Macroeconomics

Inhoudsopgave
Lecture 1: introduction.................................................................................................................................. 1

Lecture 2:...................................................................................................................................................... 4

Lecture 3: IS/LM.......................................................................................................................................... 12

Lecture 4: labor market................................................................................................................................ 14

Tutorial lecture 1:........................................................................................................................................ 19

College 5: math............................................................................................................................................ 24

Tutorial lecture 2......................................................................................................................................... 25

Lecture 6: Phillips curve, inflation/employment........................................................................................... 27

Tutorial meeting 3........................................................................................................................................ 29

Math lecture 2............................................................................................................................................. 33

Lecture 8: Expectations and spending........................................................................................................... 34

Lecture 9: policymakers and monetary and fiscal policy................................................................................37

Lecture 1: introduction

In the news:
- Inflation
- Oil prices (middle east)
- Wage increases
- Minimum wage
- Government spending on fossil fuel subsidies
- Budget deficit (nowadays enormous, no limit on government spending, increasing
government debt)
- Government debt (can increase if the size of your economy also increases)

Definition:
A branch of economic dealing with the performance, structure, behaviour, and decision-
making of an economy as a whole rather than individual markets
 Features of national, regional and global economies
Not microeconomics (individual actors, consumers, firms)
Macroeconomics:
- Functioning of economic system
- Top- down perspective
- Distinguish between short, medium and long run
- Aggregated indicators to consider how system changes

- What do we want to learn about the economy of a country?

Major aggregated indicators:

1. GDP: size economy, not welfare
2. Unemployment rate
3. Inflation rate
- Interest rate
- Government defciti
- Government debt
- Savings rate
Aggregation at different levels

Key indicator 1: GDP

- Measure the economic size of a country
- Origin: for governments knowing the size of economy meant having an image of how
much war material you would be able to produce
- Major invention: data that is representing economy activity of all people in a country
3 definitions:
1. GDP is the value of the final goods produced in the economy during a given period
2. GDP is the sum of the value added created in the economy during a given period
3. GDP is the sum of the incomes earned in the economy during a given period

3 ways of measuring:
2 perspectives
- Production side:
1. Expenditures/ final goods approach
2. Value- added approach
- Income side:
3. Income approach

Nominal vs. real GDP

We care more about real GDP
Nominal = GDP measured in prices and you don’t take in account that the prices may change
overtime (GDP in current $)
Real = correct over price changes (GDP in constant $) adjusted for inflation, conversion using
GDP deflator
- Base year: nominal terms higher, because the prices have risen
- Pick one year as base year: we calculate with the price level of 2012, look at data and
correct for price changes: you get the real GDP
- Growth rate GDP
Key indicator 2: unemployment rate
- Labor force (L) = employment (N) + Unemployment (U)
- Unemployment rate (U) = U/L
- Participation rate = labor force / population (L/O)

Why unemployment matters?

- You are only unemployed if you are looking for a job
- Personal tragedy for individual (people unable to find a job)
- Societal welfare costs / underuse of resources (not good for a society if you have
people who want to work but are unable to do so)
High or low U says something about the state of a country’s economy
Bad economy  high unemployment

Key indicator3: inflation

Inflation rate = rate at which price level increases  tracking the prices
GDP deflator: average price of output
Consumer price index (CPI) = average price of consumption based on a basket of goods (cost
of living)
Inflation formula

Why is inflation bad:

Not because your money becomes less valuable (your wages also increase, inflation
compensation)
- Arbitrary redistribution of wealth
- Uncertainty and allocative frictions
- If inflation is high, its really difficult ot make predictions about the future, very
uncertain, nobody wants to make decisions  economic problems
1 positive side:
Deflation means things are getting cheaper: postponing buying things
Options for companies: Firing people or paying less
Inflation you can make the wages a bit larger, 1% higher wages and 2% inflation, keep people
employment but paying lower real wages than they used too.

