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You are on page 1of 84

Fall 2016

Last Updated: August 31

Professor Virgiliu Midrigan

Contents

1 Growth Facts (Chapter 3 in Jones)

1.1

1.2

1.2.1

1.2.2

Natural logarithm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.2.3

11

2.1

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

11

2.2

Model of Production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

12

2.2.1

Production Function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

13

Development Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

18

2.3.1

21

2.3

Productivity Differences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

23

3.1

23

3.2

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

25

3.3

Changes in population . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

28

3.4

Productivity growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

29

3.5

The AK model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

30

4.1

32

32

4.1.1

Comparative Statics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

33

4.2

33

4.3

Growth Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

34

5.1

36

36

5.1.1

Households Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

36

5.1.2

Firms Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

37

5.2

37

5.3

38

40

6.1

40

6.2

41

6.3

41

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

45

7.1

Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

45

7.2

46

7.3

Efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

47

7.4

Sources of At fluctuations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

48

7.5

49

8 Business Cycle Analysis: Keynesian view (Chapters 11 (skim) and 12-13 in Jones)

49

8.1

. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

50

8.2

52

8.3

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

52

8.4

54

8.5

54

8.6

55

8.7

Experiments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

56

8.8

56

8.8.1

56

8.8.2

Steady State . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

57

8.8.3

57

8.8.4

Disinflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

57

8.8.5

Persistent AD shock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

58

59

9.1

59

9.2

61

9.3

62

9.4

62

9.5

65

9.6

67

10 Consumption, Savings and Ricardian Equivalence (Chapters 16 and 18 in Jones, 3rd ed.)

71

71

73

73

74

74

76

77

79

. . . . . . . . . . . . . . . . . . . . . . . . .

80

11.1 Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

80

82

83

These notes describe some mathematical tools that are useful in thinking about economic growth.

1.1

gt =

yt yt1

yt1

(1)

The growth rate is just the percentage change in a given variable. Given this definition, we have

yt = (1 + gt )yt1

(2)

Example 1. Suppose that a countrys GDP is equal to 200,000 in 2005 and 220,000 in 2006. Find the GDP

growth rate. Using the formula in (1) we have

g2006 =

y2006 y2005

220, 000 200, 000

=

= 0.10

y2005

200, 000

Example 2. Suppose that a countrys GDP is equal to $200,000 in 2006. From 2006 to 2007 it grows by 7%.

What was GDP equal to in 2007?

Using the formula in (2), GDP in 2007 is equal to

y2007 = (1 + g2007 ) y2006 = (1 + 0.07) 200, 000 = 214, 000

yt

ytk

so that the ratio of GDP in years t and t k is just the product of the rates of growth in each of these years. If

the growth rates are constant, gt = g, we have

yt

ytk

= (1 + g)k

(3)

Set k = t and rearrange to get what your book calls the constant growth rule:

yt = y0 (1 + g)t

(4)

Example 3. Suppose you invest $100 in a bank at a constant interest rate of 2% per year. How much money

do you have after 5, 20, 50 years?

after 5 years :

after 20 years :

after 50 years :

You should also practice with using this rule backwards. Given information on yt and y0 , you should be able

to calculate the growth rate in this time period using:

g=

yt

y0

1

t

(5)

Example 4. Suppose that the price level (CPI) was equal to 1000 in 1990 and grew to 2000 in the next ten

years. Assume the annual rate of inflation was constant in all these years, what was the rate of inflation equal to?

Answer: Inflation, , is equal to the growth rate of the price level: 1 + t =

1.2

2000

1000

1

10

Pt

Pt1 .

So

1 = 0.0718

Some of the formulas involving growth rates may be quite involved. The exponential and logarithmic functions

provide an alternative and extremely convenient way to compute growth rates.

The exponential function is

exp (x) = ex

where e = 2.718281828...

This is an important function that we will use frequently in this course. It has the property that its derivative

is equal to the function itself:

dex

x

= ex = lim 1 +

n

dx

n

n

The first example where you encounter exponentials in finance and economics courses is that of continuous

compounding. Consider an asset that pays an interest rate of r (e.g. 0.05) per year. If you invest $1000 in such

an asset and interest is compounded annually, you have

$1000(1 + r) = $1050

at the end of the year. If interest is compounded semiannually, and you receive

r

2

receive

r

r

r 2

$1000 1 +

1+

= 1+

= (1 + 0.025)2 = 1050.60

2

2

2

at the end of the year. Notice that this is a better deal than the former since in the second half of the year the

investor earns interest both on its principal ($1000), as well as on the interest payment ($25) that it receives after

half a year. Similarly, if interest is compounded daily and you receive

$1000 1 +

x

365

365

= 1+

0.05

365

r

365

365

= 1051.26

at the end of the year which is an even better deal. Finally, suppose that interest is compounded continuously.

(n times where n goes to infinity, i.e., every nanosecond). The exponential function gives the answer:

$1000 exp (0.05) = 1051.27

The example above tells you a very useful property of exponential functions. When the argument x is sufficiently close to 0, we have

exp (x) 1 + x

In the above example, since the interest rate is quite low, 0.05, whether interest is compounded annually or

continuously doesnt make much difference ($1050 v. $1051.27) for how much you receive at the end of the year.

When interest rates are high, however, say 50%, the difference can be substantial ($1500 vs. $1649).

1.2.1

ex+y = ex ey

ex

exy =

ey

xy

e

= (ex )y

x

ey

= (ex ) y

e0 = 1

d x

e = ex

dx

d bx

ae

= abebx

dx

6

1.2.2

Natural logarithm

ln (ex ) = x

The following are some properties of logarithms

ln (xy) = ln x + ln y

ln (x/y) = ln x ln y

ln (x ) = ln x

ln (1) = 0

The most useful property of logarithms that we will use in this course is that they transform products into sums

and ratios into differences. The other important property is that

ln (1 + x) x

for small x. To see why this is useful, consider the log of the ratio of a variable in one period to another:

ln

yt

yt1

= ln yt ln yt1

ln

yt

yt1

= ln 1 +

yt yt1

yt1

yt yt1

yt1

The difference in the logarithm of a variable from one year to another is therefore approximately equal to its

growth rate.

Example 5.

Suppose that GDP was equal to 2000 in 2005 and 2300 in 2006. Calculate the growth rate

yt yt1

2300 2000

=

= 0.15

yt1

2000

ln yt ln yt1 = 0.14

The graph below shows the growth rate of U.S. real GDP (the nominal value of GDP divided by the price

level in each year). The left panel plots the series in levels, while the right panel plots the series in logs.

7

US Real GDP (1929 = 1): Levels

14

12

2.5

10

1.5

0.5

0

1920

1940

1960

1980

2000

0.5

1920

2020

1940

1960

1980

2000

2020

Notice that the left panel makes the Great Depression in the 30s look much milder than the last recession of

2007. This is surprising since GDP fell by 30% in the former and less then 5% in the latter. The reason the left

panel is misleading is because the $ drop in GDP (yt yt1 ) was indeed smaller in the 30s, but that drop was

very large compared to the level of GDP (yt1 ). The right panel of the Figure plots everything in logarithms and

by doing so implicitly divides changes by the level of GDP. For this reason the Great Depression indeed looks a a

lot larger.

We will only plot logarithms of variables in this course so that the series are more easily interpretable. Figure

1 shows two additional striking features of the data. First, the growth rate of real GDP is roughly constant over

long-horizons, with perhaps slightly faster growth until the 1970s than thereafter. To calculate the (average)

annual growth rates using the Figure, notice that the logarithm of GDP was equal to 0 in 1929, 1.47 in 1970 and

2.61 in 2011. The average growth rate from 1929 to 1970 was therefore equal to

g19291970 = (1.47 0)/42 = 0.035 = 3.5%

and

1.2.3

Suppose we have some variables xt , yt , zt that grow at rates gx , gy , gz respectively. We would like to say something

about the rate at which various functions of these variables grow.

For example, in the GDP numbers we computed above we calculated the growth rate of real GDP. But we

may be interest in computing the growth rate of real GDP per person, which is clearly lower than the growth rate

of GDP because of population growth.

That is, we may be interested in calculating the growth rates of the following functions of x, y, and z:

xt yt

zt

xt yt

xt

zt

Directly computing growth rates using the definition of growth rates is hard. The approximations are however

straightforward:

x t yt

xt1 yt1

ln

= ln xt + ln yt ln zt ln xt1 ln yt1 + ln zt1 =

zt

zt1

(ln xt ln xt1 ) + (ln yt ln yt1 ) (ln zt ln zt1 ) = gx + gy gz

ln

Similarly,

ln xt yt ln xt1 yt1

= ln xt + ln yt ln xt1 ln yt1 = gx gy

In a similar fashion we can show that the approximate growth rate of the last expression,

equal to

gx zt

To wrap up, we have that

xt

,

zt

is approximately

the growth rate of a product is equal to the sum of the growth rates

g (x y) = g (x) + g (y)

the growth rate of a ratio is equal to the difference in growth rates

g (x/y) = g (x) g (y)

the growth rate of a variable raised to a power is the power times the variables growth rate

g (x ) = g (x)

Example 7. Returning to our original GDP example, suppose that the growth rate of the U.S. population

was 1.5% in the previous century. Then the growth rate of U.S. real GDP per capita was equal to 2% (3.5 - 1.5)

until the 70s and 1.3% (2.8 - 1.5) in the second half of the period.

Example 8. Suppose that nominal GDP grows at 5% per year, while the price level grows at 2%. What is

the growth rate of real GDP? Since

RGDP =

N GDP

P

we have that

g (RGDP ) = g (N GDP ) g (P ) = 5% 2% = 3%

1

yt = (kt ) 3 (lt ) 3

where yt is output, kt is capital and lt is labor. Suppose capital grows at 6% per year and labor grows at 9% per

year. How fast does output grow? To calculate this, note that:

1

2

g (yt ) = g (kt ) + g (lt ) = 2% + 6% = 8%

3

3

10

2.1

Introduction

There is a great deal of disparity in the standards of living across various countries in the world. For example,

the richest 5 countries are 25 times richer than the poorest 5 countries. The obvious question is: what do rich

countries have that poor dont?

This chapter starts by exploring one possible answer to this question: Poor countries are poor simply because

they lack the capital (machines, equipment, structures) that rich countries possess. Our goal is to evaluate the

validity of this answer. That is, we ask: what fraction of the 25-fold income gap between rich and poor countries

is due to differences in capital? How much richer would poor countries be if they had the stock of capital of the

U.S.? Should poor countries governments implement policies that stimulate investment?

We will try to answer this question using data and a model, since it turns out that simply staring at the data

doesnt help much. To see why, consider the following table which shows the amount of capital per person and

GDP per person for a number of countries. All numbers are expressed in 2000 US $.

Country

US

Canada

France

Hong Kong

S. Korea

Argentina

Mexico

Indonesia

Kenya

Ethiopia

79,900

76,000

73,300

69,100

48,500

25,200

18,700

6,500

1,400

300

33,300

26,900

22,400

26,700

15,900

11,000

8,800

3,600

1,200

630

Figure 2 shows this information graphically: each point on the graph represents a (k,y) combination for a

given country.

Poor countries indeed have less capital, but the table does not really provide an answer to the question: how

much richer would Ethiopia be if it had the U.S. capital stock. The reason is that a statistical relationships (a

correlation) does not necessarily indicate causality. Poor countries may be poor because they lack the institutions,

11

100,000

10,000

1,000

100

100

1,000

10,000

capital per person, k

100,000

rule of law, climate, level of human capital ... necessary to allow production at an efficient scale. So perhaps there

is a third factor that leads to a low level of output as well as a low level of capital. If this is indeed the case,

simply adding more capital would not cure poor countries fundamental problems and thus raise output.

2.2

Model of Production

We introduce the concept of a production function, study a model of a production economy and then use the

model to answer some questions about the gap between rich and poor countries in the data.

12

2.2.1

Production Function

A production function gives a relationship between the amount of inputs (capital, K, and labor, L) used in an

economy and the amount of output (GDP, Y ) the economy produces.

We will require that the production functions we work with have 4 properties:

1. The function should be increasing in its arguments: increasing K or L leads to an increase in Y . This

requirement is very intuitive.

2. Constant returns to scale: simultaneously doubling (or tripling or halving) the amount of K and L used in

production should lead to a doubling (or tripling or halving) of output. This requirement is intuitive as well:

doubling the number of factories in the economy should allow it to produce twice more output.

Alternatively, if doubling all inputs leads to a less than doubling of output, we say that the production

function exhibits decreasing returns to scale. If doubling all inputs leads to a more than doubling of output,

we say that the production function exhibits increasing returns to scale.

Formally: a production function Y = F (K, L) exhibits constant, decreasing, increasing returns to scale if:

constant returns :

decreasing returns :

increasing returns :

Example 1. Do the following production functions exhibit constant, decreasing, or increasing returns to

scale?

a) F (K, L) = 13 K + 12 L

1

b) F (K, L) = K 3 L 3

1

c) F (K, L) = K 2 L

d) F (K, L) = K 2 + L 2

2

Notice that having constant returns to scale does not imply that doubling one factor (say capital) in isolation

would double output. The latter would not make much sense. Although a university would be able to double

the number of students it accepts each year if it would double the number of classrooms and teachers it

hires, simply doubling the number of teachers (without increasing the number of classrooms) or doubling the

13

number of classrooms (without increasing the number of teachers) would not allow it to teach twice more

students.

