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Y = F (N, K),
Y is aggregate production
N is aggregate employment
Properties:
FN > 0, FK > 0
Short-run profit:
PY WN
WN
= P F (N, K)
F (N,K)
N
W = 0,
P FN (N, K)
with respect to N
F (N, K)
See Figure 1.1 for the graphical derivation
panel (a)
WN
B
!
PF(N,K)
A
!
panel (b)
A
!
A(N)
C!
B
!
= W/P
FN (N D , K)
| {z }
real wage
first-year trick comes in handy: total differentiation of the expression to see how N D ,
are related:
W/P , and K
= d(W/P )
dFN (N D , K)
= d(W/P )
FN N dN D + FN K dK
FN N dN D = d(W/P ) FN K dK
+ (1/FN N ) d(W/P )
dN D = (FN K /FN N ) dK
D
with NW/P
W/P
ND(W/P, K1)
ND(W/P, K0)
N
10
C is household consumption
Properties
11
Budget constraint:
P eC = W N S
{C,N S }
e
S
S
maxU U (W/P )N , 1 N
{N S }
12
13
C1
E1
C 0
CC
EN
U1
E0
!
C0
U0
!
0
!
1-NCS
!
1-N1S
!
1-N0S
!
1
1-NS
14
NS(W/Pe)
NS(W/Pe,U0)
E1
!
(W/Pe)1
(W/Pe)0
!
0
N0
! EN
E0
N1 S
NCS
!
1
15
gN R 0
or equivalently:
W
=
P
P
P
SE R |IE |,
g(N S )
Supply side of the model consists of the labour market plus the production function
(link to the supply side of the goods markethence the name). To complete the
supply side model we must say something about expectations, i.e. about P e
16
e
= Pt + (1 ) Pt Pt 0 < < 1
| {z }
]
e
Pt+1
= [Pt Pte ]
(AEH)
]: expectational error. Pte is given in the short run but it adjusts slowly over time.
If Pte > Pt then expectations are adjusted downwards and vice versa if Pte < Pt
PFH: Perfect foresight hypothesis:
Pe = P
(PFH)
Later in this course we will discuss the rational expectations hypothesis (REH)
which is the extension of PFH to the stochastic economy
17
The key thing to note is that the aggregate supply curve (AS) depends very much on
whether we assume AEH or PFH! See Figure 1.5 for a graphical derivation of AS
under both AEH and PFH
PFH plus clearing labour market gives vertical AS curve (Classical). Modigliani
(1944) shows that, even if PFH is used, AS may have an upward sloping segment if
the nominal wage is downward inflexiblesee Figure 1.6 Hence, PFH itself is not
enough to get Classical conclusions!! [same with REH]
W=P0 eg(NS )
E1
!
W1
AS PFH
W=P2 g(NS)
ASAEH
E1
P1
!
W0
18
!! A
E0
!
P0
! E0
W2
P2
!B
! !
E2
W=P1FN
! E2
W=P2 FN
W=P0 FN
A
E0
B
!A
!
!
!
E0
Y=F(ND, K0)
W=P2 FN
A
W0
W=P2 g(NS)
!
E0
AS
W=P0 g(N )
W1
19
W=W 0
P1
!B
P0
! E0
P2
W=P1 FN
W=P0FN
N*
N2
E0
N2S
Y
!
E0
A!
!A
Y=F(ND, K0 )
20
21
mD
T
M
P
D
= k(Y ),
kY > 0
= l(R),
lR < 0
speculative motive
mST
M
P
D
S
22
= RMIN )
that people are indifferent between money and bonds. Additional money is
willingly absorbed without the need to lower the interest rate.
If R
= RMAX then people hold no money for speculative purposes. Bond prices
are very low and are expected to rise. Hence capital gains on bonds are
expected.
23
R
RMAX
l(Y,R)
RMIN
l(Y,R)
Figure 1.7: The Liquidity Preference Function
Foundations of Modern Macroeconomics Chapter 1
24
where M is the exogenous money supply (under control of the monetary authority)
The LM curve summarizes money market equilibrium. See Figure 1.8 for the
derivation.
RMAX !
!
-kY/lR>0
lR<0
lR6-4
LM
-kY/lR64
lR=0
25
-kY/lR=0
!