- Interest rates
- Savings rate

Short, medium and long run

Short run = 1-3 years (changes in outpur are demand driven)
Medium run = 3-10 years (production level goes back to its equilibrium level) determined by
the supply side of the economy. Capital stock (capital supply) and labor force (labor supply)
state of technology and labor skills
Long run = 10- 30/40/50 years
Technological process and savings rate

Business cycles
Graph: Output and time and the trend (recession, recovery, peak and trough)

Lecture 2:
GDP (Y) = output = production

 components of GDP
- Consumption (C): Goods and services purchased by consumers
- Investments (I): Frms investments in physical goods (machines eg.) (not financial
assets)
- Government Expenditures (G): purchases of goods and services by government (not
income transfers, taxes etc. more like new roads and universities)
- Exports (X): goods and services sold abroad
Imports (M): goods and services bought abroad
C, I and G are subcomponents, percentages of the GDP

Demand for goods (Z)

Z = C + I + G + (X – M)
= = by definition

Simplifications:
- All firms produce the same good
- Both consumption and investment
- Both tangible and intangible (Services)
- All firms willeng and able to supply this good for price P
- Closed economy
-

Consumption (C)
- Behavioural equation
- Human behaviour
 - How much would you consume and why
- Consumption is bepaald door inkomen en prijs

Simple model:
- Consumption is function of disposable income (income after taxes) (Yd)
- Individuals do not consume all their income (consume 80% of disposable income)
- Individuals also consume without income
- c1 = marginal prospensity to consume
- c0 = autonomous consumption
- C = C(Yd)
- Yd = Y – T
-

Drawing relationship graphically

Mathematical relationship = summary of above

MPC (linear function|)

Demand for goods

- Investments are exogenous (they are given, may change, analyse the changes, not
part of model in an endogenous way)
- Exogenous = value of variable determined outside the model (given, don’t worry
about this)
- Endogenous = value of the variable is going to be an outcome of the model
- Government policy (G) and Taxes (T) are exogenous

Equilibrium in the goods market

Demand equals output (equilibrium helps solve the model)
Equilibrium: demand = supply
In equilibrium: Y = Z

Demand for goods is going to be uqual to supply in the equilabirum

56

The value of Y:

G up  Y also up
T up  Y down
Not surprising that different G has influence on the output
Increase G spending with 5 billion  not automatically 5 billion more in Y
Or increase in I with 5 billion: output Y will increase with at leat 5 billion but a whole
sequence start, I increase with 5 billion, output Y is also income  affects how people
consume  increase incomes  increase consumption  output Y will increase and 
incomes increase  consumption increase etc…
 This is the multiplier effect involving human behaviour

solving the model

mathematically, but this is the graphical solution  easier to only find the intersection 
that is the equilibrium (Y = Z)

Using the model:

What if a couple of variables change
 Macroeconomics are interested in finding out what happens to output due to:
 Changes in autonomous spending (exogenous variables such as autonomous
consumption)
 Changes in government policy (G or T)
 Changes in private sector behavior (c0 and c1, I)

Components of analysis
1. Verbally : explaining multiplier effect
2. Graphically: illustrate using graphs
3. Mathematically: illustrate using algebra, calculations
Sample of verbal analysis
Causal chain:

Sample of graphical analys:

Shifting the curve

You can see the multiplier effect

3: money, assets, and rate of return: financial markets

Building a model with demand and supply, financial markets: money
Building a model for money demand

- What do we use money for?

3 functions of money:
1. Medium of exchange (widely used/accepted as medium of exchange)
2. Unit of account (looking at GDP numbers)
 3. Store of value (store here you keep your financial assets)

What is money?
- Currency
- Checkable deposits / checking accounts

Financial assets:
1. Money:
Upside: very liquid form In which you can hold your financial assets. Liquid = easily
using money for transactions
Downside: money does not give you a rate of return: no interest
2. Other assets:
Downside: less liquid or illiquid: cannot be used to buy goods directly
Upside: higher return: earn an interest (rate of return)

We assume:
Only 2 types of assets: money (liquid, no return) and bonds (illiquid, interest bearing)
Choice for people: keep part of your financial assets in money but you can also keep part of it
in the form of bond. Investing in bonds pays an interest

Demand for money:

- Moneyb demand is the amount of assets that people are willing to hold as money
- Money is needed to buy goods, so greater desire to buy goofd increases demand for
money
- Money does not pay interest, while bonds do, so higher interest rate makes holding
money less attractive
There is an opportunity cost of holding money

Md = money demand
$Y = nominal income
Y = real income

When nominal income increases: more demand for money to do purchases

Interest rate: affects money demand because of opportunity costs of holding money
Graphically:

If interest rate increases holding money becomes less attractive  You can see this in the
shape of the graph (higher interest rate  lower demand for money)
Nominal income increase  money demand increases  people are more willing to hold
money

Financial markets equilibrium

Money supply equals money demand
Ms = Md
 Money supply is set by the central bank
Equilibrium in financial market means Ms = Md
This is called LM relation  M = $YL(i)
Interest rate (i) changes to bring about equilibrium
$Y increase  i increase
Ms increase  i down
Dit stukje even terug kijken..?
If money supply is fixed nominal income changes, interest rate also changes
If central bank increases money supply, money demand will only increase to equal money
supply if holding money becomes more attractive (alternative less attractive  interest rate
goes down)

Graphically  check college

How does CB change money supply?

- Central bank buys bonds using money:  this affects money supply
- Demand for bonds increase  price of bonds rises  interest rates lower  supply
of money increases (more money interest rate goes down)
 - For individuals: cost of holding money (i) goes down willingness to hold money
increases

Adding commercial banks & checkable deposits

Money = currency
Money = currency + checkable deposits
Liquid assets that individuals hold at commercial banks

Commercial banks
- Use checkable deposits to lend money to borrowers
- Maintain reserves to fulfil withdrawals from checkable deposits
- Keep a little bit of money in reserves (reserve ratio) not 100%
- Reserve ration is a policy variable that can be set by the CB
- Banks are allowed to lend out 90% and keep 10%

CB and central banks together

Central banks have reserves (central bank money = reserves + currencies)
Banks store their reserves at the central bank

if the central bank decides to change the money

supply, in interaction with commercial banks  affecting the reserves of the commercial
banks  if the reserves of commercial banks change their ability to lend out money, low
reserves  less lending
Aanvullen reserves: borrowing from central banks, this can be cheap or expensive
If lending from CB is cheap  Using this money to lend loans
Lecture 3: IS/LM
Predicting the economy in the short run
- IS curve
- LM curve
- Goods market
- Financial market

Goods market
Equilibrium: demand = output
IS relation = alternative statement of equilibrium
Investments (I) = total savings (S) (private + government savings)
Negatief verband tussen interest rate en het inkomen in de economie
IS: Y = C + I + G
Dalende lijn

Financial market
Equilibrium: money demand = money supply
(supplied by central bank)
LM relation = M = $YL(i)
$Y = nominal income
Y = real income
L(i) = liquidity preferences
Money demand increases with national income $Y
Money demand increases when interest rate increases  money supply increases
F(x) means that something is a function of F
Positief verband tussen inkomen en interest
Stijgende lijn

IS relation: I = S
(Without government)
Bij equilibrium van IS/LM zijn interest en income gelijk
Lecture 4: labor market
IS/LM = short run
Medium run
Natural rate of employment
- Recession as loss of output
- Recession as increase of unemployment

Labour force:

Flow:
Instead of snapshot in time
Decisions translate to a dynamic labour market
It goes a lot of ways

Caveat:
Looking at the unemployment rate as a percentage:
percentage of people that is unemployment goes to
out of the labor force, the unemployment rate goes
down
Ceteris paribus: unemployment rate goes down when
more workers move out of labor force
You are only unemployed if you don’t have a job and are looking for a job. If you are not
looking for a job you are not unemployed
Unemployment rate = unemployment/labor force
Participation rate = labor force/ population

Terms for consideration of working and wages

- Attractiveness of the wage
- If the money is not high enough you dont work = reservation wage
- Having a job depends on leisure
2 main factors affecting individuals wages:
- Bargaining power: Influencing the wage that you’re getting. Scarcity of labor depend
the wages
- Efficiency wage (people are more productive with higher wages)

Wage setting (employee perspective)

- Job needs to be attractive opposed to the alternative (leisure)
Nominal wage = W