3. Diminishing marginal products (of capital and labor).

To understand this property we need to calculate a factors marginal product. Formally, the marginal

product is just the partial derivative of the production function: the increase in output resulting from an

(infinetisimal) increase in capital (labor). To see what this means, consider increasing the capital stock by

K units, from K to K 0 = K + K. How much would output increase? When K is very small, K 0,

we have that the change in output is

Y = Y 0 Y = F (K + K, L) F (K, L)

F

K

K

(6)

The answer to the question of how output increases in response to (small) changes in capital and labor is

therefore given by the partial derivatives of F with respect to K and L. We refer to these derivatives as the

marginal product:

MPK =

Y

K

MPL =

Y

K

A production function is said to exhibit a diminishing marginal product of capital or labor if, as the amount

of capital (labor) increases, the marginal product of capital (labor) decreases. Diminishing marginal product

implies that

K = MPK

L = MPL

Example 2. Which of the following production functions exhibit diminishing, constant, increasing marginal

product of capital?

1

a) F (K) = K 2

b) F (K) = log(K)

c) F (K) = K 2

d) F (K) = K

14

4. Constant factor shares. This property is the most difficult to understand. Let r be the rental rate of capital

and w be the wage rate. Then the share of an economys income that is paid to labor is equal to wL/Y

and the share of income that is paid to capital owners is rK/Y . An important feature of the data is that

the share of income paid to labor, in short the labor share, is approximately constant over time and equal

to 2/3. Moreover, since profits are essentially equal to 0 in the data, the capital share is also approximately

constant over time and equal to 1/3. We will thus work with a production function that implies a constant

labor share.

It turns out that the only function that simultaneously satisfies all four of the above properties is:

Y = F (K, L) = AK L1

(7)

where Y is output, K is the stock of capital, L is the amount of labor used (number of workers), and A for now is a

parameter which we will refer to as total factor productivity. The reason we refer to A as productivity (efficiency)

is that doubling A (holding K and L constant) would double Y , so A measures the efficiency with which capital

and labor are utilized. Finally, (0, 1) is a parameter.

We will use this function throughout this course (and even if you go on to pursue a PhD career in economics,

you will likely use this function 99.9% of the time). We refer to it as the Cobb-Douglas production function.

Let us next verify the 4 properties.

1. Clearly, Y is increasing in both of its arguments since > 0 and 1 > 0.

2. Imagine doubling all inputs: K 0 = 2K and L0 = 2L. Then we have constant returns to scale since output

will double:

Y 0 = AK 0 L01 = A(2K) (2L)1 = 2AK L1 = 2Y

(8)

3. Diminishing Product.

Calculating the relevant derivatives gives

MPK = AK 1 L1

MPL = (1 ) AK L

Clearly M P K is a decreasing function of K, while MPL is a decreasing function of L : adding more capital

increases output but less and less so as K decreases. See the example in Figure 3 in which I plot F (K, L) =

K L1 in the K space while holding L constant: the marginal product is simply the slope of the tangent

15

to the function at a particular point. Notice that the slope becomes flatter and flatter as K increases so this

particular production function has diminishing marginal product of capital.

Figure 3: Diminishing marginal product of capital

10

9

8

Low M P K

6

5

4

3

High M P K

2

1

0

100

200

300

400

500

K

600

700

800

900

1000

To derive the payments to capital and labor, consider the problem of a firm that must decide how much

capital and labor to hire. The firm must pay w for any unit of labor and r for any unit of capital it uses.

Its problem is therefore to

max AK L1 wL rK

K,L

(9)

From your calculus classes, it clearly follows that the optimal choice of K and L satisfies:

F

= MPK = AK 1 L1 = r

K

and

16

(10)

F

= MPL = AK L = w

L

(11)

Figure 4 illustrates the solution graphically. (Also show in the derivative space: MPK is just the demand

for K and MPL is just the demand for L).

Figure 4: Optimal choice of factors

6

MPL

Y

4

wL

2

0

0

100

200

300

400

500

Notice further that MPK = Y /K and MPL = (1 )Y /L, so we can write the two optimality conditions

as

Y /K = r

(12)

(1 )Y /L = w

(13)

and

17

which finally gives wL/Y = (1 ) and rK/Y = . Hence, the shares of capital and labor are constant

and given by the exponent in the production function. In the U.S. economy (and most other developed

economies), the share of labor income is approximately 2/3, while all other (capital) income is 1/3. This

suggests = 1/3.

Economic profits: revenues (Y ) minus all factor payments (including those to capital whether you own the

firms capital stock or rent it): Y wL rK.

Accounting profits: revenues minus all payments excluding capital: Y wL. Accounting profits are either

retained by the firm or returned back to shareholders (dividends and equity repurchases).

In the above example economic profits are equal to zero, while accounting profits are positive. Economic profits

subtract not only the payments to labor, but also the opportunity cost of capital. Instead of using the capital to

operate the factory, the owner could have invested it in bonds, the stock market etc and in a risk-less world this

would provide rK each period. Thus the owner is not really earning Y wL, but rather Y wL minus whatever

it gives up by tying up its capital in production, rather than investing it elsewhere, rK.

Stock market value of a firm. Imagine buying 1 share in a firm. Such a share entitles you to the stream of

current and future accounting profits of the firm. The stock market value of a firm is therefore equal to the value

of the firms capital stock.

2.3

Development Accounting

We are ready to use this model to think about the role of k in accounting for cross-country income differences. To

do so, we use the data in Table 2 together with the assumptions on production function we made above. First,

note that the data in Table 2 is in per-capita terms: the table gives us information on

y =

k =

Y

L

K

L

Y = AK L1

and divide throughout by L :

Y

AK L1

K

=

= AK L = A

L

L

L

18

Therefore

y = Ak

This is an alternative way of writing the production function in (6) . Notice here output per person is decreasing

returns to scale in capital per person, since < 1.

The next step is to recognize that we want to understand relative income difference, not absolute income

difference. That is, we want to understand why US is 50 times richer than Ethiopia, not why the US GDP

happens to be equal to $79,900 the latter question is meaningless since its answer depends on the particular

choice of units in which we measure GDP which is arbitrary. So we express the data in Table 1 as ratios of

output/person and capital/person of any particular country relative to the US. That is:

yi =

yi

yU S

and

ki

ki =

kU S

Obviously, the choice of units is irrelevant so

yi = Aki

Table 3 below presents the same information as in Table 2, except for all variables are normalized relative to their

US values:

Country

ki

yi

US

Canada

France

Hong Kong

S. Korea

Argentina

Mexico

Indonesia

Kenya

Ethiopia

1

0.95

0.92

0.86

0.61

0.32

0.23

0.08

0.018

0.004

1

0.81

0.67

0.80

0.48

0.33

0.26

0.11

0.036

0.019

Given this table, we can answer the following question: what fraction of per-capita income differences is

accounted for by different in capital stocks? To answer this question, let us compute the level of output per capita

19

predicted by our model, normalizing A = 1 across all countries (i.e., assuming all countries are equally efficient at

transforming K, L into Y :

yipred = ki

There is no reason for yipred to be equal to the actual level of output, but we would like a sense of how far off we

are in explaining yi . Table 4 reports the predicted level of output, given =

1

3

Country

ki

yi

Predicted yi

yipred

US

Canada

France

Hong Kong

S. Korea

Argentina

Mexico

Indonesia

Kenya

Ethiopia

1

0.95

0.92

0.86

0.61

0.32

0.23

0.08

0.018

0.004

1

0.81

0.67

0.80

0.48

0.33

0.26

0.11

0.036

0.019

1

0.98

0.97

0.95

0.85

0.68

0.62

0.43

0.26

0.15

Interestingly, the model predicts much smaller cross-country y differences than we see in the data. For example,

Canadas GDP should be 98% of the US (81% in the data), Mexicos GDP should be 62% of the US (26% in the

data), while Ethiopias GDP should be 15% of the US (2% in the data) if differences in capital were the only factor

explaining why poor countries are poor. Overall, when we use data from all countries in the world to conduct the

above exercise, we find that only about 1/3 of the per-capita income differences across countries are accounted for

by differences in k-stocks.

The reason k alone doesnt explain much income variation (even though, say Ethiopias k stock is only 0.4%

of that in the US) is because of the strong decreasing returns to capital ( = 1/3) we have assumed. Since

adding more and more capital adds increasingly less and less output, the much larger stock of K in the US is less

productive than the stock in Ethiopia (0.4% of the US capital stock, according to the model, produces 15% of the

output of the US).

20

2.3.1

Productivity Differences

Since k alone didnt do much, what else is there to explain y differences across countries? One answer: differences

in productivity (the efficiency with which k and l are utilized across countries). Let now A differ across countries:

We have

yi = Ai ki

Given data on yi and Ai , we can compute Ai using:

Ai =

yi

ki

Country

ki

yi

ki

Ai = yi /ki

1

0.95

0.92

0.86

0.61

0.32

0.23

0.08

0.018

0.004

1

0.81

0.67

0.80

0.48

0.33

0.26

0.11

0.036

0.019

1

0.98

0.97

0.95

0.85

0.68

0.62

0.43

0.26

0.15

1

0.82

0.69

0.84

0.56

0.49

0.43

0.25

0.14

0.12

US

Canada

France

Hong Kong

S. Korea

Argentina

Mexico

Indonesia

Kenya

Ethiopia

The Table says that Canada is 80% as productive as the US is, Mexico is 43% as productive, while Ethiopia is

12% as productive as the U.S. Differences in productivity thus explain a big chunk of differences in output across

countries (e.g. for the first 5 countries, it is mostly differences in productivity that explain why Canada, France,

Hong Kong, S. Korea produce less output per person than the US). Across all countries in the world, A explains

roughly 2/3 of all income differences.

Figure 5 illustrates the above arguments graphically for a different set of countries.

Notice how the model predicts that China should be 1/2 as rich as the U.S. even though in only has 1/10th of

the U.S. capital stock. The reason is that capital in China is much more productive than in the U.S. due to the

diminishing returns. Moreover, even though China is capital poor, the model badly overstates Chinas income: in

reality CHina is 1/5th as rich as the U.S.

21

have a high MPK or low? What about Japan?

Figure 6 shows that the only way our simple model can explain he U.S.-China income differences if we also

allow productivity (A) in China to be lower (1/3rd as large) than in the U.S.

22

Most differences in income across countries are due to historical differences in growth rates. In Chapter 5 we

study one source of growth: capital accumulation (investment). In particular, we ask: does capital accumulation

drive economic growth in a) the short-run (over several decades) and b) the long-run (over centuries)? We use

the model of Chapter 4 to show that the answer to a) is yes, and the answer to b) is no.

3.1

We extend the production model. The important additional ingredient here is that we endogenize the stock of

capital, rather than take it as given. We assume that consumers save a portion of their income every period. Since

23

this is a closed economy, savings must equal investment, so the consumers savings decisions will determine how

much first invest and thus how much capital the economy will have in future periods.

Workers/Consumers To keep things simple, assume that every worker supplies 1 unit of its time to the

labor market. There are Lt workers in the economy. We assume that Lt is constant for now. At the end of

this section we study what happens if we have i) a one-time change in Lt and ii) permanent increases in Lt , i.e.,

population growth.

The workers budget constraint is

Ct + St = wt Lt + rt Kt = Yt

where Ct represents consumption, St savings, wt is the wage, rt is the rental rate of capital and Yt is output.

Notice we have also introduced time subscripts since this is a model of economic growth and variables are no

longer constant over time.

That Yt equals income (labor and rental) follows from the assumption that firms are perfectly competitive and

that the production function has constant returns to scale. As shown above, this implies that economic profits

are equal to 0.

Finally, since this is a closed economy, savings must be equal to investment. So we write

St = It ,

and therefore we have

C t + I t = Yt .

This is just an accounting identity: there is nothing deep about this. Since this is a closed economy and there

is no government, there are only two uses for a countrys output: it can be either consumed or used as investment.

Production Function We assume the same Cobb-Douglas production function as early, but now use timesubscripts to indicate variables that may change over time (notice L does not, and neither does productivity A

which is assumed constant for now).

Yt = AKt L1

Next, let us express all variables in per-capita terms: a lower-case letter indicates the per-capita value. For

example, yt = Yt /L, ct = Ct /L, kt = Kt /L etc.

The per-capita production function is then:

yt = Akt

24

Capital Accumulation Assume that a portion of capital stock depreciates every period. For example, if

= 0.10, then 10% of the capital stock is lost each period). The capital stock next period is therefore:

kt+1 = kt + it kt

Define

kt+1 = kt+1 kt

and we have that

kt+1 = it kt

which says that the change in the capital stock is new investment net of the depreciation.

Example Suppose that = 0.1 and it = 200 each period. The economy starts with 1000 units of capital.

How does capital evolve over time?

t

kt

it

kt

kt

0

1

2

3

4

1000

1100

1190

1271

1344

200

200

200

200

200

100

110

119

127

134

100

90

81

73

66

Note even though investment is constant each period, capital accumulation slows down over time. Why?

Consumption-Investment decision

We assume for now that households save a constant portion s of their income. (Later in the course we will

explicitly study savings decisions in great detail. For now, this is a useful simplification). We therefore have

it = syt

and

ct = (1 s) yt

3.2

kt+1 = it kt

25

kt+1 = syt kt

kt+1 = sAkt kt

This is a first-order difference equation which is easiest to analyze on the graph in Figure 7.

Figure 7: Solving Solow Model graphically

t

Kt+1 = sYt dK

2/3

1/3 L

Yt = AK

t

We can use this graph to study where kt is heading from any initial condition. We note that the economy

converges to k regardless of were it starts.

