Intermediate Macroeconomics - Summary FK

Frédéric Kröger Intermediate Macroeconomics - Summary
Intermediate Macroeconomics – Summary
❖ National Income (Chap 3)

o 4 LONG-RUN QUESTIONS
o What determines the level of real GDP?
→ How much do the firms in the economy produce, what determines a nation’s total income?
o What determines the income distribution between owners of labour and

owners of capital?
→ Who gets the income from production, how much to compensate workers, and how much
goes to compensate owners of capital?
o What determines how GDP is allocated to C (consumption), I (investment),

and G (government spending)?
o What ensure equilibrium of flows in the economy?

→ What equilibrates the demand and supply for/of GaS (Goods and Services), what ensures
that desired spending on C, I and G equals the level of production?
o CIRCULAR FLOW OF $ THROUGH THE ECONOMY

▪ Reflects how real economies function
▪ Shows link btw economic actors: households, firms, and the government
AND how dollars flow among them through various markets
o Households
▪ Receive income
▪ Use it to pay taxes, to consume GaS, to save through financial markets
o Firms
▪ Receive revenue from sales of GaS
▪ Use it to pay for factors of production
o Households and firms
▪ Borrow financial markets to buy investment goods (house, factories, …)
o Government
▪ Receive revenue from taxes Public saving :
▪ Use it to pay for government purchases - Negative ➔ Budget deficit
▪ Any excess of tax revenue is called public saving - Positive ➔ Budget surplus
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o WHAT DETERMINES THE TOTAL PRODUCTION OF GaS?

▪ Economy’s output of GaS depends on
• Factors of production ➔ Qtt of input
• Production function ➔ Ability to turn inputs into outputs
o Factors of production
▪ Two most important are Capital
• Capital (K) ➔ Set of tools workers use
• Labour (L) ➔ Time people spend working
▪ We assume in this chapter that K and L are fixed and fully used
o Production function
▪ Function of amount of K and L
𝒀 = 𝑭(𝑲, 𝑳)
▪ Constant returns to scale ➔ If increase of certain percentage in all factors
of production, increase the output by same percentage
𝒛𝒀 = 𝑭(𝒛𝑲, 𝒛𝑳)
o Supply of Goods and Services
▪ Economy’s output ➔ Factors of production AND Production function
• Because K and L are assumed fixed → Output Y is also fixed
̅, 𝑳
𝒀 = 𝑭(𝑲 ̅)
o HOW IS NATIONAL INCOME DISTRIBUTED TO FACTORS OF PRODUCTION?

▪ Total output in economy = Total income
→ Factors of prod and prod function also determine national income
o Modern Theory of how income is divided among factors of prod is based on
▪ Classical (18th)
• Idea that price adjusts to balance supply and demand
▪ Neoclassical theory of distribution (19th)
• Demand for each factors of prod depends on its marginal productivity
o Factor Prices
➔ Amounts paid to each unit of factors of production (K and L)
▪ Determines distribution of national income
▪ Price received by each factor of prod depends on its supply and demand
• Assumption of fixed factors of prod
▪ Factor supply curve is vertical
▪ Supply is the same regardless of the price
▪ Equilibrium factor price (intersection)
• Demand for factors comes from firms that use K and L
→ Examine decisions firms make about how much factors to use?
o Decisions Facing a Competitive Firm

▪ Competitive firm has no influence on price (P), wage (W), or rent (R)
→ Sells at P, engage workers at W, and rent capital at rate R (market conditions)
▪ Goal of firm is to maximize profit
• Profit ➔ What owner keeps after paying for cost of production
𝑷𝒓𝒐𝒇𝒊𝒕 = 𝑹𝒆𝒗𝒆𝒏𝒖𝒆 − 𝑪𝒐𝒔𝒕
▪ Revenue
𝑹𝒆𝒗𝒆𝒏𝒖𝒆 = 𝑷𝒔𝒆𝒍𝒍𝒊𝒏𝒈 𝒑𝒓𝒊𝒄𝒆 × 𝒀𝒂𝒎𝒐𝒖𝒏𝒕 𝒐𝒇 𝒈𝒐𝒐𝒅𝒔 𝒇𝒊𝒓𝒎 𝒑𝒓𝒐𝒅𝒖𝒄𝒆𝒔
▪ Costs
▪ Labout costs
= 𝑾𝒘𝒂𝒈𝒆𝒔 × 𝑳𝒂𝒎𝒐𝒖𝒏𝒕 𝒐𝒇 𝒍𝒂𝒃𝒐𝒖𝒓
▪ Capital costs
= 𝑹𝒓𝒆𝒏𝒕𝒂𝒍 𝒑𝒓𝒊𝒄𝒆 × 𝑲𝒂𝒎𝒐𝒖𝒏𝒕 𝒐𝒇 𝒄𝒂𝒑𝒊𝒕𝒂𝒍
2
• Profit = Revenue – Labour costs – Capital costs

𝑷𝒓𝒐𝒇𝒊𝒕 = 𝑷𝒀 − 𝑾𝑳 − 𝑹𝑲
▪ To see how profit depends on factors of prod, use prod function to
substitute for Y
𝑷𝒓𝒐𝒇𝒊𝒕 = 𝑷𝑭(𝑲, 𝑳) − 𝑾𝑳 − 𝑹𝑲
→ Shows that profit depends on product price P, factor prices W and R,
and factors qtt L and K
➔ Competitive firm takes prices as given and chooses amounts
of labor and capital that maximize profit
o Firm’s Demand for Factors

(What are those profit-maximizing quantities?)
▪ For Labour
• If extra revenue > cost from hiring, extra unit of labour increases profit
→ Manager continues to hire labour until extra revenue = cost
• Marginal Product of Labour (MPL) ➔ Extra amount of output firm gets
from one extra unit of labour (holding amount of capital fixed)
𝑴𝑷𝑳 = 𝑭(𝑲, 𝑳 + 𝟏) − 𝑭(𝑲, 𝑳)
▪ Diminishing marginal product
▪ If K is fixed, MPL decreases as amount of labour (L) increases
▪ MPL is slope of prod function
→ As amount of labour increases, prod function becomes flatter
• Extra revenue
▪ Extra unit of labour produces MPL units of output
𝑬𝒙𝒕𝒓𝒂 𝒓𝒆𝒗𝒆𝒏𝒖𝒆 = 𝑷 × 𝑴𝑷𝑳
• Extra unit of labour costs wage (W)
• Change in profit from hiring an additional unit of labour is
∆𝑷𝒓𝒐𝒇𝒊𝒕 = ∆𝑹𝒆𝒗𝒆𝒏𝒖𝒆 − ∆𝑪𝒐𝒔𝒕
∆𝑷𝒓𝒐𝒇𝒊𝒕 = (𝑷 × 𝑴𝑷𝑳) − 𝑾
• Competitive firm’s demand for labour is determined by

𝑾
𝑷 × 𝑴𝑷𝑳 = 𝑾 𝑴𝑷𝑳 =
𝑷
▪ Real wage (W/P) ➔ In term of units of output rather than in $
➔ To maximize profit, firm hires until MPL = Real wage
▪ For Capital
• Same way as for labour
• Marginal Product of Capital (MPK) ➔ Extra amount of output firm gets
grom one extra unit of capital (holding amount of labour fixed)
𝑴𝑷𝑲 = 𝑭(𝑲 + 𝟏, 𝑳) − 𝑭(𝑲, 𝑳)
▪ Diminishing marginal product
• Extra unit of capital costs machine’s rental price (R)
• Change in profit from renting an additional machine is
∆𝑷𝒓𝒐𝒇𝒊𝒕 = ∆𝑹𝒆𝒗𝒆𝒏𝒖𝒆 − ∆𝑪𝒐𝒔𝒕
∆𝑷𝒓𝒐𝒇𝒊𝒕 = (𝑷 × 𝑴𝑷𝑲) − 𝑹
• Competitive firm’s demand for capital is determined by

𝑹
𝑷 × 𝑴𝑷𝑲 = 𝑹 𝑴𝑷𝑲 =
𝑷
▪ Rental price of capital (R/P) ➔ In term of units of goods rather than in $
➔ To maximize profit firm rents until MPK = R/P
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o Division of National Income

• After analyzing how firm decides qtt of each factor to employ
→ Can explain how markets for factors of prod distribute total income
▪ If all firms in economy are competitive and profit maximizing, then each
factor of prod is paid its marginal contribution to the prod process
• Real wage paid to each worker = MPL
• Real rental price paid to each owner of capital = MPK
• Total real wages paid to labor → MPL x L
• Total real return paid to capital owners → MPK x K
• Economic profit of owners of the firm
➔ Income that remains after firms paid factors of prod
𝑬𝒄𝒐𝒏𝒐𝒎𝒊𝒄 𝒑𝒓𝒐𝒇𝒊𝒕 = 𝒀 − (𝑴𝑷𝑳 × 𝑳) − (𝑴𝑷𝑲 × 𝑲)
▪ Total income is divided among return to labor, return to capital, economic

profit 𝒀 = (𝑴𝑷𝑳 × 𝑳) + (𝑴𝑷𝑲 × 𝑲) + 𝑬𝒄𝒐𝒏𝒐𝒎𝒊𝒄 𝑷𝒓𝒐𝒇𝒊𝒕
How large is economic profit?

• If production function has property of constant returns to scale (as often
thought to be the case), economic profit must be zero
• Nothing is left after factors of prod are paid
• This conclusion comes from Euler’s theorem
▪ If prod function has constant returns to scale, then
𝑭(𝑲, 𝑳) = (𝑴𝑷𝑳 × 𝑳) + (𝑴𝑷𝑲 × 𝑲)
▪ So, constant returns to scale, profit maximization, and competition imply
that economic profit is zero
If economic profit = 0, how can we explain existence of “profit” in economy?
• Term profit as normally used is different from economic profit
• 3 types of agents (workers, owners of capital, owners of firms) and total
income divided (among wages, return to capital, economic profit)
BUT
Real world, most firms own rather than rent the capital they use
Because firm owners and capital owners are same people, economic profit
and return to capital are often lumped together
• If we call this alternative Accounting profit
𝑨𝒄𝒄𝒐𝒖𝒏𝒕𝒊𝒏𝒈 𝒑𝒓𝒐𝒇𝒊𝒕 = 𝑬𝒄𝒐𝒏𝒐𝒎𝒊𝒄 𝒑𝒓𝒐𝒇𝒊𝒕 + (𝑴𝑷𝑲 × 𝑲)
How income of the economy is distributed from firms to households

➔ Each factor of prod is paid its marginal product. If prod function has
constant returns to scale (Euler’s theorem), all output is used to
compensate the inputs. Total output is divided btw payments to capital
and payment to labour, depending on marginal productivities
o Cobb-Douglas Production Function (1927)

▪ Noticed that division of national income btw K and L had been roughly
constant over a long period of time
→ Total income of workers and of capital owners grew at same rate as
economy grew overtime
▪ For prod function to produce constant factor shares, if factors always earn
their marginal products, it need to have the property that:
• Parameter A is greater than 0 and measures productivity of available

technology
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o WHAT DETERMINES THE DEMAND FOR GOODS AND SERVICES

How is output from production used?
▪ Circular flow diagram contains 3 of 4 components of GDP
• We assume closed economy so net exports = 0
▪ 3 uses for produced GaS, expressed in the national income account identity
𝒀 = 𝑪+𝑰+𝑮
How is GDP allocated among the 3 uses?
o Consumption
▪ 2/3 of GDP
▪ Households receive income from labour and ownership of capital
→ Income = economy’s output Y
▪ Depends on disposable income
• Disposable income = Y – T ➔ Income after paying for taxes
• Households divide disposable income btw consumption and saving
• Level of consumption is function (depends directly) of disposable income
→ Higher disposable income means higher consumption
𝑪 = 𝑪(𝒀 − 𝑻)
▪ Marginal propensity to consume (MPC) ➔ Amount by which consumption
changes when disposable income increases by 1$ (/!\ 0 < MPC < 1)
E.g. If MPC = 0.7 → for each extra $, spend 0.7$ on consumption and save 0.3$
• MPC = Slope of consumption function
o Investment
▪ Depends on the interest rate 𝑰 = 𝑰(𝒓)
• Firms buy investment goods to add/replace their capital
Households buy new houses
▪ r → Measures cost of funds used to finance investment
To be profitable, cost of investment (= interest rate) must be less than its return
• If interest rate rises, demand for investment goods falls
▪ Nominal interest rate ➔ Interest rate as usually reported
▪ Real interest rate ➔ Nominal interest rate corrected for effect of inflation
• Measures true cost of borrowing (so determines qtt of investment)
o Government purchases
▪ Exogenous variables
• Fixed outside our model, not affected by model
• Set by fiscal policymakers
▪ Endogenous variables are C, I and r
• They are affected by exogenous variables
▪ Transfer payments ➔ Payment not made in exchange of some outpu
• Public assistance, social security, …
• Not included in G
• Opposite of taxes
→ They increase households’ disposable income
→ Increase in transfer payment financed by taxes
= unchanged disposable income
𝑻 = 𝑻𝒂𝒙𝒆𝒔 − 𝑻𝒓𝒂𝒏𝒔𝒇𝒆𝒓 𝒑𝒂𝒚𝒎𝒆𝒏𝒕𝒔