People are not interested because of nominal wage, but the real wage
Deciding to work or not: formulating an expectation with the expected price level
How much can I buy with this salary?
If the unemployment rate goes up (labor less scarce)  bargaining power goes down 
nominal wage goes down
Trade off  alternatives, is het unemployment benefit higher than the salary?
Wage- setting relation (by workers)

Real wage determined by bargaing power and z

If u increases, the real wage goes down
Z is not on one in the axws, variable that has the power to set the curve
From the perspective of employers, at what real wage are they willing to work

Price setting relation (by firms)

Output of an economy is produced by people
Y = AN = N
A = state of technology, productiveness
N = people that are working
Firms have enough market power to set prices above marginal cost
Labor only production factor  prices higher than wages
Selling it on the market for the price making it + 25% or something
This is the markup

only markup in case there is no perfect

competition
Price setting = determines the real wages that firms are willing to pay. Look at the costs, sell
it for a bit of a plus. Price setting relationship determines the real wage by firms

Firms don’t care that much about nominal wages: it only matters with the prices they ask for
their products. Higher wages mean charging higher prices. Don’t care about nominal costs,
but the real costs. Costs relative to the price they are selling their products.
Unemployment is low, high wage demands  You can see in the graph
Straight line because looking at behavior of firms setting their prices using a simple rule of
thumb
Real wages on the axes
Prices = wages + markup
If PS curve shifts, a movement along the WS curve to a new equilibrium

Going towards medium run equilibrium: (complex!)

How does the labor market gets to its medium run equilibrium  Adjustment is needed 
expected price level is adjusted

- We have the expected price level above > the price level
- And u > un
  because some people are not willing to work because the wages are too low. If you
think the price level is getting higer, a certain salary is not attractive.  Unemployment
will be high

Adjustment:
 People will notice unemployment rates are quite high  accepting lower wages
 nominal wages go down, companies can reduce prices a bit..  people will notice lower
prices  expected price level P decreases  actual price level P equal to expected price
level Pe
Repeated process of adjustment  till the unemployment rate is equal to natural
employment

Things working the other way around:

- Underestimating the price level: Pe < P & u < Un
- You are willing to work with a certain salary, overestimating the real wage 
unemployment rate will be low, lower than the natural unemployment  working is
attractive
- People start to notice  they have made mistakes and adjust

Adjustment:
Unemployment rate is low, they can demand higher wages, bargaing power  firms will
comply,  prices increase  Revise expectations concerning price level, also a different
perspective on the wages
Process that unfolds in a couple of years: medium run equilibrium labor market
Shocks that we can capture by shifting the curve:

Tutorial lecture 1:

a) 2021: (100 x 30.000 = 3.000.000) + (1 x 1.000.000 )= 4.000.000

 2022: (130 x 32.000 = 4.030.000) + (1,5 x 850.000 = 1.275.000) = 5.435.000
b) 2021: same as nominal
2022: 30.000 x130 + 1 x 850.000 = 4.750.00
Looking at change in output  use the same price as the base level, only change the
quantity

c) GDP deflator 2021: Nominal GDP / real GDP x 100 = 4.000.000/ 4.000.000 x 100 = 100
GDP deflator 2022: nominal GDP 2022 / real GDP2022 x 100 = 5.435.000 / 4.750.000
x 100 = 114.42  showing inflation in percentages compared to the base year
d) CPI = average price of consumption of bread and cars
Quantity stays the same, looking at the change of price
Change of price x same quantity / value of basket of goods 2021 x 100

Nominal GDP increase in price or increase in output

Real GDP increase only change in output
If you have a decrease in output but the price increases

a) The CPI is constantly

increasing, which means that
there is inflation because the
cost of living is higher, it is also
from 2007 onward higher than
the 2% path of inflation. From
2009 there is a decrease in the
average price of output (GDP
deflator), so that means
deflation? How can you tell the
difference?

b) Central banks and countries

want a 2% inflation rate, way higher or lower is bad for an economy

a) CPI is higher than 2% but GDP deflator is lower than 2%

It depends on what they’re measuring. CPI only focusing on the prices of a certain
goods. GDP deflator measures it differently
Hard for central bankers to kn ow where to look at
Question 4:

