Foreign Trade University

Faculty of International Economics

Macroeconomics II

PhD

Hoang Xuan Binh

Introduction
Module title: Macroeconomics II
Semester: I
Year 2011-2012
Level: Undergraduate
Module Convenor: Hoang Xuan Binh
Office hours: 15:00 -17:00 on Monday
Room: A703- Foreign Trade University
(Hanoi Campus)
T: 844-8345801 ext 506
H: 0912782608

*Objectives
* Text books:
N. Gregory Mankiw, Macro economics
Dornbusch R., FischerS., Startz R., (2001), Macroeconomics,
8thEdition
David Begg, Stanley Fischer, Rudiger Dornbusch, Economics
Macro economics II, National economics University

Assessment:
Class Participation: 10%; Assignment: 30%;
Final Open book exam: 60%.

CHAPTER ONE

introduction

I. Revision: macro economics I

Lecture 1: The Data of Macroeconomics
Lecture 2: Economic growth
Lecture 3 : Savings, Investment and Financial system
Lecture 4 : Aggregate Demand and Aggregate Supply

Lecture 5 : AD and fiscal policy

I. AD in simple economy
II. AD in closed economy with Government
III. AD in open economy
IV. Fiscal policy

Lecture 6: Money and monetary policy

I. Money
II. Money supply .
III. Money demand
Interest rate
Monetary policy

Lecture 7 : Unemployment
I. Definition
II. Natural unemployment
III. Cyclic unemployment
IV. Impacts of unemployment
Lecture 8: Inflation
I. Definition
II. Theories of inflation
In short -run:
In long - run:
III. Impacts of inflation:
Costs of inflation
Relationship between inflation and unemployment

Lecture 9: Macroeconomics in open economy

I. Balance of payments
II. Nominal exchange rate and real exchange rate
III. Foreign exchange market
IV. Exchange rate regime
V. Role of exchange rate for economy

II. Introduction to Macroeconomics

II
COntent
Chapter 1: Revision macroeconomics I and introduction to
macroeconomics II
Chapter 2: IS-LM model and AD in close economy
Chapter3: Mundell-Fleming Model and AD in open economy
Chapter 4: AS and Phillips curve
Chapter 5: Consumption
Chapter 6: Neoclassical theory of fixed investment for doing
business*
Chapter 7: Theory of Money demand*
Chapter 8: Economic growth model
Chapter 9: Macroeconomic policy debates

CHAPTER TWO

AGGREGATE DEMAND
IN CLOSE ECONOMY AND IS-LM
MODEL

A PowerPoint Tutorial
to Accompany macroeconomics, 7th ed.
N. Gregory Mankiw

 Content:
Analysis AD based on IS-LM model(developed by Sir J. Hicks,
oxford,
UK,1904-1989, nobel price in 1972 with
Kenneth J. Arrow), and developing from
1930s to explain well-known theory,
which was written by Keynes General
theory of employment, interest and
money
IS-LM model is contructed by balancing in
both goods market and money market.

I. Goods market and IS curve

1. The Keynesian cross model (5/6/188321/4/1946)

* Some main points:
- APE
-aggregate
planned
expenditure- Aggregate demand differ
from quantity or income Y
-Close economy with 3 sectors
House hold=> Consumption=> C
Firm => I
Government=> Expenditure=> G

APE = C + I + G

APE = C ( Y T) + I ( r) +
G

APE and Income is positive relationship

At equilibrium point : APE = Y
APE= Y

APE

APE >Y

APE<Y
APE

45o

Y1

Y
Y0

Y2

Question: G increases and Y?

G = 1 bil $ => GDP increases ?
Productine increases 1 bil $ =>Income
increases 1bil $=> C increases G
C 0,75x1 bil $ => Y increase MPCx 1bil$
=MPCx G
G + MPCx G = (1+MPC). G = 1,75 t
Cons..
MPCx(MPCx G)= MPC.MPC. G
Y = (1+MPC+MPC2 +MPC3 +..)x G
=> Y = (1/1-MPC)x G
=> Multiflier of Consuption m = Y/ G=1/1MPC

APE

APE= Y

APE= C + I + G2
G

APE= C + I + G1
Y

45o

2. IS model
2.1.Definition: relationship (r, Y) where
APE=Y; I=S
2.2. Derivation of IS Curve

E2

APE2

E1

0
r
r1

APE
1

45o

Y
E1
E2

r2

IS
0

Y1

Y2

*Slope of IS curve: downward

sloping IS curve
2.3. Related Factors to slope of IS
* I and r:

*Multiflier of consuption:

II. Money market and LM curve

1. The Theory of Liquidity
preference
* Equilibrium point in money
market:

M/P = L (i,Y)<=> Ms = Md

Real Money demand and Y.

Real Money demand and I
Nominal interest rate is O. C of
holding money
Real money demand belongs to
nominal money supply, which is

r0

Ms

L=L(r,Y)
0

Central
Bank

Real Money
quantity

2. LM curve
2.1. Definition:
Relationship ( r ,Y) Real MS =

Real MD
<=> L ( Md)
= M ( Ms)

2.2. Deviration of LM curve

LM

Ms=M
/P

r2

r2

r1

r
1

L2=L2(Y2,
r2)
L1=L1(Y1,
r1)

Y1 Y2

Y 0

M/
P

2.3. Slope of LM curve:

an upward sloping LM curve

2.4. Situation of LM:

MS1=> LM1
MS2=> LM2

r
LM1

r1

E1

M1/P

M2/P

LM2
r1

r2

r
2

L1=L1(Y1,
r1)
Y2 Y1

Y 0

M/
P

III. Equilibrium point in both goods

market and money market

IS: Y = C(Y-T) + I(r) + G

r

LM: M/P= L (Y,r)

LM
E*

r
*
IS
0

Y*

IV. Fiscal policy and IS curve:

* Fiscal policy: G v T=>IS shift to
leftwards or rightwards
-Expansionary fiscal pol.G increases or T
decreases=>IS shifts to rightwards
-Contractionary fiscal pol. G decrease or
T increases=>IS shifts to leftwards

r
LM
Crowding-out
E2investment

r2

E1

E1

r1

IS
2
IS
1
0

Y1

Y2

Y1

* Crowding-out investment effects ???

V. Monetary policy and LM curve:

* Monetary policy:
-Expansionary Monetary pol.: Ms
increases=>
LM
shifts
to
rightwards
-Contractionary Monetary pol.: Ms
decreases
=>
LM
shifts
to
leftwards

Ms increases=>r decreases=>I
increases=>APE
increases => Y
r
LM1
increases

LM2

E1
r1
r2

E2

r1

E1

Y1

IS

Y2

VI. Coordinate Fiscal policy and

Monetary policy
1.Fiscal policy or monetary
policy?

*Expansionary fiscal
policy
IS steeper,
LM
IS flatter, LM steeper
flatter
r

LM
r

IS1
0

Effective

LM

IS2
IS1

IS2
Y

Ineffective

*Expansionary monetary
IS steeper, LM policy:
IS flatter, LM steeper

rflatter

LM1

LM2
LM1

IS

IS
0

LM2

ineffective

Effective

2.Coordination Fiscal policy and

Monetary policy
2.1. Expansionary fiscal policy and
monetary policy:
Curbing crowding-out domestic investment
r
LM1
E2
LM2
r2
r1

E1

E1
IS1

IS2
Y

2.2.Contractionary fiscal policy and

monetary policy Y increase, r unchanged,
with overheating AD
r
LM2
LM1
E2

r1

E1
IS2

Y2

IS1
Y1

2.3.Contractionary fiscal pol and

expansionary monetary pol: Y unchanged,
r decreases=> apply for increasing I and C
due to r rdecreases but Y unchanged
LM1
E1
LM2
r1
r1
E2

r2

IS1
IS2
0

Y
1

Y1

2.4.Expansionary fiscal pol and

contractionary monetary pol: apply for
decreasing I and C , but Y unchanged
r
LM2
E2
LM1
r1
r1

E1
E1

r1

IS2
IS1
0

Y1

CHAPTER THREE
Aggregate demand in open economy
and Mundell Fleming model

A PowerPoint Tutorial
to Accompany macroeconomics, 5th ed.
N. Gregory Mankiw

I. Mundell-Fleming model:
-The M-F model was developed in the early
1960s. Mundells contribution are collected in
Robert A. Mundell, International economics
(NY, Macmillan,1968)
- Standard open macro economy
model
explains
how
do
GDP,BP,exchange
rate,
- Based on IS-LM model but with
interest...interact?
international trade and international
capital flows
- Some constrains of this model for
developing or trans economies

