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Macroeconomics EBC1018 Summary

Author: Ferdinand Kraemer

CHAPTER 1

Output: Level of production of the economy as a whole

Unemployment rate: proportion of workers in the economy who are not employed
and are looking for a job

Inflation rate: Rate at which the average price of the goods in the economy is
increasing over time.

Recession: period of negative growth

CHAPTER 2

Aggregate Output
Measure of aggregate output: gross domestic product GDP
- GDP is the value of the final goods and services produced in the economy
during a given period (production side)
- GDP is the sum of value added in the economy during a given period
(Production side)
- GDP is the sum of incomes in the economy during a given period (Income
side).

Nominal GDP, $Y(t): Sum of the quantities of final goods produced x their current
price.
- Increases over time
o production of most goods increases over time
o The prices of most goods also increases over time.
Real GDP, Y(t): Sum of the quantities of final goods x constant prices

GDP growth: (Y(t) Y(t-1)) / Y(t-1)

Expansions: periods of positive GDP growth

Recession: periods of negative GDP growth

Unemployment rate
Labor force: Sum of those employed and those unemployed.
L = N + U
(L = labor force; N = employed; U = Unemployed)
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Unemployment rate: ratio of the number of people who are unemployed to the
number of people in the labor force.
u = U/L

Discourage workers: People without jobs that have given up looking for a job.

Participation rate: ratio of the labor force to the total population of working age.

Unemployment and Output
Okuns Law: Relation between unemployment and GDP growth
- High output growth is typically associated with decrease in the unemployment
rate.
- Low output growth is typically associated with increase in the unemployment
rate.

Why are we interested in unemployment?
a. Where does the economy stand and what growth rate is desirable?
b. Is the economy operating above or below its normal level of activity?
c. Has social consequences.
d. Direct effects on the welfare of the unemployed.

Inflation: sustained rise in the general level of prices price level.

Inflation rate: rate at which the price level increases.

Deflation: sustained decline in the price level.

To define price level: GDP deflator and consumer price index (CPI)

GDP deflator: P(t) = nominal GDP(t) / Real GDP(t) = $Y(t) / Y(t)

Rate of inflation: (P(t) P(t-1)) / P(t-1)

CPI: measures the average price of consumption, or the cost of living.

Inflation and Unemployment
Phillips Curve: Negative relation between inflation and the unemployment rate.
- High Unemployment => increase in inflation
- Low unemployment => decrease in inflation

Why care about inflation?
a. During periods of inflation, not all prices and wages rise proportionally, which
affects income distribution.
b. Inflation leads to other distortions (Verzerrungen)
Inflation affects income distribution, creates distortions and increases
uncertainty.

CHAPTER 3 The Goods Market

3.1 The Composition of GDP
- Consumption, C: goods and services purchases by consumers
- Investment, I: sum of non-residential investment (purchase by firms) and
residential investment (purchase by people).
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- Government spending: purchase of goods and services by the government.
- Net export, X IM: Difference between Imports, IM, and Exports, X.

Trade surplus: Exports > Imports
Trade deficit: Exports < Imports

Inventory investment: difference between products sold and produced in a given
year.

3.2 Demand for Goods
Total demand for goods, Z:
Z = C + I + G + X IM

Assumptions:
- All firms produce the same product.
- All firms are willing to supply the good at a given price P.
- Economy is closed

Z = C + I + G

Consumption, C: depends on disposable income

Disposable income: Income that remains once consumers have received transfers
from the government and paid their taxes. Y(d) = Y T

Consumption: C = C (Y(d))
+

C = c0 + c1Y(d)
(c1 = propensity to consume; c0 = what people would consume if their disposable
income would be 0.)

C = c0 + c1(Y T)
Consumption, C, is a function of income, Y, and taxes, T.

Endogenous variable: variable, which depend on other variables in the model.

Exogenous variable: Variable, which is takes as given.

Investment, I exogenous variable

Government Spending, G exogenous variable

3.3 The Determination of Equilibrium Output

Demand Function: Z = C+I+G => Z = c0+c1(Y-T) + I + G

Equilibrium in the goods market: production = demand
Y = Z

Y = c0 + c1(Y-T) + I + G


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Autonomous spending: |c0 + I + G c1T | - does not depend on output.

Multiplier: 1 / (1 c1) always greater than 1 due to propensity to consume.



Demand increases => Production increases => Income Increases
Result: Increase in output that is larger than the initial shift in demand, by a factor
equal to the multiplier.

3.4 Investment equals Savings
Keynesian model: The general theory of employment, interest and Money.

Private Saving: Disposable income their consumption:
S = Y(D) C
=> S = Y T - C

Investment: I = S + (T G)

a. If Taxes exceed government spending => Budget surplus
b. If Taxes are less than government spending => Budget deficit.

Equilibrium in the goods market: IS RELATION Investment for saving

CHAPTER 4: Financial Markets

Currency: Coins and bills, which can be used for transaction

Checkable deposits: bank deposits, which can be used for transaction

Income: what one earns from working + what is received in interests and dividends.
Flow since it is mostly expressed per unit of time.

