marginal unit of capital to its replacement cost.
Effect of a change in output

It is not just current output but its entire path over time that affects investment. The
comparison of permanent and temporary output movements shows that investment is higher
when output is expected to be higher in the future than when it is not. Thus expectations of
high output in the future raise current demand. In addition, as the example of a permanent
increase in output shows, investment is higher when output has recently risen than when it
has been high for an extended period. This impact of the change in output on the level of
investment demand is known as the accelerator.
Effect of a change in the interest rate

Both past and expected future interest rates affect investment. The short term interest rate,
r, is the instantaneous rate of return. The short-term rate does not reflect all the information
about interest rates that is relevant for investment. Long-term interest rates are likely to
reflect expectations of future short-term rates. If long-term rates are less than short-term
rates, it is likely that investors are expecting short-term rates to fall; if not, they are better off
buying a series of short term bonds than buying a long-term bond, and so no one is willing to
hold long-term bonds. Thus, since increases in expected future short-term rates reduce
investment, it implies that, for a given level of current short-term rates, investment is lower
when long-term rates are higher.
14) Inter-temporal Macroeconomics
A value of kt such that kt+1 = kt satisfies a balanced growth path. Wherever k starts, it
converges to k*. Once the economy has converged to its balanced growth path, the savings
rate is constant, output per worker is growing at a rate g and the capital-output ratio is
constant. A fall in the discount rate p causes the young to save a greater fraction of their
income, causing the kt+1 function to shift up, increasing the value of k *.

Macroeconomics Revision Notes: 1) Demand Side of The Economy

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Macroeconomics Revision Notes: 1) Demand Side of The Economy

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Macroeconomics Revision Notes

1) Demand side of the economy

National Accounts can be calculated via 3 methods:

e.g. Pessimistic expectations would shift the IS

1 |Macroeconomics Revision Notes

Consumption smoothing- desire to have a stable

Permanent Income Hypothesis (PIH)

Investment function: I = a0 – a1r

2 |Macroeconomics Revision Notes

2) Supply Side of the economy

The utility from working and receiving a

WS curve- pins down the unemployment

Employers set the nominal wage in order

3 |Macroeconomics Revision Notes

4 |Macroeconomics Revision Notes

Imperfect Competition model- when firms set prices to maximise profits.

WS curve (linear form): WWS (yt) = (W/P)WS = B + α (yt- ye) + ZW

5 |Macroeconomics Revision Notes

3) The 3 equations model

Inflation targeting- the government gives

6 |Macroeconomics Revision Notes

Loss function L = (yt – ye)2 + β ( π t – π T)2

7 |Macroeconomics Revision Notes

Dynamic IS curve: yt = At – art-1

Temporary positive demand shock

Period 0: IS shifts to IS1 for one period only. The economy

Period 1: the economy moves to C. The higher interest

8 |Macroeconomics Revision Notes

Permanent positive demand shock

Period 0: IS shifts to IS1 permanently. The economy shifts

Period 1: the economy moves to C. The higher interest

Period 2: the economy moves to D. Output increases and

Zero lower bound- min r≥ - π e

Permanent negative demand shock →

Period 0: IS shifts to IS1 permanently. The

9 |Macroeconomics Revision Notes

Permanent positive supply shock

Period 1: the lower interest rate increases output. The

Period 2: the economy moves to D. Output falls and

Adaptive Expectations-Rules of thumb such as adaptive expectations may provide a better

10 |Macroeconomics Revision Notes

Under Rational Expectations

Under Adaptive Expectations

5) Money banking and the Financial Crisis

12 |Macroeconomics Revision Notes

The Monetary Sector

13 |Macroeconomics Revision Notes

Banks built up a large portfolio of

Asset price bubbles

A shock to the housing market means agents expect a lower

14 |Macroeconomics Revision Notes

Plain Vanilla Financial Crisis

15 |Macroeconomics Revision Notes

Stylized facts about the financial cycle:

The zero lower bound (ZLB)

16 |Macroeconomics Revision Notes

US house prices began to fall in mid 2006 as the

1. The fall in house prices reduced

In 2008, the situation was even worse and