▪ Y – T include the positive impact of transfer payment and the negative
impact of taxes on disposable income
▪ Government can have
• Balanced Budget ➔ Government purchases = Taxes – Transfer payments
𝑮=𝑻
• Budget Deficit ➔ It can fund it by borrowing in financial markets
𝑮>𝑻
• Budget Surplus ➔ It can use it to repay some of its debt
𝑮<𝑻
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o WHAT BRINGS THE SUPPLY AND DEMAND FOR GaS INTO EQUILIBRIUM
▪ In circular flow diagram, interest rate ensures that sum of consumption,
investment, government purchases equals the amount of output produce
• It equilibrates supply and demand
▪ 2 approaches (2 sides of the same coin)
• How interest rate affects supply and demand for GaS
• How interest rate affects supply and demand for loanable funds
Summary equations o Equilibrium in Market for GaS: The Supply and Demand for Output
of demand for GaS: • Factors of prod and the prod function determine the quantity of output
supplied to the economy
▪ Substitue the consumption function and investment function into national
income accounts identity
→ 𝒀 = 𝑪(𝒀 − 𝑻) + 𝑰(𝒓) + 𝑮
▪ G and T are exogenous (fixed by policies) and Y is fixed by factors of prod
→𝒀 ̅ = 𝑪(𝒀 ̅−𝑻 ̅ ) + 𝑰(𝒓) + 𝑮̅
▪ Meaning that supply of output = its demand
• Demand is the sum of C, I, and G
• r is only variable not determined; it has key role as it adjusts to ensure that
demand for goods = supply
▪ If interest rate too high → Investments too low and Demand < Supply
▪ If interest rate too low → Investments too high and Demand > Supply
▪ At equilibrium interest rate → Demand = Supply
How does it balances? (Look at financial markets)
o Equilibrium in Financial Markets: The Supply and Demand for Loanable Funds
• Interest rate is cost of borrowing and the return to lending here
▪ Can rewrite national income accounts identity
→ 𝑰=𝒀−𝑪−𝑮 𝑰=𝑺 𝑺= 𝒀−𝑪−𝑮
▪ National saving is the sum of 2 pieces
• Public saving ➔ Tax revenue gov has left after paying for its spending
𝑺 = (𝒀 − 𝑻 − 𝑪) + (𝑻 − 𝑮) = (𝑻 − 𝑮)
• Private saving ➔ Income households have left after paying taxes and C
= (𝒀 − 𝑻 − 𝑪)
▪ Circular flow diagram states that flow into financial markets (Savings) must
balance the flows out the financial markets (Investments)
▪ Substitute consumption function and investment function
AND
G and T are exogenous (fixed by policies) and Y fixed by factors of prof
̅ − 𝑪(𝒀
𝒀 ̅−𝑻 ̅ = 𝑰(𝒓)
̅) − 𝑮
̅ = 𝑰(𝒓)
𝑺
▪ Left side → National saving depends on income Y, G, and T, for fixed values
of Y, G, and T, national saving S is also fixed
▪ Right side → Investment depends on interest rate
▪ Saving vertical bc doesn’t depend on interest rate
▪ Investment downward sloping
▪ Bc investment depends on interest rate, qtt of loanable funds demanded
also depends on interest rate
→ Interest rate adjusts until amount firms want to invest equals amount
that households want to save
• If r too high → Households want save more than firms want to invest
→ Loanable funds Qtt Demanded < Qtt Supplied
• If r too low → Investors want more of economy’s output than households
want to save → Loanable funds Qtt Demanded > Qtt Supplied → r rises
• At equilibrium r → Households want to save as much as firms want to
invest → Loanable funds Qtt Demanded = Qtt Supplied
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o Changes in Saving: Effects of Fiscal Policy

• When gov changes its spending or level of taxes
→ Affects demand for economy’s output of GaS and changes National
saving, investment and interest rate
▪ Increase in gov purchases
• Interest rate increases and investment decreases
→ Gov purchases crowds out investment
▪ If gov increases purchases by amount ΔG
→ Increase demand for GaS by ΔG
BUT total output is fixed by factors of prod
→ Decrease in another factor
▪ BUT Disposable Income (Y-T) is unchanged
→ C is also unchanged
→ Investment decrease
→ Interest rate must increase
• Impact on market for loanable funds
▪ Bc increase in G not accompanied by increase in T
→ Increase in G financed by borrowing
→ Reduces public saving
→ Supply curve shifts to the left
▪ Decrease in taxes of ΔT
• Interest rate increases and investment decreases
→ Reduction in taxes crowds out investment
▪ Raises disposable income by ΔT
→ Raises C by MPC* ΔT (greater the MPC, greater the impact)
BUT economy’s output is fixed
→ Decrease in another factor
▪ BUT G fixed by gov
→ Investment decrease
→ Interest rate must increase
• Impact on market for loanable funds
▪ Tax cut increases disposable income by ΔT
→ C goes up by MPC* ΔT
→ National savings falls by same amount as C rises
→ Supply curve shifts to the left
o Changes in Demand for Investment
▪ Different reasons for increase in demand for investment
• Technological innovation
▪ Leads to increase in investment demand bc before being able to take
advantage of innovation, firms or households must buy investment goods
• Encouragement from gov through tax laws
▪ Increase personal taxes and use extra revenue to cut taxes for those who
invest in new capital → investments are more profitable so demand rises
→ Increase in demand shifts investment curve to the right
But bc we assumed that consumption function did not depend on interrest rate,
supply curve is vertical
→ Equilibrium amount of investment is unchanged and interest rate rises
▪ BUT If consumption does depend on interest rate
• Higher interest rate means higher return on saving
→ Might reduce consumption and increase saving
o CONCLUSION
o Assumptions we made
▪ Ignored role of money
▪ No trade with other countries
▪ Labour force is fully employed
▪ Capital stock, Labour force, and production technology
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❖ Inflation – Its Causes, Effects, and Social Cost (Chap 5)

▪ Inflation ➔ Increase in average price
▪ Price ➔ Rate at which money is exchanged for GaS
▪ Rate of inflation ➔ Percentage change in overall level of prices
▪ Hyperinflation ➔ Episodes of extraordinarily high inflation
▪ We assume that prices are flexible
o THE QUANTITY THEORY OF MONEY

▪ Money supply ➔ Qtt of money available in the economy
▪ Quantity theory of money ➔ Theory explaining how qtt of money is
related to other economic variables, and how it affects economy in long run
• Qtt of money determines the price level
• Rate of growth in qtt of money determines rate of inflation
o Quantity Equation
• Ppl hold money to buy GaS, the more money they need for transactions,
the more money hold
→ Qtt of money is related to number of $ exchanged in transactions
▪ Quantity equation is link btw money and transactions
𝑴×𝑽=𝑷×𝑻
• Left side (about money used to make the transactions)
▪ 𝑴 ➔ Qtt of money
▪ 𝑽 ➔ Transaction velocity of money ➔ Rate at which money circulates in
economy (number of times a $ bill changes hand in a given period of time)
• Right side (about the transactions)
▪ 𝑻 ➔ Total number of transactions during some period of time
(Number of times in a period that GaS are exchanged for money)
▪ 𝑷 ➔ Price of typical transaction
(Number of $ exchanged)
▪ 𝑷𝑻 ➔ Number of $ exchanged in a year
o Income Velocity of Money
• Number of transactions (T) is difficult to measure
→ Replace it by total output of economy (Y)
Bc $ value of transactions is roughly proportional to $ value of output
▪ The more economy produces, the more goods are bought and sold
▪ Equation (most common version)
𝑴×𝑽=𝑷×𝒀
▪ 𝑽 ➔ Income velocity of money
▪ 𝒀 ➔ Real GDP
▪ 𝑷 ➔ GDP deflator
▪ 𝑷𝒀 ➔ Nominal GDP ($ value of output)
o Money demand function
• 𝑴/𝑷 ➔ Real money balance
(Measure purchasing power of stock of money)
▪ Money demand function is an equation showing determinants of qtt of real
money balances that people wish to hold
(𝑴/𝑷)𝒅 = 𝒌𝒀
• Qtt of real money balance demanded is proportional to real income
▪ Bc holding money makes it easier to make transactions
▪ Higher income leads to greater demand for real money balances
𝟏
• 𝒌 ➔ Money demand parameter (constant) (opposite of 𝑽) 𝑽=
𝒌
(How much money ppl want to hold for every $ of income)
▪ Add to money demand function a condition
→ Demand for real money balance (𝑴/𝑷𝒅 )MUST equal supply (𝑴/𝑷)
𝑴/𝑷 = 𝒌𝒀 𝑴(𝟏/𝒌) = 𝑷𝒀 𝑴𝑽 = 𝑷𝒀
• Small 𝑽 → Ppl want to hold a lot of money for each $ of income → Large 𝒌
• Large 𝑽 → Ppl want to hold little of money for each $ of income → Small 𝒌
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o Assumption of Constant Velocity 𝑴×𝑽=𝑷×𝒀

• Qtt equation defines velocity (V) as ratio of nominal GDP (PY) to the qtt of
money (M)
→ If assume that V is constant, becomes theory about effect of money
supply on economy ➔ Quantity theory of money
▪ If V is fixed, qtt of money determines $ value of economy’s output
→ Economy’s level of prices
• When ECB changes supply of money → proportional change in nominal
value BUT factors of prod and prod function are already determined Y
→ PY can only adjust if the price level P changes
▪ 3 buildings blocks to the theory
• Output Y is determined by factors of prod and prod function
→ Productivity capability of economy determines real GDP
• Nominal value of output (PY) determined by money supply (M) set by ECB
• Price level (P) is ratio of nominal value of output (PY) to output
→ GDP deflator is ratio of nominal GDP to real GDP
o Theory of Inflation Rate
• Inflation rate ➔ % of change in price level
→ Theory of inflation rate
▪ Write quantity equation in percentage-change form
%∆𝑴 × %∆𝑽 = %∆𝑷 × %∆𝒀
▪ %∆𝑴➔ Under control of Central bank
▪ %∆𝑽 ➔ Zero because V is constant
▪ %∆𝑷 ➔ Rate of inflation
▪ %∆𝒀 ➔ Depends on growth in factors of prod and technological progress
• Price level is determined by growth in money supply
• Qtt theory of money states that central bank has ultimate control over
rate of inflation (Bc it controls money supply)
o SEIGNIORAGE: THE REVENUE FROM PRINTING MONEY

▪ 3 ways for government to fund its expenses
• Taxes
• Selling bonds to borrow from the public
• Seigniorage ➔ Printing money
o Printing money is called an inflation tax (➔ Tax on holding money)
▪ Printing money increases money supply, makes price rise and real value of
money decrease
▪ The need to print money to finance expenditure is primary cause of hyperinflation
o INFLATION AND INTEREST RATES

▪ Real interest rate (𝒓) = Nominal interest rate (𝒊) – Rate of inflation (𝝅)
𝒓= 𝒊−𝝅 • Nominal interest rate ➔ What bank pays on money you deposit
• Real interest rate ➔ Increase in purchasing power
o Fisher Effect
𝒓=𝒊+𝝅
▪ One-for-one relation between inflation rate and nominal interest rate
(1% increase in rate of inflation → 1% increase in nominal interest rate)
▪ Shows that nominal interest rate can change for 2 reasons
• Real interest rate changes
• Inflation rate changes
o Ex Ante vs Ex Post real interest rates
▪ 2 concepts of real interest rate
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▪ Link with Fisher Effect

• Nominal interest rate can’t adjust to actual inflation bc we don’t know it
when nominal interest rate is set by the lender and borrower
→ Nominal interest rate can only adjust to expected inflation
→ Fisher effect more precisely written as
𝒓 = 𝒊 + 𝑬𝝅
• Ex ante real interest rate (𝒓) is determined by equilibrium in market for GaS
▪ Nom interest rate (𝒊) moves 1-to-1 with changes in expected inflation (𝑬𝝅)
▪ /!\ If nominal interest rate adjusts to expected inflation and not actual
Why does it follow same graph as actual inflation?
→ Bc actual inflation is usually persistent
o NOMINAL INTEREST RATE AND DEMAND FOR MONEY