3 basics of macroeconomics:
-AD (IS curve, LM curve )
-AS ( production function & labour
market)
-Balance of payments (current and capital
account)
-AD-AS model:
-Mundell-Fleming model: AD v BP

1. IS curve in open economy:

Y = (C + I + G) + ( X-M)
Y= C(Y-T) + I(r*) +G +
NX(e)
Absorption

+ Trade

balance
Note: A real depreciation
in domestic
Domestic demand
+ Foreign
currency
Demandincrease X and decrease M =>
trade balance improve

2. IM curve in open economy:

*Assumptions: Single currency
- Constant price level

Mundell_Fleming r unchanged, e
changable

3. Balance of payments (BP)

BP= T (current acc.)+ K (capital

acc.)
- The balance of payments situation will
depend on the type of foreign exchange rate
adopted (Flexible or fixed)

II.Mundell-Fleming Model under flexible

foreign exchange rates
1. Assumptions
-Monetary authority does not intervene in the
foreign exchange market
- Perfect capital mobility
-Exchange rate expectation is static (todays =
future)
-Foreign interest rate (i*) equals to domestic
interest rate (i) (i=i*)
-Same inflation, real exchange rate is equal to
nominal exchange rate, and r =i

i
Massive capital inflow

BP

i*
Massive capital outflow

2. Equilibrium point
- IS, LM, BP-All three curves will intersect
-G, Ms, Y*, i*, P =>exogenous
-Y, i, => endogenous

LM

BP

i*

IS
0

Ye

3.Expansionary fiscal policy

-G increases=>IS shift rightwards
-An increase in G will shift IS rightwards
-Pressure on domestic interest rate i>i*
This puts an upward pressure on domestic interest
rate i. (i>i*)
- Massive capital flows domestically.
-Nominal and real exchange rate increases

-X decreases & M increases => Trade

balance worse off
Domestic demand increases through fiscal spending,
trade balance is reduced by exactly the same amount. Y is
unchanged!)

To sum up: Under the floating exchange rate and

perfect mobility, fiscal policy is ineffective!!!)

LM

i1

1
B
P

i*

IS1
0

Y0

Y1

IS2
Y

4.Expansionary monetary policy

- Money supply increases, causing a rightward shift in
LM curve
-Downward pressure on domestic interest rate (i<i*).

-Massive capital outflow

-Depreciation in nominal and real exchange rate
-Improves trade balance

-Depreciation leads to an increase in

trade balances
(net exports) so that it matches the
initial
increase
in Ms.
- Net exports
tng
=>IS shift to
rightwards=>IS1=>IS2
=>Y1=>Y2 & i1=>i*
* To sum up: Under a floating exchange rate
and perfect capital mobility, monetary policy is
very effective
Trade policy?

LM1

LM2
B
P

i*
i1
IS1
0

Y0 Y1 Y2

IS
2

III. Mundell -Fleming model under

fixed foreign exchange rates

*Ms is endogenous variable to

control exchange rates

1. Expansionary fiscal policy

- G increases, it pushes up IS curve rightwards
-Interest rate increases, attractive a massive
capital inflows).
-Domestic currency appreciate)
-To prevent an appreciate of the domestic
currency, the central bank must buy the dollars)
-This causes Ms to increase, thus shifting the LM
curve rightwards.)
-I =>i* and Y1 => Y2

* Conclusion: Under the fixed exchange rate

regime and perfect capital mobility, fiscal policy is very
effective!!!

LM1

LM2

i
B
P

i*

IS1
0

Y0

Y2

IS
2

2. Expansionary monetary policy

-An increase in Ms (through the purchase of bonds on the
open market operation), LM shifts rightwards.)
-This will lead to massive capital outflows)
-Depreciation in domestic currency,Government
prevents by selling $
-LM shift leftwards again. Total of monetary base remains
unchanged
- i and Y is unchanged

*Conclusion:Under fixed exchange rate regime, monetary policy is

ineffective

LM1
2
1

LM2
B
P

i*
i
IS1
0

Y0 Y1

***Trade policy???

IV. Mundell-Fleming model in (e-Y) The

small Open Eonomy (capital mobility)
1.Assumptions:
- i =i* ( i = r due to domestic inflation =
Foreign inflation
-er = en
- r - exogenous by inter. financial
market and only one income level to let
Md=Ms => The vertical LM* vertical.
- e increases=> domestic currency
appreciates =>X decreases and M
increases=>NX
decreases=>AD
decreases => Y decreases => rel. e

IS* : Y = C (Y-T) +I ( r *) + G +
NX (e)
LM*:
e M/P= L (r*,Y)
LM*

IS*
0

Ye

2. Mundell-Fleming model in (e-Y)

the Small, Open eonomy under
Floating Exchange Rates
*Expansionary Fiscal policy
LM*
- G increase (sell e
e
bond)
2
-r increases
-Inflow capital
-Domestic curr.
app
-Y unchanged

e
1

IS2
IS1

0
=>Exp. Fiscal policy is

Y1

*Expansionary Monetary policy

-Ms increases
=> LM1=>LM2

LM1 LM2
1

- r decreases
-Outflow
capital
-Domestic
curr.Depr.
-NX increases
-Y1=>Y2

e
1

E1

e
2
0

=>Monetary policy is very

effective

IS1
Y1

Y2

* Trade policy:
-Trade policy decreases M =>NX tng=>IS
shift => domestic
currency =>appreciate=>e1=>e2 but Y
unchanged
e
LM*
e
=> ineffective
2
e
1

IS2
IS1

Y1

3.M-F model in (e-Y), The small open

economy under fixed exchange rates
Under fixed exchange rate regime, Ms
endogenous, NHTW cant
e control Ms.
LM1
* Exp. Fiscal
2
- policy:
G
increases=>IS1=>I e
-r
2
S2
increases=>inflow e
-Domestic curr.
capital
E1
1
app
-Keep fixed ex.rate

is
LM2

E2
1

=>buy $=>Ms tng

LM1=>LM2:Y1=>Y
=>Fiscal
pol. is

IS1
0

Y1

Y2

IS2

*Expansionary monetary policy

-Ms increases
=>LM1=>LM2
-r decreases=>
outflowcapital
-Domestic curr.
Depre.
-Keep fixed
ex.rate
-Sell $=>Ms
decreases
-LM2=>LM1:
Y2=>Y1

LM1 LM2
1
2

e
1

E1

E2

e
2
0

=>Exp. Monetary pol. is

IS1
Y1

Y2

* Trade policy
Trade pol reduces M=>NX tng=>IS
shift=>domes. curr appre.=>buy $=>Ms
increasese=>LM shift back=>Y
LM1 LM2
unchanged
2
e
2
e
1

E1

E2
1
IS1

Y1

Y2

IS2
Y

CHAPTER FOUR

Aggregate Supply
and Phillips curve

A PowerPoint Tutorial
to Accompany macroeconomics, 5th ed.
N. Gregory Mankiw

When
Whenwe
weintroduced
introducedthe
theaggregate
aggregatesupply
supplycurve
curveof
ofchapter
chapter9,9,we
we
established
establishedthat
thataggregate
aggregatesupply
supplybehaves
behavesdifferently
differentlyin
inthe
theshort
shortrun
run
than
thanin
inthe
thelong
longrun.
run. In
Inthe
thelong
longrun,
run,prices
pricesare
areflexible,
flexible,and
andthe
the
aggregate
aggregatesupply
supplycurve
curveisisvertical.
vertical. When
Whenthe
theaggregate
aggregatesupply
supplycurve
curveisis
vertical,
vertical,shifts
shiftsin
inthe
theaggregate
aggregatedemand
demandcurve
curveaffect
affectthe
theprice
pricelevel,
level,but
but
the
theoutput
outputof
ofthe
theeconomy
economyremains
remainsatatits
itsnatural
naturalrate.
rate. By
Bycontrast,
contrast,in
in
the
theshort
shortrun,
run,prices
pricesare
aresticky,
sticky,and
andthe
theaggregate
aggregatesupply
supplycurve
curveisisnot
not
vertical.
vertical. In
Inthis
thiscase,
case,shifts
shiftsin
inaggregate
aggregatedemand
demanddo
docause
causefluctuations
fluctuations
in
inoutput.
output.In
Inchapter
chapter9,9,we
wetook
tookaasimplified
simplifiedview
viewof
ofprice
pricestickiness
stickiness
by
bydrawing
drawingthe
theshort-run
short-runaggregate
aggregatesupply
supplycurve
curveas
asaahorizontal
horizontalline,
line,
representing
representingthe
theextreme
extremesituation
situationin
inwhich
whichall
allprices
pricesare
arefixed.
fixed.So,
So,
now
nowwell
wellrefine
refineour
ourunderstanding
understandingof
ofshort-run
short-runaggregate
aggregatesupply.
supply.