Steady State The graph illustrates that the economy eventually settles at a point k at which kt = 0. We

want to characterize the level of k and y at this point. To do so, solve the equation kt = 0 for

sAkt = kt

26

s

kt1 = A

therefore

kt =

s

A

1

1

yt = Akt = A

s

A

A 1

Output is higher, the higher is the savings rate and productivity, and is lower when the rate at which capital

depreciates is lower. The Solow model therefore says that poor countries need to increase their savings rate in

order to be richer.

Economic Growth Figure 7 shows that the model predicts no growth in the long-run: economies eventually

settle at k and stay there forever. Consider next 2 transitional experiments:

Increase in s. Using the diagram we see that we have temporary increase in the growth rate that eventually

slows down to 0.

Increase in productivity, A. Using the diagram you should be able to show that this leads to a temporary

increase in growth rate and eventually slows down to 0.

Principle of Transition Dynamics

The Solow model says (holding all else constant), countries that start poorer should grow faster. This explains

the OECD growth vs. level of output graph. To see this, note first from

yt = Akt

that the growth rate of y is proportional to the growth rate of k:

g(yt ) = g(kt )

Note also that

g(kt ) =

kt

= sAkt1

kt

Since 1 < 0, a higher capital stock is associated with lower growth. The reason is again the diminishing

returns to capital and the fact that the rate of depreciation is constant.

27

To summarize, the Solow model is not a great model of growth since it predicts no growth in the long-run,

contrary to what we see in the data.

But it is useful in that it clearly illustrates the limits of capital accumulation. The model can also explain

short-run transition differences. For example, South Korea grew extremely fast in the 70s primarily because of

a sustained increase in the savings rate. In contrast, the Phillipines started with similar initial conditions but

experienced much smaller growth because of their low savings rates. The model can also explain convergence: the

observation that poorer countries tend to grow faster than rich countries that have similar fundamentals (levels

of s and A). Ultimately however to understand long-run growth we need a theory in which A grows over time.

3.3

Changes in population

Consider two experiments. First, assume a one-time increase, say doubling, of the countrys population, L. For

an initial stock of capital, Kt , doubling Lt would cut the per-capita amount of capital available for production

in half, since kt = Kt /Lt . No other changes take place, so kt would simply fall in half in the Solow diagram and

converge back to the original steady state. Thus, the increase in population would initially cut the amount of

output per person, since yt = Akt , but eventually output per person would catch up to the steady state level.

In the long-run, the country will eventually have twice the amount of output, enough to ensure that per-capita

output returns to its original level.

Next, suppose that population grows at a constant rate, n, so that

Lt+1

=1+n

Lt

We now have to re-derive the law of motion for capital. Recall that capital (express in levels, as opposed to

per-capita) evolves according to

Kt+1 Kt = sAKt L1

Kt

t

Before we have divided both sides of this expression by a constant Lt to express everything in per-capita terms.

Now, however, we can no longer do that because Lt+1 > Lt . Instead, we have, dividing everywhere by Lt ,

Kt

Kt+1 Kt

= sA

Lt

Lt

Lt

Kt

Lt

Kt+1 Lt+1 Kt

Kt

= sA

Lt+1 Lt

Lt

Lt

kt+1 (1 + n) kt = sAkt kt

28

Kt

Lt

1

(sAkt ( + n)kt )

1+n

kt+1 kt =

This shows that population growth is akin to depreciation: it erodes the per-capita value of the capital stock

and so it reduces steady state capital and output.

3.4

Productivity growth

Suppose next that productivity grows at some constant rate, say, gA . What can we say about the growth rate of

output per worker in this economy? Recall the production function expressed in per-worker terms:

yt = At kt

Let us introduce a new variable, zt , that is simply a function of productivity. Define zt implicitly using

zt1 = At .

It turns out that we can simplify the algebra considerably if we work with zt as opposed to At . Now the production

function is

yt = zt1 kt

Clearly (1 )gz = gA , so the growth rate of z is just a constant times the growth rate of A:

gz =

1

gA

1

The reason zt is more useful is that all variables in this economy will grow (once the economy reaches a steady

state) at the same rate as zt . So let us define the following:

yt =

yt

zt

kt

kt =

zt

and consequently

kt+1

kt+1 =

zt+1

Next, divide both sides of the production function yt = zt1 kt by zt so we have

yt = kt

29

Next, the law of motion for capital used to say kt+1 kt = sAkt kt and now we divide by zt :

zt+1

kt+1

kt = skt kt

zt

kt+1 (1 + gz ) kt = skt kt

(1 + gz )(kt+1 kt ) = skt ( + gz )kt

1

skt ( + gz )kt

1 + gz

Thus, we have, as in the basic Solow model, that k converges to a steady-state level. This implies that kt /zt

kt+1 kt =

will eventually be constant, and that kt and yt will thus grow at the same rate at zt .

3.5

The AK model

We saw above that the Solow model predicts that investment in capital is not a source of long-run growth: only

productivity improvements can generate growth in the long run. In this sense, the Solow model is an exogenous

growth model: all growth occurs due to exogenous growth in productivity which is simply assumed, rather than

established as a result in the model.

The reason for this result is diminishing returns to capital: adding more and more capital reduces its marginal

product and slows down growth.

We next ask: what happens if we assume away the diminishing marginal product of capital. This leads us to

the AK model: the first model of endogenous growth you encounter. To get to the AK model, simply set = 1

in the Cobb-Douglas production we started with:

Yt = AKt

and the law of accumulation of capital now gives:

The growth rate of capital is thus:

gK =

Kt+1 Kt

= (sA )

Kt

Since output is a linear function of the capital stock, the growth rate of output is

gY = gK = (sA )

30

Thus, as long as sA > , this economy grows over time. Unlike in the previous section in which growth was due

to exogenous increases in productivity, here growth is caused by capital accumulation (investment). Moreover,

the higher the savings rate is, the higher is the growth rate of the economy. This is thus an endogenous growth

model: the growth rate is a result of the model and growth rates depend on parameters that policymakers could

presumably be able to influence, such as the savings rate.

31

We will next explicitly model the accumulation of knowledge (productivity, ideas), which we label At . Instead of

assuming At is exogenous as in the Solow model, we will think of how At is accumulated over time. Because the

focus is on explicitly modeling the dynamics of At , this model is called an endogenous growth model. The Solow

model, in which At is not explicitly modeled, is called an exogenous growth model.

For simplicity we assume there is no capital, so that labor is the only factor of production. There are two

sectors in this economy. One sector produces output. Another produces new ideas.

The output sector has a production function

Yt = At Ly,t

where Ly is the number of people that work in the output sector.

The ideas sector (think universities) also uses labor to produce new ideas, At = At+1 At . We assume

At = zAt La,t

where z is a parameter, and La is the number of people in the ideas sector (researchers). The key implicit

assumption here is that the stock of old ideas At helps produce output, as well as new ideas. Thus the more we

know, the more new goods AND new ideas we produce. Let L be the total number of workers in this economy.

We must have

L = La,t + Ly,t

Finally, assume a constant fraction of people is assigned to the ideas sector:

La,t = L

Ly,t = (1 ) L

For example, if = 0.05, 5% of the population is doing research and the rest produce output.

4.1

Solving the model is straightforward. First divide the output expression by L to express in per-capita terms:

yt =

Then let gt =

At

At

Yt

Ly,t

= At

= (1 ) At

Lt

L

gt =

At

= zLa,t = zL

At

32

The growth rate of productivity is thus constant, gt = g, so we can use the formula from chapter 3 to conclude

that

At = A0 (1 + g)t = A0 (1 + zL)t

where A0 is the initial productivity level. Finally, we have

yt = (1 ) At = A0 (1 ) (1 + zL)t

Clearly, the growth rate of yt is equal to that of At .

Notice this economy grows forever and never slows down. This is because of constant returns to scale to At .

(As we showed above, if we had constant returns to scale to Kt in the Solow model we would also obtain long-run

growth). This model really relabels Capital in the Solow model with Ideas and makes a convincing argument

(see the original paper or your textbook if you are interested) that it is reasonable to assume constant returns to

Ideas and not to Capital.

The sense in which K and A are the same in Solow, Romer, respectively is that in the two models these are

the only accumulated factors (K and A are potentially non-zero, all other factors are constant (labor and

A in Solow, labor in Romer)). Solow assumes decreasing returns to the accumulated factor, so eventually these

decreasing returns kick in and wipe out all growth. Romer cleverly argues there are no decreasing returns to ideas,

so we have permanent growth.

4.1.1

Comparative Statics

: drop in yt (fewer production workers), but faster growth.

4.2

So far, we have assumed constant returns in ideas sector. Suppose we have decreasing returns:

At = zAt Ly,t

where < 1. We have:

gt =

At

= zA1

t

At

Therefore gt goes to 0 as At increases. Decreasing returns means that when we have more and more ideas it is

increasingly harder to produce new ones. So eventually we slow down. This is exactly like Solow.

What if population grows over time:

Lt = L0 (1 + n)t

33

gt = zA1

Lt = zL0 A1

(1 + n)t

t

t

To figure out what happens to gt over time, let us calculate its growth rate. From our first few classes, the

growth rate of gt is

growth rate of gt = ( 1)gt + n = n (1 )gt

Suppose gt is very high so that n < (1 )gt . Then the growth rate is negative so gt will fall. If, in contrast,

gt is low, we have n > (1 )gt so the growth rate is positive. Thus, regardless of where we start, the economy

eventually converges to a point at which (1 )gt = n and the growth rate is therefore constant.

This implies that in the long run

g=

n

1

So we have growth in the long-run as long as population grows. The ideas is that higher population leads to more

researchers which leads to more ideas. Note as n goes to 0, so does growth.

4.3

Growth Accounting

Yt = At Kt L1

t

In per-capita terms:

yt = At kt

Therefore

g(yt ) = g(At ) + g(kt )

The Table below decomposes the growth rate of income per worker, yt , into growth associated with increases

in productivity, At , and growth associated with increases in the capital stock, kt , for the United States:

Annualized

1948-2002

1948-1973

1973-1995

1995-2002

g(y), %

2.5

3.3

1.5

3.0

g(k), %

0.9

0.9

0.7

1.3

g(A), %

1.4

2.1

0.6

1.2

The Table shows the slow-down in the 70s mostly due to a sharp decline in productivity growth (productivity

slowdown).

34

Three explanations:

a) measurement (shift to service sector and service output (quality) incorrectly measured). That is g(y) was

actually higher than reported by NIPA due to quality increases

b) increase in relative price of energy. Leads to abandonment of old capital equipment that was not energy

efficient. [Also a type of measurement problem: this says we are overstatting the growth in k in the table since

we are not counting abandoned capital.]

c) early 1970s is birth of information technology. Researchers switch to the new sector but because it hasnt

picked up yet, growth in the traditional technology slows down. Eventually (mid 90s) investment in new technologies pays off and we recover growth.

35

These notes describe a simple General Equilibrium model that allows us to think of the effect of taxes etc. on the

labor market. We then discuss the a simple search model of unemployment, which your textbook refers to as the

bathtub model.

5.1

5.1.1

Households Problem

The household derives utility from consumption. It dislikes work. We represent its preferences with a utility

function:

U =c

n1+

1+

Here > 0 governs the curvature of the utility function with respect to the number of people that work. If

= 0, then utility is linearly decreasing in n, while if > 0, the marginal disutility from work is higher for

households where n is higher.

The household income comes in form of wages w. We assume that wages are taxed at rate , so the after-tax

wage rate is (1 )w. The households budget constraint is therefore:

c = (1 )wn,

which says that consumption is equal to after-tax income (as earlier, we normalize the price level to p = 1 here).

To solve the households problem, simply plug the budget constraint into the utility function to get:

U (n) = (1 )wn

n1+

1+

(1 )w n = 0

Solving for n:

1

n = ((1 )w)

A higher after-tax wage (1 )w increases labor supply, with an elasticity given by . When is low, agents

disutility from work is not very steep, so small changes in wages induce larger changes in labor supply. When is

high, agents disutility from work is steep, so agents are unwilling to increase labor supply even if wages increase

a lot.

36

Notice that total government revenues are T = wn = w ((1 )w) . This function is concave in , initially

increasing then decreasing, and is referred to as the Laffer curve.

5.1.2

Firms Problem

Suppose that firms produce output using the following production function:

y = Al1

where l is the amount of labor they hire and y is the output they sell, while A is productivity. The problem of

the firm is to:

max Al1 wl

l

so maximization requires

w = M P L = (1 )Al

Thus, the amount of labor firms demand at any given wage is equal to

l=

5.2

(1 )A

w

1

To solve for an equilibrium, equate labor demand to labor supply and find the equilibrium wage rate

1

((1 )w) =

(1 )A

w

1

1

1

+

((1 )A)

1

(1 )

Clearly, an increase in A increases the equilibrium wage and an increase in increases it as well (why?).

Notice that there is no unemployment in this model: the definition of an equilibrium is one in which all workers

that would like to work have a job (the wage adjusts so as to ensure this is the case). So when productivity, say,

falls, employment falls because wages fall, but there is no unemployment. Only way to have unemployment here is

to assume wages cannot adjust fast enough to clear the markets. This is the topic of the New Keynesian literature

which we study later on in this course.

37

5.3

This section describes what your book refers to as the bathtub model. The motivation for this model is that

the economy we studied above has 0 unemployment. The model here introduces unemployment by recognizing

that looking for a job takes time.