▪ Qtt theory of money assumes that demand for real money is proportional
to income
In fact there is another determinant of qtt of money demanded
→ Nominal interest rate
o Cost of Holding Money
• Qtt of money demanded depends on income AND cost of holding money
▪ Nominal interest rate (𝒊) = Opportunity cost of holding money
→ What you give up for holding money
▪ 2 Explanations:
• If instead of holding money you used it to buy gov bonds or deposit into
saving account, you would earn nominal interest rate (𝒊)
→ Reason why 𝒊 = Opportunity cost of holding money
• Assets other than money (E.g. Gov bonds) earn real return (𝒓)
AND
Money earns an expected real return of (−𝑬𝝅)
Bc real value declines at rate of inflation
Holding money means giving up difference btw theses 2 returns
→ Cost of holding money is = 𝒓 − (−𝑬𝝅), which Fisher tells us = 𝒊
▪ General money demand function
(𝑴/𝑷)𝒅 = 𝑳(𝒊, 𝒀)
• 𝑳 ➔ Money demand (bc most liquid asset)
▪ Demand for real money balances is function of income and 𝒊
▪ Higher level of income → Greater demand for real money balance
▪ Higher nom interest rate → Lower demand for real money balance
o Future Money and Current Prices
• Money supply and money demand determine equilibrium price level
(Qtt theory of money)
→ Changes in price level are inflation
→ Inflation affects nominal interest rate through Fisher Effects
→ Nominal interest rate affects demand for money
▪ Effect of money on prices more complicated than what qtt theory says
→ Today’s price level depends on both current money supply AND on
expected future money supply
10
▪ Inflation set by current growth money supply and expected future growth
• Qtt theory of money, true if nom interest rate and output are constant
→ price level stay proportionate to money supply
BUT
• Nom interest rate is not constant (depends on expected inflation, which
depends on growth in money supply)
E.g. If announced that money supply in future will increase, but current money
supply doesn’t change
→ Ppl expect higher money growth and higher inflation
Fisher effect → Increase in expected inflation raises nom interest rate
→ Increases cost of holding money
→ Reduces demand for real money balances
Bc qtt of money available today is unchanged, leads to higher price level
▪ ➔ Expectations of higher growth in future lead to higher price level today
o SOCIAL COSTS OF INFLATION
▪ Layman’s assumption ➔ Inflation makes us poorer bc without inflation
would get same wage and be able to buy more with it (more bc raise)
▪ Classical response ➔ When inflation slows, firm increase prices of their
product less each year so give smaller raises to labour
▪ Classical theory of money ➔ Change in price level is like changing
measurement, numbers get larger, but nothing really changes
→ Economic well-being depends on relative prices not overall price level
o Costs of Expected Inflation
▪ Shoeleather cost
• Inconvenience of reducing money holding (High inflation means people
lower their money balances and spend the same amount)
▪ Menu costs
• High inflation forces firms to change posted prices more often
▪ Microeconomics inefficiencies in allocation of resources
• Higher rate of inflation means greater variability in relative prices
→ If firm issues catalogues every January, but inflation happens every
month, at beginning of year relative prices are high but at end will be low
▪ Alternation of individual’s tax liability
• Tax code doesn’t take effects of inflation into account, it measure tax on
nominal income, not real income
▪ Inconvenience
• Changing price levels means $ is less useful measure of comparison bc it is
always changing, and we need to correct for inflation when comparing $
figures from different times (E.g. Deciding how much put aside for retirement)
o Costs of Unexpected Inflation
▪ More harmful, redistributes largely and arbitrarily wealth among people
E.g. LT loans are based on rate of inflation expected at time of agreement
If inflation is higher → debtor wins (repays loan with less valuable $)
If inflation is lower → both loses (repayment is worth more)
E.g. Pensions are like loans: worker provide labour and is fully paid until old age with deferred earnings
If inflation is higher → worker (creditor) loses
If inflation is lower → firm (loaner) loses
▪ The more variable rate of inflation, the more uncertainty faced
▪ In countries with high and variable inflation rate, contracts are written in
real terms (like indexing); in others written in nominal terms
• High inflation is variable inflation (very observed not well understood fact)
o Benefit of Inflation
▪ Little inflation (2-3%) allows to regulate real wages without having to cut
nominal wage
Without inflation, real wages would be stuck above equilibrium level resulting in
higher unemployment (bc supply and demand in labour always changing)
E.g. Workers refuse 2% wage cut, but same as 3% raise with 5% inflation
11
o HYPERINFLATION
▪ Hyperinflation ➔ Extreme inflation (over 50% per month)
o Costs of Hyperinflation
• Same as for inflation but way more severe
▪ Shoeleather cost
• So costly in time, energy, money, that economy runs less efficiently
▪ Menu costs
• Becomes impossible to change prices rapidly enough
▪ Tax system are distorted
• Different way than for moderate inflation
• Real tax revenue of gov falls by a lot bc there is always a delay btw the
time taxes are levied, and time people pay the tax
• During this delay, money fall already in value so gov gets less real revenue
▪ Inconvenience
• Need carry more and more money, bc its value changes so rapidly, money
loses role of store of value, unit of account and medium of exchange
→ more stable and unofficial monies start to replace official money
o Causes of Hyperinflation
▪ Due to excessive growth in money supply (BCE prints money too quickly)
▪ To stop hyperinflation, Central bank must reduce rate of money growth
▪ Central bank still prints money, bc gov has insufficient tax revenue
→ Causes rapid money growth and hyperinflation
▪ But then budget deficit becomes even larger: delay in collecting tax
payment cause real tax revenue to fall as inflation rises
→ Self-reinforcement ➔ Gov need to rely even more on seigniorage
→Rapid money creation → Hyperinflation → Larger budget deficit
→ Even more rapid money creation
▪ End of hyperinflation almost always coincide with fiscal reforms. Once

magnitude of problem becomes apparent, gov musters the political will to
reduce gov spending and increase taxes. These fiscal reforms reduce need
for seigniorage, which allows a reduction in money growth
o CONCLUSION
▪ Classical Dichotomy ➔ Theoretical separation of real and nominal variables
▪ Real variables ➔ Measured in physical units
▪ Nominal variables ➔ Expressed in term of money
▪ Monetary neutrality ➔ In classical economic theory, changes in money
supply does not influence real variables
/ !\ Doesn’t really work in ST economic fluctuation
12
❖ Economic Growth I – Capital Accumulation and Population Growth (Chap 8)

▪ What causes differences in income over time and across countries?
(Can’t use analysis used until now as it describes economy at a point of time (static))
▪ Need broader analysis to describe changes in economy over time
→ Solow growth model
• Factors of prod (K, L) and prod technologies are sources of economy’s
output/total income → Differences across time and countries must come
from differences in capital, labour, and technology
• Solow model shows how growth in capital stock, labour force, advances in
technologies interact with economy and how affect nation’s output of GaS
• No longer fixed K and L
o ACCUMULATION OF CAPITAL
How supply and demand for goods determine accumulation of capital?
▪ We assume labor force and technology fixed
o Supply and Demand for Goods
• 2 main actors of Solow model → Prod function and consumption function
▪ Supply
• Production function → 𝒀 = 𝑭(𝑲, 𝑳) 𝒀 = 𝑭(𝑲, 𝑳)
▪ Output depends on capital stock and labor force
• Model assumes constant return to scale, which allows to analyze all
quantities in the economy relative to size of labor force (set 𝒛 = 𝟏/𝑳)
𝒀/𝑳 = 𝑭(𝑲/𝑳, 𝟏)
▪ Amount of output per worker → function of amount of K per worker
• Constant return to scale implies that size of economy (number of workers)
does not affect relationship btw output per worker and K per worker
→ Size of economy doesn’t matter so we can write all qtt in per-worker
▪ 𝒚 = 𝒀/𝑳 ➔ Output per worker
▪ 𝒌 = 𝑲/𝑳 ➔ Capital per worker
▪ 𝒚 = 𝒇(𝒌) ➔ Production function (where 𝒇(𝒌) = 𝑭(𝒌, 𝟏)
• Production function has diminishing marginal product of capital
▪ 𝒌 is high ➔ Slight increase in production with extra unit of capital
▪ 𝒌 is low ➔ Large increase in production with extra unit of capital
▪ Demand
• Comes from consumption and investment
→ Output per worker (𝒚) divided btw consumption per worker (𝒄) and
investment per worker (𝒊) 𝒚 = 𝒄+𝒊
• Per worker version of economy’s national income accounts identity
(omits gov purchases, and net exports bc assumed closed economy)
• Solow model → each year ppl save fraction (𝒔) of income and consume a
fraction 𝟏 − 𝒔
▪ 𝒔 ➔ Saving rate (0 < 𝒔 < 1)
• Consumption function → 𝒄 = (𝟏 − 𝒔)𝒚 𝒊 = 𝒔𝒚
➔ Production and Consumption function describe economy at any moment in time
For any given stock (𝒌), prod function determines how much economy produces
Saving rate (𝒔) determines allocation of that output btw consumption and
investment
o Growth in the Capital Stock and the Steady State
• Capital stock is key determinant of economy’s output
→ But It can change over time which leads to economic growth
• 2 forces that influence capital stock
▪ Investment ➔ Expenditure on new plant and equipment
→ Causes capital stock to rise
▪ Depreciation ➔ Wearing out of old capital
→ Causes capital stock to fall
13
▪ Investment (𝒊)
• 𝒔𝒚 ➔ Investment per worker
Investment per worker (𝒔𝒚) a function of capital per worker
• If we substitute prod function for 𝒚 → 𝒊 = 𝒔𝒇(𝒌)
Links existing stock of capital (𝒌) to accumulation of new capital (𝒊)
→ For any value of 𝒌, amount of output is determined by prod function 𝒇(𝒌),
and allocation for that output btw consumption and investment is determined by
saving rate (𝒔)
▪ Depreciation rate (δ)
• Fraction of capital stock that wears out every year
E.g. If capital last 25 years, depreciation is 4% → = 0.04
• Amount of capital that depreciates each year is δk
• Shows that amount of depreciation depends on capital stock
▪ Impact of investment and depreciation on the capital stock

• Changes in Capital stock = Investment – Depreciation
∆𝒌 = 𝒊 − 𝜹𝒌
▪ ∆𝒌 ➔ Change in capital stock from one year to another
• Substitute 𝒊 = 𝒔𝒇(𝒌) ∆𝒌 = 𝒔𝒇(𝒌) − 𝜹𝒌
▪ Higher capital stock → Greater amount of output and investment
AND greater amount of depreciation
• Steady-state level of capital
➔ Long-run equilibrium of economy
➔ Level of capital stock (𝒌∗ ) at which investment = depreciation
→ Change in capital is 0 → Capital stock 𝒌 and output 𝒇(𝒌) are steady over time
▪ Below 𝒌∗ ➔ Investment > Depreciation → Capital stock grows
▪ Above 𝒌∗ ➔ Investment < Depreciation → Capital stock shrinks
• Regardless of level of capital with which economy begins, it will end up

with the steady-state level of capital
→ Once at steady state, no pressure for capital stock to rise or fall
o Numerical Example
▪ Economy’s production function: 𝒀 = 𝑲𝟏/𝟐 × 𝑳𝟏/𝟐 (Cobb-Douglas with α=1/2)
→ Get the per-worker function by dividing by 𝑳:
𝑲 𝟏/𝟐
𝒀/𝑳 = ( )
𝑳
→ 𝒚 = 𝒀/𝑳, and 𝒌 = 𝑲/𝑳, so 𝒚 = 𝒌𝟏/𝟐 ↔ 𝒚 = √𝒌
▪ This means output per worker is square root of amount of capital per worker
▪ Economy’s saves 30% of output → 𝒔 = 𝟎. 𝟑