Lets now examine three prominent models of aggregate supply, roughly

in the order of their development. In all the models, some market
imperfection causes the output of the economy to deviate from its
classical benchmark. As a result, the short-run aggregate supply curve
is upward sloping, rather than vertical, and shifts in the aggregate
demand curve cause the level of output to deviate temporarily from
the natural rate. These temporary deviations represent the booms and
busts of the business cycle.
Although each of the three models takes us down a different theoretical
route, each route ends up in the same place. That final destination is a
short-run aggregate supply equation of the form

Y = Y + (P-Pe) where
Expected
price level

positive constant:
an indicator of
Output
Actual price level
how much
Natural
rate of output output responds
to unexpected
changes in the
price level.

This equation states that output deviates from its natural rate when
the price level deviates from the expected price level. The parameter
indicates how much output responds to unexpected changes in the
price level, 1/ is the slope of the aggregate supply curve.

ASLR

ASSR

p1
p1
p2

p2

Y*

Y 0

Y2
Y1

2. Four models of aggregate supply

in short-run :
+ The Stricky-Wage Model
+ The Worker Misperception
Model
+ The Imperfect- Information
Model
+ The Stricky-Price Model

The sticky-wage model shows what a sticky nominal wage implies for
aggregate supply. To preview the model, consider what happens to the
amount of output produced when the price level rises:
1) When the nominal wage is stuck, a rise in the price level lowers the
real wage, making labor cheaper.
2) The lower real wage induces firms to hire more labor.
3) The additional labor hired produces more output.
This positive relationship between the price level and the amount of
output means the aggregate supply curve slopes upward during the time
when the nominal wage cannot adjust.
The workers and firms set the nominal wage W based on the target real
wage and on their expectation of the price level Pe. The nominal wage
they set is:
W
=

Pe
Nominal Wage = Target Real Wage Expected Price Level

W/P

(Pe/P)

Real Wage=Target Real Wage (Expected Price Level/Actual Price Level)

This equation shows that the real wage deviates from its target if the
actual price level differs from the expected price level. When the actual
price level is greater than expected, the real wage is less than its target;
when the actual price level is less than expected, the real wage is greater
than its target.
The final assumption of the sticky-wage model is that employment is
determined by the quantity of labor that firms demand. In other words,
the bargain between the workers and the firms does not determine the
level of employment in advance; instead, the workers agree to provide
as much labor as the firms wish to buy at the predetermined wage. We
describe the firms hiring decisions by the labor demand function:
L = Ld (W/P),
which states that the lower the real wage, the more labor firms hire and
output is determined by the production function Y = F(L).

Income, Output, Y

real wage, W/P

L = Ld (W/P)
Labor, L

Labor, L
Price level, P

An
Anincrease
increasein
inthe
theprice
pricelevel,
level,
reduces
reducesthe
thereal
realwage
wagefor
foraagiven
given
nominal
nominalwage,
wage,which
whichraises
raises
employment
employmentand
andoutput
outputand
and
income.
income.

Y = F(L)

Y=Y+(P-Pe)

Income, Output, Y

2.2. The Worker-Misperception Model

This come from the classic article by Milton
Friedman The role of Monetary Policy
American Economic Review 58 (March
1968)-1-17
* Similarity: focus
on labour market
*Differences:
3 points
-Flexible wage =>keep labour market at
equilibrium point
-Assup. Worker Misperception on price
-Ld is based on real wage
-Firms have no accurate information about
price level=>Ld is based on real wage but
Ls depends on expected real wage.

-IF P >Pe=>Ls increases because workers

think that real wage is higher then Y
increases
w

Ls

w.Pe
Ld(P>P
Ld(P=P e)
e)

Ld(P<P
e)
0

* Conclusion:
-AS curve is upward sloping but steeper
than AS in The stricky- wage model due to
smaller
-Actually, workers pay attention to
common price, firms care about price of
product. In macroeconomics, it has no
differences on firm price and average
price in economy however, it is necessary
to differ two prices in this case.

2.3. The Imperfect-Information

Model
*Similarity: assup. Misperception on real
price and expected price
*Differences: +no differences between
firm price and worker price
+No assuption that some one has
more accurate information that others
* The Imperfect Information Model was
developed by R.Lucas in1970, to model
worker misperception model but all people
has imperfect information in this model.

- Firms dont distinguish between private

price shock (changeable price) and
common
price
shocks
(unchanged
Y)=>they have two options
- IF P >Pe=> Firms think that: + price of
all goods increases (due to Ms increases)
=> Y unchanged
+Goods demand
increases=> Y should increase.
=>The
Imperfect-Information
Model
points out that P is higher expected price,
price should be increased
AS
: Y= Y +.(P-Pe)

2.4.The Stricky Price Model:

*Differences: Firms fixed price, some times
prices are set by long-term contracts between firms
and custumers. So Firms do not instantly adjust the
price they charge in response to changes in
demand
The firms desired price p depends on two
macroeconomic variables:
+The
overall
level
of
price:
P
increases=>firmcosts are higher=> firms need
to increase price
+The
level
of
aggregate
income
Y:
Y
increases=>Demand
for
firms
products
increases=>higher the firms desired price

Firms desired price as : p = P

+ .(Y-Y)

*Now assume that there are two types of

firms
+Flexible prices, set prices according to this
equation
p = Pe + a (Ye - Ye),
If s is fraction of firms with sticky prices
+Firms
setthe
fixed
price according
to this
and (1-s)
fraction
of firms with
flexible
equation
p=Pe
prices, then
Overall price level is P=s.Pe + (1-s).
[ <=>P=
P+a. (Y-s.Pe
Y)] + (1-s).P +(1-s).a. (Y- Y)
=>P- (1-s).P = s.Pe + . (1-a). (Y- Y)
=>s.P = s. Pe +a. (1-s). (Y - Y)

=>P= Pe + [a. (1-s)/s].(Y - Y)

*Conclusion:
-IF Y=Y =>P=Pe ( actual price level =
expected price level) Firms with fixed price
set their prices at Pe, but Firms with
flexible
prices
set their prices
at actual
-AD high
=>Y>Y=>actual
price
level (P) >
price.
expected price level (Pe).
When AD high, the demand for goods is
high. Those firms with flexible prices set
their prices high, which leads to a high price
level. The effect of output on the price level
depends on the proportion of firms with
flexible prices. If proportion of firms with
flexible prices is high, Y wont be higher

Rearrangement puts this aggregate pricing

equation in to more familiar form

Y= Y +.(P-Pe) vi = s/[(1-s).a]
An upward sloping AS curve in short run
IF s goes up and a goes down, AS is
flatter, elasticity between Y and P is high.
This model explains differences that Y is
high which leads to P high. In the past, P
is high which leads to Y high. But both
P,Y u endogenous variables

*Conclusions:
- Models 1,2 focus on labour market,
Model 3,4 focus on goods market.
-Model 1,4 point out that fixed wages and
prices keep supply and demand balancing
in the short- run.
-Model 2,3 emphasize that role of
information for explaining fluctuation in
short-run. If Actual Price level is different
from expected price level, Y can go out of
Ye

II. Phillips curve:

1. Introduction:
-2/1958: first paper of A.W.Phillips

-1960
Samuelson
&
Robert
Solow
explained mentioned relationships with
Phillips curve.

inflatio
n

B
A
Phillips
curve
0

unemployment

Phillips curve point out the rule as folows:

inflation increases which let unemployment
decreases, there fore, policy maker have to
trade
off
between
inflation
and
unemployment.

Y = Y + (P-Pe)

SRAS (Pe=P
2)at point A; the economy is at full employment Y and the
Start

LRAS*
SRAS (Pe=P0)actual price level is P . Here the actual price level equals the
expected price level. Now lets suppose we increase the price
B
level to P .
A'
Since P (the actual price level) is now greater than P (the
expected price level) Y will rise above the natural rate, and we
A
AD' slide along the SRAS (P =P ) curve to A' .
0

P2
P1
P0

AD
Y Y' Output

Remember that our new SRAS (Pe=P0) curve is defined by the

presence of fixed expectations (in this case at P0). So in terms
of the SRAS equation, when P rises to P1, holding Pe constant
at P0, Y must rise.

