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Current Events

As a result of the „mortgage crisis‟. the U.S. and many foreign economies have recently experienced deep recessions

GDP declined substantially, many countries still in recession

Intermediate Macroeconomics

June 2, 2010

2

5%) Intermediate Macroeconomics June 2. 2009 Still very high as of April 2010 (9.1% in October.Current Events U. unemployment rate reached its peak at 10. 2010 3 .S.

Current Events Stock-market prices declined 40% in 2008 Stock-market prices have risen 45% since March S&P 500 Index 1800 1600 1400 1200 1000 800 600 400 200 0 1/3/1950 1/3/1953 1/3/1956 1/3/1959 1/3/1962 1/3/1965 1/3/1968 1/3/1974 1/3/1977 1/3/1980 1/3/1983 1/3/1989 1/3/1992 1/3/1995 1/3/1998 1/3/2001 1/3/2004 1/3/2007 2/2/2009 Intermediate Macroeconomics June 2. 2010 1/3/2010 1/3/1971 1/3/1986 4 .

2010 5 .Current Events Federal Reserve has lowered interest rates to virtually zero percent “Credit spreads” at their highest levels ever Intermediate Macroeconomics June 2.

2010 6 .Current Events Federal Reserve has lowered interest rates to virtually zero percent “Credit spreads” at their highest levels ever Intermediate Macroeconomics June 2.

2010 7 .Current Events Inflation level and wage rates declined substantially Intermediate Macroeconomics June 2.

Theory Is “aggregate demand” weak? Is “aggregate supply” weak? IS/LM framework is not sufficient for in-depth analysis Price Level ? AS ? AD GDP Intermediate Macroeconomics June 2. 2010 8 .

2010 9 .Theory Contemporaneous (within the same period) AND Dynamic (across periods) interactions of variables Employment Production Wages Consumption Intermediate Macroeconomics June 2.

etc.. Capital/asset markets Microeconomic Foundation: Profit Maximization Can we feasibly model the decisions of every consumer and firm and every interaction between them?. 5.Theory Macroeconomic Outcomes: MACROECONOMY 1.. Fiscal policy (taxes and government spending) PUBLIC SECTOR (GOVERNMENT) Modern Macroeconomic Theory: CONSUMERS FIRMS Build a theory of aggregate outcomes by studying microeconomic decisions and interactions between firms and consumers Interact through three types of markets: Microeconomic Foundation: 1.. 2010 10 .. Monetary policy (interest rates) 2. Labor markets Utility Maximization 3. GDP Inflation Unemployment Trade balances Etc. 4. Goods markets 2. 2. AGGREGATE OUTCOMES PRIVATE SECTOR Interact through policy: 1. 3.probably not… Intermediate Macroeconomics June 2.

. 2010 11 .e. and predictions Intermediate Macroeconomics June 2. economy-wide) consumption = $500 Average consumption = $100 Macroeconomics is most concerned with aggregate outcomes If we want to take a micro-based approach to explaining aggregate outcomes… …model Consumer C‟s behavior/decision-making A simplistic approach – turns out to yield surprisingly rich results. insights.Theory Consumer A: Consumer B: Consumer C: Consumer D: Consumer E: Consumed $50 in Year X Consumed $75 in Year X Consumed $100 in Year X Consumed $125 in Year X Consumed $150 in Year X No other consumers in the economy THE REPRESENTATIVE CONSUMER Aggregate (i.

c2) > 0 and uii(c1. c4. 2010 12 . cN) Intermediate Macroeconomics June 2. c2) < 0 for each of i = 1. c2). with ui(c1. with du/dc > 0 and d2u/dc2 < 0 Recall interpretation: strictly increasing at a strictly decreasing rate Diminishing marginal utility Two-good case: u(c1. c2. the (partial) slope of utility with respect to that good Alternative notation: du/dc OR u‟(c) OR uc(c) OR u1(c) One-good case: u(c).….2 Utility strictly increasing in each good individually (partial) Diminishing marginal utility in each good individually Readily extendable to N-good case: u(c1. c3.Review of Consumer Theory Describe how much “happiness” or “satisfaction” an individual experiences from “consuming” goods – the benefit of consumption Marginal Utility The extra total utility resulting from consumption of a small/incremental extra unit of a good Mathematically.

c2) Viewed in good-by-good space c1 c2 Intermediate Macroeconomics June 2. 2010 13 . c2) = sqrt(c1) + sqrt(c2) u(c1. c2) = ln c1 + ln c2 or u(c1.Review of Consumer Theory One-good case u(c) Slope (marginal utility) asymptotes to (but never reaches…) zero Example: u(c) = ln c or u(c) = sqrt(c) Two-good case c Example: u(c1.c2) u(c1.