There are L individuals in the economy. Total population is assumed constant here. An individual can be

either employed or unemployed. Let Et be the number of employed and Ut be the number of unemployed. Assume

no-one is out of the labor force so

Et + Ut = L

We think of Ut as a stock variable, just like capital or ideas in the growth models. We thus need to describe

how it evolves over time. Assume that a constant fraction s of the employed people lose their job in any given

period. Assume that a constant fraction f of the unemployed find a job. Then Ut evolves over time according to:

This is very intuitive. sEt is the total number of people that lost their job at t. So all these agents enter the

unemployment pool and increase Ut+1 . f Ut is the total number of people that were unemployed and found a new

job at t: they leave unemployment and thus contribute to a decline in Ut .

To solve this system, first let lower-case letters denote per-capita variables: let ut = Ut /L be the unemployment

rate and et = Et /L be the employment-population ratio. Then we have:

Finally, note that et = 1 ut so we have

ut+1 = s (s + f )ut

First, notice in steady state ut+1 = 0 so

ut =

s

s+f

In the U.S., 45% of the unemployed find jobs in the typical month. Thus, f = 0.45. Also, 2.4% of the employed

lose their job in any given month. Thus, s = 0.024. So ut = 0.024/(0.024 + 0.45) = 0.051. That is, the model

predicts a steady-state unemployment rate of 5.1%.

38

Notice unemployment here arises because of search frictions: it takes time for workers to find a new job. This,

combined with the fact that some people lose their job in any given period (perhaps due to firm closings etc.),

implies that unemployment is positive even absent wage rigidities.

39

This chapter is concerned with the long-run determinants of the rate of growth of prices (inflation). It uses a

simple theory (the quantity theory of money) and argues that, in the long-run, the rate of inflation is necessarily

pinned down by the rate of money growth. The reason these are only long-run results is that the key assumptions

the theory makes only hold in the data over long-horizons. In particular, the classical dichotomy (the assumption

that monetary factors have no real consequences) empirically fails at short horizons.

6.1

Mt Vt = Pt Yt

or alternatively

Vt =

P t Yt

Mt

where Pt is the price level, Yt is total (real) GDP, Mt is the money supply and Vt is the velocity of money. The

velocity definition is quite intuitive: the numerator in the above expression is Pt Yt : nominal GDP, while Mt is the

amount of money in circulation. For the public to be able to buy Pt Yt dollars of goods with Mt dollars, it must be

the case that each dollar is used

P t Yt

Mt

times in any given year. For example, if nominal GDP is $200,000 and Mt

is only $100,000, every dollar issued by the Fed (or banks, since Mt includes both currency and checking/savings

accounts opened by commercial banks) must have been used twice (on average) in that year: had it only been

used once, the public would have only purchased $100,000 dollars of goods.

It turns out that Vt is roughly constant over the long-run (say tens of years). Moreover, the growth rate of

output is essentially independent of monetary factors in the long-run. Thus, in the long-run, we have that the

growth rates of these variables satisfy:

gM + gV = gP + gY

and therefore inflation (the growth rate of the price level)

= gP = gM gY

Since gY is roughly 2-3% for most countries, the quantity theory states that inflation is ultimately pinned

down by the growth rate of the money supply.

40

6.2

Your text states that the nominal interest rate is the real interest rate plus the rate of inflation (Fisher equation).

Recall that nominal variables are measured in dollars, while real variables are measured in units of goods. What

really matters for our decisions are real variables since this is what we derive utility from (we consume goods, not

dollars).

To understand the Fisher equation, note that if you invest $100 at date t, you give up

100

Pt

(e.g. if Pt = 2, the price of coffee, you give up 50 cups of coffee in that period). (Recall that in reality Pt is the

general price index, the CPI a weighted average of the prices of all goods in the economy).

Suppose the interest rate is it . The $100 savings thus yields $100(1 + it ) next year, and this allows one to buy

100(1+it )

Pt+1

goods. For example if it = 0.5 and Pt+1 = 3, then you receive $150 and therefore the equivalent of 50

1 + rt =

100(1+it )

Pt+1

100

Pt

In our example the real return is equal to 1: you give up the equivalent of 50 cups of coffee in return for 50 cups

of coffee next period, and thus the real interest rate is equal to 0. More generally, the above expression reduces to

1 + rt =

1 + it

1 + it

=

Pt+1 /Pt

1 + t

with the second equality following from our definition of inflation, t , as the growth rate of the price level. Taking

logs, we have

ln(1 + rt ) = ln(1 + it ) ln(1 + t )

or approximately

rt = it t

In the long-run, the real interest rate is roughly constant (it is pinned down by the growth rate of productivity

(output) and the extent to which workers discount the future (prefer to consumer today rather than next year).

So the Fisher equation says that differences in nominal interest rates are solely due to differences in the rate of

inflation (and therefore due to difference in the rate of money growth).

6.3

Pt Gt = Tt + Bt + Mt

41

where Gt is real government spending, and Pt Gt is the nominal value of government spending. Tt are the (nominal)

taxes it collects, Bt are net (nominal) debt issues, Bt (1 + it )Bt1 : the newly-issued stock of government

liabilities net of repayment on the existing liabilities, while Mt = Mt Mt1 is the change in the money supply.

Now suppose the government decides to pay for its spending by issuing money, rather than raising taxes or

borrowing (which effectively implies raising future taxes, unless of course one allows for default). Is money issuance

a free source of government funding or does society end up paying for it, just as it does if the government collects

taxes? In other words, does the public care about whether the government pays for G using taxes or by raising

the money supply (seignorage revenue)?

To be concrete, consider an example. Suppose Mt1 = $1000, Gt = 100, Yt = 500, Vt = 1 and the government

is trying to decide whether to finance Gt by raising taxes, Tt = Pt Gt or by issuing more money.

Consider first a scenario in which the government only uses taxes to finance its spending. That is, the

government leaves the money supply unchanged at Mt = 1000, and finances all of its spending using taxes.

From the quantity theory, we have

Pt =

Mt V t

$1000

= $2

=

Yt

500

. so that the government must raise Tt = Pt Gt = $2 100 = $200. (Assume for simplicity no government

borrowing, Bt = 0).

Consider next the publics budget constraint:

Pt Ct + Mt = Pt Yt Tt + Mt1

The right hand side is the $ value of what the public has available to spend: its after-tax (nominal) income,

Pt Yt Tt , plus whatever holdings of money it inherits from last year, Mt1 . The left-hand side is what the public

spends its money on: consumption or holdings of money Mt that it will use in future periods.

In our first example, Mt = Mt1 = 1000, and therefore Pt Ct = Pt Yt Tt = 2 500 200 = 800. Since Pt = 2,

we have Ct = 800/2 = 400.

Consider the second scenario, where Tt = 0, but Mt Mt1 = Pt Gt , so that the nominal government spending

is financed by increasing the money supply. The publics budget constraint now says:

Pt Ct = Pt Yt + (Mt1 Mt ) = Pt Yt Pt Gt

Notice that Pt drops out and therefore

Ct = Yt Gt = 500 100 = 400

as in the previous example.

42

Total consumption is therefore unchanged: the public is indifferent as to whether government spending is

financed using money issuance or taxes. Why is that? The simple explanation is that output is fixed, at Yt = 500

units. If the government consumes 100 of this output, it must be the case that consumption is 400 = 500-100:

how exactly the government pays for its output is entirely irrelevant.

The deeper question is: How is the government able to finance its spending given that it does not tax anyone?

The answer is that it does implicitly levy an inflation tax on the public. Such a tax arises not because of explicit

taxation, but rather because the government, by increasing inflation, erodes the real value of its existing monetary

liabilities, Mt1 . Since prices are higher, holders of government currency are made worse off by higher inflation:

the real value of these liabilities, Mt1 /Pt , decreases.

To see what happens in our example, notice that absent the increase in the money supply, the real value of

existing government liabilities would have been Mt1 /Pt = 1000/2 = 500. So the government implicitly owes the

public 500 units of the good.

When the government raises the money supply to pay for its spending it will increase the price level. In

particular, the quantity theory says that

Mt = Pt Yt

while the governments budget constraint says that

Mt = Mt1 + Pt Gt

Combining these, we have,

Pt (Yt Gt ) = Mt1

or

Pt =

Mt1

1000

=

= 2.5

Yt G t

400

The price level thus increases by 25%, which implies that the real value of governments liabilities is only

1000

2.5

= 400. Thus, in the second scenario the government pays for its 100 units of real spending by simply

Now the government does not directly control the price level, Pt , but the money supply, Mt . But from the

quantity theory and the assumption of classical dichotomy (Yt is independent of monetary factors and constant

in this example) we have

43

Pt

Mt

=

Mt1

Pt1

so the government needs to issue a total of

Mt =

Pt

2.5

Mt1 =

1000 = 1250

Pt1

2

of money (a 25% increase in the money supply) to be able to finance its spending.

44

Note that at this point my notes will depart in many ways from your textbook. I tried to keep the discussion

of the short-run model a bit more concise, as well as study the Real Business Cycle (classical) model which the

textbook does not. I discuss in the notes below what part of the textbook covers the topics below

7.1

Overview

There are two main views of what causes business cycle fluctuations. The classical view (real, supply-side) view is

that business cycles arise due to short-term fluctuations in the level of technology around trend, or alternatively

other real factors that reduce the amount of labor and capital the economy uses (e.g. fluctuations in tax rates or

preference shocks that make people more willing to work in some periods and less so in others). An important

prediction of a large class of classical models is that business cycle fluctuations (including recessions) are efficient:

a recession is the optimal response of the economy to an underlying negative shock to productivity or preferences.

The Keynesian view is that business cycle fluctuations arise because of fluctuations in the level of the money

supply or equivalently, nominal interest rates and/or by shifts in the consumers or firms or government spending.1 Such fluctuations (in money, interest rates or spending decisions) would, on their own, not be sufficient to

cause changes in output. Such models therefore generate short-run movements in output by making one of two

key assumption: prices are sticky or consumers/firms do not have perfect information (about monetary policy,

aggregate demand conditions etc.). Absent one of these 2 assumptions, fluctuations in money, interest rates or

desired demand would have no consequence and simply translate into higher prices. The reason is that in the

absence of price or information frictions output would be pinned down by the production function: Y = AF (K, L)

and thus be entirely independent of other factors. Importantly, both recessions (fall of output below potential) and

expansions (an increase in output above potential) are inefficient. Keynesian models thus predict that governments

should actively stabilize the economy, by expansionary monetary or fiscal policy in recessions and contractionary

policies in booms, to avoid inefficient fluctuations in output.

Whether the real or Keynesian view is the right way to think about the business cycle is still very much up to

debate. In all likelihood, some recessions can clearly be described as having been caused by monetary/financial

factors (the Great Depression, the Volcker disinflation, the Great Recession), while others may have well been the

optimal response of the economy to productivity slowdowns, oil price shocks etc. It is thus useful to understand

both class of models.

1

Some classical economists, the monetarists, e.g., Milton Friedman, also agree with the view that shifts in monetary policy cause

fluctuations.

45

7.2

We already did most of the work necessary to understand the classical view in the employment chapter. Suppose

the production function is

Yt = At Kt L1

t

where At is productivity which now fluctuates over time (it is sometimes high and sometimes low) and Lt is

employment.

Consumer preferences (these are identical to those assume in Chapter 7) are:

U (Ct , Nt ) = Ct

1

Nt1+

1+

Ct = Wt Nt ,

where we assume that there are no labor income taxes.

There is no money in this classical model so the price level is not pinned down and thus we may just as well

normalize it to Pt = 1. (of course, we now know how to introduce a quantity-theory equation, assume a particular

level of M and pin down the price level, but having money is pointless in a classical model since prices are flexible

and money plays no role other than determining the price level).

As we showed earlier, labor supply is equal to

1

Nt = Wt :

higher wages induce workers to supply more hours. Alternatively, we can write

Wt = Nt

The firms problem is simple as well. The firm chooses labor so as to maximize profits, or

max At Kt Lt1 Wt Lt ,

Lt

Lt =

(1 )At Kt

Wt

1

or alternatively

Wt = (1 )At Kt L

t

46

Solving for the equilibrium employment requires equating demand and supply (Nt = Lt ) which gives

L+

= (1 )At Kt

t

from which it is clear that Lt is increasing in At .

The Real Business Cycle theory thus postulates that fluctuations in At (technology) bring about changes in

Lt (it makes more sense to work when productivity (and therefore wages) are higher as well as fluctuations in Yt

(the later arise directly, because of fluctuations in productivity, as well as indirectly, because of fluctuations in

labor induced by productivity).

7.3

Efficiency

An important prediction of the above model is that fluctuations in output and employment are efficient. To see

this, suppose that we let a benevolent planner the task of choosing output and employment in this economy in

order to maximize the societys preferences. Can the planner do better than markets? The answer is no. To see

why, note that the planner seeks to maximize the consumers welfare (since she or he is benevolent):

U (Ct , Nt ) = Ct

1

N 1+

1+ t

The planner does not use markets, so there are no prices, since the planner can simply dictate to everyone

how much they should produce and work. But the planner cannot violate the economys resource constraint, i.e.

the production function:

Ct = Yt = At Kt Nt1

(For simplicity, i assume Kt is exogenous here and there is no investment.)

Substituting the last expression into the utility function and choosing Nt = Lt clearly gives the same solution

that the market economy gives: the planner also chooses to reduce output in times when At is low. The classical

view is thus that there isnt room for government intervention to prevent recessions.