Y = Y + ( P-Pe)

The long-run will be defined when the expected price level equals the actual price level. So, as price level
expectations adjust, PeP2, well end up on a new short-run aggregate supply curve, SRAS (Pe=P2) at point B.
Hooray! We made it back to LRAS, a situation characterized by perfect information where the actual price
level (now P2) equals the expected price level (also, P2).
In terms of the SRAS equation, we can see that as Pe catches up with P, that entire expectations gap
disappears and we end up on the long run aggregate supply curve at full employment where Y = Y.

Y = Y + (P-Pe)

The Phillips curve in its modern form states that the inflation rate
depends on three forces:
1) Expected inflation
2) The deviation of unemployment from the natural rate, called
cyclical unemployment
3) Supply shocks
These three forces are expressed in the following equation:

= e n) +
Expected
Inflation

Inflation

Cyclical
Unemployment

Supply
Shock

The Phillips-curve equation and the short-run aggregate supply equation

represent essentially the same macroeconomic ideas. Both equations
show a link between real and nominal variables that causes the
classical dichotomy (the theoretical separation of real and nominal
variables) to break down in the short run.
The Phillips curve and the aggregate supply curve are two sides of the
same coin. The aggregate supply curve is more convenient when
studying output and the price level, whereas the Phillips curve
is more convenient when studying unemployment and inflation.

To make the Phillips curve useful for analyzing the choices facing
policymakers, we need to say what determines expected inflation. A
simple often plausible assumption is that people form their expectations
of inflation based on recently observed inflation. This assumption is
called adaptive expectations. So, expected inflation e equals last years
inflation -1. In this case, we can write the Phillips curve as:

= -1 n) +

which states that inflation depends on past inflation, cyclical

unemployment, and a supply shock. When the Phillips curve is written in
this form, it is sometimes called the Non-Accelerating Inflation Rate of
Unemployment, or NAIRU.
The term -1 implies that inflation has inertia-- meaning that it keeps going
until something acts to stop it. In the model of AD/AS, inflation inertia
is interpreted as persistent upward shifts in both the aggregate supply
curve and aggregate demand curve. Because the position of the SRAS
will shift upwards overtime, it will continue to shift upward until
something changes inflation expectations.

The second and third terms in the Phillips-curve equation show the two
forces that can change the rate of inflation. The second term, (u-un),
shows that cyclical unemployment exerts downward pressure on inflation.
Low unemployment pulls the inflation rate up. This is called
demand-pull inflation because high aggregate demand is responsible for
this type of inflation. High unemployment pulls the inflation rate down.
The parameter measures how responsive inflation is to cyclical
unemployment. The third term, shows that inflation also rises and falls
because of supply shocks. An adverse supply shock, such as the rise in
world oil prices in the 70s, implies a positive value of and causes
inflation to rise.
This is called cost-push inflation because adverse supply shocks are
typically events that push up the costs of production. A beneficial
supply shock, such as the oil glut that led to a fall in oil prices in the
80s, makes negative and causes inflation to fall.

In
Inthe
theshort
shortrun,
run,inflation
inflationand
andunemployment
unemployment
are
arenegatively
negativelyrelated.
related.At
Atany
anypoint
pointin
intime,
time,aa
policymaker
policymakerwho
whocontrols
controlsaggregate
aggregatedemand
demand
can
canchoose
chooseaacombination
combinationof
ofinflation
inflationand
and
unemployment
unemploymenton
onthis
thisshort-run
short-runPhillips
Phillips
curve.
curve.

e +

un Unemployment, u

Lets start at point A, a point of price stability (=0%) and full employment (u=un).
Remember, each short-run Phillips curve is defined by the presence of fixed expectations.
Suppose there is an increase in the rate of growth of the money supply causing LM and AD to shift out
resulting in an unexpected increase in inflation. The Phillips curve equation = e (u-un) + v implies
that the change in inflation misperceptions causes unemployment to decline. So, the economy moves to a
point above full employment at point B.
As long as this inflation misperception exists, the economy will
n

LRPC (u=u )
remain below its natural rate un at u'.
When the economic agents realize the new level of inflation, they
will end up on a new short-run Phillips curve where expected
D
E
10%
inflation equals the new rate of inflation (5%) at point C, where
actual inflation (5%) equals expected inflation (5%).
If the monetary authorities opt to obtain a lower u again,
then they will increase the money supply such that is
B
C
10%, for example. The economy moves to point D, where
5%
actual inflation is 10% but, e is 5%.

u'

A
un

When expectations adjust, the

economy will land on a new SRPC, at
e
SRPC ( =10%) point E, where both and e equal
10%.
e

SRPC ( =5%)

Unemployment, u

SRPC (e=0%)

Rational expectations make the assumption that people optimally use all
the available information about current government policies, to forecast
the future. According to this theory, a change in monetary or fiscal
policy will change expectations, and an evaluation of any policy change
must incorporate this effect on expectations. If people do form their
expectations rationally, then inflation may have less inertia than it first
appears.
Proponents of rational expectations argue that the short-run Phillips
curve does not accurately represent the options that policymakers have
available. They believe that if policy makers are credibly committed to
reducing inflation, rational people will understand the commitment and
lower their expectations of inflation. Inflation can then come down
without a rise in unemployment and fall in output.

Our entire discussion has been based on the natural rate hypothesis.
The hypothesis is summarized in the following statement:
Fluctuations in aggregate demand affect output and employment only
in the short run. In the long run, the economy returns to the levels of
output,employment, and unemployment described by the classical model.
Recently, some economists have challenged the natural-rate hypothesis
by suggesting that aggregate demand may affect output and employment
even in the long run. They have pointed out a number of mechanisms
through which recessions might leave permanent scars on the economy
by altering the natural rate of unemployment. Hyteresis is the term
used to describe the long-lasting influence of history on the natural
rate.

CHAPTER FIVE

Consumption

The consumption function was central to Keynes theory of economic

fluctuations presented in The General Theory in 1936.
Keynes conjectured that the marginal propensity to consume-- the
amount consumed out of an additional dollar of income-- is between
zero and one. He claimed that the fundamental law is that out of
every dollar of earned income, people will consume part of it and save
the rest.
Keynes also proposed the average propensity to consume-- the ratio of
consumption to income-- falls as income rises.
Keynes also held that income is the primary determinant of
consumption and that the interest rate does not have an important role.

MPC.Y
Y
CC == CC++MPC.

C
Y
Y
c
+c
+
C
C
=
=
C
C

income
consumption depends
Marginal
spending by
Propensity to
C
on
households
consume (MPC)
Y
Autonomous
consumption
The slope of the consumption function
is the MPC.

APC == C/Y
C/Y== C/Y
C/Y++ MPC
MPC
APC
C

C
11

APC1
APC2
Y

This
Thisconsumption
consumptionfunction
function
exhibits
exhibitsthree
threeproperties
propertiesthat
that
Keynes
Keynesconjectured.
conjectured.First,
First,
the
themarginal
marginalpropensity
propensityto
to
consume
consumeccisisbetween
betweenzero
zero
and
andone.
one.Second,
Second,the
theaverage
average
propensity
propensityto
toconsume
consumefalls
falls
as
asincome
incomerises.
rises.Third,
Third,
consumption
consumptionisisdetermined
determinedby
by
current
currentincome.
income.

As Y rises, C/Y falls, and so the average propensity to consume C/Y

falls. Notice that the interest rate is not included in this function.

To
Tounderstand
understand the
the marginal
marginal propensity
propensityto
to
consume
consume (MPC)
(MPC) consider
consideraa shopping
shopping scenario.
scenario.A
A
person
person who
who loves
loves to
to shop
shop probably
probably has
has aa large
large
MPC,
MPC, lets
letssay
say (.99).
(.99).This
This means
means that
that for
forevery
every
extra
extra dollar
dollarhe
he or
orshe
sheearns
earns after
aftertax
tax deductions,
deductions,
he
he or
orshe
she spends
spends $.99
$.99 of
of it.
it. The
The MPC
MPC measures
measures
the
the sensitivity
sensitivity of
of the
the change
change in
in one
one variable
variable (C)
(C)
with
with respect
respect to
to aa change
changein
in the
the other
othervariable
variable (Y).
(Y).