Review of Consumer Theory Alternative views Emphasizing the contours Indifference Curve: the set of all consumption bundles that deliver a particular level of utility/happiness Viewing only the contours Intermediate Macroeconomics June 2. 2010 14 .

c2 ) Using Implicit Function Theorem (see Practice Problem Set 1) Summary: whether graphically.e. c2)) MRS equals ratio of marginal utilities c1 c2 MRS (c1 . MRS(c1.. c2 ) u1 (c1 .or mathematically-formulated. c2 ) u2 (c1 . the (negative of the) slope of an indifference curve MRS is itself a function of c1 and c2 (i. 2010 15 .Review of Consumer Theory Marginal Rate of Substitution (MRS) Maximum quantity of one good consumer is willing to give up to obtain one extra unit of the other good Graphically. utility functions describe the benefit side of consumer optimization Intermediate Macroeconomics June 2.

The Graphics of Consumer Theory Describe the cost side of consumption One-good case (trivial): Pc = Y Assume income Y is taken as given by consumer for now… Two-good case (interesting): P1c1 + P2c2 = Y Assume income Y is taken as given by consumer for now… Plotted in 2D-consumption-space Plotted in 3D-consumption-space Slope = -P1/P2 Intermediate Macroeconomics June 2. 2010 16 .

2010 17 . choose c = Y/P No decision to make here… Two-good case How to optimally allocate Y across the two goods c1 and c2? A non-trivial decision problem… Utility increasing in the northeast direction Y/P c OPTIMALITY CONDITION: At the optimal choice.The Graphics of Consumer Theory Consumer‟s decision problem: maximize utility subject to budget constraint – bring together both cost side and benefit side u(c) One-good case Trivially. MRS = -slope of budget line c2 Optimal choice occurs at point of tangency between budget line and an indifference curve ratio of marginal utilities Highest attainable indifference curve c1 = price ratio Intermediate Macroeconomics June 2.

and λ 1) 2) 3) f x ( x. 2010 18 . y ) 0 Rationale: setting first derivatives to zero isolates maxima (or minima…technically. need to check second-order condition…) Intermediate Macroeconomics June 2. y ) g x ( x.y) = 0 (Note formulation of constraint) Step 1: Construct Lagrange function Lagrange multiplier L( x. y ) g y ( x. y. y.y)… …subject to the constraint g(x. y) to maximize a given objective function f(x. y) g ( x. y ) 0 g ( x. y ) 0 f y ( x.The Mathematics of Consumer Theory Consumer optimization a constrained optimization problem Maximize some function (utility function)… …taking into account some restriction on the objects to be maximized over (budget constraint) Lagrange Method: mathematical tool to solve constrained optimization problems General mathematical formulation Choose (x. ) f ( x. y) Step 2: Compute first-order conditions with respect to x.

y) Optimality condition: at the optimum (x*.y) x Intermediate Macroeconomics June 2. isolate λ: f x ( x. y) 0 g x ( x.) is tangent to the function g(. y) f y ( x. y ) g x ( x. y ) g y ( x. y*) f x ( x*.) The constrained optimum (x*. y*) g(x. y*) y f(x. the function f(. and λ Often most interested in simply eliminating the multiplier… From eqn 1). 2010 19 . y*) g y ( x*.y) Graphical interpretation: at the constrained optimum. y*) g x ( x*. y. y*) f y ( x*. y) Insert expression for λ in eqn 2): Rearrange f x ( x.The Mathematics of Consumer Theory Step 3: Solve the system of first-order conditions for x.

c2) Constraint: g(c1. MRS = price ratio Intermediate Macroeconomics June 2. λ Step 3: Solve (with focus on eliminating multiplier) * * u1 (c1 ..c2) = Y – P1c1 – P2c2 = 0 Step 1: Construct Lagrange function L(c1 .The Mathematics of Consumer Theory Apply Lagrange tools to consumer optimization Objective function: u(c1.e. 2010 20 . c2. ) u(c1 . c2 . c2 ) P2 OPTIMALITY CONDITION i. c2 ) P 1 * * u2 (c1 . c2 ) Y Pc1 P2c2 1 Step 2: Compute first-order conditions with respect to c1.

Next Time Read by end of the week Chapter -1 (mathematical refresher) Chapter 0 (introduction to representative-agent framework) Chapter 1 (consumer theory) Read for next week Chapter 2.4 (static consumption-leisure model) Practice Problem Set 1 Practice with partial derivatives Reviews consumer theory Intermediate Macroeconomics June 2. 2010 21 .3.

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