Savings: part of after-tax income that is not spent.
Flow
0 1
1
1
1
Y c I G cT
c
( = + +

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Wealth: value of ones financial assets all financial liabilities.
Stock variable, since it is the value of wealth at a specific moment in time.

Investment: purchase of new capital goods (machines, plants, buildings)

Financial investment: purchase of financial assets (shares, stocks etc.)

4.1 The Demand for Money

Money: can be used for transaction, pays no interest

Bonds: positive interest rate, i, but cannot be used for transaction.
How much bonds and how much money?
1. The level of transaction
2. Interest rate on bonds

Demand for money: M^d = $Y L(i)


4.2 The Determination of the Interest rate
Two suppliers for money:
1. Checkable deposits: Banks
2. Currency: Central bank

Equilibrium in financial markets: Demand = Supply
M^s = M^d
M^s = $Y L(i)
Interest rate, i, much be such that $Y, people are willing to hold an amount of
money = existing money supply.

Equilibrium in money market: LM Relation liquidity and money



Effects on changes in nominal income or in the money stock on the equilibrium
interest rate, i:
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a. Increase in nominal income => increase in interest rate
b. Increase in money supply => decrease in interest rate

Monetary Policy and Open Market Operations

Central bank: changes money supply by buying or selling bonds in the bonds
market.
- Expansionary operations: central bank buys bonds and pays for them
- Contractionary operations: central bank sells bonds and removes money.

Interest rate on bond: i = $100 - $P(B) / $P(B)
($P(B) = price of the bond today)
The higher the price of the bond, the lower the interest rate.

Liquidity trap: people are willing to hold more money at the same interest rate.

4.3 The Determination of the Interest rate
What Banks do?
Financial Intermediaries: institutions that receive funds from people and firms, and
use these funds to buy bonds or stocks, or to make loans to firms and people.

The Supply and Demand for Central Bank Money by Banks
- The demand for central bank money = demand for currency + demand for
reserves by banks.
- Supply of central bank money is under control of central bank
- Equilibrium interest rate: demand and supply for central bank money are
equal.


The Demand for Money M^d = $Y L(i)
-
How much money to hold in currency and how much in checkable deposits?
CU^d = cM^d and D^d = (1-c)M^d

(CU^d = demand for currency; D^d demand for deposits; c = proportion of money
people wants to hold in currency; 1-c = proportion people wants to hold in deposits)

The demand for Reserves
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Demand for checkable deposits => demand for reserves by banks

R = u D
(R = demand for reserves; u = reserve ratio; D = dollar amount of checkable deposits
owed by the bank)

Combination of demand for deposits, D^d, and demand for reserves by banks, R:
R^d = u (1-c) M^d

The Demand for Central Bank money

H^d = demand for central bank money

H^d = CU^d + R^d
- H^d = cM^d + u(1-c) M^d
- H^d = |c + u(1-c)| $Y L(i)

The Determination of the Interest Rate
Equilibrium: Supply of central bank money, H, = demand for money for central bank,
H^d
H = H^d
or
H = |c + u(1-c)| $Y L(i)



Increase in central bank money => decrease in interest rate & vice versa.

Federal funds market: market for bank reserves

CHAPTER 5 Goods and Financial Markets: The IS LM
Model

5.1 The Goods Market and the IS relation
- Equilibrium in goods market: Production = Demand for goods Y = Z
- Equilibrium condition: Y = C (Y T) + I + G
- Consumption and disposable income was linear

Investment, Sales, and the Interest Rate
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Investment depends on two factors:
1. Level of sales: increasing sales may lead to the need for investing
2. The interest rate: height of the interest rate influences firms decision on
investment.

I = I (Y, i)
(+,-)

The Determination of Output
Y = C(Y T) + I(Y,i) + G

Production = demand for goods => expanded IS relation

- Increase in output => increase in income => increase in disposable income
=> increase in consumption
- Increase in output => increase in investment

Deriving the IS Curve
What happens if the interest rate changes to the demand curve?

1. Increase in interest rate => decreases
demand for goods => decrease in equilibrium
level of output.
2. Equilibrium in the goods market implies:
a. Increase in interest rate =>
decrease in output.
IS curve is downward sloping










Shifts of the IS Curve
What happens with a change in either Taxes or
Government Spending with the IS Curve?

Taxes increases => disposable income decreases => decrease in consumption =>
decrease in demand for goods => decrease in equilibrium output.
IS curve shifts to the left.

General:
a. Any factor that, for a given interest rate, DECREASES the equilibrium level of
output => IS curve shifts to the LEFT
b. Any factor that, for a given interest rate, INCREASES the equilibrium level of
output => IS curve shifts to the RIGHT

5.2 Financial Markets and the LM Relation
M^d = $Y L(i)
-

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Real Money, Real Income and the interest rate
M / P = YL(i)
-

Equilibrium condition: Real money supply = Real money demand
LM RELATION

Deriving the LM Curve
Real money supply is vertical line M/P. For a given level of real income, Y, money
demand is a decreasing function of the interest rate => downwards sloping M^d

Increase in income => demand for money increases => M^d shifts to the right =>
higher interest rate.