During World War II, on the basis of Keynes consumption function,

economists predicted that the economy would experience what they
called secular stagnation-- a long depression of infinite duration-unless fiscal policy was used to stimulate aggregate demand. It turned out
that the end of the war did not throw the U.S. into another depression, but
it did suggest that Keynes conjecture that the average propensity to
consume would fall as income rose appeared not to hold.
Simon Kuznets constructed new aggregate data on consumption and
investment dating back to 1869 and whose work would later earn a
Nobel Prize. He discovered that the ratio of consumption to income was
stable over time, despite large increases in income; again, Keynes
conjecture was called into question.
This brings us to the puzzle

The
Thefailure
failureof
ofthe
thesecular-stagnation
secular-stagnationhypothesis
hypothesisand
andthe
thefindings
findingsof
of
Kuznets
Kuznetsboth
bothindicated
indicatedthat
thatthe
theaverage
averagepropensity
propensityto
toconsume
consumeisisfairly
fairly
constant
constantover
overtime.
time. This
Thispresented
presentedaapuzzle:
puzzle:why
whydid
didKeynes
Keynes
conjectures
conjectureshold
holdup
upwell
wellin
inthe
thestudies
studiesof
ofhousehold
householddata
dataand
andin
inthe
the
studies
studiesof
ofshort
shorttime-series,
time-series,but
butfail
failwhen
whenlong
longtime
timeseries
serieswere
were
examined?
examined?
C

Long-run
consumption
function
(constant APC)
Short-run
consumption
function
(falling APC)
Y

Studies
Studiesof
ofhousehold
householddata
dataand
andshort
short
time-series
time-seriesfound
foundaarelationship
relationship
between
betweenconsumption
consumptionand
andincome
income
similar
similarto
tothe
theone
oneKeynes
Keynesconjectured-conjectured-this
thisisiscalled
calledthe
theshort-run
short-runconsumption
consumption
function.
function.But,
But,studies
studiesusing
usinglong
longtimetimeseries
seriesfound
foundthat
thatthe
theAPC
APCdid
didnot
notvary
vary
systematically
systematicallywith
withincome--this
income--this
relationship
relationshipisiscalled
calledthe
thelong-run
long-run
consumption
consumptionfunction.
function.

The
Theeconomist
economistIrving
IrvingFisher
Fisherdeveloped
developedthe
themodel
model
with
withwhich
whicheconomists
economistsanalyze
analyzehow
howrational,
rational,
forward-looking
forward-lookingconsumers
consumersmake
makeintertemporal
intertemporal
choices-choices--that
thatis,
is,choices
choicesinvolving
involvingdifferent
differentperiods
periods
of
oftime.
time. The
Themodel
modelilluminates
illuminatesthe
theconstraints
constraints
consumers
consumersface,
face,the
thepreferences
preferencesthey
theyhave,
have,and
andhow
how
these
theseconstraints
constraintsand
andpreferences
preferencestogether
togetherdetermine
determine
their
theirchoices
choicesabout
aboutconsumption
consumptionand
andsaving.
saving.
When
Whenconsumers
consumersare
aredeciding
decidinghow
howmuch
muchto
toconsume
consume
today
todayversus
versushow
howmuch
muchto
toconsume
consume
in
inthe
thefuture,
future,they
theyface
facean
anintertemporal
intertemporal
budget
budgetconstraint,
constraint,which
whichmeasures
measuresthe
thetotal
total
resources
resourcesavailable
availablefor
forconsumption
consumptiontoday
todayand
andin
inthe
the
future.
future.

Here
Hereisisan
aninterpretation
interpretationof
ofthe
theconsumers
consumersbudget
budgetconstraint:
constraint:
The
Theconsumers
consumersbudget
budgetconstraint
constraintimplies
impliesthat
thatififthe
theinterest
interest
rate
rateisiszero,
zero,the
thebudget
budgetconstraint
constraintshows
showsthat
thattotal
total
consumption
consumptionin
inthe
thetwo
twoperiods
periodsequals
equalstotal
totalincome
income
in
inthe
thetwo
twoperiods.
periods. In
Inthe
theusual
usualcase
casein
inwhich
whichthe
the
interest
interestrate
rateisisgreater
greaterthan
thanzero,
zero,future
futureconsumption
consumptionand
andfuture
futureincome
income
are
arediscounted
discountedby
byaafactor
factorof
of11++r.r.This
Thisdiscounting
discountingarises
arisesfrom
fromthe
the
interest
interestearned
earnedon
onsavings.
savings. Because
Becausethe
theconsumer
consumerearns
earnsinterest
intereston
on
current
currentincome
incomethat
thatisissaved,
saved,future
futureincome
incomeisisworth
worthless
lessthan
thancurrent
current
income.
income.Also,
Also,because
becausefuture
futureconsumption
consumptionisispaid
paidfor
forout
outof
ofsavings
savings
that
thathave
haveearned
earnedinterest,
interest,future
futureconsumption
consumptioncosts
costsless
lessthan
thancurrent
current
consumption.
consumption.The
Thefactor
factor1/(1+r)
1/(1+r)isisthe
theprice
priceof
ofsecond-period
second-period
consumption
consumptionmeasured
measuredin
interms
termsof
offirst-period
first-periodconsumption;
consumption;ititisisthe
the
amount
amountof
offirst-period
first-periodconsumption
consumptionthat
thatthe
theconsumer
consumermust
mustforgo
forgoto
to
obtain
obtain11unit
unitof
ofsecond-period
second-periodconsumption.
consumption.

Secondperiod
consumption

Here are the combinations of first-period and second-period consumption

the consumer can choose. If he chooses a point between A and B, he
consumes less than his income in the first period and saves the rest for
the second period. If he chooses between A and C, he consumes more that
his income in the first period and borrows to make up the difference.

Y2

Consumers
Consumersbudget
budgetconstraint
constraint
Saving
A

Borrowing

Vertical
Verticalintercept
interceptisis
(1+r)Y
(1+r)Y11++YY22

Horizontal
intercept
isis
Horizontal
intercept
C
YY11++YY22/(1+r)
/(1+r)
Y1
First-period consumption

The
Theconsumers
consumerspreferences
preferencesregarding
regardingconsumption
consumptionin
inthe
the
two
twoperiods
periodscan
canbe
berepresented
representedby
byindifference
indifferencecurves.
curves. An
An
indifference
indifferencecurve
curveshows
showsthe
thecombination
combinationof
offirst-period
first-periodand
and
second-period
second-periodconsumption
consumptionthat
thatmakes
makesthe
theconsumer
consumerequally
equally
happy.
happy. The
Theslope
slopeatatany
anypoint
pointon
onthe
theindifference
indifferencecurve
curve
shows
showshow
howmuch
muchsecond-period
second-periodconsumption
consumptionthe
theconsumer
consumer
requires
requiresin
inorder
orderto
tobe
becompensated
compensatedfor
foraa1-unit
1-unitreduction
reductionin
in
first-period
first-periodconsumption.
consumption.This
Thisslope
slopeisisthe
themarginal
marginalrate
rateof
of
substitution
substitutionbetween
betweenfirst-period
first-periodconsumption
consumptionand
andsecondsecondperiod
periodconsumption.
consumption. ItIttells
tellsus
usthe
therate
rateatatwhich
whichthe
the
consumer
consumerisiswilling
willingto
tosubstitute
substitutesecond-period
second-periodconsumption
consumption
for
forfirst-period
first-periodconsumption.
consumption.

Secondperiod
consumption

Z
X

IC2

IC1
W
First-period consumption
Indifference
Indifferencecurves
curvesrepresent
representthe
theconsumers
consumerspreferences
preferencesover
overfirstfirstperiod
periodand
andsecond-period
second-periodconsumption.
consumption.An
Anindifference
indifferencecurve
curvegives
givesthe
the
combinations
combinationsof
ofconsumption
consumptionin
inthe
thetwo
twoperiods
periodsthat
thatmake
makethe
theconsumer
consumer
equally
equallyhappy.
happy.Higher
Higherindifferences
indifferencescurves
curvessuch
suchas
asIC
IC22are
arepreferred
preferredto
to
lower
lowerones
onessuch
suchas
asIC
IC11..The
Theconsumer
consumerisisequally
equallyhappy
happyatatpoints
pointsW,
W,X,
X,
and
andY,
Y,but
butprefers
prefersZZto
toall
allthe
theothers-others--Point
PointZZisison
onaahigher
higherindifference
indifference
curve
curveand
andisistherefore
thereforenot
notequally
equallypreferred
preferredto
toW,
W,XXand
andY.
Y.