10% of capital stock depreciates every year → 𝜹 = 𝟎. 𝟏
Economy starts off with 4 units of capital per worker → 𝒌 = 𝟒
What happens over time?
▪ Steps to look at production and allocation of output in first year:
• 𝒚 = √𝒌 so with 𝒌 = 𝟒, economy produces 2 units of output per worker
• 30% is saved and invested so 70% is consumed → 𝒊 = 𝟎. 𝟔 and 𝒄 = 𝟏. 𝟒
• 10% of capital stock depreciates → 𝜹𝒌 = 𝟎. 𝟒
• Investment of 0.6 and depreciation of 0.4 → ∆𝒌 = 𝟎. 𝟐
 Economy begins its second year with 4.2 units of capital per worker
 Investment is higher than depreciation, so output is growing
 Do same calculation for each year until see it approaches steady state of 9 units
of capital stock and output is no longer growing
▪ Other way to calculate steady state level of capital per worker:
• We know ∆𝒌 = 𝒔𝒇(𝒌) − 𝜹𝒌 and at steady state ∆𝒌 = 𝟎
𝒌∗ 𝒔
𝟎 = 𝒔𝒇(𝒌∗ ) − 𝜹𝒌∗ =
𝒇(𝒌∗ ) 𝜹
• Then square both sides to find 𝒌∗ = 𝟗
14
o How Saving Affects Growth

▪ What causes international differences in economic performance?
→ Saving rates
▪ Saving rate ➔ Key determinant of steady-state capital stock
• If saving rate high → Economy has large capital stock and high level of
output at steady state
• If saving rate low → Economy has small capital stock and low level of
output at steady state
▪ Example
• Economy starts at steady state 𝒌∗𝟏 , with saving rate 𝒔𝟏
• Saving rate increase from 𝒔𝟏 to 𝒔𝟐 , → 𝒔𝒇(𝒌) curve shifts upward
→ Investment is higher but capital stock and depreciation are unchanged,
so capital stock rises until it reach new steady state 𝒌∗𝟐
• 𝒌∗𝟐 has higher level of capital stock and higher level of output
→ Long run consequences of reducing saving rate:
▪ Lower capital stock
▪ Lower national income
▪ Gov budget deficit can reduce national saving and crowd out investment
→ Bc of long run consequences of a reduced saving rate, economists are
critical of persistent budget deficit
▪ Solow model says: Higher savings leads to faster growth
BUT
Only temporary (until economy reaches new steady state)
• If economy maintains high saving rate it can maintain large k and high
level of output, but not a high-growth rate forever
▪ Growth effect ➔ Policies who alter steady-state growth rate of income per
person
▪ Level-effect ➔ Bc only level of income per person (not its growth rate) is
influenced by saving rate in steady state
→ Higher saving rate said to be level-effect
▪ Post-war countries see period of very rapid growth bc Solow model says
that when economy is far from its steady state, growth during transition to
its new equilibrium is rapid (after destruction of capital stock bc of war,
economy is not at steady state anymore)
AND
Bc higher saving leads to faster growth
o GOLDEN RULE LEVEL OF CAPITAL

▪ In Solow model, increase rate of saving has level-effect on income per person
→ Causes period of rapid growth but eventually growth slows as new steady state is
reached
▪ Although high saving rate yields high steady state level of output, saving by itself
cannot generate persistent economic growth
▪ Level of capital that maximizes steady-state consumption is called Golden Rule level
• If an economy has more capital than Golden Rule steady state
→ Reducing saving → Increase consumption at all points of time
• If an economy has less capital than Golden Rule steady state
→ Reaching Golden Rule requires increase in investment → Lower consumption
for current generations
o Comparing Steady States
▪ Higher saving rate brings higher level of capital stock
But what good does it makes if it is not consumed
→ Optimal amount of capital accumulation for economic well-being of individuals?
• Search for steady state with highest level of consumption
15
▪ Golden Rule level of capital ➔ Steady-state value of k that maximizes

consumption (𝒌∗𝒈𝒐𝒍𝒅)
How to find the steady-state consumption per worker?
• Economy’s output is used for consumption or investment
• In steady state, investment = depreciation 𝒚= 𝒄+𝒊 ↔ 𝒄 =𝒚−𝒊
→ Steady state consumption is gap btw output and depreciation
𝒄∗ = 𝒇(𝒌∗ ) − 𝜹𝒌∗
• Steady-state (s-s) consumption ➔ what’s left of steady-state output after
paying for steady-state depreciation
▪ Increase in steady-state capital has 2 opposing effects on s-s consumption
▪ More capital → More output
▪ More capital → More output is used to replace capital wearing out
• S-s output and s-s depreciation as a function of s-s capital stock
• S-s consumption is maximized at Golden Rule s-s
▪ 𝒌∗𝒈𝒐𝒍𝒅 ➔ Golden Rule capital stock
▪ 𝒄∗𝒈𝒐𝒍𝒅 ➔ Golden Rule level of consumption
▪ Higher levels of capital affects both output and depreciation
• If capital below Golden Rule level
Increase in capital stock → Raises output more than depreciation
→ Consumption rises
• If capital above Golden Rule level
Increase in capital stock → Raises depreciation more than output
→ Consumption falls
• If capital at Golden Rule level
Prod function and 𝜹𝒌∗ line have same slope
→ Consumption maximized
▪ Simple condition characterizing Golden Rule level of capital
• Slope of prod function is MPK, and slope of 𝜹𝒌∗ line is 𝜹
→ 2 slopes are equal at 𝒌∗𝒈𝒐𝒍𝒅
• Golden Rule ➔ 𝑴𝑷𝑲 = 𝜹
▪ /!\ Economy doesn’t automatically gravitates towards Golden Rule s-s
If we want a particular s-s capital stock, need particular rate of saving
▪ There is only 1 saving rate that produces Golden Rule level of capital 𝒌∗𝒈𝒐𝒍𝒅
▪ Any changes in saving rate would shift 𝒔𝒇(𝒌) curve and would move
economy to s-s with lower level of consumption
o Numerical Example
How to identify Golden Rule steady-state? (2 ways)
▪ Looking at s-s consumption
• Prod function → 𝒚 = √𝒌
Depreciation → 𝜹 = 𝟎. 𝟏
Policymaker pick saving rate s → Economy at steady state
Equation holding in the steady-state 𝒌∗ 𝒔
=
𝒇(𝒌∗) 𝜹
𝒌∗
𝒔
• In this economy → =
√𝒌 ∗ 𝟎. 𝟏
• Square both sides → 𝒌∗ = 𝟏𝟎𝟎𝒔𝟐

▪ With this we can compute s-s capital stock for any saving rate
▪ Here s-s consumption first rises with higher saving rates then declines
→ Consumption higher when s = 0.5
➔ Saving rate of 0.5 produces Golden Rule steady state
▪ Looking at marginal product of capital (MPK)
• Find capital stock at which net marginal product of capital (𝑴𝑷𝑲 − 𝜹) = 0
• For this prod function → 𝑴𝑷𝑲 = 𝟏/𝟐√𝒌
• Last 2 columns of table present values of 𝑴𝑷𝑲 and 𝑴𝑷𝑲 − 𝜹 in different
steady states
▪ At s = 0.5, 𝑴𝑷𝑲 − 𝜹 = 𝟎
 Easier method to know if economy is currently at/above/below Golden Rule

capital stock
16
o Transition to the Golden Rule Steady State

• If policy makers CANNOT choose economy’s s-s and economy begins with
lower or higher capital than Golden Rule s-s
→ Impact of transition btw steady-states?
• Lower or Higher capital than Golden Rule s-s give problems to policymaker
▪ Too much capital
• When capital stock exceeds Golden Rule level, policymakers must pursue
policies aimed at reducing saving rate in order to reduce capital stock
▪ 𝒕𝟎 ➔ Reduction in saving rate
→ Immediate increase in consumption, and equal decrease in investment
▪ Investment smaller than depreciation (were same at s-s but no longer s-s)
→ So overtime gradually falls
▪ Overtime, output, consumption and investment fall together
▪ New s-s (Golden Rule one) has higher consumption than initial s-s
(With lower output and investment)
▪ Too little capital
• Policymakers must raise saving rate to reach Golden Rule
▪ ➔ Increase in saving rate
→ Immediate fall in consumption, and equal increase in investment
▪ Overtime, capital stock grows
▪ Output, consumption and investment increase to reach new s-s-
▪ New s-s has higher consumption
▪ When economy begins above, reaching GR produces higher consumption at
all points in time
▪ When economy begins below, reaching GR requires initially to reduce
consumption so that it increases in future
• Policymakers face trad-off in welfare of different generations
▪ Reaching GR will benefit infinite number of future generations but lower
consumption for current generations
▪ Optimal capital accumulation depends on that, GR says we should give all
generations equal weight, so optimal to reach GR steady state
o Other Factors
▪ Solow model shows that capital accumulation by itself can’t explain
sustained economic growth
▪ Higher saving rates leads to temporary high growth but then economy
reaches steady state in which capital and output are constant
→ Incorporate 2 other sources of growth (pop growth and techno progress)
o POPULATION GROWTH
▪ Solow model shows that economy’s rate of population is another long-run
determinant of standard of living
• According to Solow, higher rate of population growth, the lower s-s levels
of capital per worker and output per worker
• Other theories highlight other effects of pop growth
▪ Malthus → pop growth will strain natural resources used to produce food
▪ Kremer → large pop may promote technological progress
▪ Now we suppose population and labor force grow at a constant rate 𝒏
o Steady State with Population Growth
▪ Investment, Depreciation AND pop growth affect accumulation of 𝒌
• Investment increases 𝒌
• Depreciation decreases 𝒌
• Growth in nbr of workers decreases 𝒌
(By spreading k more thinly among larger pop of workers)
▪ Change in capital stock per worker → ∆𝒌 = 𝒊 − (𝜹 + 𝒏)𝒌
→ Shows how investment, depreciation and pop growth influence 𝒌
▪ Break-even investment ((𝜹 + 𝒏)𝒌) ➔ Amount of investment necessary to
keep capital stock per worker constant
17
▪ Substitute 𝒔𝒇(𝒌) for 𝒊 → ∆𝒌 = 𝒔𝒇(𝒌) − (𝜹 + 𝒏)𝒌

• For investment to be in steady state, investment must offset effects of
depreciation and pop growth
→ Represented by intersection of 2 curves
▪ If 𝒌 < 𝒌∗ → Investment > break-even investment → 𝒌 rises
▪ If 𝒌 > 𝒌∗ → Investment < break-even investment → 𝒌 falls
▪ If 𝒌 = 𝒌∗ → positive effect of investment on 𝒌 exactly balances negative
effect of depreciation and pop growth → ∆𝒌 = 𝟎 AND 𝒊∗ = 𝜹𝒌∗ + 𝒏𝒌∗
• Once economy is in s-s, investment has 2 purposes
▪ Replaces depreciated capital
▪ Provides new workers with s-s amount of capital
o Effects of Population Growth on Solow Model
▪ Pop growth helps sustained growth in total output
• In steady state with pop growth, 𝒌 and 𝒚 are constant?
However total capital and total output must be growing at rate 𝒏 bc nbr of
workers is growing at rate 𝒏
• /!\ Pop growth CANNOT explain sustained growth in standards of living
Bc output per worker is constant in s-s
But can help explain sustained growth in total output
▪ Countries with higher rates of pop growth will have a lower level of
capital per worker so lower incomes
• Increase in 𝒏 shifts line of pop growth and depreciation upward
→ New steady state has lower level of 𝒌
• Change in 𝒏 has level effect on income per person but does not affect s-s
growth rate of income per person
▪ In GR s-s, MPK net of depreciation equals rate of pop growth
• Pop growth affects our criterion for GR level of capital
• Consumption per worker is 𝒄 = 𝒚 − 𝒊
• Level of 𝒌∗ maximizing consumption is one where

𝑴𝑷𝑲 = 𝜹 + 𝒏 𝑴𝑷𝑲 − 𝜹 = 𝒏
o Alternative Perspective on Population Growth

▪ Solow model emphasizes interaction of pop growth with capital
accumulation
• High pop growth reduces y bc rapid growth in L forces K to be spread more
→ In s-s each worker is equipped with less capital
▪ Model omits 2 other potential effect of pop growth
• Malthusian Model ➔ Pop growth will strain natural resources used for
food and would stick mankind into poverty forever
Proven wrong
• Kremerian Model ➔ More people, more scientists, more inventors
2 evidences
▪ Separated continent → More pop, more rapid growth)
▪ World growth rates have increased together with world pop
o CONCLUSION
▪ Solow model explained
• Why Germany and Japan grew rapidly after WW2
• Why countries that save and invest a higher fraction of output are richer
• Why countries with higher pop growth are poorer
▪ But can’t explain persistent growth in living standard
• Output per worker stops growing when economy reaches its s-s
→ Need to introduce technological progress into model
18
❖ Economic Growth II – Technology, Empirics, and Policy (Chap 9)