To see this, substitute the planners resource constraint into the utility function:

U (Ct , Nt ) = At Kt Nt1

1

N 1+

1+ t

(1 )At Kt Nt = Nt

47

or

Nt+ = (1 )At Kt

which is the same as in the decentralized equilibrium.

Intuitively, the planner would like to equate the marginal product of labor to the marginal disutility from

work. The decentralized economy has workers choose labor supply so as to equate the marginal disutility from

work to the wage, while the firms choose labor demand so as to equate the marginal product of labor to the wage.

Since firms and workers face the same wage, the decentralized equilibrium ensures that the marginal product of

labor is equal to the marginal disutility from work.

7.4

Sources of At fluctuations

One criticism of the real business cycle literature is the argument that since At is the stock of knowledge of the

economy, it is unreasonable to think that At suddenly falls in recessions. How is it possible that people forget a

substantial part of what they know in such short periods of time?

This criticism is not entirely fair. The reason is that At is not the efficiency of one individual firm, but rather

the efficiency (productivity, stock of knowledge) of a large number of firms that interact in the economy. It is

possible for At to fall even though the efficiency of individual firms does not.

To see this, consider a simple example. Suppose there are 2 firms in the economy, firm 1 and firm 2, each

operating with a constant returns technology:

Y1t = A1t L1t

Y2t = A2t L2t

Total output in this economy is the sum of the output produced by the 2 firms:

Yt = Y1t + Y2t = A1t L1t + A2t L2t

The economys productivity is, by definition,

At =

Yt

A1t L1t + A2t L2t

=

Lt

L1t + L2t

At =

L1t

L2t

A1t +

A2t

L1t + L2t

L1t + L2t

Thus aggregate productivity is a weighted average of individual productivities, with weights given by the

fraction of total labor hired by individual firms.

48

For concreteness, suppose that firm 2 is more productive than firm 1. Then if for whatever reasons labor flows

from firm 2 to firm 1 (so 1s share of total labor increases), then aggregate productivity in this economy falls. For

example, a decline in firm 2s ability to borrow (firm 2 is larger so needs to borrow more) may force it to cut back

its employment, thus allowing firm 1 to borrow more. Similarly, a disproportionate increases in taxes on the larger

firms (size-dependent policies) which are ubiquitous especially in poorer countries, would reduce the economys

productivity.

7.5

Another type of criticism is that the real business cycle model admits no role for credit, financial, monetary

or demand factors (e.g. household spending), while in the data measure of credit, finance money strongly

correlate with the business cycles. But correlation is not causality. The observation that house prices or the

money supply are strongly correlation with output does not mean that house prices or the money supply changes

cause expansions/recessions. House price or money supply increases may be caused by the rising output itself, as

opposed to the other way around.

in Jones)

(You should not read chapter 11 in much detail, as my exposition is very different, but focus on the lecture notes

instead.)

The model we study (your book refers to it as the short-run model) has 3 building blocks:

1. IS equation, which relates the consumers (or firms) decision of how much to spend to the (real) interest

rates.

2. Phillips curve which relates inflation to output. This equation captures the idea that prices are sticky and

therefore inflation gradually responds to changes in output.

3. Monetary policy rule which describes how the Fed chooses the nominal interest rates. Because prices are

sticky, changes in nominal interest rates end up affecting real interest rates as well.

I start by describing the micro-foundations of the IS equation, then those of the inflation equation, and finally

describe the monetary policy rule.

49

8.1

(Most of this is not in your textbook. The book does introduce the IS curve in Chapter 11, but it motivates it

somewhat differently. The expression for the IS curve is identical (note they use Rt for the real rate and I use rt )

and so you may find it useful to study the Figures in Chapter 11, but not much else.)

In the classical model we have assumed a one-period model since there was no role for inter-temporal choice.

Inter-temporal choice is, however, critical for our discussion in the Monetarist/Keynesian model since monetary

policy matters primarily through its effect on interest rates (an inter-temporal price - the relative price of current

vs. future consumption).

To think about inter-temporal choices, consider the following simple model which I use to motivate the IS

curve assumed in your text. Suppose now that consumers live for 2 periods and their preferences are given by

U (C1 , C2 ) =

C11

C 1

+ 2

1

1

where < 1 captures the idea that consumers are impatient and care more about todays consumption rather

than future consumption, while 0 captures the consumers desire for consumption smoothing. When = 0,

there is no preference for consumptions smoothing: with = 1 the consumer is indifferent between consuming

100 in period 1 and 0 in period 2 or 0 in period 1 and 100 in period 2. As increases, the consumers utility

function becomes more and more concave and so the consumer prefers a smooth consumption path. For example,

with = 1/2 the utility from consuming (100,0) is equal to 2 10 = 20 which is lower than consuming (49, 49)

which gives 2 7 + 2 7 = 28.

Let the price level be P1 and P2 in the two periods, and let (1 + i) be the gross nominal interest rate between

periods. Suppose the consumer begins its life with some (real) wealth E and needs to decide how much to save

in the first period, anticipating that whatever it saves in period 1 it consumes (with interest) in period 2. Here

we assume that the consumer earns no income, but allowing the consumer to earn income Y1 and Y2 in the two

periods of its life does not change any of the analysis below.

The budget constraints in the 2 periods are:

P1 C1 = P1 E B

and

P2 C2 = (1 + i)B

Lets now consolidate the 2 budget constraints into one:

P 1 C1 +

1

P 2 C2 = P 1 E

1+i

50

C1 = E

1 P2

C2

1 + i P1

or

1

C2

1+r

C1 = E

Plug this into the utility function:

U (C1 , C2 ) =

where 1 + r =

1+i

P2 /P1

(E

1

1

1+r C2 )

C21

,

1

is the (gross) real interest rate. Next, differentiate with respect to C2 to get

C1 /(1 + r) + C2 = 0

or

1

C1 = ((1 + r)) C2

Clearly, consumption is negatively related to the (real) interest rate.

More generally, we can write

1

Ct = ((1 + rt )) Ct+1

for any period t. This equation is the backbone of all dynamic macroeconomics (where it is known as the Euler

equation) and finance (where it is referred to as the CCAPM Consumption Capital Asset Pricing Model).

Absent investment (and government spending), output is entirely used in consumption, so Yt = Ct and we

thus have

1

Yt = ((1 + rt )) Yt+1

We can take logarithms of both sides of this expression, letting yt = log(Yt ) and thus we have

yt = yt+1

1

1

log() rt

Finally, let

at = yt+1

1

log()

and

b=

1

,

yt = at brt .

51

Here the slope b captures the sensitivity of spending decisions to interest rates and since b = 1/ the slope of

the IS curve is a function of the consumers preference parameter . The lower is, the less the consumers desire

to smooth consumption, and thus the more willing it is to cut its consumption to take advantage of an increase

in interest rates.

The intercept at is usually referred to as an aggregate demand shock. For example, at can increase if falls.

Intuitively, a lower means that the consumer is more impatient so would like to consume more in the present

(at t) rather than in the future (at t + 1). So holding all else equal consumption (and thus output) would increase.

Alternatively, suppose yt+1 increases the consumer expects more income (and thus consumption) in the future.

This would lead to an increase in at as well. Intuitively, recall that the consumer desires to smooth consumption.

So the anticipation of an increase in income in the future leads consumers to demand more consumption in the

present by borrowing against their future income.

8.2

In the classical model of the business cycle, demand shocks (changes in at ) in the IS equation would not lead

to any changes in output, and only affect real rates. To see this, recall our previous discussion of the classical

business cycle model in which we argued that Yt is simply a function of aggregate productivity. Thus, output is

determined by supply-side factors (employment and productivity), as opposed to demand.

Since yt is exogenously given, the IS curve pins down the interest rate that ensures that the market clears:

rt =

at yt

b

An increase in demand at mechanically leads to an increase in interest rates. Why? Recall that individual

consumers would like to increase their consumption as at increases. But they cannot do so collectively because

the total amount of output in the economy is exogenously fixed. So to ensure that markets clear, interest rates

must increase to prevent consumers from borrowing to finance the desired increase in consumption.

Question: what happens to interest rats if consumers expect a productivity slowdown, that is, a reduction in

productivity in future periods?

8.3

The key assumption of the Keynesian model is that yt is not longer solely determined by supply factors alone.

At the heart of the Keynesian model is the Phillips Curve, an equation that relates the output produced in the

52

economy to inflation. You can think of the classical model as a special case of the Keynesian model with this

Phillips curve being vertical.

I next describe the Phillips curve. (This topic is covered in Chapter 12.3 and my discussion below is closely

related, though I changed the notation a bit.

I will simply state this equation, without deriving it. Let t be the rate of inflation and te denote the

expectation of inflation that firms form. The Phillips curve is then

yt = ytClassical +

1

(t te ),

where ytClassical is the level of output that would arise in the Classical model (recall simply as a function of the

exogenous productivity) and is a parameter that measures the strength of the Keynesian mechanism as goes

to infinity, the model collapses to the classical one.

One simple model that gives rise to this equation is the Lucas model. The idea is that firms sell different

products and can only observe demand for their own product. Demand for their own product can be high either

because of an idiosyncratic shock that makes customers prefer that particular product, or because of an increase

in the money supply which leads people to spend more.

Firms would find it optimal to raise output in response to demand shocks that are firm-specific (since those

signal the consumers willingness to buy more of that particular good), but not in response to changes in the

money supply which simply increase the quantity of cash in circulation and affect all firms equally. But since they

dont perfectly observe either shock, an increase in the money supply by the Fed (which raises overall inflation

relative to expected inflation) ends up confusing firms, leading them to believe that consumers like their products

more, and thus end up selling more output than they would in the classical model. For this reason output ends

up increasing above that in the classical model in periods with higher than anticipated inflation. A lower kappa

implies more such confusion and thus a bigger sensitivity of output to inflation.

From now on, we ignore fluctuations in output arising due to classical forces (productivity) and simply normalize ytClassical = 0. We can thus write the Phillips curve as

t = te + yt

We can modify this equation slightly to introduce a cost shock (say an increase in oil prices), which we denote

by ot :

t = te + yt + ot ,

Changes in ot will shift the Phillips curve around over time.

53

8.4

(The Adaptive Expectations are discussed in Chapter 12.3 and loosely motivated in 12.5. That with such expectation the Fed can manipulate real rates is explained in Chapter 12.2. I find it strange that the book talks about

12.2 before 12.3 and 12.5, so I recommend that you read my notes first, then 12.3, then 12.5 and only then go to

12.2.)

We have not yet discussed how the public forms expectations of inflation, i.e., how te is determined. Note

that te = Forecast(ln(Pt+1 /Pt )) so forming expectations requires forecasting next periods price level, not an easy

task. We will assume the following simple rule: firms simply expect inflation to be whatever it used to be at t 1.

That is,

te = t1 .

So if yesterdays inflation was 2%, firms and households simply believe that it will be again 2% in the next period.

Next, consider the real interest rate in the economy. With imperfect information, it is the expectations of inflation

that matter for consumers and firms decisions of how much to spend. Thus the real interest rate relevant for

their decisions is:

rt = it te

The fact that expectations are adaptive (based on past data) gives the Fed the ability to manipulate real

interest rates. Unlike in the classical model, in which rt was pinned down by consumption (and thus output)

growth which was outside the control of the Fed, the Keynesian model predicts that, by changing it , the Fed

changes rt as well. The reason is that te = t1 is predetermined at t 1 and thus independent of what the Fed

does at time t. Indeed, given a particular t1 , the Fed can implement any rt it wants by simply changing it

appropriately. From the IS curve,

yt = at brt

so the Feds ability to pick any interest rate it desires also implies that it is free to implement any level of output

it wants. So for example, if the Fed desires yt = 0 (which recalls we assumed is the level of output in the classical

model, i.e. the efficient level of output), it just sets rt = a/b and thus responds to negative demand shocks by

lowering interest rates. (See diagram in class.)

8.5

Question: why doesnt the Fed keep lowering rt so as to generate increases in output? The answer is that

such a change raises inflation permanently and the public finds inflation to be costly. To see this, lets put all the

54

equations that we had so far together, where for simplicity I assume at = a is a constant and ot = 0:

yt = a brt

t = t1 + yt

According to these equations, the Fed can easily lower rt at t and thus increase output. For example, a 1%

decrease in rt would raise yt by b%. But then t will increase by b in period t. If the Fed leaves yt unchanged in

all future periods (yt+1 = yt+1 = 0), future inflation will be higher because t+1 = t . Thus a one-time increase

in output will permanently raise the rate of inflation.

The Fed can also engineer a deflation, as Volcker did in the 80s. According to the model, such deflation requires

a temporary drop in output. See Figures 12.8-12.12 in your textbook.

8.6

The Fed does not have the ability to directly change nominal interest rates those are chosen by commercial

banks, i.e., lenders, not by the Fed. The Fed can, however, increase the supply of money in circulation. In

practice it does so via open market operations: it prints dollar bills, uses the money to buy government bonds

from banks and hopes that the banks will lend this money to the public. Only the money reaches the public can

it be used for transactions and is part of the money supply (currency). While on the banks balance sheets this

extra money is simply bank reserves, it is not used for transactions, and is thus not part of the money supply.

Now let us suppose as earlier that the publics demand for money is given by the quantity theory

M t V t = P t Yt ,

but assume now that Vt is not constant, but is rather an increasing function of the interest rate:

Vt = V (it ),

with V 0 > 0. An increase in interest rates increases the opportunity cost of holding currency because currency

pays no interest and is even more dominated by interest-bearing assets. The demand for money is thus

Mt =

P t Yt

,

V (it )

and is decreasing in interest rates as people find holding currency more costly.