Secondperiod
consumption

O
IC3
IC2
IC1
First-period consumption

The
Theconsumer
consumerachieves
achieveshis
hishighest
highest(or
(oroptimal)
optimal)level
levelof
ofsatisfaction
satisfaction
by
bychoosing
choosingthe
thepoint
pointon
onthe
thebudget
budgetconstraint
constraintthat
thatisison
onthe
thehighest
highest
indifference
indifferencecurve.
curve. At
Atthe
theoptimum,
optimum,the
theindifference
indifferencecurve
curveisistangent
tangent
to
tothe
thebudget
budgetconstraint.
constraint.

Secondperiod
consumption

O
IC2

IC1

First-period consumption
An increase in either first-period income or second-period income
shifts the budget constraint outward. If consumption in period one and
consumption in period two are both normal goods-- those that are
demanded more as income rises, this increase in income raises
consumption in both periods.

Secondperiod
consumption

Economists
Economistsdecompose
decomposethe
theimpact
impactof
ofan
anincrease
increasein
inthe
thereal
realinterest
interest
rate
rateon
onconsumption
consumptioninto
intotwo
twoeffects:
effects:an
anincome
incomeeffect
effectand
andaa
substitution
substitutioneffect.
effect.The
Theincome
incomeeffect
effectisisthe
thechange
changein
inconsumption
consumption
that
thatresults
resultsfrom
fromthe
themovement
movementto
toaahigher
higherindifference
indifferencecurve.
curve.The
The
substitution
substitutioneffect
effectisisthe
thechange
changein
inconsumption
consumptionthat
thatresults
resultsfrom
fromthe
the
change
changein
inthe
therelative
relativeprice
priceof
ofconsumption
consumptionin
inthe
thetwo
twoperiods.
periods.

Y2

New budget
constraint
B
A

Old budget
constraint
C

IC2
IC1

Y1
First-period consumption

An
Anincrease
increasein
inthe
theinterest
interestrate
rate
rotates
rotatesthe
thebudget
budgetconstraint
constraint
around
aroundthe
thepoint
pointC,
C,where
whereCCisis
(Y
(Y11,,YY22).). The
Thehigher
higherinterest
interestrate
rate
reduces
reducesfirst
firstperiod
periodconsumption
consumption
(move
(moveto
topoint
pointA)
A)and
andraises
raises
second-period
second-periodconsumption
consumption
(move
(moveto
topoint
pointB).
B).

The
Theinability
inabilityto
toborrow
borrowprevents
preventscurrent
currentconsumption
consumptionfrom
fromexceeding
exceeding
current
currentincome.
income.AAconstraint
constrainton
onborrowing
borrowingcan
cantherefore
thereforebe
beexpressed
expressed
as
asCC11<<YY11..
This
Thisinequality
inequalitystates
statesthat
thatconsumption
consumptionin
inperiod
periodone
onemust
mustbe
beless
lessthan
than
or
orequal
equalto
toincome
incomein
inperiod
periodone.
one. This
Thisadditional
additionalconstraint
constrainton
onthe
the
consumer
consumerisiscalled
calledaaborrowing
borrowingconstraint,
constraint,or
orsometimes,
sometimes,aaliquidity
liquidity
constraint.
constraint.
The
Theanalysis
analysisof
ofborrowing
borrowingleads
leadsus
usto
toconclude
concludethat
thatthere
thereare
aretwo
two
consumption
consumptionfunctions.
functions. For
Forsome
someconsumers,
consumers,the
theborrowing
borrowing
constraint
constraintisisnot
notbinding,
binding,and
andconsumption
consumptionin
inboth
bothperiods
periodsdepends
depends
on
onthe
thepresent
presentvalue
valueof
oflifetime
lifetimeincome.
income.For
Forother
otherconsumers,
consumers,the
the
borrowing
borrowingconstraint
constraintbinds.
binds.Hence,
Hence,for
forthose
thoseconsumers
consumerswho
whowould
would
like
liketo
toborrow
borrowbut
butcannot,
cannot,consumption
consumptiondepends
dependsonly
onlyon
oncurrent
currentincome.
income.

In the 1950s, Franco Modigliani, Ando and Brumberg used Fishers

model of consumer behavior to study the consumption function. One of
their goals was to study the consumption puzzle. According to Fishers
model, consumption depends on a persons lifetime income.
Modigliani emphasized that income varies systematically over peoples
lives and that saving allows consumers to move income from those
times in life when income is high to those times when income is low.
This interpretation of consumer behavior formed the basis of his
life-cycle hypothesis.

In 1957, Milton Friedman proposed the permanent-income hypothesis

to explain consumer behavior. Its essence is that current consumption is
proportional to permanent income. Friedmans permanent-income
hypothesis complements Modiglianis life-cycle hypothesis: both use
Fishers theory of the consumer to argue that consumption should not
depend on current income alone. But unlike the life-cycle hypothesis,
which emphasizes that income follows a regular pattern over a persons
lifetime, the permanent-income hypothesis emphasizes that people
experience random and temporary changes in their incomes from year
to year.
Friedman suggested that we view current income Y as the sum of two
components, permanent income YP and transitory income YT.

CHAPTER SIX

Investment

why
in
la
p
x
e
l
l
e
w
r,
te
p
a
h
c
is
In th
to
d
te
la
re
ly
e
v
ti
a
g
e
n
is
t
n
e
investm
s the
e
s
u
a
c
t
a
h
w
,
te
ra
st
re
te
in
the
d
n
a
t
if
sh
to
n
o
ti
c
n
fu
t
n
e
m
invest
ng a
ri
u
d
s
e
s
ri
t
n
e
m
st
e
v
in
y
h
w
.
n
o
si
s
e
c
re
a
g
n
ri
u
d
s
ll
boom and fa

 Business fixed investment includes the equipment and

structures that businesses buy to use in production.
Residential investment includes the new housing that
people buy to live in and that landlords buy to rent out.
Inventory investment includes those goods that businesses
put aside in storage, including materials and supplies, work
in progress, and finished goods.

The standard model of business fixed investment is called the

neoclassical model of investment. It examines the benefits and costs of
owning capital goods. Here are three variables that shift investment:
1) the marginal product of capital
2) the interest rate
3) tax rules
To develop the model, imagine that there are two kinds of
firms: production firms that produce goods and services
using the capital that they rent and rental firms that make
all the investments in the economy.

To see what variables influence the equilibrium rental price, lets

consider the Cobb-Douglas production function as a good approximation
of how the actual economy turns capital and labor into goods and
services. The Cobb-Douglas production function is: Y = AKL1- ,
where Y is output, K capital, L labor, and a parameter measuring the
level of technology, and a a parameter between 0 and 1 that measures
capitals share of output. The real rental price of capital adjusts to
equilibrate the demand for capital and the fixed supply.
Real rental
price, R/P

Capital supply

Capital demand (MPK)

Capital stock, K

The marginal product of capital for the Cobb-Douglas production

function is MPK = A(L/K)1-Because the real rental price equals
the marginal product of capital in equilibrium,
we can write R/P = A(L/K)1-This expression identifies the
variables that determine the real rental price. It shows the
following:
the lower the stock of capital, the higher the real rental price of
capital
the greater the amount of labor employed, the higher the real
rental price of capitals
the better the technology, the higher the real rental price of capital.
Events that reduce the capital stock, or raise employment, or
improve
the technology, raise the equilibrium real rental price of capital.

Lets consider the benefit and cost of owning capital.

For each period of time that a firm rents out a unit of capital, the rental
firm bears three costs:
1) Interest on their loans, which equals the purchase price of a unit of
capital PK times the interest rate, i, so i PK.
2) The cost of the loss or gain on the price of capital denoted as -PK .
3) Depreciation defined as the fraction of value lost per period
because of the wear and tear, so PK .
Therefore the total cost of capital = i PK - PK + PK or
= PK (i - PK/ PK + )
Finally, we want to express the cost of capital relative to other goods in
the economy. The real cost of capital-- the cost of buying and renting
out a unit of capital measured in terms of the economys output is:
The Real Cost of Capital = (PK / P )(r + ), where r is the real interest
rate and PK / P equals the relative price of capital. To derive this
equation, we assume that the rate of increase of the price of goods in

Now consider a rental firms decision about whether to increase or

decrease its capital stock. For each unit of capital, the firm earns real
revenue R/P and bears the real cost (PK / P )(r + ).
The real profit per unit of capital is

Profit rate = Revenue - Cost

= R/P
- (PK / P )(r + ).
Because the real rental price equals the marginal product of capital, we
can write the profit rate as

Profit rate = MPK

- (PK / P )(r + ).