▪ Starting point of this chapter: basic version of Solow Model
→ Continue analysis of forces governing long-run growth,
Adding 4 new tasks:
• Make Solow model more general and realistic (Add technology)
• Move from theory to empirics
How well Solow model fits facts?
• How nation’s public policies influence level and growth of its citizens
standard of living?
• Consider what Solow model leaves out
(Solow simplifies the reality) → Endogenous growth theories
o TECHNOLOGICAL PROGRESS IN THE SOLOW MODEL

▪ Incorporate technological progress into prod function
𝒀 = 𝑭(𝑲, 𝑳) 𝒀 = 𝑭(𝑲, 𝑳 × 𝑬)
• Efficiency of Labour (𝑬) ➔ Reflects society’s knowledge of prod methods

▪ 𝑬 rises when improvement in available technology, health, education or in
skills of labour force
→ Each hour of work contributes more to prod of GaS
▪ 𝑳 × 𝑬 ➔ Measures effective number of workers
▪ Assumption: Technological progress causes 𝑬 to grow ate some constant
rate 𝒈
▪ 𝒈 ➔ Rate of labor-augmenting technological progress
• Labour augmenting
▪ 𝑳 is growing at a rate 𝒏, and efficiency of each unit of labor 𝑬 is growing at
rate 𝒈, so effective number of workers (𝑳 × 𝑬) is growing at rate (𝒏 + 𝒈)
o The Steady state with Technological Progress
• Inclusion of technological progress doesn’t substantially alter our analysis
of steady state (s-s)
▪ Pop growth increases actual number of workers
▪ Technology increases the effective number of workers
• Economy now analysed in terms of qtt per effective workers
(not qtt per worker)
▪ 𝒌 = 𝑲/(𝑳 × 𝑬) ➔ Capital per effective worker
▪ 𝒚 = 𝒀/(𝑳 × 𝑬) ➔ Output per effective worker
▪ 𝒚 = 𝒇(𝒌)
• Equation showing evolution of 𝒌 overtime becomes
∆𝒌 = 𝒔𝒇(𝒌) − (𝜹 + 𝒏 + 𝒈)𝒌
▪ Change in ∆𝒌 equals investment 𝒔𝒇(𝒌) minus break-even investment
▪ Break-even investment now includes 3 terms
▪ Replace depreciating capital
▪ Provide capital for new workers
▪ Provide capital for new effective workers
▪ Increase in effective number of workers tend to decrease 𝒌
▪ Conclusion: Inclusion of technological progress doesn’t really change analysis of s-s
o Effects of Technological Progress
▪ According to Solow model, only technological progress can explain
sustained increases in standard of living
• While high rates of saving lead to high rate of growth only until It reaches
s-s, technological progress lead to sustained growth in output per worker
→ Once at s-s, rate of growth of 𝒚 depends only on 𝒈, Because:
▪ 𝒌, 𝒚 are constant in steady state
▪ Output per worker: 𝒚 is constant, and 𝑬 grows at rate 𝒈
→ Output per worker must be growing at rate 𝒈 in steady state
▪ Total output: 𝒚 is constant, 𝑬 grows at rate 𝒈, 𝑳 grows at rate 𝒏
→ Total output grows at rate 𝒏 + 𝒈 in steady state
19
▪ Introduction of technological progress also modifies Golden Rule

• Now Golden Rule level of capital
➔ Steady state that maximizes consumption per effective worker
• S-s consumption per effective worker is
𝒄∗ = 𝒇(𝒌∗ ) − (𝜹 + 𝒏 + 𝒈)𝒌∗
• S-s consumption is maximized if
𝑴𝑷𝑲 = 𝜹 + 𝒏 + 𝒈 𝑴𝑷𝑲 − 𝜹 = 𝒏 + 𝒈
• So, at GR level of capital, net MPK equals rate of growth of total output
→ In steady state of Solow growth model, growth rate of income per
person is determined solely by exogenous rate of technological progress
o FROM GROWTH THEORY TO GROWTH EMPIRICS

o Balanced Growth
▪ Balanced Growth ➔ According to Solow model, technological progress
causes values of many variables to rise together in steady state
• Describes long run data for US economy
▪ Technological progress affects 2 things
• Output per worker Y/L and capital stock per worker K/L in steady state
Capital-output ratio remains approximatively constant over time
• Factor prices: in s-s, real wage grows at rate of technological progress
But real rental price of capital is constant over time
▪ Contrast with Karl Marx’s theory of development of capitalist economies
• Predicted return to capital would decline over time and this would lead to
economic and politic crisis
→ Economy history has not supported that prediction
→ Partly explains why we follow Solow’s theory rather than Marx’s
o Convergence
▪ Convergence ➔ Process of catch-up – Economies start off poor
subsequently grow faster than economies that start off rich, so tend to
catch up with world’s rich economies
▪ When does convergence happen according to Solow model?
• If 2 economies start off with different capital stock but have same s-s
(determined by saving rate, pop growth rates, efficiency of labour)
→ Converge
• If 2 economies have different rates of saving
→ Not converge, each approach their own steady-state
▪ Conditional convergence ➔ Economies appear to be converging own s-s,
which in turn are determined by saving, pop growth, human capital
• If researchers examine only data of income per person, they find little
evidence of convergence; BUT when use statistical techniques to control
some of determinants of s-s → data show convergence at rate of 2%
o Factor Accumulation Vs Production Efficiency
Is large gap btw rich and poor countries explained by?
▪ Difference in capital accumulation (factors of production)
▪ Differences in production function (efficiency with which use factors of prod)
➔ No exact answer but observe that capital accumulation and production
efficiency are positively correlated
▪ Nations with high levels of physical and human capital also tend to use
factors efficiently
▪ Different hypothesis to interpret this correlation:
• Efficient economy may encourage capital accumulation
• Capital accumulation may include greater efficiency
→ If positive externalities to physical and human capital, then countries that save
and invest more will appear to have better prod function
→ Greater prod efficiency may cause greater factors of accumulation (or other way)
• Both factor accumulation and prod efficiency are driven by common third
variable (may be quality of nation’s institutions)
20
➔ Empirical studies have examined the extent to which Solow model explain long-
run economic growth. Model can explain much of what we see in data, such as
balanced growth and conditional convergence
Recent studies also found that international variation in standards of living is due to
combination of capital accumulation and efficiency with which capital is used
o POLICIES TO PROMOTE GROWTH

▪ Key determinant of nation’s citizens’ standard of living is how much nation
saves and invest
▪ Saving rate determines s-s levels of capital and output and one particular
saving rate produces the GR steady-state that maximizes consumption per
worker and thus economic well-being
o Evaluating the Rate of Saving
▪ Use GR s-s as a benchmark against which we can compare US economy
• To know if s-s is below/at/above GR
→ Compare (𝑴𝑷𝑲 − 𝜹) with s-s growth rate of total output (𝒏 + 𝒈)
▪ Below ➔ 𝑴𝑷𝑲 − 𝜹 > 𝒏 + 𝒈
→ Increasing rate of saving will increase capital consumption and growth
▪ → Eventually leading to s-s with higher consumption (lower during transition)
▪ At ➔ 𝑴𝑷𝑲 − 𝜹 = 𝒏 + 𝒈
▪ Above ➔ 𝑴𝑷𝑲 − 𝜹 < 𝒏 + 𝒈
→ Reducing rate of saving lead to higher consumption immediately and in
long run
• In practice, economies mostly concerned with insufficient savings,
possibility of excess saving and capital accumulation appears not to be a
problem in real economy
▪ To make comparison for real economies
E.g. US economy → need to estimate (𝑴𝑷𝑲 − 𝜹) AND (𝒏 + 𝒈)
• Real GDP grows average of 3% per year → 𝒏 + 𝒈 = 𝟎. 𝟎𝟑
• Can estimate net MPK from 3 facts:
▪ Capital stock about 2.5 times one year’s GDP ➔ 𝒌 = 𝟐. 𝟓𝒚
▪ Depreciation of capital is about 10% of GDP ➔ 𝜹𝒌 = 𝟎. 𝟏𝒚
▪ Capital income is about 30% of GDP ➔ 𝑴𝑷𝑲 × 𝒌 = 𝟎. 𝟑𝒚
• Solve for rate of depreciation AND Solve for MPK
➔ Net marginal product of capital = 8% = 0.08

𝑴𝑷𝑲 − 𝜹 > 𝒏 + 𝒈 → Capital stock is below GR: Economy has lower saving
rate than it would have in GR steady state
o Changing the Rate of Saving
▪ Policymakers can enact policies to encourage national saving
• Higher national saving means either :
▪ Higher public saving
▪ Higher private saving
▪ Combination of the 2
▪ Most direct way for gov to affect saving is through public saving
• Budget deficit → Negative public spending which raises interest rate and
crowds out investment so reduction of capital stock
• Budget surplus → Gov retire some of national debt and stimulate
investment
▪ Affecting national saving by influencing private saving
How much ppl decide to save depends on incentives they save
→ Incentives can be altered by various public policies :
• High tax rates on capital (discourages private saving by reducing rate earn)
• Tax-exempt retirement accounts (encourages private saving by giving
benefits to income saved)
• Replaceing system of income taxation by system of consumption taxation
(encourage private saving)
21
o Allocating the Economy’s Investment

▪ Solow model uses simplified assumptions that there is only one type of
capital and usually only includes physical capital (reality there are more)
• Physical capital (Traditional, Newer types, Infrastructure)
• Human capital ➔ Knowledge and skills that workers acquire through
education
▪ Similar to physical capital, raising it increases ability to produce GaS
▪ Raising human capital requires investment in teachers, libraries, …
▪ Research showed human capital at least as important as physical capital in
explaining international differences in standards of living
→ Can model that by making def of capital broader to include both
• Public capital ➔ One type of capital necessarily involving gov
▪ Measuring marginal product hard bc benefits are more diffuse than for
private capital (private → profit for firm owning capital)
AND
▪ Allocation of resources for public capital involves political process and
taxpayer funding
▪ Policymakers that try to promote economic growth have issue of what kind
of capital does the economy need the most
• Could rely on marketplace to allocate savings to different types of
investment
(Industries with higher marginal products of capital will naturally borrow more at
market interest rates to finance new investments)
OR
• Gov could promote specific forms of capital
(creation of capital could create technological externalities which can happen by
“learning by doing”, then benefit of capital accumulation to society is greater than
what Solow model predicts)
(Some types of capital accumulation create greater externalities so gov could use
tax laws to encourage investment in those ➔ Industrial policy)
▪ But success of this depends on gov’s ability to accurately measure
externalities of economic activities so that it can give correct incentives
▪ 2 reasons why economists are sceptical about industrial policies
• Measuring externalities from different sectors is hard
→ Could be worse than no policy at all if not well measured
• Political process is far from perfect
→ Once gov starts rewarding specific industries, rewards are likely to be
based not only on externalities but also on political clout
o Establishing the Right Institutions

• Some international differences in standard of living are attributed to
inputs of physical and human capital, and some to productivity with which
test inputs are used
• Adam Smith
→ 3 things are needed for economic growth and living standards
“peace, easy taxes, and a tolerable administration of justice”
• Reasons for different levels of production efficiency:
▪ Nations have different institutions guiding allocations of scarce resources
• Democratic capitalist nations have more advanced economic dvplmt
• E.g. Authoritarian North Korea Vs Democratic capitalist South Korea
▪ Nations having English-style common law-system better capital markets
• Subtle difference among democratic capitalist nations
• Leads to more rapid growth bc easier for small start-ups to finance
investment projects → More efficient allocation of nation’s capital
▪ Quality and honesty of gov officials
• Opposed to corruption
22
o Supporting a Pro-growth Culture

▪ Nation’s culture ➔ Values, attitudes, and beliefs of its people
• May have an important influence on economic growth
• Max Weber: Acceleration of economic growth in northern Europe in 16th
due to rise of Calvinism (promoted hard work and frugality)
• Cultural differences help explain why some nations are rich and other poor
4 examples of what societies differ in:
▪ Treatment of women
• Some nation’s culture keep women poorly educated and out of labour
force which decreases standard of living
▪ Attitudes towards education of children and nbr of children to have
• Higher pop growth can decrease income
• Greater human capital can increase income
▪ How open to new ideas
• More open nations quickly adopt technological advances
• Less open driven further from world’s technological frontier
▪ Trust among people
• Easier to coordinate economic activities when trust is high bc legal system
is not perfect for enforcing agreements
→ Positive correlation btw level of trust and nation’s income per person
• Social capital ➔ Network of cooperative relationships among ppl
→ Trust related to social capital
o Encouraging Technological Progress