In this case changes in the money supply, Mts will lead to changes in it , as shown in Figures 12.14-12.15 in

your textbook.

55

8.7

Experiments

1. Negative demand (a) shock. (E.g. The end of the housing bubble reduces consumers wealth and thus leads

to less consumption). The IS equation changes from

yt = a brt

to

yt = a0 brt

where a0 < a = 0

If the Fed leave it and thus rt = it te = it t1 unchanged, then yt declines by a0 . The Fed could, of

course, lower rt to exactly offset the a shock. Simply lowering rt to a0 /b will ensure output stays constant

at 0.

2. Good news about the future (high Yt+1 ). Recall from our consumption example that good news about future

Yt make it optimal for consumers to demand higher consumption today as well (for consumption-smoothing

reasons). So at increases and so does output if rt remains unchanged.

8.8

We close the model by deriving an Aggregate Demand curve that relates output to inflation. Together with the

Inflation equation (Phillips curve), this gives a complete system that allows us to study the effect of various shocks

on output and inflation.

8.8.1

We will assume that the Fed chooses a path for (nominal) interest rates to ensure that real interest rates increase

when inflation is high. In particular, the Fed chooses

rt = m(t

),

where

is the Feds target (desired) rate of inflation and m > 0 determines how aggressive the Fed is in responding

to deviations of the actual inflation rate from its target.

Given this policy rule, we can now write:

yt = at bm(t

)

56

We refer to this last equation as the Aggregate Demand curve. The higher m is, the more aggressive the Fed

is (the more it dislikes missing its inflation target), and therefore the flatter the t vs.yt profile.

Finally, we will use the term Aggregate Supply curve to refer to the inflation equation:

t = t1 + yt + ot

The Aggregate Supply and Aggregate Demand curves jointly pin down output and inflation as a function of

at , ot as well as past inflation t . Substituting the AD curve into the AS curve, we have

t = t1 + at bmt + bm

+ ot .

Solving for t gives:

t =

1

bm

1

t1 +

+

at +

ot

1 + bm

1 + bm

1 + bm

1 + bm

A higher m reduces the sensitivity of inflation to both demand (at ) as well as supply (ot ) shocks. By setting

m = , the Fed can ensure t =

at all times.

The cost of raising m is that it may generate too much variability in output. To see this, write

yt =

8.8.2

bm

1

bm

bm

t1 +

+

at

ot

1 + bm

1 + bm

1 + bm

1 + bm

Steady State

In the steady-state there are no shocks, ot = at = 0, inflation is constant, so from the Aggregate supply curve

yt = 0, and from the aggregate demand curve we must have t =

.

8.8.3

See Figures 12.6-12.9 in your textbook: inflation increases and output falls (why?). Notice that even though the

shock only lasts for one period, inflation and output take some time to return to the steady state. The reason is

that the expectations of inflation adjust gradually since they depend on past inflation.

8.8.4

Disinflation

Suppose Fed decides to lower its inflation target pi.

as output (since the Fed raised rt in the background). The lower inflation at t reduces future expectations of

inflation, thus shifting the AS curve right over time. Eventually a new steady state is reached in which yt is back

at 0 and t is equal to its new target.

57

8.8.5

Persistent AD shock

Suppose at persistently increases so AD shifts right. This raises t and yt . In future periods expectations of

inflation increase thus leading to shifts in AS to the left. Eventually inflation converges to a new higher point and

output returns to 0. Thus, if left unchecked, persistent demand shocks lead to temporary changes in output but

have a persistent effect of inflation. By their very nature, at shocks eventually must return to 0, so eventually AD

shifts back to the original one, leading to a temporary drop in output and causing inflation to gradually return to

its original level.

58

1. An IS equation describing consumption (or investment) demand given the real rate, rt :

yt = at brt

2. A monetary policy rule that has the Fed increase real rates in periods of higher then desired (

) inflation:

rt = m(t

)

3. A Phillips curve that captures the idea that prices are sticky (or information is imperfect) so that increases

in inflation relative to what the public expected are expansionary:

t = t1 + yt

There are two main views of what caused the large and persistent reductions in output (relative to trend) and

employment in the last recession. Ultimately, both can be described as declines in at in the IS equation.

9.1

The recession was associated with a sharp reduction in asset prices, including the price of equity and housing.

Such reductions reduced household wealth, especially so for those households that were highly leveraged. Consider

the following table which compares household median net worth and income in 2007 and 2010.

Table 10.1: Median income, $ 1,000

Median

Less 20

20-40

40-60

60-80

80-90

90-100

%

%

%

%

%

%

2007

2010

47.3

45.7

12.3

28.8

47.3

75.1

114.1

206.7

13.2

28.5

45.7

71.2

112.8

205.3

59

Median

Less 20

20-40

40-60

60-80

80-90

90-100

%

%

%

%

%

%

2007

2010

121.0

77.0

8.8

37.8

88.4

204.7

357.5

1102.1

6.1

27.7

64.9

127.1

288.9

1190.0

Median net worth (the value of the typical households assets minus liabilities) fell from 121,000 in 2007 to

77,000 in 2010, a massive drop.

The reason net worth fell so much is that many households were highly levered: the value of their assets were

very close to the value of their liabilities. To understand this, consider 3 households. All of them have purchased

a house worth $200,000. Household 1 paid for it using a $ 100,000 loan and $100,000 of its life-time savings. Its

leverage (ratio of assets to net worth) is thus equal to 2. Household 2 paid for the house by borrowing $160,000

from the bank and using only $40,000 of its own savings. Its leverage ratio is thus equal to 5. Finally, household

3 only put $20,000 down when signing the mortgage so its leverage ratio was 10.

Consider next a 10% decrease in house prices. All houses are now worth only $180,000. Since the value of

liabilities is unchanged, Household 1s net worth declines from $100,000 to $80,000, a 20% drop. Household 2s

net worth, in contrast, declines from $40,000 to $20,000, a much larger $ 50% drop. Finally, household 3s net

worth declines from $20,000 to 0, a 100% drop. Clearly, leverage magnifies net worth losses when asset prices

decline (just like it magnifies gains when asset prices increase which is why financial institutions arent terribly

happy with regulation that reduces their leverage ratios).

To see this more formally, let denote the leverage ratio, the ratio of ones assets to net worth. Thus, assets

are equal to a multiple of ones net worth:

A = E,

and consequently debt is

D = A E = ( 1) E.

Assume next that the value of ones assets changes by a fraction x. So the new level of assets is

A0 = (1 + x)A = (1 + x)E.

60

For example, if x = 0.2, the value of ones assets falls by 20%. Since the value of debt is unchanged when the

value of ones assets falls, we have that the new level of equity is

E 0 = A0 D = (1 + x)E ( 1)E = (1 + x)E.

The percent change in equity is therefore:

E0 E

= x.

E

In words, if the value of the asset changes by x%, the value of ones equity changes by x% higher leverage

therefore increases ones losses.

Thus, with leverage, even small changes in the value of underlying assets lead to large changes in household

wealth. Since changes in the value of assets were, in fact, quite larger, many households experienced extremely

large declines in their wealth, as evidenced in the table above.

Changes in household wealth, in turn, lead to reductions in consumption. The reasons are subtle and we will

not discuss the details in this course. One reason is that declines in household wealth lead households who rely

on their wealth for consumption (e.g. retirees) to cut back their spending. In addition, declines in the value of

housing equity prevent people who would have otherwise refinanced their mortgages or taken a home equity line of

credit from doing so. These two forces push down consumption, and thus the demand term at in the IS equation.

9.2

The idea here is that rt , the rate at which households and firms borrow, is not equal to the federal funds rate set

that the Fed can control. Rather, we have

rt = ft + pt ,

where pt reflects a risk premium. For example, the risk premium is extremely high for credit card borrowing

(around 10-15%), but fairly high as well for collateralized borrowing, given that typical mortgage rates are about

3-4%, while the Fed funds rate is near 0.

One salient feature of the crisis was a sharp increase in risk premia, both for households, as well as for corporate

debt. To see how such an increase changes our analysis, let now monetary policy rule be:

ft = m(t

)

and derive the AD curve:

yt = at brt = at b(ft + pt ) = at bpt bm(t

),

which says that an increase in the risk premium once again shows as a negative aggregate demand shock.

61

9.3

We already know what the effect of a negative at shock is in the model: a temporary drop in output and inflation

away from the steady state. In such a model, however, the Fed can perfectly offset at shocks.

One simple way to do so is to modify the monetary policy rule to explicitly allow it to respond to at shocks.

Consider our original system, with

yt = at brt

We can modify the monetary rule to

1

rt = m(t

t ) + at ,

b

so that the Fed responds to demand shocks by increasing rates. In this case the aggregate demand curve is

yt = bm(t

t ),

and the at shocks disappear from the system.

What prevents the Fed from adoption a rule such as rt = m(t

t ) + 1b at in practice? The answer is: the

zero lower bound. Since it 0, the real rates are constrained by the rate of inflation: rt = it te te . Thus, in

environments with low expected inflation the real rate cannot fall too much: if expected inflation is 2%, the real

rate cannot fall below - 2% and so the Fed may not be able to fully offset a particularly large at shock.

A policy rule such as rt = m(t

t ) + 1b at is referred to as conventional monetary policy. Indeed, such a rule

(also called a Taylor rule) is an excellent description of Fed behavior prior to 2007.

9.4

Before we discuss unconventional measures of monetary policy (conducted at the zero lower bound on nominal

interest rates), it is useful to briefly discuss how the money supply is determined in normal times (when interest

rates are above 0).

Recall that the Fed issues 2 types of liabilities: currency (C) which are dollar bills held by the public (firms

and households) and reserves (R) which you can think of as dollar bills held by banks. The difference between

these is a crucial one: currency is used in transactions and is thus part of the money supply, while reserves are not.

Assume for simplicity that there is only one other type of liquid liabilities that the public uses for transactions:

deposits (D) issued by commercial banks (think of checking accounts against which one can access by writing a

check or using a debit card).

Thus, the money supply in this economy is

M S = C + D,

62

M B = C + R.

The question is: what is the relationship between the money supply (something that, through the quantity theory,

matters for inflation) and the monetary base, and in particular the amount of reserves issued by the Fed?

Let us start answering this question using a simple example. Suppose there is one single commercial bank

in the economy, which we will refer to as Bank. Consider a Fed that has $ 100 of currency outstanding and

contemplates issuing another $ 100 of reserves. Thus, C = 100 and R = 100, a situation depicted in the two

balance sheets below.

Bank on Day 0

Assets

Reserves

Fed on Day 0

Assets

Liabilities

100

Net Worth

Liabilities

Govt Bonds

100

200

Currency

Reserves

100

100

We are silent in this example as to what exactly the Bank gave the Fed in exchange for the reserves, but you

could think of the Bank initially owning $100 worth of government bonds which it ended up selling to the Fed as

part of the Feds open market operations.

Notice that at this point (call it Day 0), the money supply in this economy is simply equal to the $100 in

currency held by the public: reserves on the banks balance sheet do not count.

In normal times the situation depicted above is unsustainable. Banks are in the business of making money by

issuing loans (for which borrowers pay interest), not in the business of keeping 0-interest reserves on their balance

sheets. (recall that reserves are like currency which pays no interest).

So the Bank above will choose to lend its reserves out, by making a loan to some firm, converting its reserves

into a loan:

Bank on Day 1

Assets

Loans

Liabilities

100

Net Worth

63

100

This transaction increases the money supply in the economy from the original $ 100 to $200, now that an

additional $ 100 is in the hands of a firm.

Next, the firm that received the loan will presumably use it for some transaction, thus giving up those dollars

to yet another firm. Suppose that firm decides to deposit that money with the commercial bank on Day 2. The

banks balance sheet would now read:

Bank on Day 2

Assets

Loans

Reserves

Liabilities

100

100

Deposits

Net Worth

100

100

Once again, the bank is unhappy with this scenario since it is stuck with $100 of 0-interest reserves. It will try

to lend them out, but heres the catch: there is a law that states that the bank must hold 10 dollars of reserves on

its balance sheet for every 100 dollars of deposit. This fraction, the required reserve ratio (10% in this example)

is intended to protect depositors from being unable to withdraw their funds at will in case they choose to do so:

if the banks would lend ALL of their reserves, nothing would be left to pay for those depositors that are trying to

use their checking accounts, say, to make a purchase.

The bank must comply with this rule and will thus only lend out 90$ of its reserves, keeping the rest as required

reserves:

Bank on Day 3

Assets

Loans

Reserves

Liabilities

190

10

Deposits

Net Worth

100

100

Notice the final 90$ loan increases the money supply further, to $290 since the loan ends up as currency in

some firms pocket. As earlier, the firm that borrowed that amount will use it to finance some transaction and

the ultimate recipient of that currency will choose to deposit it again with the bank. Hence on Day 4 the banks

balance sheet will read:

Bank on Day 4

64

Assets

Loans

Reserves

Liabilities

190

100

Deposits

Net Worth

190

100

The next step will entail the bank making yet another loan. Now, however, the bank has $190 of deposits, so

it has to keep $19 in reserves, its next loan is thus only $81. The balance sheet will thus be:

Bank on Day 5

Assets

Loans

Reserves

Liabilities

271

19

Deposits

Net Worth

190

100

Notice the money supply now increases by yet another $81, to $371. You can work out for yourself what will

happens in the next rounds: the bank will keep getting its reserves back as deposits and continue making new

loans, of size $72.9 (90% of $81), $65.6 (90% of $72.9) etc. Clearly, the process will only stop when the total

amount of loans made by the bank is equal to $1000 = 100/0.1.