Equilibrium in financial markets implies that for a given money stock, the
interest rate is an increasing function of the level of income => LM CURVE

Shifts of the LM Curve
Changes in M/P will shift the LM curve.
- Increases in the money supply, M^s, shift the LM curve down
- Decreases in the money supply, M^s, shift the LM curve up.

5.3 Putting the IS and LM Relation together
IS relation: Y = C(Y T) + I (Y,i) + G
LM relation: M / P = YL(i)

1. Equilibrium in the goods market: Increase in interest rate => decrease in
output (IS curve)
2. Equilibrium in financial market: Increase in output => increase in interest
rate (LM curve)
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Fiscal consolidation / Fiscal contradiction: change in fiscal policy where
government decides to REDUCE the budget deficit.
- Increasing taxes, while keeping government spending constant

Fiscal Expansion: change in fiscal policy where government decides to INCREASE
the budget deficit.
- Decreasing taxes, or increasing government spending.

Steps to answer what is the effect of the policy:
1. How much affects the goods and financial markets equilibrium relations
2. Characterize the effect of theses shifts on the intersection of the IS and LM
curve.
3. Describe the effects in words.

Monetary expansion: INCREASE in money supply

Monetary contradiction: DECREASE in money supply.

5.4. Using a policy mix

CHAPTER 7 The Medium run

7.1 A tour of the labor market
- Population working age: potentially available people for employment.
- Labor force: sum of people. Either working or looking for a job.
- Out of labor force: neither working or looking for a job
- Participation rate: ratio of the labor force to the population working age
- Unemployment rate: ratio of the unemployed to the labor force.

Shift of IS Shifts of LM Movement in Y Movement in i
Increase in taxes left None Down Down
Decrease in taxes right None Up Up
Increase in spending right None Up Up
Decrease in spending left None Down Down
Increase in money (MONETARY) none Down Up Down
Decrease in money (MONETARY) None Up Down Up
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The large Flows of workers
Quits: Workers leaving their jobs for a better alternative

Layoffs: changes in employment levels across firms

Flows in and out the labor force: number f people that move in and out from the
labor force.

Non-employment rate: ratio of population minus employment to population.

During periods of high unemployment: probability of losing a job increases, and
the probability of a job decreases.

7.2 Wage Determination
Wages can be set in many ways:
1. Collective bargaining: bargaining between firms and unions.
2. By employers
3. By bargaining between employer and individual employees.

Workers are paid above the reservation wage: wage that would make them
indifferent between working or becoming unemployed.
Labor-market conditions: The lower the unemployment rate, the higher the wages.

Bargaining
Bargaining power depends on:
1. How costly it would be for a firm to replace the worker, was he to leave the
firm.
2. How hard it would be for the worker to find another job, was he leave the firm.
=> depends on labor market conditions.

Efficiency Wages
Why would then firms be willing to pay more than the reservation wage?
Efficiency wages theories: links the productivity or the efficiency of workers to the
wage they are paid.

lower unemployment => higher wages

Wages, Prices and Unemployment
W = P^e F(u,z)
(-,+)
(P^e = expected price level; u = unemployment rate; z = other variables that may
affect the outcome of wage setting.)

The expected price level
Workers and firms care about real wages, not nominal wages.
- Workers care about how much they can buy with their wages, not how many
they receive.
- Firms care about the nominal wages they pay in relation to the price of
output they sell.
increase in P^e => increase in wage
decrease in P^e => decrease in wage

Decreasing the unemployment rate => increase in wages. (vice versa)


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The other factors
- The height of unemployment insurance
- Increase in minimum wage
- Increase in employment protection
increase in z => increase in W

7.3 Price Determination
Production function: relation between the inputs used and the quantity of output
produced, and on the price of the inputs.

Y = AN
(Y = Output; A = labor productivity; N = Employment)

Labor productivity output per worker - is constant and equal to A.

Assumption: A = 1
Y = N

one more unit of output = cost of one more employee.
P = (1 + ) W
( = Markup of the price over the costs)

The higher the degree of competition, the lower the mark up and vice
versa.
= f(PMR)
(+)
(PMR = product market regulation)

7.4 The Natural Rate of Unemployment

The Wage setting (WS) relation:
W/P = F(u,z)
(-,+)
(W/P = real wage)

Graph of WS: always downward sloping with W/P on the Y-axis and u in the X-Axis

The Price Setting (PS) relation:
W/P = 1/(1 + )

Price setting decisions determine the real wage paid by firms. An Increase in the
mark up => increase in their price given the wage => to a decrease in real wage.
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Equilibrium Real Wages and Unemployment
Real wage price setting = real wage setting

Wage setting: W/P = F(u,z)
Price setting: W/P = 1/(1+)

Equilibrium unemployment rate:
F(u,z) = 1/(1+)
(-,+)

Natural rate of unemployment: Equilibrium unemployment rate

The position of the wage-setting and price-setting curves, and thus the natural rate of
unemployment depend on z and .

Situation 1: Increase in
unemployment benefits => increase in
z => increases in wages => shift of
wage setting curve => natural level of
unemployment increases.









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Situation 2: Enforcement of
competition law => Increase in =>
decrease in real wages => shift of
price setting curve => natural level of
unemployment increases.