▪ Solow model shows that sustained growth in income per worker must
come from technological progress, but it takes technological as exogenous
(doesn’t explain it)
▪ Determinants of technological progress are not well understood
BUT
Many public policies are designed to stimulate technological progress
• Most encourage private sector to devote resources to innovation
(patent, tax breaks, subsidies, …)
• If intellectual property rights were better enforced around the world,
firms would have more incentives to engage in research and it would
promote worldwide technological progress
o Conclusion
▪ Increased public saving and tax incentives for private saving encourage
capital accumulation
▪ Policymakers can also promote economic growth by setting up appropriate
legal and financial institutions to allocate resources efficiently and by
ensuring proper incentives to encourage research and technological
progress
o BEYOND THE SOLOW MODEL: ENDOGENOUS GROWTH THEORY

▪ Endogenous growth theory ➔ Model explaining technological advance,
and reject Solow model’s assumption of exogenous technological change
• Used to fully understand process of economic growth
o Basic Model
▪ Start with simple prod function → 𝒀 = 𝑨𝑲
• 𝑲 ➔ Capital stock
• 𝑨 ➔ Constant measuring amount of output produced per unit of capital
• Key difference with Solow is that there is no exhibit of property of
diminishing returns to capital
23
▪ Assume fraction 𝒔 of income is saved and invested, so capital accumulation

described as: (change in capital stock = investment - depreciation)
∆𝑲 = 𝒔𝒀 − 𝜹𝑲
∆𝒀 ∆𝑲
▪ Combined with prod function → = = 𝒔𝑨 − 𝜹
𝒀 𝑲 ∆𝒀
• Which shows what determines growth rate of output ( )
𝒀
▪ R/ If 𝒔𝑨 > 𝜹 then economy’s income grows forever, even without the

assumption of exogenous technological progress
→ Simple change dramatically alter predictions about economic growth
Should we abandon assumption of diminishing returns to capital?
→ Depends on how we interpret K in the production function

• If traditional K (only includes the economy’s stock of plants and equipment)
→ Natural to assume diminishing returns
• If broader K (includes for example knowledge)
→ less natural to assume property of diminishing returns → endogenous
model with assumption of constant return more plausible
o Two-sector Model
• Another model for endogenous growth theory taking more than one
sector of production
▪ Gives better description of forces that govern technological progress
▪ 2 sectors → Manufacturing firms, Research universities
▪ Economy is described by 3 equations
• Production function in manufacturing firms → 𝒀 = 𝑭[𝑲, (𝟏 − 𝒖)𝑳𝑬]
• Production function in research universities → ∆𝑬 = 𝒈(𝒖)𝑬
• Capital accumulation → ∆𝑲 = 𝒔𝒀 − 𝜹𝑲
▪ 𝒖 ➔ Fraction of labour force in universities
▪ 𝑬 ➔ Stock of knowledge (Which determines efficiency of labour)
▪ 𝒈 ➔ Function showing how growth in knowledge depends on fraction of
labour force in universities
▪ Cousin of 𝒀 = 𝑨𝑲 model
• Prod function for manufacturing firms is assumed with constant returns to
scale (if x2 both 𝑲 AND effective nbr of workers in manufacturing then 𝒀 is x2)
• Prod function has constant return to capital, as long as capital includes
knowledge (if x2 both 𝑲 AND 𝑬, then x2 output of both sectors in economy)
• This model can generate persistent growth without assumption of
exogenous shifts in prod function
• Persistent growth is endogenous and comes from creation of knowledge
in universities that never slows down
▪ Cousin of Solow model
• If 𝒖 is held constant, 𝑬 grows at a constant rate 𝒈(𝒖) (Constant growth in
efficiency of labour at rate 𝒈 is precisely assumption made in Solow model with
technological progress)
• Rest of the model also resembles the Solow model so for any given 𝒖, the
endogenous growth model works just like Solow model
24
o Microeconomics of Research and Development

▪ 3 microeconomic facts about process of research and development
• Knowledge is largely a public good, but much research is done in firms that
are driven by profit motives
• Research is profitable because innovations give firms temporary
monopolies, either because of a patent or bc there is an advantage in
being the first firm with new product
• When on firm innovates, other firms build on that innovation to produce
next generation of innovations
▪ Micro facts are not easily connected with macro growth model we have
discussed so far
→ Some models offer a more complete description of process of
technological innovation
▪ Does private profit-maximizing firms tend to engage in too little or too much
research, from the standpoint of society as a whole?
Is social return (➔ what society cares about) to research greater or smaller than
private return (➔ what motivates individual firms)?
→ Depends if negative “stepping on toes” effect or if positive “stepping on
shoulders” is more prevalent
• “Stepping on toes” effect ➔ When firm invests in research, it makes
other firms worse off if it becomes the first to discover a technology that
another firm would have invented in due course (duplication of effort)
• “Stepping on shoulders” effect ➔ When firm creates new technology, it
makes other firms better off by giving them a base of knowledge on which
to build future research
o Process of creative destruction

▪ Joseph Schumpeter → Economic progress comes through a process of
creative destruction (Winner and losers from technological progress)
• Driving force behind progress is entrepreneur with an idea of innovation
• When firm enters market, it has degree of monopoly over its innovation
▪ Good for consumers (expanded range of choices)
▪ Often bad for incumbent producers (Harder competition)
• Over time, process keeps renewing itself, entrepreneur’s firm becomes
incumbent, enjoying high profitability until its product is displaced by
another firm with next generation of innovations
▪ Confirmed by history
o CONCLUSION
▪ Long-run economic growth is single most important determinant of
economic well-being of nation’s citizens
▪ Solow growth model and more recent endogenous growth models show
how saving, pop growth, and technological progress interact in determining
level and growth of nation’s standard of living
▪ These theories don’t ensure an economy achieves rapid growth, but give
much insight, and provide intellectual framework for much of debate over
public policy aimed at promoting long-run economic growth
25
❖ Introduction to Economic Fluctuation (Chap 10)

▪ Long-term average of real GDP hides its economic fluctuations
→ Economy’s output of GaS does not grow smoothly
• Fluctuation in output highly associated with fluctuations in employment
▪ Recession ➔ Economy experiences period of falling output and rising
unemployment
▪ Great Recession (late 2007) ➔ Production went approximately flat, then real GDP plunged
sharply, unemployment rate doubled. Recession officially ended in June 2009, growth resumed
but weak recovery and unemployment remained low, returning to previous rate in 2016
▪ Business Cycle ➔ Short-run fluctuation in output and employment
▪ This chapter takes look at short-run fluctuations
• Examine data describing short-run fluctuations
• Discuss key differences btw economy behaviours in long run Vs short run
• Introduce model of aggregate supply and demand to explain short run
o THE FACTS ABOUT BUSINESS CYCLE

▪ Facts describing short-run fluctuations in economic activity
▪ Business Cycle = BC
o GDP and its Components
• GDP broader measure, use it to analyze the business cycle
▪ Economic growth is not steady and occasionally turns negative
(Shaded areas → periods of recession)
• Business cycle peak ➔ Starting date of a recession
• Business cycle through ➔ Ending date
• National Bureau of Economic Research (NBER)’s Business Cycle Dating
Committee is official arbiter of when recessions begin and end
▪ No real fixed rule of how to decide
▪ Old rule of thumb → Recession period of at least 2 consecutive quarters of
declining real GDP (not always used)
▪ 2 major components of GDP are consumption and investment
• When economy goes into recession, they both decline
BUT investment is way more volatile than consumption over the BC
▪ Households consume less but decline in spending on business equipment,
structures, new housing, even more substantial
o Unemployment and Okun’s Law

▪ Okun’s law ➔ Negative relationship btw unemployment and real GDP
• Increase in unemployment rate should be linked with decrease in real GDP
Bc employed workers help to produce, and unemployed workers do not
• Scatterplot shows that increase in unemployment tend to be associated
with lower-than normal growth in GDP
▪ Magnitude of Okun’s law
• Line says → %∆𝑹𝒆𝒂𝒍 𝑮𝑫𝑷 = 𝟑% − 𝟐 × %∆𝑼𝒏𝒆𝒎𝒑𝒍𝒐𝒚𝒎𝒆𝒏𝒕 𝒓𝒂𝒕𝒆
• If unemployment doesn’t change, real GDP grows about 3%
(growth in labor force, capital accumulation, and technological progress)
▪ Declines in production of GaS occurring during recessions always associated
with increase in unemployment
26
o Leading Economic Indicators

• Both businesses and gov forecast short-run fluctuation
▪ Business economists
▪ To help companies plan for changes in economic environment
▪ Government economists
▪ Economic environment affects gov (E.g. Tax revenue)
▪ Can use policy to affect economic activity
→ Economic forecasts are input into policy planning
▪ Leading indicators ➔ Variables often fluctuating before we see movements
in overall economy (Are not precise forecast of future, bc short run fluctuations
are unpredictable)
• Average weekly hours in manufacturing
▪ ➔ Firms often adjust work hours of employees before hiring or firing
→ leading indicator of employment changes
▪ Longer workweek → firms experiencing strong demand
→ more likely to increase hiring and prod in future
▪ Short workweek → firms more likely to lay off workers and decrease prod
• Average weekly initial claims for unemployment insurance
▪ ➔ Nbr of ppl making new claims on unemployment-insurance system
→ most quickly available indicators of conditions in labour market
▪ Increase in nbr of ppl making new claims → firms are laying off workers
and cutting back prod
• Manufacturers’ new orders for consumer goods and materials
▪ ➔ Direct measure of demand for consumer goods that firms experience
▪ Increasing orders → increases in prod and employment
• Manufacturers’ new orders for nondefense capital goods NOT planes
▪ ➔ Direct measure of demand for investment goods
▪ Increasing orders → increase prod and employment
▪ Aircrafts are excluded bc often placed so far in advance that contain little
information about near-term economic activity
• ISM new orders index
▪ ➔ Based on nbr of firms increased orders – nbr decreased orders
▪ ➔ Measures proportion of companies reporting rising orders
▪ Many firms experience increased orders → prod and employment likely
soon follow
• Building permits for new private housing units
▪ ➔ Construction of new buildings part of investment
▪ Increase in permits → Planned construction increasing → rise overall
economic activity
• Index of stock prices
▪ ➔ Stock market reflects expectations about future economic condition
▪ Increase in stock prices → Investors expect economy grow rapidly
▪ Decrease in stock prices → Investors expect economy slowdown
• Leading Credit Index
▪ ➔ Composition of 6 financial indicators (such as investor sentiment,
lending conditions, …)
▪ Bad credit conditions → harder to get financing
▪ Decline of credit conditions → decline spending, prod, employment
• Interest rate spread
▪ ➔ Yield in 10-year Treasury bonds – federal funds rate
▪ ➔ Reflects market’s expectation about future interest rates
Reflects condition of the economy
▪ Large spread → interest rates expected to rise
→ Economic activity increase
• Average consumer expectations for business and economic conditions
▪ ➔ Optimism about future economic conditions among consumers
▪ Increase optimism → increased consumer demand for GaS
→ Encourage businesses to expand prod, employment to meet demand
▪ Fluctuations are associated with movement in many macroeconomic
variables, but these short-run fluctuations are largely unpredictable
27
o TIME HORIZONS IN MACROECONOMICS

▪ Classical macroeconomic theory applies to long-run but not to short-run
→ Need model of short run fluctuations
o How Short Run and the Long Run Differ
▪ Key difference ➔ Behaviour of prices
• Long run → Flexible prices and respond to changes in supply and demand
• Short run → Prices are ‘sticky’ at some predetermined level
▪ Classical dichotomy ➔ Theoretical separation of real and nominal variables
▪ Effect of monetary policy on the 2-time horizons
o Model of Aggregate Supply and Aggregate Demand

▪ In classical theory output depends on supply
AND prices adjust to ensure that D = S
▪ But bc prices are sticky in short run, output also depends on economy’s
demand for GaS
• Demand can be influenced by monetary and fiscal policies, and demand
itself influences the economy’s output in short run when prices are sticky
→ Policies might be useful in establishing economy in short run
▪ Model of Aggregate Supply and Aggregate Demand
• ➔ Allows to study how aggregate price level and qtt of aggregate output
are determined in short run
AND
Provide a way to compare with economy’s behaviour in long run
• Helps explain short run fluctuations
o AGGREGATE DEMAND (AD)

▪ Curve slopes downward
▪ Tells us that:
• The lower the price level → The greater aggregate qtt of GaS demanded
▪ AD ➔ Relationship btw qtt of output demanded and aggregate price level
→ Qtt of GaS ppl want to buy at any given level of prices
o Quantity Equation as Aggregate Demand
▪ Quantity theory → 𝑴𝑽 = 𝑷𝒀
• If 𝑽 is constant → 𝑴 determines nominal value of output (𝑷 × 𝒀)
• Rewriting qtt equation in term of supply and demand for real money 𝒅
▪ Where parameter 𝒌 = 𝟏/𝑽 𝑴 𝑴
= ( ) = 𝒌𝒀
▪ How much ppl want hold for every $ of income 𝑷 𝑷
𝑴
▪ Equation states that supply of real money balances ( ) equals demand for
𝑷
𝑴 𝒅
real money balances (( ) ) and that demand is proportional to output
𝑷
• Assuming 𝑽 is constant → Assuming constant demand for real money
balances per unit of output
• If assume 𝑽 is constant AND 𝑴 fixed by central bank
→Qtt equation yields negative relationship btw price level 𝑷 and output 𝒀
▪ Aggregate demand curve
• Combination P and Y that satisfy qtt equation
(Holding M and V constant)
28
▪ Why AD curve slopes downward?