Thus, the money supply in this economy will ultimately equal to $1100 of which $100 is currency, and $1000

is deposits. In general, letting rr denote the required reserve ratio, we have

D=

R

,

rr

so that for every dollar of reserves issued by the Fed, deposits and thus the money supply increases by 1/rr dollars.

9.5

Unconventional monetary policy involves attempts to directly change the gap between the Federal Funds rate

(essentially the rate on short-term government liabilities) and other securities (such as long-term government

liabilities, mortgages etc.). The idea is that the Fed prints money to purchase such securities in an attempt to bid

their price up and thus the interest rate down. That is, the Fed is attempting to directly lower pt .

To see how this works, consider two banks, banks A and B that initially (prior to the crisis), have the following

Balance Sheet:

65

Bank A

Assets

Reserves

Loan to B

Bank B

Assets

Liabilities

10

100

Deposits

Net Worth

Reserves

Loans

100

10

Liabilities

10

200

Deposits

Loan from A

Net Worth

100

100

10

In this example, bank A raises $ 100 by issuing demand deposits, and uses an additional $10 of the owners

capital (net worth) to finance $ 10 worth of reserves and a $100 loan to bank B. Reserves, unlike loans, do not

earn interest, but regulation requires that banks hold at least 10% of reserves against their deposits to ensure that

enough funds are available to repay depositors who would like to withdraw.

Similarly, bank B raises $ 100 by issuing its own deposits, borrows another 100$ from bank A, and has $100

of net worth. It holds $10 of reserves, as required by the Fed, and uses the rest of its funds, $200 to make loans

to firms.

If these two banks are the only banks in this economy, total reserves in the banking system are equal to $20.

The Feds balance sheet may thus look as follows (where I assume that in addition to reserves, the Fed has issues

$100 worth of currency):

Fed

Assets

Govt Bonds

Liabilities

120

Reserves

Currency

20

100

Consider next a crisis of confidence in which Bank A, fearing that some of Bs loans are no longer going to be

repaid, refuses to roll over its loan to B and is about to cut Bs financing. In such a case Bank B will have to

liquidate a part of its assets, possibly at a discount, and would thus a) stop lending to firms and b) possibly go

bankrupt if the value of its assets falls below that of its debt.

Unconventional monetary policy involves having the Fed purchase As loan to B in exchange for reserves, thus

indirectly lending to B. Mechanically, the Fed issues $ 100 worth of reserves and buys As claim on B. The new

balance sheets look as follows:

66

Bank A

Assets

Reserves

Bank B

Assets

Liabilities

110

Deposits

Net Worth

Reserves

Loans

100

10

Liabilities

10

200

Deposits

Loan from Fed

Net Worth

100

100

10

and

Fed

Assets

Govt Bonds

Loan to B

Liabilities

120

100

Reserves

Currency

120

100

Bank A now has $110 in reserves: the original 10, plus an additional 100 it received from its sales of the claim

on B. Bank Bs balance sheet is unchanged: only the owner of its original loan issue has changed. Finally, the

Feds balance sheet has expanded by $100: the Fed has $100 more liabilities (reserves) which it has used to finance

its purchase of the claim on B. Because of the Fed intervention banks did not need to cut their loans to the real

sector (firms).

9.6

As we discussed in the previous section, in normal times the situation described above is not sustainable: notice

that bank A has $110 reserves, much more than the $10 it is required to hold to back up the $100 of deposits it

issued. Indeed, if the required reserve ratio were 10%, we know that the $100 of new reserves would increase the

money supply by $1000.

At the zero lower bound, however, the nominal interest rates are 0: banks therefore have no reasons to liquidate

their excess reserves. The Fed intervention has therefore increased the excess reserves in the system by $100: these

are in excess of the $20 that banks are required to hold due meet the 10% reserve requirement. Indeed, during the

last years the Fed was actually paying interest on reserves, thus making banks reluctant to give up their reserves.

Since reserves do not contribute to increasing the money supply, the Fed policies had no discernible effect on the

supply of money in the economy and thus inflation.

The discussion above is neatly summarized in the next two Figures. The first figure shows that prior to the

crisis excess reserved used to be essentially 0, yet increased greatly in the aftermath of the crisis, alongside the

67

total reserves in the system. The next figure shows the details of the Feds balance sheet: the Fed used its issues

of reserves (Deposits of depository institutions) to purchase mortgage-backed securities and agency debt (the

latter is debt issues by government-sponsored agencies, Fannie, Freddie, Sallie).

68

69

70

10

in Jones, 3rd ed.)

We analyze how the consumers decision of how much to save vs. how much to consume is shaped by the timing

of government taxes/transfers and deficits. We show that changes in the timing of taxes/transfers have no effect

on consumption in the absence of frictions. This result is known as Ricardian Equivalence. We then describe how

borrowing constraints break this result.

10.1

Consumers problem

This should be very familiar since this is how we derived the IS curve earlier. This is a real model. The consumer

lives for 2 periods and has preferences:

U (C1 , C2 ) = log(C1 ) + log(C2 ),

where 1 is the discount factor. We assume for simplicity that preferences are logarithmic in consumption,

but this is not crucial. The consumer is born with no wealth and earns income Y1 in period 1 and Y2 in period 2.

The government collects taxes T1 and T2 in the two periods. The consumers budget constraints are:

C1 + B2 = Y1 T1

C2 = (1 + r)B2 + Y2 T2

The first expression says that period 1 funds (after-tax income) are used to finance consumption and savings, B2 .

In period 2 the consumer no longer saves (why?), and therefore consumes its existing wealth (last periods savings,

B2 plus interest) and after-tax income Y2 T2 .

We can solve for B2 from the second constraint and plug into the first to arrive at a life-time budget constraint:

C1 +

1

1

C2 = Y1 T1 +

(Y2 T2 ),

1+r

1+r

which says that period 1 consumption plus the present value (i.e. discounted by 1 + r) of period 2 consumption

is equal to the consumers income in period 1 plus the present value of period 2 income.

Recall from our derivation of the IS curve that the consumers first order condition for C is2 :

C2

= (1 + r)

C1

2

Logarithmic preferences are a special case of the preferences we have assumed earlier with = 1.

71

We can plug back into the life-time budget constraint to see that

1

1

C1 =

Y1 T1 +

(Y2 T2 )

1+

1+r

Since 1, this says that the consumer spends about 1/2 of its life-time income in period 1 and the rest in period

2, thus preferring a relatively smooth path for consumption regardless of the path for income. This prediction

of the model is referred to as the permanent income hypothesis, PIH: it says that what matter for how much a

consumer eats in any period is its life-time (permanent) income, not its income in any given period. So in the

example above, consider two consumers. Imagine consumer 1 has high income in period 1 (Y1 T1 = 50, 000) and

no income in period 2, while consumer 2 receives all of its income in period 2 (Y2 T2 = 50, 000(1 + r)). The

PIH states that both consumer should have identical consumption in both periods of their lives, C1 =

and C2 =

1+ (1

1

1+ 50, 000

+ r)50, 000, because their life-time income is identical. Mechanically, consumer 1 should lend to

consumer 2 in the first-period and use the savings to eat in its second period.

Notice that this result has a powerful implication: consumers should save most of their transitory income

increases, and spend more only if they experience a permanent increase in their income. To see this, consider a

consumer that leaves for N periods. Its life-time budget constraint is:

1

1

1

1

C2 +

C3 +

C4 + ...

CN =

2

3

1+r

(1 + r)

(1 + r)

(1 + r)N 1

1

1

1

Y1 T1 +

(Y2 T2 ) +

(Y3 T3 ) + ...

(YN TN )

2

1+r

(1 + r)

(1 + r)N 1

C1 +

Ci = ((1 + r))i C1

we can derive consumption as:

C1 =

1

1 + + 2 + ... N 1

1

1

Y1 T1 +

(Y2 T2 ) + ...

(YN TN )

1+r

(1 + r)N 1

For 1, the first term is simply 1/N , so consumption in the first period is just the average of incomes

in all future periods. Thus, if Y1 increases by $100, the consumer should only spend 1/N th of this increase,

thus about 2$ under the assumption that it has another 50 periods to live. Consumption should increase little in

response to transitory changes in income. Of course, if income permanently increases by $100 (so that Y1 , Y2 , Y3

all increase, then consumption should increase by $100 as well.

The reason for this result is consumption-smoothing: since utility is concave in consumption, there are diminishing marginal returns to consuming, and so consumers prefer a smooth consumption stream rather than

one in which consumption fluctuates. This is also why consumers save for retirement: so they maintain their

consumption relatively flat over time even though (labor market) income abruptly decreases after retirement.

72

10.2

Graphical Analysis

Indifference curve: combination of C1 and C2 that give the same level of utility. For example, if

U (C1 , C2 ) =

C1 +

C2

then the following consumption combinations all generate equal utility of 20: (0, 400), (49, 169), (81, 121), (100,

100), (400, 0), etc. Notice that the more even consumption is in the 2 periods, the less total consumption is

needed to generate the same level of utility.

10.3

Consider next the governments problem. It too has a sequence of budget constraints:

G1 = B2 + T1

(1 + r)B2 + G2 = T2

In the first period it must spend G1 on public goods. It finances these by borrowing (B2 ) and by raising taxes,

T1 . Since period 2 is the last period, in that period it can only finance its spending and repay its debt using

taxes. (We assume no money printing here since we have shown earlier this is equivalent to formal taxation. All

variables are therefore real in this section). Combining the two budget constraints gives:

G1 +

1

1

G2 = T1 +

T2

1+r

1+r

which says that the present value of government spending and its existing debt obligations must equal to the

present value of government revenues.

[Graph of G - T and B: high G relative to T: government runs deficits, B gradually increases.)

Given this notation, we can formally state our question: Does it matter how the government finances its

spending, using T or by borrowing? Consider a given path for G: G1 and G2 . Given this path for government

spending, does it matter whether the government run a deficit initially by setting taxes low (T1 < G1 ) or if it runs

a surplus instead (T1 > G1 )? The answer is: it doesnt matter.

To see this, substitute the formula for the government budget constraint into that of the consumer. We have:

1

1

Y1 T1 +

(Y2 T2 )

C1 =

1+

1+r

which reduces to

1

1

C1 =

Y1 G1 +

(Y2 G2 )

1+

1+r

73

Thus consumption only depends on G, not on how exactly G is financed (T1 , T2 , B2 do not appear in the consumers

consumption decision). If the government initially runs a deficit (low T1 ), the consumer realizes it will have to pay

higher taxes in future periods. It perceives the low taxes as a purely transitory increase in income and thus saves

the proceeds to be able to pay off the higher taxes necessary to finance the government deficit in future periods.

In contrast, if the government runs a surplus (high T1 ), the consumer realizes this is a temporary income decline,

it borrows to smooth its consumption and repays in future periods when its after-tax income is higher.

10.4

Consider an example. Suppose = 1, r = 0, Y1 = 100, Y2 = 200 and consider a government that wants to finance

25 units of G in both periods: G1 = 50 and G2 = 50. According to our analysis above, the consumer should set

C1 = C2 =

200

= 100

2

How can it achieve this consumption plan? Suppose T1 = G1 = 50 and T2 = G2 = 50 so the government

runs no deficit. Given that the consumers period 1 after-tax income is only 50, it must borrow 50 units from

the market and finance its consumption of 100. With perfect capital markets, consumption-smoothing is perfect.

Suppose however that the consumer cannot borrow. Then it can only consume its after-tax income, Y1 T1 = 50.

An increase in T1 (government runs a surplus) would lead the consumer to cut back on its consumption even

further. In contrast, if the government were to lower T1 , (run a deficit), then consumption would increase. Thus,

the Ricardian equivalence fails in the presence of borrowing constraints.

Ricardian equivalence also fails if inter-generational links are not perfect: if the current generation does not

care much about the well-being of future generations, then government deficits today are great news: true, future

generations will have to repay the higher government debt, but the current generation does not care about the

well-being of future generations. If, however, society does care about the well-being of future generations, then

it will make sure to save the tax cuts received today in order to ensure future generations are able to repay the

future tax increases.

10.5

We have assumed up to now that the government collects its revenue using lump-sum taxes, that is, taxes that are

independent of how much income one earns. In practice, governments collect taxes in proportion to ones income.

Such taxes are called distortionary, since they change the labor supply and reduce the amount of output produced

in the economy.

That is, we have

74

Tt = t Wt Lt .

where Lt is the amounts of labor supplied by households. In this case the marginal tax rates t do have consequences

for how much labor agents supply and thus for total output.

To see this, suppose the production function is

Yt = Lt ,

so that the wage Wt = 1. The consumer supplies labor so as to maximize

1

U (Ct , Lt ) = Ct L2t .

2

The consumers budget constraint is:

Ct = (1 t )Lt ,

so the amount of labor it supplies is given by:

Lt = 1 t .

Total tax revenue is therefore

Tt = t (1 t ).

Suppose the government has a sequence G1 and G2 of government spending to finances. To fix ideas, suppose

that G1 + G2 = 0.25. Assume, for simplicity, that the interest rate r is zero, so the PV of the government budget

constraint is:

T1 + T2 = G1 + G2 = 0.25

There are several ways to finance this spending. For example, the government could set 2 = 0, in which case

its period 1 taxes would have to satisfy:

1 (1 1 ) = 0.25,

so

1 = 0.50.

Y1 = L1 = 1 1 = 0.50

and Y2 = 1, so the PV of total output would be 1.50.

