Working through the Basic Model

Step 0: Identify the real-life shock in terms of model parameters. Examples: Expected future wages increase (HW 1, Q6) Consumer Confidence Index declines (LN 3, p. 35) Business expectations decline (LN 3, pp. 72-73)

Step 1: Determine Production function: Labor market:

, i.e. look at the production function and labor market. 1. Labor demand: 2. Labor supply:

Three comments:

1. Changes to endogenous variables (before the semi-colon), e.g. represent moves along the curve. represents an increase in the function value. represents a decrease in the function value.

2. Changes to exogenous variables (after the semi-colon), e.g. , represent exogenous shocks that move the curve. represents an outward shift of the curve (to the right). represents an inward shift of the curve (to the left).

3. s are exogenous variables that subsume various other shocks, e.g. captures a productivity shock. We say that if a particular shock shifts the function outwards, then increases. Step 1A: Does the production function shift? Step 1B: Does the labor demand curve shift? Step 1C: Does the labor supply curve shift? Step 1D: Determine from the labor market equilibrium. Step 1E: Determine from the production function.

Step 2: Determine Consumption function: Goods market:

, i.e. look at the consumption function and goods market. 1. Investment demand: 2. National savings:

Stop here: Make sure you understand the notation, i.e. know what the variables stand for. Make sure you know where the +/- for all variables come from. Make sure you know where the goods market equilibrium condition, i.e. from. Direct effects (i.e. curve shifts): Step 2A: Does the consumption demand curve shift? Step 2B: Do government purchases change? Step 2C: Does the investment curve shift? Now: Final effects

, comes

Andys version Step 2DA: Does the national savings curve shift? Step 2EA: Determine from the goods market equilibrium. Step 2FA: Determine using and .

Daves version Step 2D: Determine

Step 3: Determine Be patient

, i.e. look at the asset market.

Example for Steps 0-2 Consumer Confidence Index declines (LN 3, p. 35) Step 0: Identify the real-life shock in terms of model parameters.

Step 1: Determine Production function: Labor market:

, i.e. look at the production function and labor market. 1. Labor demand: 2. Labor supply:

Step 1A: Does the production function shift? No, because the production function does not depend on

In words: A decline in future income does not change how much output is produced today with given and . Step 1B: Does the labor demand curve shift? No, because the labor demand function does not depend on In words: A decline in future income does not affect MPN or . Step 1C: Does the labor supply curve shift? No, because the labor supply function does not depend on : :

In words: According to our basic model assumption, labor supply is not affected by changes in wealth. Step 1D: Determine . If the labor supply and labor demand dont shift, then Step 1E: Determine . If doesnt change, then Summary of step 1: F 0,

do not change.

doesnt change. 0, 0, 0, 0, Y 0. Nothing happens.

Step 2: Determine Consumption function: Goods market:

, i.e. look at the consumption function and goods market. 1. Investment demand: 2. National savings:

Step 2A: Does the consumption demand curve shift? Yes, the consumption demand function decreases since it is positively related to .

, i.e.

Comment: Think about this as a shift in the consumption demand curve. This is something you dont actually draw, but it would look like this:

r
0 1

C In words: Lower future income reduces wealth. Reduced wealth decreases consumption for any given real interest rate. Step 2B: Do government purchases change? No, since they are exogenous, i.e. constant. Step 2C: Does the investment curve shift? No, since the investment function does not depend on

, i.e.

Step 2DA: Does the national savings curve shift? Yes, the national savings curve shifts outwards, since it is negatively related to

, i.e.

In words: Due to less future income and thus less wealth, households will consume less and save more today. Since national savings is household savings plus taxes less government purchases, national savings increases at a given real interest rate. Summary direct effects: , 0, 0 (The direct effect is that the investment curve doesnt shift. This does not mean that investment doesnt change, as we will see in a second.), .

Step 2EA: Determine from the goods market equilibrium. Since the national savings curve shifts outward with investment demand unchanged, the real interest rate falls and investment increases.

Step 2FA: Determine C using

and

Consumption decreases due to a shift in the consumption demand curve. However, consumption increases due to the decrease in the real interest rate. In the above equation, we have + (for ) and a for . Which effect is stronger or rephrased: What is the final effect on consumption? Does it increase or decrease? We have to use: . doesnt change (step 1E). doesnt change (step 2B). unambiguously increases, since the real interest rate decreases (step 2EA). Therefore, must decrease, since has to hold in new equilibrium.

Comment: Note that if we were to draw the consumption demand function, the final effect would look like this:

0
1 1
1

The original equilibrium is 0 0 . Right after the shock we are at equilibrium, since doesnt hold. (Question: Is it or after the shock?). Interest rates decrease until we reach the new equilibrium 1

, which is not an right .

Summary direct effects: , , (The final effect is that investment increases; this is a move along the investment curve; it doesnt shift.

Alternative to steps 2DA-2FA: Step 2D: Determine .

We start with 0 0 0 0 , i.e. our original equilibrium. (Subscripts denote the pre-shock equilibrium and subscripts 1 denote the post-shock equilibrium.) The shock hits and reduces consumption, which we figured out in step 2A. At the original equilibrium real interest rate, since consumption falls, aggregate demand is less than aggregate supply, since total output 0 doesnt change, i.e. we have 0 0 0. We dont have a market equilibrium now. This results in downward pressure on the real interest rate. Due to the decrease in the real interest rate, investment and consumption increase until we reach the new equilibrium. Note that this happens with an unchanged investment demand curve, i.e. this is simply a movement along the investment demand curve. In the new equilibrium we have 1 1 1 1 or 0 1 1 0 , since output and government purchases dont change, i.e. 0 1 and 0 1 Note that 0 . What does this mean? Consumption decreases right after the 1 shock, but then increases due to the decrease in the real interest rate. How do we know that the new equilibrium consumption is still less than the original equilibrium consumption? Answer: Since output and government purchases dont change, i.e. 0 1 and 0 1 , and since investment unambiguously increases, i.e. 1 0 , consumption must decrease, i.e. 0 1

If this confused you, sorry! Forget what you just read and look at Daves notes and slides.