Business Cycles: Theory Evidence

& Macroeconomic Policy

Graduate Centre for

Development Studies (2022-23)
Economic Model Review:

Jim Malley

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 Key Concepts

1. Parameters
2. Exogenous variables
3. Endogenous variables
4. Equilibrium
5. Linear functions (general, linear analytic and linear
numeric)
6. Labour market example
7. Comparative static exercises (e.g. change in income
taxes and change in input price)
8. Excel spreadsheet: 2a_Labour_market_example.xls
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 How Macroeconomics Studies

Key Questions

 Macroeconomists have a general

approach to study questions of interest:
 Document the facts;
 Develop a model;
 Compare predictions of the model with original
facts;
 Use the model to make other predictions that
will eventually be tested.

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 How Macroeconomics Studies

Key Questions

 Models
 Models simplify the complicated real world into
its most relevant elements.
 A model is useful if it has good predictive

power.

 Economic models often involve systems of

multiple equations.
 See: Robert Lucas (1988) What Economists Do,

homepage.ntu.edu.tw/~mjlin/lucas.pdf.

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 Parts of an Economic Model

 Parameters
 An input that is fixed over time, except when it is changed for a
policy experiment.
 Exogenous variables
 An input that can change over time, but which is not

determined by the model.

 Exogenous = “outside of the model”.

 Endogenous variables
 An outcome of the model - something that is explained by the
model.
 Endogenous = “within the model”.

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 Suppose We Have a Working

Model…

 How can we use it?

 Change parameters and exogenous variables to
see how they affect endogenous variables.
 Predict costs and benefits to individuals, firms and
industries of new government policies.

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 Model Example

 Labour supply and demand

 Variables:
 𝐿𝐿𝑠𝑠 = number of hours that workers want to work
 𝐿𝐿𝑑𝑑 = number of labour hours firms want to hire
 𝑤𝑤 = wage
 Parameters: 𝑎𝑎, 𝑏𝑏, 𝑙𝑙 ̅

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 Model Example

 Supply Function
 general function:
 linear analytic function:
 linear numeric function:

 Demand Function
 general function:
 linear analytic function: 𝐿𝐿𝑑𝑑 = 𝑏𝑏 − 𝑤𝑤
 Linear numeric function:
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 Model Example

 Let’s next rearrange the labour supply and

demand equations for w and graph them in
the wage/employment space.

𝐿𝐿𝑠𝑠 = 2𝑤𝑤 + 30

⇒ 2𝑤𝑤= 𝐿𝐿𝑠𝑠 − 30

⇒ 𝑤𝑤= (0.5)𝐿𝐿𝑠𝑠 − 15

𝐿𝐿𝑑𝑑 = 60 − 𝑤𝑤
⇒ 𝑤𝑤 = 60 − 𝐿𝐿𝑑𝑑
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 Model Example

 Supply Function
Wage
w = (0.5)𝐿𝐿𝑠𝑠 − 15 Ls

 Demand Function
𝑤𝑤 = 60 − 𝐿𝐿𝑑𝑑
 Equilibrium w*

 Note this diagram is not drawn to

to scale since the intercept for Ls Ld

is negative (see the spreadsheet L*

Employment

2a_Labour_market_example.xls for an example drawn to scale).

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 Increase in income taxes

 Suppose there is an increase in a variable that

affects supply or demand of labour other than
the wage. This will result in a shift in the curve.
 For example, an increase in income taxes, τ.
 Firm pays a wage of w.
 Worker receives a wage of (1-τ)w.
 For any given wage, the worker gets to keep less of
her wage so she supplies less labour.
 This reduces the level of employment to L*’ and raises
the wage firms pay to w*’.
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 Model Example

 Increase in income taxes

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 Increase in an input price

 Now suppose there is an increase in an input

price (other than the wage), e.g. intermediate
input such as energy, land, etc.
 In other words, it becomes more expensive for
firms to produce.
 Therefore, they demand less labour.
 This decreases the level of employment to L*’ and
lowers the equilibrium wage to w*’.

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 Model Example

 Increase in an input price

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