Similarly, the government could set 1 = 0, 2 = 0.5 and this would also imply a PV of output of 1.5. A better

way to do this, however, would be to try to maximize the total amount produced,

Y1 + Y2 = 1 1 + 1 2 ,

75

subject to the constraint that the government finances its PV of government spending:

T1 + T2 = 1 (1 1 ) + 2 (1 2 ) = 0.25

We could solve this problem formally by setting it up as a constrained optimization problem. But that is not

really necessary here. Notice that 1 and 2 enter in a symmetric way both the objective and the constraint. So

it follows that 1 = 2 . The optimal thing to do is thus equate (smooth) taxes across periods, and thus collect

t (1 t ) = 0.125

revenue in each period. This would imply

1 = 2 0.146

and thus output would be

Y1 = Y2 = 0.854

and its PV would be

Y1 + Y2 = 1.708 > 1.5

Smoothing taxes here is thus much better than levying them in one single period.

The broader implication is that in the presence of distortionary taxes, the government should attempt to

smooth the cost of such distortions across time by maintaining relatively constant rates of taxation.

10.6

Y = C + I + G + NX

The question we want to ask next is: what is the effect of a $1 increase in G on Y ? (Recall from the previous

lectures that if the government can finance its spending with lump-sum taxes, then Ricardian equivalence holds

and how exactly the government finances its spending (using deficits or taxes) is inconsequential.)

The answer to the question posed above is referred to as the government spending multiplier, formally

multiplier =

Y

G

The answer to this question is obviously critical for stabilization policies in recessions etc. To answer this question,

we separately consider the Classical Model in which prices are flexible and output is supply-determined, and then

the Keynesian model.

76

10.7

Consider the simple static model of the labor market we have studied earlier. Imagine the production function is:

Y = L.

Suppose first that the utility function is

U (C, L) = C

1

L1+

1+

Since the wage is w = 1 (why?) and since we are now in a static model (G = T ), the consumers budget constraint

is:

C =LT =LG

The consumers choice of labor is therefore:

1 = L ,

so L = 1 and therefore Y = 1 regardless of the value of G or L. The government spending multiplier is therefore

0. This is the case because here taxes are assumed lump-sum, independent of the actual amount of the consumers

income, so they do not distort labor supply decisions. If in contrast, the tax rate would be proportional to income,

then labor would fall with higher G and thus taxes.

Let us next modify the utility function to

U (C, L) = log(C)

1

L1+

1+

CL = 1

or

(L G)L = 1,

which says that an increase in G must increase L. This is due to the wealth effect of labor supply. Higher G makes

households poorer, thus prompting them to simultaneously reduce consumption as well as leisure (since the two

are normal goods). Therefore labor supply must increase.

Another way to see this is to note that if L were fixed, then higher G reduces C, therefore making agents

poorer and therefore making them value C more (since U 0 (C) is decreasing in C) and therefore making them

willing to work more. In practice, the amount by which C increases depends on , but the multiplier is always less

77

than 1 in theory: a $1 increase in G raises Y by less then $1. To see this, let us first work out a specific example,

and then describe the broader intuition for why the multiplier is necessarily less than 1.

To fix ideas, suppose = 1. Then the labor supply choice says:

(L G)L = 1

or

L2 GL 1 = 0

The (positive) solution for L is

L=

G+

G2 + 4

.

2

G

L (=Y)

0

0.10

0.20

0.50

1

2

1

1.051

1.105

1.281

1.618

2.414

1

0.951

0.905

0.781

0.618

0.414

Once again we can see the intuition for why an increase in G raises labor supply (reduces leisure). When G

increases from 0 to say 1, if the consumer didnt raise L, it would consume 0 consumption which is very costly.

So the consumer reacts to the increase in G by cutting back on leisure, thus increasing labor supply to 1.618. It

now has 0.618 units of consumption, achieved at the expense of a decline in leisure (higher labor supply).

Why is the multiplier in this Classical economy necessarily less than 1? Note that output increases here only

because of the increase in L which itself is caused by the consumption drop. Assuming no investment or net

exports (or that the response of these is fixed), we have the accounting identity

Y =C +G

If the government spending multiplier were greater than 1, Y would increase by more than G which would lead

to an increase in C. But if consumers would consume more, this would lead to a decline in labor supply and thus

output. This is a contraction (since we initially guessed Y would increase, not fall) which refutes the possibility

that Y can increase by more than G. The only reason for the increase in output is that consumers are poorer in

78

the presence of higher G, and thus find it optimal to work harder. Thus C necessarily must fall for Y to increase

and the drop in C partially offsets the effect of G on output.

10.8

In Keynesian models the multiplier is also low as long as the Fed has a rule that attempts to stabilize output

by raising nominal interest rates when output increases. Only when i = 0 so monetary policy is irresponsive to

changes in the environment is the multiplier larger.

To see this, consider the basic Keynesian model. For simplicity, suppose prices are perfectly fixed, so that the

Phillips curve is

t = 0

This can be achieved by setting = 0 in the original Phillips curve we worked with earlier in the course. Suppose

that Fed has a rule of the form

rt = nyt

so it raises interest rates (here both nominal and real) whenever it sees output increase. Next, suppose consumption

is a negative function of interest rates,

ct = brt ,

and output is consumption plus government spending

yt = ct + gt .

We thus have

yt = gt brt ,

which makes it clear that an increase in government spending acts like an increase in demand. To find the actual

value of output, plug in the monetary policy rule into this IS curve so we have

yt = gt bnyt ,

which says that output is

yt =

gt

.

1 + bn

So if n is sufficiently high (the Fed sufficiently responsive to output fluctuations), then changes in g do not raise

output much. The reason is that the Fed reacts by raising the interest rate so as to prevent output from increasing.

The response is different however at the zero lower bound. If r = 0, the Fed can no longer respond to changes

in g by changing interest rates, and so an increase in g translates one-for-one into an increase in output. (The

government spending multiplier is 1, since C is fixed by the interest rate stuck at 0.).

79

11

11.1

Investment

Consider a firm that must decide how much to invest in period t. It starts from some capital stock Kt and given

investment It , its capital stock next year is

Kt+1 = (1 ) Kt + It ,

as in the Solow model.

The firms production function is:

Yt = At Kt L1

t

where Lt is the labor the firm hires. Suppose the firm discounts future profits at rate r, then its objective is:

max

i

1 h

1

At+1 Kt+1

Lt+1

W Lt+1 + (1 ) Kt+1 Kt+1

1+r

The first term is the discounted value of what the firm gets next year from choosing a stock of capital Kt+1 (by

investing It = Kt+1 (1 ) Kt today). The firm receives output Yt+1 as well as the undepreciated portion of its

capital stock, both of which are discounted at rate r, the real interest rate in the economy.

The optimality conditions are:

Yt+1

1

+ (1 ) = 1

1+r

Kt+1

or

Yt+1

=r+

Kt+1

This expression is fairly intuitive. The LHS is the marginal product of capital: the derivative of the production

function with respect to Kt+1 . This is what the firm receives (on the margin) in additional output by increasing

its capital stock by an extra unit. The RHS is the user cost of capital: this is what it costs the firm to buy one

extra unit of capital. Since capital is bought at t (and only used at t + 1), the firm loses the interest r that it

would have earned if it kept its funds with the bank. Similarly, a fraction of capital is lost to depreciation.. For

example, if r = 0.04 and = 0.06 (4% interest rate and 6% depreciation), the user cost of capital is 10%: this is

the effective cost of hiring one extra unit of capital (just like the wage rate W was the cost of hiring one extra

unit of labor).

Corporate income tax. Suppose the government taxes the income of the firm at a rate . Thus, the firm

receives

(1 ) [Yt W Lt ]

80

in income, the rest is taxed. This tax reduces the firms returns to buying an extra unit of capital, or equivalently,

raises the capitals user cost. To see why, note that the firms problem is now:

max

i

1 h

Kt+1

(1 ) At+1 Kt+1

L1

+

(1

)

K

W

L

t+1

t+1

t+1

1+r

(1 )

Yt+1

+ (1 ) = 1 + r

Kt+1

or

Yt+1

r+

=

Kt+1

1

So, for example, a corporate income tax of = 0.25 (1/4) boosts the user cost of capital by 1/(1 0.25) = 4/3.

[I kept things simple here by assuming the price of capital is equal to 1 and constant over time. Your book

allows for changes in the price of capital, but this makes the algebra messier without much additional insights.]

From Y /K to K and investment. So far we have discussed the models implications for the marginal

product of capital. But the marginal product of capital is a function of K, so we can easily back out the models

implications for K and I.

For example, suppose labor is fixed, L = 1, so the optimality condition is

1

=

At+1 Kt+1

r+

1

we then have

(1 ) At+1

=

(r + )

Kt+1

1

1

(14)

This says K is higher when A is higher, is lower or r is lower. And given information on Kt , we have

It = Kt+1 (1 ) Kt

One prediction that this model has is that investment is much more volatile than output. To see why, suppose

A increases by 1%. From (14) we know Kt+1 will increase by

1

1 %.

1.5%. Next,

Yt = AK A1+ 1 = A 1

so Y will also increase by

1

1 %.

It = Kt+1 (1 ) Kt

81

we have that the steady state level of I is simply K. So if = 0.10, investment is 10% of the level of capital. For

concreteness, suppose K is 1000 in steady state, then I = 100 in steady state. A productivity shock that raises

the desired level of K by 1.5% will change K from 1000 to 1015. But then investment has to be:

I = 1015 0.9 1000 = 115

of which 100 are just to replace the depreciated old capital and 15 to increase K to the new higher level. So the

increase in K is 15% or 10 times larger than the increase in the level of capital and output.

11.2

Suppose a firm issues equity and its price at t is Pt . Next year the price will be Pt+1 and the firm will issue dividends

Dt+1 . The question is: what determines the stocks current price, Pt . Assuming again that agents discount the

future at rate r, we have the following arbitrage equation:

Pt =

1

[Dt+1 + Pt+1 ]

1+r

which says that what the agent gives up to hold one unit of firm equity today (Pt ), must be equal to the discounted

value of what it will receive next year: dividends plus the ability to re-sell back equity at a different price Pt+1 . If

this equation were not satisfied, say Pt >

1

1+r

[Dt+1 + Pt+1 ], then the price of equity today is too high: investors

would like to sell equity at the high price Pt (thus bidding its price down) since in doing so they would get more

than what they would get by holding on to equity until next year.

We can update the above expression by noting that

Pt+1 =

1

[Dt+2 + Pt+2 ]

1+r

so that

Pt =

1

1

Dt+1 +

[Dt+2 + Pt+2 ]

1+r

(1 + r)2

Pt =

1

1

1

1

Dt+1 +

Dt+2 +

Dt+3 +

Dt+4 + ...

2

3

1+r

(1 + r)

(1 + r)

(1 + r)3

which says that the price of equity is equal to the discounted sum of all future dividends. If dividends are expected

to be high in the future, prices react immediately by increasing. Similarly, if r increases, say because of a financial

crisis (an increase in risk premia) or because of contractionary monetary policy, then the price of equity will fall:

even if the dividend process itself is unchanged, agents value those dividends less when r increases.

82

Next, suppose Dt+1 = Dt+2 = Dt+3 = ...D, i.e. dividends are expected to always stays constant. We can then

see that

Pt =

D

1

1

D=

1

1 + r 1 1+r

r

Notice that the price-dividend ratio is then equal to 1/r: making investors indifferent between lending directly

at r or owning shares in the firm implies that the price of a share must be 1/r times the dividends it expects

to receive. E.g., if r = 0.05, the price-dividend ratio is 20. Of course, monetary and business cycle factors

would imply fluctuations in the price dividend ratio, either because of changes in r or because of changes in D.

(Empirically, most movements in P/D are due to movements in r, not the due to movements in dividends).

11.3

Recall that in deriving the price of equity, we have made use of the no-arbitrage equation:

Pt =

1

[Dt+1 + Pt+1 ]

1+r

Dt+1 + Pt+1

Pt

The left-hand side is the (gross) return to directly lending at an interest rate r. The right hand side is the

1+r =

(gross) return to buying 1 unit of equity today (at Pt ) and receive the dividends and capital gains next period.

The no-arbitrage condition states that these two returns should be equal, or else agents will only invest in the one

with the higher return.

In reality, however, this no-arbitrage condition is grossly violated. Historically, corporate bonds have paid an

average of 4% real interest rate per year. In contrast, the average real return on S&P 500 was about 10% per

year. There is thus an equity premium: stocks pay an average return that is 6 percentage points greater than

bonds. Since this premium is so large, this feature of the data is called the equity premium puzzle. The puzzle

is that people would choose to invest in corporate bonds as opposed to directly in the stock market: why would

they do so if bonds pay so little?

The answer to this question is: risk. Bond returns are typically much less volatile than equity returns: whereas

20-30% movements in the S&P 500 are not uncommon, bond prices do not fluctuate nearly as much. Remember

that bond holders have a seniority clause: they get paid first, and the equity holders are the residual claimants to

the firms assets and may thus be wiped out if there is a recession.

But it is not the volatility of the stock market itself that is costly. Rather, it is the covariance between the

returns on the stock market and aggregate consumption. The stock market pays well exactly in those periods

83

in which consumption is booming and therefore the marginal utility of consumption is low and the high equity

returns less valuable. The stock market suffers losses exactly in those periods in which consumption falls because

of the recession. This is when the marginal utility of consumption is particularly high and investors particularly

upset that they suffer losses. The equity premium is thus compensation for this additional risk that equity holders

suffer.

84

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