RMIN
l(R)
!
k(Y)
! k(Y)
26
0 < CY T < 1,
IR < 0,
T = T (Y ), 0 < TY < 1,
M/P = l(Y, R),
lY > 0, lR 0,
G is government consumption
27
Slope of IS curve:
Y
= C(Y T (Y )) + I(R) + G
dY
= CY T [dY TY dY ] + IR dR + dG
dY
= CY T [1 TY ] dY + IR dR + dG
IR dR + dG
=
1 CY T [1 TY ]
dY
(A)
Slope of LM curve:
M/P = l(Y, R)
d(M/P ) = lY dY + lR dR
d(M/P ) lY dY
dR =
lR
Foundations of Modern Macroeconomics Chapter 1
(B)
28
The IS-LM equilibrium represents (Y, R) combinations for which the money market
and the demand side of the goods market are in equilibrium, given the exogenous
variables M and G and the price level P .
dY
{1 CY T (1 TY )} dY
IR lY
dY
1 CY T (1 TY ) +
lR
Foundations of Modern Macroeconomics Chapter 1
IR
d(M/P )lY dY
lR
+ dG
1 CY T (1 TY )
d(M/P ) lY dY
= IR
+ dG
lR
IR
=
d(M/P ) + dG
lR
Version 1.01 April 2004
Ben J. Heijdra
dM
dP
P
29
(AD)
30
)
****
31
32
33
Classical Economists
Names: Adam Smith (1723-1790), David Hume (1711-1776), David Ricardo
(1772-1823), John Stuart Mill (1806-1873), Knut Wicksell (1851-1926), Irving Fisher
(1867-1947).
34
Fiscal policy useless. Just raises interest rate and crowds out investment (see
Figure 1.9)
Monetary policy useless. Just raises prices and does nothing to real things (see
Figure 1.9)
Classical dichotomy : money is a veil which determines nominal prices but does not
affect real quantities and relative prices. Monetary neutrality.
35
R
LM(M0/P0)
LM(M1/P1)
R1
R0
IS(G1)
IS(G0)
P1
AS
!
AD(M1)
P0
!
AD(M0)
Y*
36
Keynes?????
Names: too many interpreters to mention.
37
Fiscal policy very useful. Raises demand (and thus moves economy towards full
employment); no interest rate change and thus no crowding out investment (see
Figure 1.10)
C = C Y T , M/P
+
38
R
LM(M0/P0)
RMIN
B
!
!
A
LM(M0/P1)
IS(G1)
IS(G0)
AD(G1)
AD(G0)
P1
A
!
P0
B
!
Y0
AS
B
!
Y1
Y*
39
Neoclassical synthesizers
Names: Paul Samuelson (1915-), James Tobin (1918-2002), Franco Modigliani
(1918-2003), Robert Solow (1924-) plus virtually all economists in 1950s and 1960s
except Milton Friedman (1912-)
40
Both monetary and fiscal policy can affect the economy (see Figure 1.11)
Underlying presumption is that the government should pursue a counter-cyclical
policy
41
LM(M0/P1)
LM(M0/P0)
!
!
!
LM(M1/P1)
LM(M1/P0)
!
!
!
IS(G1)
IS(G0)
Y
AS(Pe=P2)
AS(Pe=P0)
P2
P1
P0
!
!
AD(G0,M1)
AD(G1,M0)
AD(G0,M0)
Y*
Figure 1.11: Monetary and Fiscal Policy in the Neo-Keynesian Synthesis Model
42
Monetarists
Names: Milton Friedman (1912-) and his Chicago boys
interest sensitivity of investment high (|IR | large and IS flat) strong crowding out of I
by G
quantity theory of money (lR 0 in our notation; near vertical LM curve)
Friedman hates the REH
monetary policy is potent but ....
policy maker makes timing errors (long and variable lags) and may exacerbate the
cycle
43
44
Supply siders
Names: Arthur Laffer, Robert Mundell (1932-)
radical conservatives
strong distrust of the government [Leviathan]
emphasis on distorting aspects of taxation
policy advice too good to be true: you can cut the tax rate without reducing
government spending. The tax cut pays for itselfsee the so-called Laffer curve in
Figure 1.12
45
A
!
B
! C
tL
46