(Higher unemployment is required to
make the workers accept the lower
wages)








From Unemployment to Employment
Natural Level of employment: level of employment that prevails when
unemployment is equal to natural level.

u = U/L = L-N/L = 1 (N/L)
(u = unemployment rate; U = unemployment; L = Labor force, N = Employment)

N(n) = L(1-u(n))

From Employment to Output
Natural Level of output: level of output when employment is equal to natural level.

Y(n) = N(n) = L(1 u(n))



natural level of output: Unemployment rate, the real wage chosen in wage
setting(left) = real wage implied by the price setting (right)


CHAPTER 8 Putting all Market together: The AS AD Model
Wage and Price determination in the labor market.

8.1 Aggregate Supply (AS)
Aggregate supply relation: Captures the effect of output on the price level.

1. W = P^e F(u,z)
(-,+)
2. P = (1 + )W

AS relation: gives us a relation between price level, output level and expected price
level => relation between PS and WS.

Step 1: eliminate nominal wage between 1. und 2.
P = P^e(1 + ) F (u,z)
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price level, P, depends on expected price level, P^e, and on the
unemployment rate, u.
Step 2: Replace the unemployment rate by its expression in terms of output.
u = 1 (Y/L)
For a given labor force, L, the higher is output => lower is unemployment rate

AS Relation: P = P^e(1+) F(1 (Y/L),z)
price level depends on expected price level, P^e, and on the level of output,Y,
and the constants , t and L.

Properties of the AS relation:
1. An increase in output => increase in the price level
a. Increase in output => increase in employment
b. Increase in employment => decrease in unemployment
c. Decrease in unemployment => increase in nominal wages
d. Increase in nominal wages => increase in price level
2. An increase in expected price level => increase in the actual price level
a. If wag setters expect higher price level => higher nominal wage
b. Increase in nominal wage => increase in price level.

AS Curve:


Properties:
1. AS curve is upward sloping (increase in output => increase in price level)
2. AS curve goes through point A, where Y = Y(N); P = P^e
3. Increase in the expected price level, P^e, shifts the AS curve up (vice versa)

8.2 Aggregate Demand (AD)

Aggregate Demand Relation: captures the effect of the price level on output and is
derived from the equilibrium conditions in the goods and financial markets.

Goods market: IS: Y = C(Y-T) + I(Y,i) + G
IS: Output = Demand for goods.
Financial market: LM: M/P = Y L(i)
LM: Supply of money = demand for money


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Situation:
- IS LM relation is drawn. Equilibrium
of financial (LM) and goods (IS) market at
point A.
- Increase in price => decreases the
real money stock (M/P) => increase in interest
rate
A => A; i => i; Y => Y
Increase in price Level => decrease in
output









Any other variable than the price level
that shifts the IS or LM curve also shifts the AD relation.

AD Relation: Y = Y(M/P, G, T)
(+ , + , -)

An increase in price level, P, => decrease in real money stock, M/P => decrease in
output

8.3 Equilibrium in the Short Run and in the Medium Run

AS Relation: P = P^e (1 + ) F|1 (Y/L),z|
AD Relation: Y = Y(M/P, G, T)

Equilibrium in the Short Run
- AS curve, drawn for given value
of P^e => upward sloping
o The higher the level of
output, the higher the
price
- AD Curve, drawn for given
values of M, G and T =>
downward sloping
o The higher the price level,
the lower the output



Equilibrium:
a. Labor market (AS curve) in
equilibrium comes from
intersection of the curves
b. Goods and financial markets (AS curve) in equilibrium come from
intersection of the curves.

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From the short run to the medium run



Situation:
- Output is higher than the natural output.
- Price level is higher in the short run than expected.
o Price setters revise upwards their expectation. P^e => P^e
next period the AS curve will shift upwards from AS to AS

Y > Y(n) => P > P^e => increase P^e => increase W => increase P =>
decrease M/P => increase u => decrease Y

Moves up until Y(n) is reached again.

In the medium run: Output = natural level of output

8.4 The Effects of a Monetary Expansion
The dynamics of Adjustment
AD: Y = Y(M/P, G, T)

Expansionary monetary policy: increase in the level of nominal money.

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Situation:
- Short Run: Increase in nominal money, M => increase real money, M/P =>
shift of the AD curve to the right => increase in Output
increase M => Increase M/P => increase Y
- Medium run: price expectation => Shift up of the AS curve => natural level
of output.

If M/P is unchanged, it MUST be that M and P has changed in the same proportion!!!

The Neutrality of money
Summary of monetary policy:
1. Short run: monetary expansion => increase in output => decrease in interest
rate => increase in price level.
2. Medium run: Increase in nominal money => increase in price level,
BUT DOESNT AFFECT THE OUTPUT!!!
Monetary policy cannot sustain higher output forever.

7.5 Decrease in the Budget Deficit
Government decides to reduce its budget deficit by decreasing government spending
from G to G, while taxes are unchanged.


Situation:
- Short run: G => G=> shift of the AD Curve to the left =>output is lower
- Medium run: Y = Y(n)

Budget Deficits, Output, and Investment
Summary of fiscal policy:
1. Short run: budget reduction => decrease in output => decrease in
investment
2. Medium Run: Output returns to natural level of output AND INTEREST
RATE IS LOWER!