• The lower the price level → The greater aggregate qtt of GaS demanded
• The higher the price level → The lower level of real balances (𝑴/𝑷)
• Mathematical explanation
▪ M and V determine nom value of output (PY)
▪ Once PY is fixed, it P goes up → Y must go down
• Logical explanation
▪ As assumed V fixed, M determines $ value of all transactions
If price level rises, each transaction requires more $
→ Nbr of transactions must fall → Qtt of GaS purchased must fall
▪ Supply and demand:
If output is higher, ppl do more transactions and need higher real balances
→ For fixed money supply, higher real balances imply lower price level
If price level lower, real money balances is higher
→ Higher level of real balances allows more transactions; greater demand
▪ Shifts in AD curve
▪ AD curve gives possible combinations of P and Y for fixed M
→ If Fed changes M then possible combinations change → shift
• Inward shift (to the right)
▪ If Fed reduces M, qtt equation tells us leads to proportionate reduction in
nom value of output (PY)
→ For any given P amount of output Y is lower
→ For any given amount of output, P is lower
→ AD curve shifts inward
• Outward shift (to the left)
▪ If Fed increases M, raises nom value of output (PY)
→ For any given P, output Y is higher
→ AD curve shifts outward
• R/ In reality AD can shift even if M stays constant
Bc of events that cause changes in V (will use IS-LM model to consider other
possible reasons)
o AGGREGATE SUPPLY (AS)

▪ AS ➔ Relationship btw qtt of GaS supplied and price level
• Intersection of AD and AS determines economy’s price level and qtt of
output (can’t know it only with AD)
• AS depends on times horizons bc prices are flexible (LR) or sticky (SR)
▪ 2 different AS curve: LRAS and SRAS
o Long run Aggregate Supply (LRAS)
▪ LRAS is vertical [𝒀 = 𝑭(𝑲
̅ , ̅𝑳)]
• Output is determined by amount of capital, labour and technology
• NOT by level of prices
▪ Shift in AD, affects only price level, doesn’t affect output or employment
(Satisfy classical dichotomy (money supply doesn’t affect output))
▪ Full-employment or natural level of output
➔ LR level of output 𝒀
̅ at which economy’s resources are fully employed
or at which unemployment is at its natural rate
o Short run Aggregate Supply (SRAS)
▪ Equilibrium is intersection btw AD and Horizontal AS
▪ SRAS is horizontal
• Wages and prices are at sticky predetermined levels (don’t adjust to
change in demand)
▪ Shift in AD affect output and employment bc prices do not adjust instantly
• Reduction in M, causes economy to move from old intersection to new
➔ Decline in output at a fixed price level
▪ After sudden fall in AD, firms are stuck with high prices
→ Demand is low and prices high → Firms sell less
→ Reduce prod and lay off workers → Recession
▪ R/ In reality all prices are not sticky, so a bit upward sloping (Chap 14)
Here extreme case where all prices are stuck
29
o Transition of Economy from SR to LR

▪ Economy begins in LR equilibrium, where AD crosses LRAS (3 curves)
• AD
• LRAS
• SRAS
▪ Prices have adjusted to reach this equilibrium, so SRAS crosses it too
▪ Reduction in Money Supply
• AD shifts inward
• In SR
▪ Prices are sticky so economy moves from A to B
▪ Output and employment fall below natural levels ➔ Recession
• In LR
▪ Wages and prices fall in response to the low demand
→ Economy gradually moves downward along AD curve to new LR
equilibrium C
• In C
▪ Output and employment are back at natural levels
▪ Prices are lower than in A
 Shift in AD affect output in SR, but dissipates over time as firms adjust P
o STABILIZATION POLICY
▪ Demand or Supply shocks ➔ Exogenous events that shift AD or AS
• Cause economic fluctuations (push output and unemployment rate away
from natural levels)
• Fed can shift AD curve to attempt to offset shocks to maintain output and
employment at natural levels
▪ Stabilization policy ➔ Policy actions aimed at reducing severity of SR
fluctuations
o Shocks to AD
▪ Fed could reduce/eliminate impact of demand shocks on output and
employment if it can skilfully control money supply
▪ Example
• Introduction of expanded availability of credit cards
▪ More convenient than using cash → Reduce qtt of money people hold
→ Reduction in money demand is equivalent to increase in velocity
(each $ changes hand more quickly, V rises) → V=1/k → k falls
• If M is fixed, increase in V causes PY to rise
→ AD curve shifts outward
• In SR
▪ Increase in demand raises output → firms sell more output at old prices
→ Hire more and use factories and equipment more
• In LR
▪ Wages and prices rise as Qtt of output declines
→ Economy approaches natural level of prod BUT during transition to
higher prices, output was higher than natural rate
• If Fed reduces M it could offset increase in velocity, which stabilizes AD
o Shocks to AS
▪ Supply shocks ➔ Alters cost of producing GaS, thus prices that firms charge
• Also called Price shock (direct impact on price level)
▪ Examples of adverse supply shocks
→ Push costs and prices upward
• Drought that destroys crop
• New law that reduces firm’s emissions of pollutants
• Increase in union aggressiveness
▪ Examples of favourable supply shocks
→ Push costs and prices downward
• Breakup of international oil cartel
30
▪ Effect of adverse supply shock

• Pushes up costs and thus prices
▪ If AD is held constant → Economy moves from A to B
→ stagflation (➔ Combination of increasing prices and falling output)
▪ As prices fall, economy returns to natural level of output A
• Fed has 2 options
▪ Keep AD constant
→ Output and employment are lower than natural level but eventually
process fall and restore natural level
▪ Cost: Painful recession
▪ Increase AD to prevent reduction in output by bringing economy toward
natural rate level more quickly
→ Economy immediately moves from A to C
➔ To accommodate the supply shock
▪ Cost: Permanently higher level of price
31
❖ Aggregate Demand I – The IS-LM Model (Chap 11)

• Classical theory couldn’t explain Great Depression (1930) bc it says
national income depends on factor supplies and the available technologies
but there was no substantial change in those factors in 1930
→ Need for new model
▪ John M. Keynes presented new model
• Said that Low AD responsible for low income and high unemployment that
characterize economic downturn
• Suggests gov policies that might reduce the economic hardship faced
• He criticised classical theory for assuming AS alone (capital, labour and
technology) determines national income
▪ Here we look more closely to AD, to identify variables that shift AD curve,
causing fluctuation in national income (also examine tools policymakers can
use to influence demand, monetary and fiscal policies)
▪ We use IS-LM Model
➔ leading interpretation of Keynes theory, shows what determines
national income at a given price level. 2 equivalent ways of viewing it:
• As model showing what causes income to change in SR when P fixed (sticky)
• As model showing what causes AD curve to shift
➔ 2 parts to IS-LM Model
• IS curve ➔ Investment and Saving, what’s going on in market of GaS
• LM curve ➔ Liquidity and Money, what’s happening to Supply and
Demand for money
▪ The interest rate is variable linking the 2 parts
(It influences both investment and money demand)
▪ Model shows how interactions btw goods and money markets determine
position and slope of AD, and therefore, level of national income in SR
o THE GOODS MARKET AND THE IS CURVE

▪ IS curve ➔ Plots relationship btw interest rate and level of income that
arises in market for GaS
o Keynesian Cross Model
▪ Keynesian Cross Model
• Takes fiscal policy and planned investment as exogenous → Show there is
one level of national income at which expenditure = planned expenditure
▪ Shows that changes in fiscal policy have multiplied impact on income
▪ Simplest interpretation of Keynes theory of how national income is
determined
• According to Keynes, it is spending plans of households and businesses
that determine economy’s total income
→ The more ppl want to spend, the more GaS firms can sell
→ The more output they prod and the more they hire
• Problem during recessions is inadequate spending
▪ Planned expenditure (1st piece of Keynesian Cross)
• Actual expenditure ➔ Amount households, firms, gov, spend on GaS
▪ = GDP of economy
• Planned expenditure ➔ Amount households, firms, gov, would like to
spend on GaS
• Difference → Firms have unplanned inventory investment when their
sales do not meet their expectations
▪ If sell more, stock inventories fall
▪ If sell less, stock inventories rise
32
• Plan expenditure is function of income 𝒀, planned investment 𝑰̅, and fiscal

̅ and 𝑻
policy variables 𝑮 ̅
▪ Assume closed economy, so NX = 0
Plan expenditure (𝑷𝑬), sum of consumption, planned investment, and gov purchases
𝑷𝑬 = 𝑪 + 𝑰 + 𝑮
▪ Add consumption function to the equation
𝑪 = 𝑪(𝒀 − 𝑻)
→ Consumption depends on disposable income (𝒀 − 𝑻)
▪ Take planned investment as exogenously fixed and Fiscal policy is fixed
𝑰 = ̅𝑰 𝑮=𝑮̅ 𝑻=𝑻 ̅
▪ Combining 5 equations → 𝑷𝑬 = 𝑪(𝒀 − 𝑻 ̅) + 𝑰̅ + 𝑮̅
▪ Graphically
▪ Slopes upward (higher income → Higher consumption → Higher PE)
▪ Slope = Marginal propensity to consume (MPC)
(How much PE increases when income rises by 1$)
▪ The economy in equilibrium (2nd piece of Keynesian Cross)
• Assumption that economy is in equilibrium when actual expenditure =
planned expenditure (no reason to change if plans are realized)
• Equilibrium condition → 𝑨𝒄𝒕𝒖𝒂𝒍 𝑬𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆 = 𝑷𝒍𝒂𝒏𝒏𝒆𝒅 𝑬𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆
𝒀 = 𝑷𝑬
R/ Y as GDP represents both total income AND total actual expenditure
• Keynesian cross ➔ 45-degree line plots where condition holds
• Adjustment to Equilibrium
▪ When economy not in equilibrium, firms experience unplanned changes in
inventories → Have to change production levels
→ Influences total income and expenditure → economy to equilibrium
▪ Example
▪ GDP above equilibrium level (Y1)
PE < Production → Firms selling less than they are producing
→ Add unsold goods to inventories
→ unplanned rise in inventories → less workers and prod
→ Reduce GDP
➔ Process continues until Y falls to equilibrium level
▪ GDP below equilibrium level (Y2)
PE > Production → Firms meet high level of sales by drawing
down inventories → Stock of inventories decrease
→ Hire more and increase prod → GDP rises
➔ Process continues until Y reaches equilibrium level
 Keynesian cross model can be used to show how income changes when one
of exogenous variables changes
▪ Fiscal policy and the Multiplier
▪ Fiscal policy ➔ Level of gov purchases and taxes
• Government Purchases
▪ Increase in 𝑮 → Raises planned expenditure by ∆𝑮
→ Equilibrium goes from A to B, and income from Y1 to Y2
▪ If increase in income ∆𝒀 > ∆𝑮
→ fiscal policy has multiplied effect on income
▪ Government-purchase multiplier (∆𝒀/∆𝑮) ➔ how much income rises in
response to 1$ increase in gov purchases
▪ In Keynesian cross, gov-purchases multiplier larger than 1
▪ To calculate the multiplier
▪ Expenditure rises by ∆𝑮, income rises by ∆𝑮
▪ Increased income rises consumption by 𝑴𝑷𝑪 × ∆𝑮
▪ Raises expenditure and income once again
▪ 2nd increase in income of 𝑴𝑷𝑪 raises consumption again by 𝑴𝑷𝑪(𝑴𝑷𝑪 × ∆𝑮)
and so on, …
▪ Total impact on income is
▪ Which can be written as ∆𝒀/∆𝑮 = 𝟏/(𝟏 − 𝑴𝑷𝑪)
33
• Taxes
▪ Decrease in 𝑻 → Raises disposable income by ∆𝑻
▪ Increases consumption by 𝑴𝑷𝑪 × ∆𝑻
▪ For any given 𝒀, planned expenditure is now higher
→ 𝑷𝑬 shifts upward by 𝑴𝑷𝑪 × ∆𝑻
→ Equilibrium goes from A to B
▪ Increase in 𝑮 has multiplied effect on taxes
▪ Initial change in expenditure (𝑴𝑷𝑪 × ∆𝑻) multiplied by
𝟏/(𝟏 − 𝑴𝑷𝑪)
Overall effect on income of a change in taxes is
∆𝒀/∆𝑻 = −𝑴𝑷𝑪/(𝟏 − 𝑴𝑷𝑪)
▪ Tax multiplier ➔ Amount income changes in response to 1$ change in 𝑻
▪ Negative sign indicates income moves in opposite direction from taxes
o The Interest rate, Investment, and the IS curve

