Lecture 1

Syed Zahid Ali

06-April-2020

1. DSGE Model
DSGE (Dynamic Stochastic General Equilibrium Model) models are developed

overtime which account for micro-foundation missing in the orthodox Keynesian

analysis. These models also account for rational expectation hypothesis. In what

follows we will develop a model, which is popularly known as New-Keynesian

macro economics model. This model consists of three equations; forward-looking IS

curve, forward-looking Phillips curve (PC), and either Taylor rule (TR) or the LM

curve:

2. New-Keynesian Model (Summary)

IS:

PC:

TR:

LM:
Where y = output, i = nominal rate of interest, pi = inflation rate, M = nominal
money supply, p = price level, and u = stochastic disturbance terms.

2.1 Derivation of the IS curve

2.1.1 Households
Consider an economy consisting of many identically, infinitely-lived households,

with measure normalized to one. We assume that a representative house-hold

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 derive positive satisfaction by consuming composite of many goods (C) and

holding real money balances (M/P) but dislike work (N). The utility function of

the representative house-hold is defined as follows:

(1)
the preferences of house-holds are as follows where we assume law of

diminishing marginal utility of consumption and money.

and that marginal utility

of one specific element in the utility function is independent of the level of other

elements:

Where etc.

A representative household maximizes lifetime utility and discounts the future

proportionally by a factor :

(2)

Where
In (2) we may note that utility function is separable in its arguments. C t is a

composite consumption index defined as follows:

[ ]
1 ε−1 ε
1−ε
C t= ∫ C¿ ε
di (3)
0

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If different varieties of goods are not continuous than (3) may be written as:

(4)

The parameter ε measures the elasticity of substitution between varieties of

goods (0,1,2,….) available for consumption.

Quiz 1 Using (2) show that

and

Quiz 2 Write the above utility function as sum of period utilities when

Quiz 3 In (2) above if

. True or false? Explain your answer.

Quiz 4 Using (4) show that if different varieties of goods are perfect

substitutes of each other than .

Households maximize their utility (2) subject to the following single period

budget constraint:

(5)

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here P¿ is the price of good i, Bt−1 is the number of bonds purchased last year, each

yielding a payoff of one dollar, and is the price of bond bought in period

t , W t is the nominal wage, and T t measures the lump-sum transfer or taxes.

2.2.2 Optimal consumption vector and the aggregate price index

The household’s decision problem can be dealt with in two stages. First, for any

given level of consumption expenditures, it will be optimal to purchase the

consumption vector that maximizes total consumption . Second, given this

optimal bundle of consumption goods, the household must choose the utility

maximizing combination of consumption, labor and money. Let us find the optimal

consumption vector first. For a given level of consumption expenditures, say

, the consumption maximization problem is given by:

(6)

First-order condition while we are choosing good i:

(7)

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 (8)

The above relationship also true for good j (replace I with j)i.e.,

(9)
Equation (8) divided by (9) gives us:

(10)

Inserting (10) in the budget constraint we get:

(11)

Note that in (11) are independent to i therefore we can take these terms

outside the integral sign just like a constant. From (11) we can write:

(12)
Since the relationship (12) is also true for good j, we can also write (12) as follows:

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 (13)

[ ]
1 ε−1 ε
1−ε
Substitute (13) into C t= ∫ C¿ ε
di and evaluate the expression for
0

(14)

We may define as the expenditure needed to purchase a unit-level of :

Substituting into (14) we get:

(15)

Equation (15) can be defined as an aggregate price index . We can

also write (15) as follows:

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 (16)
Rewriting (11)

(17)
Inserting (16) into (17) we get:

(18)
We can write (18) for good i as follows:

(19)
From (19) we can note that

(20)

[ ]
1 ε−1 ε
1−ε
Substitute (20) into C t= ∫ C¿ ε
di we get
0

(21)
From (21) we can write:

(22)

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 Lecture 2

Substituting into (5) we get:

(23)
where C t is consumption index (sum of consumption of all goods i as defined in (3)

and Pt is the expenditure needed to purchase a unit-level of C t . Household

maximization problem is defined as follows:

(24)

Where is a langrage multiplier. For convenience we write (24) as follows:

(25)

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 Mt
choosing C t , N t , , and Bt we get the following first-order conditions for utility
Pt

maximization problem where λ t is Lagrange multiplier:

(26)

(27)

(28)

(29)

Quiz 5: Consider the following utility maximization problem where is term

deposit which yield interest :

Maximize:

Subject to
Derive first-order condition of the above utility maximization problem.
(26)/(27) gives

(30)
From (29) we can note:

(31)
From (26) and (29) we can write:

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 (32)
Substituting (31) into (32) gives

(33)

Using (26) we can also write:

(34)
Forward (34) by one period:

(35)
(35)/(34) gives:

(36)
Combining (31) and (36) we get:

(37)

Our Key Equations are

(30)
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 (33)

(37)

2.2.3 Log-Linearization of the model

Taking natural log (ln) of equation (30) gives us the labor supply function:

Using lower case letter to represent log of the corresponding variable (e.g., )

the above equation can be written as:

(38)

Similarly, log linearization of (33) gives us:

(39)

The first-order Taylor expansion of around the steady state value of

which is gives us:

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 (40)

Ignoring the constant term in (40) i.e., , substituting (40) into (39)
gives us the following money demand function:

(41)

Where
Now we do Taylor expansion of (37), which may be written as:

(42)
To proceed further we define the following:

(43)

(44)

In the steady-state we note the following . In the

steady-state (44) can be written as:

(45)
Equation (45) will be true if and only if

(46)
Taylor expansion of (44) around steady-state while using (46) gives us:

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 (47)
2.2.4 RESOURCE CONSTRAINT
The resource constraint in case of closed economy with no private investment is

given as follows:

(48)

using steady-state values the Taylor expansion of (48) gives

us:

(49)

Substituting (49) into (47) we get our IS curve:

(50)

In most textbooks it is assumed no government expenditure ( ). In this case our

IS curve will be:

(51)

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where is real rate of interest.
Similarly, substituting the resource constraint (49) into (41) we get the following LM
curve:

(52)

Again in case of our LM curve will be:

(53)

Quiz 6: Plot the IS curve in space where is measured in the vertical axis.
Quiz 7: Identify the shift variables of the IS curve.

Quiz 8: Plot LM curve in space where is measured in the vertical axis.

Quiz 9: Plot both IS and LM curve in a same graph and determine the impact of
increase in (a) , (b) , (c) , (d) , (e) and (f) on equilibrium
interest rate and output.

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Derivation of the new-Keynesian Phillips curve

The derivation of our Phillips curve is based on Calvo (1983) and Gali and Gertler

(1999). Starting from Calvo pricing, which captures the probability that firms cannot

change its price (η ), the aggregate price level in the Calvo model evolves by the

following equations, where all variables are expressed in log-form:

pt =η p t−1 +(1−η) p¿t 0< η<1 (54)

¿
where pt denotes the index for the prices set in period t.

What is Average Price Duration?

Suppose that in each period, the probability of not being able to reset the price is a

constant and denoted by . What is the average price duration among a set of firms

of measure 1, given that they all set a new price today (period t)? By definition, the

price duration after today is 1. Looking forward, the probability of not being able to

reset the price tomorrow (period t+1) is . Thus, the probability of a price duration

equal to 2 after tomorrow is . Among the measure of the firms (e.g., 25% of

firms) that cannot reset the price tomorrow, a fraction will not be able to change

their price the day after tomorrow (period t+2) either. Thus, after two periods from

now, a measure of firms will be stuck with today’s price. Their price duration in

period t+2 is 3. One can continue with the same argument any arbitrary number of

periods ahead. For instance, there is a probability of a price duration of T

period. Taking the sum of all these probabilities for T periods we get expected

duration of the price and when T is very large, we can

show that

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Thus, the average price duration with Calvo technology in price setting is . We

can show that if ,the price will not change and same price will continue forever.

In contrast, if , the current price will stay only for 1 period. Normally, we

assume that which means that four periods. We

normally measure time in quarters, in this case, 4 periods means 1 year.

What price firm i will choose if she has the choice of setting the price at time t?

Firm i attempts to minimize the loss-function by choosing p¿, where χ =1/(1+ ρ) is

the rate of discount, which is inversely proportional to the marginal rate of time

preference ( ρ ), and m c t is the nominal marginal cost of production.

(55)

The first order condition for loss minimization yields

(56)
The above equation may be written as:

(57)

(58)

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Comparing (56) and (58) we can note that . Using
this result, we can write (58) as follows:

(59)

From (54), we can note that

(60)

(61)
Substituting (60) and (61) into (59) we get

(62)

We may also write (62) as follows by adding and subtracting :

(63)

By defining where i.e.,

real marginal cost ( ), we write (63) as follows:

(64)

Collecting terms on left hand-side of the above equation and also after doing
some manipulations we get:

(65)

By defining inflation and expected inflation as and

respectively, we can write (65) as follows:

(66)

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Where

Derivation of
In the absence of capital and no fixed cost, we may define total real cost of the firm (

T C t / Pt ) as follows:

(67)
Using (67), we derive the following real marginal cost ( RM C t ) of the firm:

(68)

where MPN = Marginal productivity of labor

Taking log both sides of (68) and set we get:

(69)

The log-linearization of production function gives:

(70)

(71)

where , and nt =ln N t . Solving equations (69), (70), and (71)

simultaneously give us the following expression for real marginal cost ( ) in the

log form:

(72)

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Combining equations (66) and (72) gives us:

(73)
Using labor supply-function (38), production function (70), and the resource

constraint (49) we can show that:

(74)

Substituting (74) into (73) and few manipulation gives us:

(75)

Ignoring we can write (74) as:

(76)

(77)

Where , ,

Equation (76 and 77) in fact is our Phillips curve or aggregate supply curve. In (77) it

is imperative to note that government spending becomes a shift variable for the

aggregate supply/Phillips curve.

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