Z=C+I+G
Z=Y
Demand = output
Y=C+I+G
Y = 0,4Yd + 600 + 550
+2100
Y = 0,4(Y-700) + 3250
Y = 0.4Y + 2970
0.6Y = 2970
Y = 4950

b) C = C0 + c1 x Yd
c) C0 = 600  450
Y will become smaller  a
change in c0 of -150 leads
to a change in Y of 250
Dus minder consumptie
betekent minder output

Multiplier shows the effect

in change in a certain valuable on output

Multiplier: 1 / 1 – c1
C1 = 0.4
1 2/3 x -150 = -250
Multiplier Geometric series
C0 = automous spending (wat sws uitgegeven wordt)
C1= marginal spending (wat toeneemt bij toename disposable income)

C = consumption
Y = output
I = investments

A) Base model: c0 goes up  total consumption goes up  Y goes up  C goes up  Y

goes up
Model 1: C0 goes up  total consumption goes up  Y goes up & Investments goes
up  Y goes up again (bigger effect in model 1)
B) Model 2: C0 goes up  total consumption goes up  I & Y go up
i0 goes up  I goes up  Y goes up  C goes up  I & Y go up
a change in C0 has a bigger effect, because you affect 2 variables at one  it has a
greater multiplier effect
C) Base model: i0 goes up  I goes up  affects Y  affects C  Y
Model 1: i0 goes up  I goes up  Y goes up  C & I go up
Model 1 the biggest, model 2 next, base model least

d) Y = C + 1
Y = c1 x Y + C0 + i0
Y – c1 x Y = c0 + i0
Y (1- c1) = c0 + i0
Y = 1/ 1-c1 x (c0+i0)
 1/ 1-0.2 = 1/0.8 = 1.25
 dit nog even uitrekenen!!!
You find it the other way around

a) Higher interest rate  less demand for money and more investments
If the income goes up the money demand will go up  it is related to the change in
interest rate. Needing less liquidity when the interest rate goes up
Md = $Y * L(i)(-)
V = $Y/M  represents level of activity in the economy
If i goes up  Md decreases  V increases
M = money goeing in circulation
V = per each unit of currencies it changes hand

How will this affect the money multiplier and money creatin:
Demand for central bank money:
 Hd = Cud + Rd
Md = Cud +Dd

College 5: math
IS: Interest rate goes up  investments go down  output goes down

LM: Output rate goes up  more demand for money  interest rates go up

Voor de berekening van IS Disposable income is income – taxes (Y-T)

Berekening voor LM: ook opzoek naar de Y
Tutorial lecture 2

1:
a) The IS curve is about the goods market, Investments and Savings it’s equilibrium is
demand = output. It is downwards sloping, because if the interest rate goes up, the
investments go down, so the output goes down (if i goes up, Y goes down)
Goodsmarket: Z = Y and I = S
Y = (C(Y-t) + I (y, i) + G
It affects the goods market through investment

b) Factors that determine investment are

- interest rates  negative relationship
- output  positive relationship

c) schrift
d) LM curve is the curve for the financial market, equilibrium is money supply = money
demand  upwards slope,
if output and interest rate and money demand decreases, the IS curve moves left
interest rates decrease  decrease in money demand  output decreases
e) IS curve: increased government spending  decrease in Taxes  Y increases, curve
shifts to the right  interest rates also increases  shift along the LM curve
f) Schrift
g) Schrift
Sensitivity of the interest rate  model 1 is more sensitive, bigger change in Investments
e) G increase  interest rates increase  investments decrease  Consumption
increases

A) Increase in output  increase in G? idk

B) ?
C) ?
sen
Lecture 6: Phillips curve, inflation/employment
1. Recap
AS curve/ relation: economic activity puts pressure on prices
P = f(Y)
High output Y  tight labor market, low unemployment, bargaining power  high nominal
wages, firms will pay this  higher price level

Aggregate Demand AD relation

Y = f(P)
Pprice level changes, real money supply changes, shifts the LM curve, towards less real
money, or more real money, affecting the interest rate
- Through IS/LM

