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Foundations of Modern Macroeconomics Second Edition: Chapter 1: Who Is Who in Macroeconomics?
Foundations of Modern Macroeconomics Second Edition: Chapter 1: Who Is Who in Macroeconomics?
Building blocks
Schools of thought
Ben J. Heijdra
1 September 2009
Outline
1 Introduction
Technology
Production function:
Y = F (N, K),
Profit maximization
Short-run profit:
PY WN
max P Y W N
{N }
WN
= P F (N, K)
Profit maximization
d W = 0,
= 0: P FN (N, K)
dN
where FN F N (N,K)
is the marginal product of labour, i.e.
with respect to N .
the partial derivative of F (N, K)
See Figure 1.1 for the graphical derivation.
A
!
C!
N
A
panel (b)
A
!
A(N)
B
C! !
N
D
with NW/P 1/FN N < 0 and NK D F
N K /FN N > 0
(cooperative factors).
See Figure 1.2 for the effect of an increase in K.
W/P
-
ND(W/P, K1)
D -
N (W/P, K0)
Preferences
U U (C, 1 N S )
C is household consumption.
N S is household supply of labour (1 is the time endowment so
1 N S is leisure).
U is (an index of) household utility.
Properties:
UC > 0, U1N > 0
UCC < 0, U1N,1N < 0
C
S
C1 !
E1
C1 !
S
C0 !
EN
CC ! U1
E0
C0 !
U0
! ! ! ! !
0 1!NCS 1!N1S 1!N0S 1 1!N S
W/Pe NS(W/Pe)
NS(W/Pe,U0)
E1
(W/Pe)1 ! !
EN
(W/Pe)0 !
E0
! !
0 N0S N1S NCS 1 N
Equivalently:
W Pe
= g(N S )
P P
W=P2 FN
N2 N1 N Y2 Y1 Y
Y Y
A
E0 ! !A
Y* ! !
E0
B
! !B
- D
Y=F(N , K)
N* N Y
N2 N* NS2 N Y2 Y
Y Y
E0,B
Y* ! ! E ,B
0
A! !
A
-
Y=F(ND, K)
N* N Y
****
Theory of money
Speculative motive.
D
M
mD
S = l(R), lR < 0
P S
R
MAX
R !
l(Y,R)
RMIN
l(Y,R)
mD mD D
S + mT = k(Y ) + l(R) = L(Y, R)
mS = M/P
D
m = mS
M is the exogenous nominal money supply (under control of
the monetary authority).
m is real money (nominal money in terms of price level).
Real demand equals real supply of money.
The LM curve summarizes money market equilibrium. See
Figure 1.8 for the derivation.
As we shall see, the slope of the LM curve is an important
source of disagreement among the different schools of thought
in macroeconomics.
Foundations of Modern Macroeconomics - Second Edition Chapter 1 29 / 51
Introduction Block 1: Labour demand
Building blocks Block 2: Labour supply
Schools of thought Block 3: Demand for money
R lR = 0 R !kY/lR 6 4 LM
A2
MAX !
R ! A1
!4 < lR < 0 !kY/lR > 0
C2 ! !
lR 6 !4 !kY/lR = 0 C1
RMIN B2
! !
D2
!
D1
!
B1
l(R)
A3 l(R) Y
! !A
k(Y) C3 k(Y) 4
! ! C4
B3
! !B
4
D3
! ! D4
l(R) + k(Y) = (M/P)0
l(R) Y
Y = C + I + G,
C = C(Y T ), 0 < CY T < 1,
I = I(R), IR < 0,
T = T (Y ), 0 < TY < 1,
M/P = l(Y, R), lY > 0, lR 0,
Y = C(Y T (Y )) + I(R) + G
dY = CY T (dY TY dY ) + IR dR + dG
dY = CY T (1 TY ) dY + IR dR + dG
IR dR + dG
dY = (A)
1 CY T (1 TY )
Slope of LM curve:
M/P = l(Y, R)
d(M/P ) = lY dY + lR dR
d(M/P ) lY dY
dR = (B)
lR
Foundations of Modern Macroeconomics - Second Edition Chapter 1 32 / 51
Introduction Block 1: Labour demand
Building blocks Block 2: Labour supply
Schools of thought Block 3: Demand for money
IR d(M/Pl)l Y dY
+ dG
dY = R
1 CY T (1 TY )
d(M/P ) lY dY
[1 CY T (1 TY )] dY = IR + dG
lR
IR lY IR
1 CY T (1 TY ) + dY = d(M/P ) + dG
lR lR
****
Classical economists
Keynesians
Neo-classical synthesis (a.k.a. neo-Keynesian synthesis)
Monetarists
New-Classical economists
Supply-siders
New-Keynesians
Distinguishing features
Classical Economists
M = kP Y
with k constant.
LM curve vertical (lR = 0 in our notation).
AD curve independent of government consumption G .
Classical Economists
Fiscal policy useless. Just raises interest rate and crowds out
investment (see Figure 1.9).
Monetary policy useless. Just raises prices and does nothing to
real things (see Figure 1.9).
Classical dichotomy: money is a veil which determines nominal
prices but does not affect real quantities and relative prices.
Monetary neutrality.
Conclusion: no need for macroeconomic policy. Leave
well-enough alone. Laissez-faire economics.
R
LM(M0/P0)
LM(M1/P1)
R1 !
R0 IS(G1)
!
IS(G0)
P
AS
P1 !
AD(M1)
P0 !
AD(M0)
Y* Y
Keynes?
Keynes?
C = C(Y T , M/P )
+ +
LM(M0/P0)
A B
RMIN ! ! LM(M0/P1)
IS(G1)
IS(G0)
P
AD(G0) AD(G1) AS
A B
P1 ! !
A B
P0 ! !
Y0 Y1 Y* Y
Neoclassical synthesizers
Neoclassical synthesizers
IS(G0)
Y
P AS(Pe=P2)
e
AS(P =P0)
P2 !
P1 !
P0 ! !
AD(G0,M1)
AD(G1,M0)
AD(G0,M0)
Y* Y
Monetarists
Supply siders
T
A
!
!
B
! C
! !
0 1 tL