Short Run Medium Run
Output Interest rate Price level Output Interest rate Price level
Monetary Increase Decrease Increases No change No change Increases
Expansion (Small)
Deficit Decrease Decrease Decreases No change Decreases Decreases
Reduction (Small)
Increase in Decrease Increase Increases Decreases Increase Increases
Oil price
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CHAPTER 9 The natural Rate of Unemployment and the
Phillips Curve

9.1 Inflation, Expected Inflation, and unemployment
Wage setting relation: W = P^eF(u,z)
AS: P = P^e (1 + ) F(u,z)

F(u,z) = e^-ou + z
This captures the notion that the higher unemployment rate, the lower the wage, and
the higher z. o captures the strength of the effect of unemployment on the wage.

P = P^e (1 + ) e^-ou + z (9.1)
t = t^e + ( + z) - ou (9.2)
(t = inflation; t^e = expected inflation)

Inflation: given last years price level, a higher price level this period implies a higher
rate of increase in the price level from last period to this period.

IMPORTANT EFFECTS:
a. An increase in expected inflation, t^e => increase in actual inflation, t.
- 9.1: increase in expected price level => increase in actual price level
o increase in expected inflation => increase in inflation
b. Given expected inflation, t^e, an increase in the markup or an increase
in the factors that affect wage determination an increase in z - =>
increase in inflation, t.
- 9.1: given expected P^e, increase in markup or z => increase in P
- 9.2: given expected t^e, increase in markup or z => increase in t
c. Given expected inflation, t^e, increase in unemployment rate =>
decrease in inflation, t.
- 9.1: given expected P^e, increase in unemployment rate => lower nominal
wage => lower price level.
o Given expected inflation, t^e, increase in unemployment rate =>
decrease in inflation, t.

Use time indexes: t(t) = t(t)^e + ( + z) - ou(t) (9.3)

8.2 The Phillips curve
Assumption: t(t)^e = 0

t(t) = ( + z) - ou(t)

Phillips Curve: Negative relation between unemployment and inflation

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Given P^e, lower unemployment => higher nominal wages =>higher price level.

Wage price spiral:
- Low unemployment rate => higher nominal wages
- higher nominal wages => higher prices => price level increases
- higher price level => workers ask for higher nominal wages
- higher nominal wages => increase in price => price level increases
- higher price level => workers ask for higher nominal wages

Mutations:
1970: negative relation between unemployment and inflation broke down.
original Phillips Curve: t(t)^e = ut(t-1)
(u= captures the effect of last years inflation rate, t(t-1), on this years expected
inflation rate, t(t)^e)
New Phillips Curve: t(t) = ut(t-1) + ( + z) - ou(t)

The higher the value of u, the more last years inflation leads to workers and firms to
revise their expectations of what inflation will be this year.

- When u = 0: Original Phillips Curve: t(t) = ( + z) - ou(t)
- When u > 0: inflation rate depends on unemployment rate and last years
inflation: t(t) = ut + (t-1) ( + z) - ou(t)
- When u = 1: relation becomes: t(t) - t(t-1) = ( + z) - ou(t)
When u = 1; u affects not only inflation rate, but the change in inflation:
High unemployment => decreasing inflation
Low unemployment => increasing inflation

Back to the natural rate of unemployment
Natural rate of unemployment: unemployment rate is such that the actual price
level = expected price level.
Natural rate of unemployment: unemployment rate such that the actual inflation
rate = to the expected inflation rate.

Natural Rate of unemployment: ou(n) = + z
the higher the markup or the other factors that affect wage setting, z, the
higher the natural rate of unemployment

t(t) - t(t-1) = -o |u(t) u(n)|
IMPORTANT:
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- Change in inflation depends on the difference between actual and the natural
rate of unemployment.
- The natural rate of unemployment is the rate of unemployment required to
keep the inflation constant.

9.3 The Phillips Curve and the Natural Rate of Unemployment in Europe

What explains European Unemployment?
- Generous system of unemployment insurance
- High degree of employment protection
- Minimum wages
- Bargaining rules

High Inflation and the Phillips Curve
Wage indexation: provision that automatically increases wages in line with inflation

CHAPTER 10 Inflation, Activity, And Nominal Money Growth

9.1 Output, Unemployment and Inflation
Three relations between output, unemployment and inflation:
1. Okuns law: Output growth affects unemployment
2. Phillips curve: Unemployment affects inflation
3. Aggregate demand relation: inflation and money growth affect output
growth

Okuns Law
Assumptions:
- if output and employment move together, a 1% increase in output => 1%
increase in employment rate
- If movements in employment rate reflect movements in unemployment.

u(t) u(t-1) = -g(yt) (10.1)
(U(t): unemployment rate in year t; u(t-1): unemployment rate in year t-1; g(yt): rate of
output from year t-1 to year t.)

Change in unemployment rate = negative growth rate of output.