Bringing them together, forming a protocol

AS/AD model: medium- run equilibrium
Does it apply a strucutual change to the labor market? does the markup or z change?
Things change until you are back at the equilibrium….
This is a dynamic adaptation process  revising expectations for price level

- Example price energies affecting prices

-
2. Phillips Curve, unemployment rate chained to inflation
So far: focus on price level
Real life: inflation rate
Before:
disequilibrium: expected prive level =/ actual price level
Equilibrium: expected price level = actual price level
Ws = Ps  W /Pe = W/P
Changing price level = inflation (positive or negative)
P -> ….

Natural rate of unemployment:

Phillips curve: observation: A negative realtion between inflation and unemployment
- High unemployment, means low inflation
- Low unemployment, means high inflation

From AS curve to philps curve 1:

Starting point: AS relation:
P = Pe [1 + markup]F(u,z)
Function:
u up  F down
z up  F upp
Check boek voor deze formule berekeningen en even opschrijven

- Self fulfilling prophecy: inflation leads to higher nominal wages, leading to more
inflation
 - Wage- price spiral
- Low unemployment  higher nominal wage
- In respones ot higher nominal wage, firms increase prives and price level increases
- Workers ask higher wage
- Higher nominal wage leads to higher prices, price level rises
- This further increases wages demanded by workers

Inflation vs unemployment
If higher inflation means lower unemployment rate
Policy makers saw a new option: we might be able to change the unemployment rate, if we
change the inflation a little bit. Get more people to work, increasing the inflation a little bit.
The catch: Involved peoples expectations

After the discovery: governments exploited the Philips curve  trying to steer the economy
 no downward sloping relationship  straight line
You cannot use inflation to bring the unemployment rate down
 wage setters adapted their inflation expectations, expecting more inflation > 0

Expected price level = actual price level

Now: natural rate of unemployment  expected inflation rate = actual inflation rate

Nonaccelerating inflation rate of unemployment

Stable inflation rate, inflation is constant

3. Facts of growth
Long run: growth of the economy
Slides
We care about the standard of livng, higher GDP, higher standard of living
Measuring the standard of living
Tutorial meeting 3

a) Efficiency wage theories  wage above the minimum wage, employer pays workers
more to get more efficiency, incentivized to be productive (reservation wage  he
smallest wage at which a worker is willing to accept a job)
b) A rise in unemployment  means a rise in prices because u is a function of P.
There is a lot of unemployment, people have no bargaining power, the wages will
decrease
W = PeF(u, z) (u-, z+) negative relationship between Wages and Unemployment
c) The wage setting relation = W = f(u). The wages are a function of the unemployment
rate. More unemployment means less bargaining power meaning lower wages, in the
graph this is a downwards sloping line because higher u means lower p

d)Any changes in nominal wages will reflect in prices so the real wages will remain
constant. Real wages is determined by competition in the market and not determined
by the unemployment. Price setting by the firm

d) The price setting (perspective of the firm) relation are the prices decided by the firms:
the nominal wage + a markup (this is a straight line) why?
Y = AN (productivity)
Price setting is not a function of unemployment
e) Nominal wages are related to the expected price level because the wages determine
how much people can buy with their money and what their expectations for the
future are (purchasing power) if the price level goes up they want the nominal wages
to go up
f) Increase in the markup: affecting price setting  prices increase  the expected
prices increase  the expected real wage decreases (want WS =PS)? 
unemployment increases  output decreases 
Graph in schrift
g) More generous unemployment benefits  workers demand higher wage  (increase
unemployment rate)  the wages increase  increase in prices
AD relation:
Y = Y (M/P, G, T)
Y is an increasing function of real money supply (increase in P -> decrease MS)
Y is an increasing function of Government spending
Y is a decreasing function of Taxes
Changes in fiscal policy shift the aggregative demand curve to left or right  does not change
the price  this does not eman a return to the medium equilibrium

Medium run equilibrium: WS = PS

 AS: PS = WS equilibirum

AD: IS =LM equilibrium

a) What is IS and what is LM  IS = LM

Is = negative relationship between

d) Aggregate demand function

AD: Y(M/P, G, T)

Schrift

a) The AS curve shows the effect of output Y on P.