The change in the capital stock, called net investment depends on the
difference between the MPK and the cost of capital. If the MPK exceeds
the cost of capital, firms will add to their capital stock. If the MPK
falls short of the cost of capital, they let their capital stock shrink, thus:

K = In [MPK - (PK / P )(r + )],

where In ( ) is the function showing how much net investment responds

We can now derive the investment function in the neoclassical model of

investment. Total spending on business fixed investment is the sum of
net investment and the replacement of depreciated capital.
The investment function is:
I = In [MPK - (PK / P )(r + )] + K.
depends on
investment

the cost of capital

amount of depreciation

marginal product of capital

This model shows why investment depends on the real

interest rate. A decrease in the real interest rate lowers the
cost of capital.

Real interest
rate, r

Notice that business fixed investment increases when the interest rate
falls-- hence the downward slope of the investment function. Also,
an outward shift in the investment function may be a result of an
increase in the marginal product of capital.

Investment, I

Finally, we consider what happens as this adjustment of the capital

stock continues over time. If the marginal product begins above the
cost of capital, the capital stock will rise and the marginal product will
fall. If the marginal product of capital begins below the cost of capital,
the capital stock will fall and the marginal product will rise.
Eventually, as the capital stock adjusts, the MPK approaches the cost
of capital. When the capital stock reaches a steady state level,
we can write:
MPK = (PK / P )(r + ).
Thus, in the long run, the MPK equals the real cost of capital. The
speed of adjustment toward the steady state depends on how quickly
firms adjust their capital stock, which in turn depends on how costly
it is to build, deliver and install new capital.

The term stock refers to the shares in the ownership of corporations, and
the stock market is the market in which these shares are traded.
The Nobel-Prize-winning economist James Tobin proposed that firms
base their investment decisions on the following ratio, which is now
called Tobins q:
q = Market Value of Installed Capital
Replacement Cost of Installed Capital

The numerator of Tobins q is the value of the

economys capital as determined by the stock
market. The denominator is the price of capital as if
it were purchased today. Tobin conveyed that net
investment should depend on whether q is greater
or less than 1. If q >1, then firms can raise the value
of their stock by increasing capital, and if q < 1, the
stock market values capital at less than its
replacement cost and thus, firms will not replace
their capital stock as it wears out. Tobins q
measures the expected future
profitability as
well as the current profitability.

1) Higher interest rates increase the cost of capital and reduce business
fixed investment.
2) Improvements in technology and tax policies such as the corporate
income tax and investment tax credit shift the business fixed
investment function.
3) During booms higher employment increases the MPK and therefore,
increases business fixed investment.

We will now consider the determinants of

residential investment by looking at a simple
model of the housing market. Residential
investment includes the purchase of new
housing both by people who plan to live in
it themselves and by landlords who plan to rent
it to others.
There are two parts to the model:
1) the market for the existing stock of houses determines the
equilibrium housing price
2) the housing price determines the flow of residential
investment.

Relative Price
of housing PH/P

The relative price of housing adjusts to equilibrate supply and demand

for the existing stock of housing capital. The relative price then
determines residential investment, the flow of new housing that
construction firms build.
PH/P

Demand

Stock of housing capital, KH

Flow of residential investment, IH

Relative Price
of housing PH/P

When the demand for housing shifts, the equilibrium price of housing
changes, and this change in turn affects residential investment.
An increase in housing demand, perhaps due to a fall in the interest
rate, raises housing prices and residential investment.
PH/P

Demand'
Demand

Stock of housing capital, KH

Flow of residential investment, IH

1) An increase in the interest rate increases the cost of borrowing

for home buyers and reduces residential housing investment.
2) An increase in population and tax policies shift the residential
housing investment function.
3) In a boom, higher income raises the demand for housing and
increases residential investment.

Inventory investment, the goods that businesses put

aside in storage, is at the same time negligible and of
great significance. It is one of the smallest components
of spending-- but its volatility makes it critical in the
study of economic fluctuations.

When sales are high, the firm produces less that it sells
and it takes the goods out of inventory. This is called
production smoothing. Holding inventory may allow
firms to operate more efficiently. Thus, we can view
inventories as a factor of production. Also, firms dont
want to run out of goods when sales are unexpectedly
high. This is called stock-out avoidance. Lastly, if a
product is only partially completed, the components are
still counted in inventory, and are called, work in
process.

The accelerator model assumes that firms hold a stock of

inventories that is proportional to the firms level of output. Thus, if
N is the economys stock of inventories and Y is output, then
N=Y
where is a parameter reflecting how much inventory firms wish to
hold as a proportion of output. Inventory investment I is the change in
the stock of inventories N. Therefore, I = N = Y.

The accelerator model predicts that inventory investment is

proportional to the change in output.
When output rises, firms want to hold a larger stock of
inventory, so inventory investment is high.
When output falls, firms want to hold a smaller stock of
inventory, so they allow their inventory to run down, and
inventory investment is negative.
The model says that inventory investment depends on whether
the economy is speeding up or slowing down.

Like other components of investment, inventory investment

depends on the real interest rate. When a firm holds a good in
inventory and sells it tomorrow rather than selling it today, it
gives up the interest it could have earned between today and
tomorrow. Thus, the real interest rate measures the opportunity
cost of holding inventories.
When the interest rate rises, holding inventories becomes more
costly, so rational firms try to reduce their stock. Therefore, an
increase in the real interest rate depresses inventory investment.

1) Higher interest rates increase the cost of holding inventories

and decrease inventory investment.
2) According to the accelerator model, the change in output
shifts the inventory investment function.
3) Higher output during a boom raises the stock of inventories
firms wish to hold, increasing inventory investment.

CHAPTER SEVEN

Economic Growth

I.Summary of economic growth in

macroeconomics 1:
1.Sources of economic growth
+ Human capital
+Capital accumulation
+Natural resource
+Technological knowledge
2. Theories of economic growth
-Classical theory: AdamSmith v Mathus: Land

-Harrod Domar Model: based on

Keynesian theory: Capital accumulation
-Neo-classical Model: Solow-Swan Model
exogenous economic growth model.
Capital
accumulation
=>
short-run
economic growth but techonological
knowledge leads to long-run economic
growth.
-Endogenous growth model, F. Romer v
Lucas in 1980s.

The Solow Growth Model is designed to show how

growth in the capital stock, growth in the labor force,
and advances in technology interact in an economy,
and how they affect a nations total output of
goods and services.
Lets now examine how the
model treats the accumulation
of capital.

1. Assumptions
*Production
-Single goods: - Y or GDP of economy
-Constant return to technology in
production. There are only two inputs, K
and L in production

-Production function Cobb-Douglas:

(diminishing returns to K and L): Y = A.
K . L1- ; (0 <<1);
-Factors of production : production
with only two inputs: K and L
+MPk, MPl: K and L have been calculated
by MPk and MPl, (simplify MPk - r, MPl wage)
+Diminishing returns to capital and
labour

-Population
and
labour
supply:
constant population, population is equal to
labour force (Assu.).
-No technological progress: relax later

*Market structure
-Perfect competition):
-Normal profit (zero profit): Firms have
normal profit. Output will belongs to owner
of capital (i) & L (w).

2. Solow Model :
2.1. Capital accumulation):
-Solow Model explains economic growth
through capital accumulation by two
relationships as follows:
+Per capita capital & capita output
+Accumulation & output

Y AK L1

Y
AK L1

y Ak
L
L

=>per capita production function

Lets analyze the supply and demand for goods, and

see how much output is produced at any given time
and how this output is allocated among alternative uses.

The
The Production
Production Function
Function
The production function represents the
transformation of inputs (labor (L), capital (K),
production technology) into outputs (final goods
and services for a certain time period).
The algebraic representation is:
zY = F (zK ,zL )
Income

is

some function of

our given inputs

Key Assumption: The Production Function has constant returns to scale.

This assumption lets us analyze all quantities relative to the size of

the labor force. Set z = 1/L.

Y/ L = F ( K / L , 1 )
the amount of
is some function of
Output
capital per worker
Per worker
Constant returns to scale imply that the size of the economy as
measured by the number of workers does not affect the relationship
between output per worker and capital per worker. So, from now on,
lets denote all quantities in per worker terms in lower case letters.
Here is our production function: y = f ( k ) , where f(k)=F(k,1).