• Keynesian cross assumes planned investment I is fixed
• Add to our model that planned investment depends on interest rate r
(important macroeconomic relationship) → 𝑰 = 𝑰(𝒓)
▪ Investment function ➔ Interest is cost of borrowing to finance investment
projects → increase in interest rate reduces planned investment
• Slopes downward
How income changes when interest rate changes?
→ Combine investment function with Keynesian-cross diagram
▪ In investment function (a)
• Increase in interest rate reduces planned investment
▪ In Keynesian cross (b)
• Decrease in planned investment shifts PE function downward
• Causes income to fall
▪ ➔ Increase in interest rate lowers income
▪ IS-curve ➔ Summarizes negative relationship btw interest rate and income
• Higher interest rate lowers planned investment
→ Lowers income → Slopes downward
• Each point on IS curve
represents an equilibrium
in goods market
• Curve shows that equilibrium
income depends on interest rate
34
o How Fiscal Policy Shifts the IS curve

▪ IS curve shows combinations of interest rate and level of income that are
consistent with equilibrium in market for GaS
• IS curve is drawn for a given fiscal policy
▪ Changes in fiscal policy raising demand for GaS
→ Shift IS curve to the right
▪ Changes in fiscal policy reducing demand for GaS
→ Shift IS curve to the left
▪ (a) shows increase in G raises planned expenditure
• For any given interest rate, upward shift in planned expenditure in ∆𝑮
→ Increase in income 𝒀 of ∆𝑮/(𝟏 − 𝑴𝑷𝑪)
• In (b) IS curve shift to right by this amount
o THE MONEY MARKET AND THE LM CURVE

▪ LM curve ➔ Plots relationship btw interest rate and level of income that
rises in market for money balances
o Theory of Liquidity Preference
▪ Theory by Keynes, basic model of determination of the interest rate
→ Says interest rate adjusts to balance supply and demand for economy’s
most liquid asset ➔ Money
• Keynesian cross ➔ Building block for IS curve
• Theory of liquidity preference ➔ Building block for LM curve
▪ Theory takes money supply and price level as exogenous
AND
Assumes, interest rate adjusts to equilibrate supply and demand for real
money balances
• Implies that increase in money supply → Lowers interest rate
▪ Development
• SUPPLY for money balances (𝑴/𝑷)
(𝑴/𝑷)𝒔 = 𝑴 ̅ /𝑷
̅
▪ M is exogenous bc chosen by central bank
▪ P also exogenous
▪ Supply of money balance is fixed
→ It doesn’t depend on the interest rate → Vertical supply curve
• DEMAND for money balances
(𝑴/𝑷)𝒅 = 𝑳(𝒓)
▪ Function L ➔ Qtt of money demanded depends on interest rate
▪ Higher interest rate → Raises cost of holding money
→ Lowers qtt demanded → Downward sloping curve
▪ Supply and Demand for real money balances determine what interest rate
is in the economy (Bc interest rate adjusts to equilibrate money market)
• Adjustment occurs bc whenever money market is not in equilibrium ppl
try to adjust their portfolios of assets which alter the interest rate
• If interest rate > equilibrium level
▪ Supply of real money balances exceeds qtt demanded
→ Individuals holding excess supply of money try to convert some of their
non-interest-bearing money into interest-bearing bank deposits or bonds
Branks and bond issuers prefer to pay lower interest rates
→ Respond to excess supply of money by lowering interest rate
• If interest rate < equilibrium level
▪ Demand exceeds supply → Individuals try to obtain money by selling
bonds or making bank withdrawals → To attract funds, banks and bond
issuers respond by increasing interest rate
• At equilibrium, ppl are happy with their portfolios
35
▪ Response of the Interest Rate to a Change in Supply of Money

(As price level is assumed fixed)
• An increase in money supply → lowers the interest rate
▪ Fed increases 𝑴
→ Raises interest rate
• A decrease in money supply → raises the interest rate
▪ Fed decreases 𝑴 → Reduces 𝑴/𝑷 (bc Prices are fixed)
→ Equilibrium interest rate rises from r1 to r2
o Income, money demand, and the LM curve
▪ Use theory of liquidity preference to derive LM curve
(𝑴/𝑷)𝒅 = 𝑳(𝒓, 𝒀)
• Greater income leads to greater money demand
→ When income is high, ppl spend more so engage in more transactions
→ Need use of money
▪ Qtt of real money balances demanded is negatively related to interest rate
Qtt of real money balances demanded is positively related to income
Explanation:
• If income increases → Money demand curve shifts to the right
→ As supply is unchanged, interest rate must rise to equilibrate
• LM curve (b) summarizes this relationship btw income and interest rate
▪ Each point represents an equilibrium in money market
▪ Curve show how equilibrium interest rate depends on income
▪ Curve slopes upward
▪ The higher level of income → The higher demand for real money
balances → The higher the equilibrium interest rate
o How Monetary policy shifts the LM curve

▪ LM curve ➔ Interest rate equilibrates money market at any level of income
▪ Equilibrium interest rate depends also on supply for real money balances
→ LM curve is drawn for a given supply
• If real money balances changes (E.g. Fed changes 𝑴)
→ LM curve shifts
➔ Decreases in supply of real money balances shift LM curve upward
➔ Increases in supply of real money balances shift LM curve downward
36
o CONCLUSION: THE SHORT RUN EQUILIBRIUM

▪ Now have all pieces of IS-LM model
o 2 Equations of the Model
▪ IS → 𝒀 = 𝑪(𝒀 − 𝑻) + 𝑰(𝒓) + 𝑮
▪ LM → 𝑴/𝑷 = 𝑳(𝒓, 𝒀)
o Model takes as exogenous
▪ fiscal policy 𝑮 and T 𝑻
▪ Monetary policy 𝑴
▪ Price level 𝑷
o Given these exogenous variables
▪ IS curve provides combinations of 𝒓 and 𝒀 that satisfy equation
representing the goods market
▪ LM curve provides combinations of 𝒓 and 𝒀 that satisfy equation
representing the money market
o Equilibrium
▪ Of economy is intersection of IS curve and LM curve
• Gives interest rate 𝒓 and Level of income 𝒀 that satisfy conditions for
equilibrium in both markets
→ It’s where actual expenditure = planned expenditure
AND
• Demand for real money balances = Supply
R/ Ultimate of IS-LM model is to analyze SR fluctuations in economic activity

This chapter developed Keynesian cross and theory of liquidity preference as building blocks
Next chapter, IS-LM model helps explain position and slope of AD curve
The AD curve, in turn, is a piece of model of AS and AD, which economists use to explain the
SR effects of policy changes and other events on national income
37
❖ Aggregate Demand II – Applying the IS-LM Model (Chap 11)

• Classical theory couldn’t explain Great Depression (1930) bc it says
national income depends on factor supplies and the available technologies
but there was no substantial change in those factors in 1930
→ Need for new model
▪ John M. Keynes presented new model
• Said that Low AD responsible for low income and high unemployment that
characterize economic downturn
• Suggests gov policies that might reduce the economic hardship faced
• He criticised classical theory for assuming AS alone (capital, labour and
technology) determines national income
▪ Here we look more closely to AD, to identify variables that shift AD curve,
causing fluctuation in national income (also examine tools policymakers can
use to influence demand, monetary and fiscal policies)
▪ We use IS-LM Model
➔ leading interpretation of Keynes theory, shows what determines
national income at a given price level. 2 equivalent ways of viewing it:
• As model showing what causes income to change in SR when P fixed (sticky)
• As model showing what causes AD curve to shift
➔ 2 parts to IS-LM Model
• IS curve ➔ Investment and Saving, what’s going on in market of GaS
• LM curve ➔ Liquidity and Money, what’s happening to Supply and
Demand for money
▪ The interest rate is variable linking the 2 parts
(It influences both investment and money demand)
▪ Model shows how interactions btw goods and money markets determine
position and slope of AD, and therefore, level of national income in SR
o FGG
38

Intermediate Macroeconomics - Summary FK

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Frédéric Kröger Intermediate Macroeconomics - Summary

Intermediate Macroeconomics – Summary

❖ National Income (Chap 3)

o What determines the income distribution between owners of labour and

o What determines how GDP is allocated to C (consumption), I (investment),

o What ensure equilibrium of flows in the economy?

o CIRCULAR FLOW OF $ THROUGH THE ECONOMY

o WHAT DETERMINES THE TOTAL PRODUCTION OF GaS?

o HOW IS NATIONAL INCOME DISTRIBUTED TO FACTORS OF PRODUCTION?

o Decisions Facing a Competitive Firm

• Profit = Revenue – Labour costs – Capital costs

o Firm’s Demand for Factors

• Competitive firm’s demand for labour is determined by

• Competitive firm’s demand for capital is determined by

o Division of National Income

▪ Total income is divided among return to labor, return to capital, economic

How large is economic profit?

How income of the economy is distributed from firms to households

o Cobb-Douglas Production Function (1927)

• Parameter A is greater than 0 and measures productivity of available

o WHAT DETERMINES THE DEMAND FOR GOODS AND SERVICES

𝑻 = 𝑻𝒂𝒙𝒆𝒔 − 𝑻𝒓𝒂𝒏𝒔𝒇𝒆𝒓 𝒑𝒂𝒚𝒎𝒆𝒏𝒕𝒔

o Changes in Saving: Effects of Fiscal Policy

❖ Inflation – Its Causes, Effects, and Social Cost (Chap 5)

o THE QUANTITY THEORY OF MONEY

o Assumption of Constant Velocity 𝑴×𝑽=𝑷×𝒀

o SEIGNIORAGE: THE REVENUE FROM PRINTING MONEY

o INFLATION AND INTEREST RATES

▪ Link with Fisher Effect

o NOMINAL INTEREST RATE AND DEMAND FOR MONEY

▪ End of hyperinflation almost always coincide with fiscal reforms. Once

❖ Economic Growth I – Capital Accumulation and Population Growth (Chap 8)

▪ Impact of investment and depreciation on the capital stock

• Regardless of level of capital with which economy begins, it will end up

▪ Economy’s saves 30% of output → 𝒔 = 𝟎. 𝟑

o How Saving Affects Growth

o GOLDEN RULE LEVEL OF CAPITAL

▪ Golden Rule level of capital ➔ Steady-state value of k that maximizes

• Square both sides → 𝒌∗ = 𝟏𝟎𝟎𝒔𝟐

 Easier method to know if economy is currently at/above/below Golden Rule

o Transition to the Golden Rule Steady State

▪ Substitute 𝒔𝒇(𝒌) for 𝒊 → ∆𝒌 = 𝒔𝒇(𝒌) − (𝜹 + 𝒏)𝒌

• Level of 𝒌∗ maximizing consumption is one where

o Alternative Perspective on Population Growth

❖ Economic Growth II – Technology, Empirics, and Policy (Chap 9)

o TECHNOLOGICAL PROGRESS IN THE SOLOW MODEL

• Efficiency of Labour (𝑬) ➔ Reflects society’s knowledge of prod methods

▪ Introduction of technological progress also modifies Golden Rule

o FROM GROWTH THEORY TO GROWTH EMPIRICS

o POLICIES TO PROMOTE GROWTH

➔ Net marginal product of capital = 8% = 0.08

o Allocating the Economy’s Investment

o Establishing the Right Institutions

o Supporting a Pro-growth Culture

o Encouraging Technological Progress

o BEYOND THE SOLOW MODEL: ENDOGENOUS GROWTH THEORY

▪ Assume fraction 𝒔 of income is saved and invested, so capital accumulation

▪ R/ If 𝒔𝑨 > 𝜹 then economy’s income grows forever, even without the

→ Depends on how we interpret K in the production function

o Microeconomics of Research and Development

o Process of creative destruction

❖ Introduction to Economic Fluctuation (Chap 10)

o THE FACTS ABOUT BUSINESS CYCLE