Okuns law:


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Okuns law: u(t) u(t-1) = -0.4(G(yt) 3%) (10.2)

Differences:
9.1 and 9.2 gives negative relation between change in unemployment and output
growth but with differences:
- Annual output growth has to be at least 3% to prevent unemployment
rate from rising.
o To maintain a constant unemployment rate, output growth must be
equal to the sum of labor force growth and labor productivity growth.
o Natural output growth: rate of output growth needed to maintain a
constant level of unemployment.
- The coefficient on the right side of equation (10.2) is -0.4 compared to -
1.0 in equation (19.1)
o Firms adjust employment less than one for one in response to
deviations of output.
o An increase in the employment rate does not lead to a one for one
decrease in the unemployment rate.

Okuns Law: u(t) u(t-1) = -|(G(yt) G(y)) (9.3)

(|: effect of output growth above normal on the change in the unemployment rate;
G(y): normal growth rate of an economy)

Output growth above normal leads to a decrease of unemployment rate
Output growth below normal leads to an increase of unemployment rate.

G(yt) > G(y) => u(t) < u(t-1) & G(yt) < G(y) => u(t) > u(t-1)

The Phillips Curve
t(t) - t(t-1) = -o |u(t) u(n)|

u(t) < u(n) => t(t) > t(t-1) & u(t) > u(n) => t(t) < t(t-1)

Aggregate demand relation

Y = Y|M(t)/P(t), G(t), T(t)|

Focus only on real money stock, M/P, and output, Y.
Y(t) = |(M(t)/P(t)|
( = positive parameter)
Equation shows that the demand for goods and thus output, is simply
proportional to the real money stock.
Relation between price level, Growth rates of output and money.

Mechanism of IS /LM model.
- Increase in real money stock => decrease in the interest rate
- Decrease in interest rate => increase in the demand for goods => increase
in output.

Relation between growth rates of output, money and price level:
G(yt) = G(mt) - t(t)
(G(yt): growth rate of output; t(t): growth rate of the price level => inflation; G(mt)
growth rate of nominal money)
23

G(mt) > t(t) => G(yt) > 0 & G(mt) < t(t) => G(yt) < 0

Summary:
Phillips curve: negative relation between unemployment rate & inflation
t(t) - t(t-1) = -o |u(t) u(n)|
- u(t) < u(n) => t(t) > t(t-1)
- u(t) > u(n) => t(t) < t(t-1)
Okuns law: negative relation between output growth & unemployment
u(t) u(t-1) = -|(G(yt) G(y))
- G(yt) > G(y) => u(t) < u(t-1)
- G(yt) < G(y) => u(t) > u(t-1)
AD Relation: Relation between growth rates of output, money and price
level.
G(yt) = G(mt) - t(t)
- G(mt) > t(t) => G(yt) > 0
- G(mt) < t(t) => G(yt) < 0

10.2 The effects of money growth
What do the three equations imply for the effects of nominal money growth on output,
unemployment rate and inflation?

Medium run
- In the medium run: unemployment rate must be constant:
o u(t) = u(t-1)
Okuns law: G(yt) = G(y)
In the medium run: output must grow at its normal rate of
growth
- nominal money growth = G(m) & output growth equal to G(y)
o In the medium run: G(y) = G(m) - t => t = G(y) G(m)
Inflation = nominal money growth nominal output
Inflation = adjusted nominal money growth
In the medium run: inflation equals adjusted nominal
money growth
- medium rung: inflation constant => inflation this year = inflation last year
o Phillips curve: u(t) = u(n)
In the medium run: unemployment rate must be equal to
the natural rate of unemployment.

Short run:
Assumption: Economy is in the medium run equilibrium:
- unemployment = natural rate
- Output growth = normal output growth
- Inflation rate = adjusted nominal money growth.

Central Bank: Decrease nominal money growth
- Aggregate demand function: lower money growth => lower real money
growth => decrease in output.
- Okuns law: Output growth below normal => increase in unemployment
- Phillips curve: increase in unemployment => decrease inflation

10.3 Disinflation
t(t) - t(t-1) = -o |u(t) u(n)|
Disinflation: decrease in inflation
24
- Can only be obtained by cost of higher unemployment.
o left side of equation to be negative,
o (u(t) u(n)) must be positive.
Unemployment level > natural level.

Point of excess unemployment: difference between actual and natural
unemployment rates of 1% point of one year.

Sacrifice Ratio: number of point years of excess unemployment needed to achieve
a decrease in inflation by 1%
Point-years of excess unemployment / decrease in inflation

Nominal rigidities and contracts
Nominal rigidities: in modern economies, many wages and prices are set in
nominal terms for some time and are not readjusted where there is a change in
policy.

Disinflation: period of high unemployment
Faster disinflation: smaller sacrifice ratio
Sacrifice ratios are smaller in countries with shorter wage contracts.

CHAPTER 11 The facts of growth

11.1 Measuring the standard of living
The reason we care about growth is that we care about the standard of living.
output per person

a. What matters for peoples welfare is their consumption rather than their
income.
i. Consumption per person
b. differences in productivity
i. Output per worker

11.4 Thinking about growth: A primer
The aggregate production function:
Y = F (K,N)
(Y = aggregate output; K = capital; N = Labor)

State of technology: How much output can be produced for given quantities of
capital and labor?