*Source of growth
-Increases in Capital per Worker: =>
increases sources of production but
diminishing returns to capital=>addition to Y is
diminishing (Grapth a)

-Improvement in the state of technology:

more per-capita output can be produced
for any given level of capital per worker,
(APF shift, Grapth b)

y=A3k1

yt

yt

y=A2k1
(A2>A1)

y=Ak y3
y2

y2

y=A1k1
y1

y1

k1

k2

Grapth a

kt

k1

Grapth b

kt

*The Relation Between Output and Capital

Accumulation):
Based
on
relationship
between I and Y, then I and capital
accumulation.
- Relationship between I and Y: 3
assumptions
+ Closed economy: no International trade
+Private Savings = Public Savings =>I

= S + (T-G)
+No Government sector: (T-G)=0 <=> I =
S (I = private savings)

-Private Savings Proportional to

Income:

S = s. Y ( 0 <s<1)
-Equilibrium Investment Spending at
time t :

It = St = s.Yt
-Per-Capita Investment and the Savings
Curve:
It
Yt
s
sAk t
L
L

Savings
y=Ak
s1Aks1>s
sAk

Hnh c

kt

*Relationship between I and capital

accumulation:
-Capital stock and capital flows
-Capital depreciation: , 0 < < 1
=>Capital depreciation in one year .Kt

=>Capital depreciation per worker:

.Kt/L = .kt

-Depreciation curve:

1k (1>)
k

kt

*Capital accumulation:

K t 1 K t I t K t
It = s.Yt; yt = A.kt

K t 1 K t Yt K t
K t 1 K t sYt K t s k t 1 k t syt k t
L L L L

k t 1 k t sAk t k t

-The Equilibrium in the Solow Model:

the Dynamics of Capital

k t 1

k t 1 k t

change in capital
from year t to year t 1

t
investment in year t

sAk

k t

depreciation in year t

-Steady-State Capital and Output:

capital and output per capital are constant
at steady state. At that point, investment is
equal to depreciation:

sA k t k t 0 sAk t
investment

k t

depreciation

sAk k t sAk

sA
k 0 k

*

1
1

y Ak
*

sA
A

yt
y=Ak
k
sAk

sAk0

Growth in per capita

capital stock

k0
k0

k1

k*
steady state
capital stock

kt

2. The role of savings for economic

growth:
.k
I, D
s2Ak
s1Ak

k1*

-S increases =>sAk shifts =>I

increases =>k and y increases at
new steady state
-Solow concluded that S plays an
important role in level of k and y at
steady state but economic gorwth still
face with steady state, S =>short run
3.
The role of population for economic
growth.
growth:
-Population rate: n, fluctuation of capital
at t as follows:

kt+1 = s.A.kt -.kt - n.kt = 0

<=> s.A.kt = (n+ ).kt

(n2+) (n1+)
.k
.k

I,D

y=Ak

s1Ak

k2*

k1*

4. Conclusions:
-Exogenous
Long-Run
Growth
Rate:
capital acc with diminishing returns
to cap. Acc => short run growth.
-Long run growth is exogenous, which
doesnt depend on economic variable
such as savings rate. Thus Government
cant intervene in long-run economic
-Growth
growth. doesnt depend on s, thus policy
aim at increasing the saving rate =>short
run growth
-Convergence and speed of growth:

5.Augmented Solow model

-Basic Solow Model point out that long-run
economic growth is exogenous
Techonology (manna from heaven),
however, tuy nhin augmented Solow
model explain that T makes productivity
-Dimensions
changeable of Technology progress:
+larger quantities of output for given
quantities of capital and labour
+better products, new products
+larger variety of products

-State of technological progress: T helps

Y increase at initial capital level:
-Production function Y = f(K,AL) = K.

(A.L)1-

+Constant return to scale

+Diminishing return to K and L
+AL: effective labour
+A: technological progress

-Assumption; technological progress

increases at gA gA=A/A

Y K ( AL)1

Y
K
Y K ( AL)1

and k

y k y
AL
AL
AL
AL

*Relationship between I and K:

- Investment = Private Savings : I= S =
s.Y (0<s<1)
-Depreciation rate v 0< <1
-Capital accumulation:

K t 1 K t I t K t g A K t K t sYt K t g A K t
K t 1
Kt
sYt K t g A K t

kt 1 kt skt kt g A kt
At L
At L At L At L
At L

*The Equilibrium in the Augmented Solow

Model:the Dynamics of Capital
kt 1 kt

change in capital
from year t to year t 1

skt

k t

investment in year t

g A kt

depreciation in year t

increase in efficiency

* Steady-State Capital and Output:

sk t k t g A k t 0 sk t kt
investment

*
*
*
*

sk t k t g A k t sk k g A k 0 k

depreciation

g
A

1
1

g A kt

increased productivity

y k
*

g
A

*Conclusions:
-gA have impacts on short-run and
long- run economic growth rate. At
steady state, we have:
+Output and capital per effective
worker are constant
+Output and capital per effective
worker increases at gA level
+Output and capital increases at gA
level

*Note: population increases at fixed rate

gL=n, increasing rate of T is gA, and
depreciation rate is , we have:

k t 1 k t sk t k t nk t

k k sk k g k nk 0
t 1
t
t
t
A t
t

gA n

1
1

Summary of impacts of population and

technological progress

Po.
=0

L=0
L
incre
ases
:n

D/
s
=
D/s=n
L
n
T=g increases
:n

AL
increases
n+g

k=K/
L
cons
K
t
k=K/
incre
ases: L
cons
n
K
k=K/AL
t
K
con
st.

increa
ses n
+g

-const

Y/L
Y
cons
con t
Yst

Y/L
incre Const
ases
:n

Y
increa
ses: n
+g

Y/L
increas
es: g

6. The policies to promote economic

growth
*Improving savings rate:
- S increases => C decreases =>choose
reasonable S and C for now and future

-S and C is trading off between short- run

and long run benefits.

-S=private +public savings: S public

increases => decreases budget deficit. IF G
increases=>S decreases and happen crowding out private investment=> k level
*Investment:
3 types of investment
is
low.
+Fixed investment
+Fixed investment supplied by Government
+Human capital
Note: Infrastructure and human capital spur
economics growth.
*Improving technological progress:
-No tax for R&D, suppor for basic
research,copy right, know-how, patent

CHAPTER EIGHT

MACROEconomIC policy DEBATES

I. Should Policy Be Active or Passive?:

* Stabilization policys views
-Classical views: Flexible price and wage =>
Allocation all resources effectively=> no
need stabilization policy
-AD-AS model=>AD changes to keep
economy stable, but many economists didnt
support for this view.
=>In order to issue good stabilization policy,
economists have better information of
shocks than other individuals in economy.

*Lags in the Implementation and

Effects of policies
-Keynes=>P and w=> fixed=>G have
more room to intervene in economy but
some economists of New Keynes wonder
about lag of policies.
-Lags come from:
+Time lags for Forcasting and issuing
policies:inside lags
+ Time lags from issuing policies to
implement policies effectively=>outside lags
=>Lags can reduce effectiveness of policies

-Lags make forcating of econmists become

difficult =>using econometric model only
forecasts key economic variables but
exogenous hard influence seems hard to
forcast.
*R.Lucas Critique
-Econometric model or classical model is less
effective.
-Focus on private expectation

II.Should Policy Be conducted by Rule or by

Discretion?
-Flexible policies help economists react
freely fluctuations of economy.

-Policies, which are conducted by Rule, is

total of engagement of reaction of
Government

* Why should policy be conducted by

Rule:
-Distrust of Policymarkers and the Political
Process
+ineffective policies due to lack of
information
+Economic policies derives from
advantages of polictics,
-The time inconsistency of Discreationary
Policy:

II.Rules for Fiscal Policy and Monetary

Policy:
1. Rules for Fiscal Policy
-No budget deficit
-Budget deficit can derive from stabilization
tools
+Recession=> T decreases=>all types of
tax reduce=>spur AD. Government
spending on social problems increases=> G
increases=>AD increases

+Budget deficit or budget surplus

let Government adjust taxrate=>G
face with budgetdeficit in recession
with low level of Y or in War time

+Budget deficit can be used

transfer tax from now to future.

to

2. Rules for Monetary Policy:

-Rule 1:
supply

Friedman

Stable

money

-Rule 2: set nominal GDP targeting

+IF GDPn < Objective =>Central Bank
increases Money supply to spur AD
+Good point: let monetary policy
adjust according to fluctuations of
money supply.

-Rule 3: Price targeting.

Central Bank set price targeting. If
real price is different from price
targeting, Ms will be adjusted to
achieve at that price. This rule is
reasonable when price is considered
as objective of monetary policy.

The end!