Returns to scale:
- Constant returns to scale: if the scale of operation is double, the output will
also double.
o 2Y = F(2K,2N)
- Decreasing returns to capital: increase in capital lead to smaller and
smaller increase in output.
- Decreasing returns to labor: increase in labor lead to smaller and smaller
increase in output.

Output per worker and capital per worker
Y/N = F(K/N; 1)
Output per worker depends on capital per worker

25


Sources of growth
- Increase in output per worker (Y/N) can come from increase in capital per
worker (K/N)
- Increase in output per worker can also come from improvements in the state
of technology that shift the production function, F, and lead to more output
per worker given capital per worker.
Growth comes from capital accumulation and from technological progress.

CHAPTER 12 Saving, Capital Accumulation and Output

12.1 Interactions between Output and Capital
- Amount of capital determines the amount of output being produced
- Amount of output determines the amount of saving and investment, and so
the amount of capital being accumulated

The Effects of Capital and Output
Aggregate production function with constant returns to scale:
Y/N = F(K/N; 1)

Y/N = f(K/N)

Assumptions:
1. Size of population, the participation rate, and the unemployment rate are all
constant => Employment is also constant.
2. There is no technological progress =>production function does not change
over time.

Y(t)/N = f|K(t)/N|
higher capital => higher output

The Effects of Output on Capital Accumulation
To derive second relation between output and capital accumulation, we use two
steps:
- Step 1: Output and Investment
o Assumptions:
a. economy is closed => I = S + (T-G)
26
b. We ignore taxes and government spending => I = S
c. private saving is proportionally to income => S = sY

=> I(t) = sY(t)
Investment is proportional to output: the higher the output => the higher
the saving rate => the higher the investment.

- Step 2: Investment and Capital Accumulation
=> K(t+1) = (1 - o) K(t) I(t)

Combination of the output and investment & investment & capital
accumulation
relation from output to capital accumulation



In words: Change in capital per worker = saving per worker minus depreciation.

12.2 The Implications of Alternative saving rates
Dynamics of capital and output
1. Y(t)/N = f|K(t)/N|
2.

K(t+1)/N K(t) / N = sf(K(t)/N) - o x (K(t) / N)

Change in capital from year t Investment - Depreciation
to year t + 1 during year t during year t

Description:
- Investment per worker (first term on the right). Level of capital per worker
this year determines output per worker this year
=> K(t)/N => f(K(t)/N => sf(K(t)/n)
- Depreciation per worker (second term on the right). Capital stock determines
the amount of depreciation per worker this year.
=> K(t)/N => o(K(t)/N)

Conclusion:
- If investment per worker > depreciation per worker => change in capital per
worker > 0 =>capital per worker increases
- If investment per worker < depreciation per worker => change in capital per
worker < 0 => capital per worker decreases.

K
N
K
N
s
Y
N
K
N
t t t t +
=
1
o
K
N
K
N
s
Y
N
K
N
t t t t +
=
1
o
27


Steady State Capital and Output
Long run
Steady state: State in which output per worker and capital per worker are no longer
changing

Sf(K*/N) = o (K*/N)

In words: Steady state value of capital per worker: amount of saving per worker (left)
= depreciation of capital per worker (right)

Y*/N = f(K*/N)

The saving rate and Output
What are the effects of the saving rate on the growth rate of output per worker?
1. Saving rate has no effect on the long run growth rate of output per worker,
which is equal to 0.
2. The saving rate determines the level of output per worker in the long run
a. Countries with higher saving rate, will achieve higher output per
worker in the long run. (Graph1)
3. An increase in the saving rate => higher growth of output per worker for some
time, but not forever. (Graph 2)


Graph 1:












28
Graph 2:













The Saving Rate and Consumption
- Increase in saving comes from equal decrease in Consumption.
- Long run: Consumption may also decrease from increase in saving.
- Increase in saving rate always => increase in the level output per worker.
BUT OUTPUT PER WORKER IS NOT CONSUMPTION!!!

Extreme values of saving rate:
- Saving rate = 0 => consumption = 0 in the long run
- Saving rate = 1 => people save all the money => consumption is 0

Golden Rule level of capital: Level of capital associated with the value of the
saving rate that yields the highest level of consumption.



The Saving rate and the golden Rule
In steady state, consumption per worker = output per worker minus depreciation per
worker
C/N =Y/N - o(K/N)

Golden Rule level of capital: is associated with a saving rate of 50%

12.4 Physical versus Human Capital
Physical Capital: Machines, Plants etc.
Human capital: skills of workers.

Extending the Production function
Y/N = f(K/N, H/N)
29
(+ , + )

- Increase in capital per worker => increase in output per worker
- Increase in average level of skills => increase in output per worker

Human Capital, Physical Capital and Output
How does the introduction of human capital change the analysis of the previous
section?
- Physical capital:
o An Increase in the saving rate => increases steady state physical
capital per worker =>output per worker
- Human capital:
o Increase in how much society saves in form of human capital =>
increases steady state human capital per worker => increase in
output.

Endogenous Growth
Models of endogenous growth: Models that generate steady growth even without
technological progress.

CHAPTER 13 Technological Progress and Growth

13.1 Technological Progress and the Rate of Growth
What will the rate of output be in an economy in which there is both capital
accumulation and technological progress?

Technological Progress and the Production function
Dimensions:
- Larger quantities of output for given quantities of capital and labor
- Better products
- New products
- Larger variety of products

State of technology: How much output can be produced from given amounts of
capital and labor at any time.

Production function: F = (K, AN)
( + , + )
(K = Capital; A = technological progress, N = labor)

- Technological progress reduces the number of worker needed to achieve a
given amount of output
- Technological progress increases AN (amount of effective labor in economy)

Interactions between Output and Capital

30


1. Output per effective worker increases with capital per effective worker but at a
decreasing rate.
2. Investment = Private saving I = sY
a. Investment per effective worker:
I/AN = sf(K/AN)
3. What level of investment per effective worker is needed to maintain a given
level of capital per effective worker?
a. An increases over time => to keep ratio K/AN constant => K has
to increase at the same rate.
i. o = depreciation rate
ii. g(A) rate of technological progress
iii. g(N) rate of population growth
1. Ratio of employment to population stays constant
=> AN = g(A) + g(N)

I = |o + g(A) + g(N)| x K

An amount of oK is needed just to keep the capital stock constant. An
additional amount (g(A) + g(N)) x K is needed to ensure that the capital stock
increases at the same rate as effective labor.

To obtain the amount of investment per unit of effective worker needed to keep a
constant level of capital per unit of effective worker.

In words: The change in the stock of capital per unit of effective worker given by
the difference between the two terms on the left is equal to saving per unit of
effective worker given by the first term on the right minus the depreciation per
unit of effective worker given by the second term on the right.

Steady state (capital per effective worker doesnt change) value of capital per
unit of effective worker:

In words: the Steady state value of capital per unit of effective labor is such that the
amount of saving (left) is exactly enough to cover the depreciation of the existing
capital stock (right).

See figure: (Red Line with slope og(A) + g(N))
31




Dynamics of Capital and Output
Medium run: Actual investment > investment level required to maintain the existing
level of capital per effective worker K/AN

Long run: Steady state of the economy is such that capital per effective worker and
output per effective worker are constant and equal to (K/AN)* and (Y/AN)*

Conclusion:
In steady state, the growth rate of output equals the rate of population growth (G(N))
plus the rate of technological progress (g(A). By implication, the growth rate of output
is independent of the saving rate.

LOGIC: Effective labor grows at rate g(A) + g(N).
Decreasing relation between Output and Capital
Economy cannot permanently grow faster than g(A) + g(N)

Output grows at rate (g(A) + g(N))
- Number of workers grows at rate g(N)
- Output per worker grows at rate g(A)
In the steady state, output per worker grows at the rate of technological
progress.

Balanced growth = steady state of the economy
o in steady state, output and the two inputs, capital and effective labor, grow in
balance at the same rate.

On the balanced growth path:
1. Capital per effective worker and output per effective worker are constant.
(13.2)
2. Capital per worker and output per worker are growing at the rate of
technological progress, g(A)
3. Labor is growing at the rate of population growth, g(N); capital and output are
growing at a rate equal to the sum of population growth and the rate of
technological progress g(A) + g(N)
32
The Effects of the saving rate

Changes in the saving rate do not affect the steady-state growth rate, but changes in
the saving rate do increase the steady-state level of output per effective worker.



Increase in saving rate => shift of investment relation up => K/AN(0) => K/AN(1) &
Y/AN(0) => Y/AN(1)




Output against time:
1. Economy is on balanced growth path AA: Output is growing at rate g(A) +
g(N) slope of AA is equal to g(A) + g(N).
2. Saving rate increases in at time t =>output grows faster for some period of
time.
3. Output ends up at higher level but with same growth rate g(A) + g(N).
4. New steady state: economy grows at same rate, but on higher growth path,
BB with slope g(A) + g(N)


33
13.2 The Determinants of Technological Progress

What determines the rate of technological progress?
Technological progress in modern economies is the result of research and
development (R&D) activities.

Level of R&D spending depends on:
1. Fertility (Fruchtbarkeit) of the research process: How spending on R&D
translates into new ideas and new products.
2. Appropriability (Anwendbarkeit) of research results: The extent to which
firms benefit from the results of their own R&D.

The Fertility of the Research Process

The fertility of research depends: on the successful interaction between basic
research and applied research and development.

Basic research: search for general principles and results.

Applied research and development: the application of the results to specific uses
and the development of new products.

The Appropriability of Research Results

Patent: right to exclude anyone else from the production or use of the new product
for some time.

13.3 The Facts of Growth Revisited

Capital Accumulation versus Technological Progress in Rich Countries

High growth rate of output per worker over some period of time can come
from:
- High rate of technological progress under balanced growth
- Adjustment of capital per effective worker, K/AN, to a higher level.

If high growth rate reflects high balanced growth: Output per worker
should be growing at a rate equal to the rate of technological progress.
If high growth rate reflects instead the adjustment to a higher level of
capital per effective worker: this adjustment should be reflected in a growth
rate of output per worker that exceeds the rate of technological progress.

Technological frontier: Advanced countries, which need to develop new ideas, new
progresses and new products.

Technological catch-up: Countries, which has to catch up to the developed
countries by imitating the ideas.