When the output increases  unemployment decreases  wages increase prices
increase  it is a positive relation, so the curve is upwards sloping
Start with an explanation of output changes
 b)
1. If the expected price level increases, the price level also increases, because the
real wages are expected to decrease, people demand higher wages, prices go up
A Decrease in the expected price level means that the AS will go down (check the
function)

2. A decrease in the markup affects the price setting, (1/1 + markup) means lower
prices??
3. Less generous employment benefits will mean that the unemployment rate wil be
lower, z goes down, wages go down -> bargaining powers decreasing, wages
decreasing and prices decreasing  real wages go up

Multiple choice:
1=C
2=?
3=D
4=D
Math lecture 2
Lecture 8: Expectations and spending
Expectations matter  it determines your behavior
Every decision you make is partly a result of your expectations (most of the time
unconscious)
1. Consumption decision generally depend on expectations
2. Investments decisions by firms (they are expecting profit)
 expectations after spending

Channels through which expectations affect spending:

What you are able to consume is far

from only a function of your disposable
income

you can give future income stream a

value in the presence (we are all
millionairs)

calculations about your future income

Rational expectations:
rational expectations are starting point for standard neoclassical macroeconomic models:
- Economic agent has complete information
- Information is free
- Agents act rationally, able to evaluate all relevant information
- Agent is always right

1. Friedman: permanent income theory of consumption

Consumption is not decided by disposable income but your permanent income. It depends
on what people expect to earn over a considerable period of time

What would people be able to consume at certain points in life. Consuming more at a certain
point by borrowing but being able to repay it with a higher income later
 2. Modigliani: Life cycle theory of consumption
3 phases:
1. Early in life, a person is a net borrower (investing in education etc)
2. In the middle years the person will save much more to repay the debt and to put
aside part of the income for retirement (making more money than youre spending)
3. In later years, a person will dissave and consume more than income (no wage income,
pension)

A very foresighted consumer:

Making consumption only a function of disposable income is not how it works in the real
world. It is a function of total wealth

Humans: impatient --> Preference for getting something now vs later

Consuming more now has a price, people are willing to pay more to get something now
We can tie this to the interest rate
What happens in the future is less valuable to you than what happens in the present
Present consumption has a more positive effect on utility than the same amount of
consumption in the future has
Future consumption is discountend by factor p > 0 (preference)

Consumption strongly affected by current income (IS/LM)

Why?
- Bounded rationality: Unable to make calculations for intertemporal consumption
that maximizes utility
- Liquidity constraints: unable to borrow money allowing for intertemporal
consumption that maximez utility
- Uncertain expectations and risk aversion: maintain buffer..

Expectations and investment:

Investment  future revenue 
Present value of profits vs cost of buying machine
Depreciation

Details of depreciation affecting present value of profits

 Taking into account that capital becomes less productive each year: depreciation rate

Investment: function of expected profit (not only interest rate)

Investments determined by future profits, current interest rate r and (fixed) depreciatin rate

In practice: investments strongly affected by current profits  depending on expectations,

but a logical way for firms to see profits…
Firms that are profitable now are probably more profitable next year: correlation between
current profits and future profits.
Firms are reluctant to borrow if current profits are low
 difficulty borrowing (liquidity constraints) effect of current income on consumption (again)
Current profits predict future profits

Rationality:
Assumption of rational agent is dominant in economic thinkinh
But other approaches are gaining in prominence
- Behavioral economics and finance
- Essential difference: bounded vs hyperrationality
- Foundations for bounded rationality: psychology, sociology
Lecture 9: policymakers and monetary and fiscal policy
Monetary policy: Taxes and Government spending
Somebody decides about the money supply (interest rate)

What do policymakers now?

2 arguments for limiting discretionary policy
1. Despite best intentions, policy makers do more harm than good
- Difference between short run and medium run
- Policy makers know too little (uncertainty)
- Policymakers are trapped (expectations and consequences of economic policy and
time- inconsistency/credibility)
- Effectiveness is conditional on people’s expectations (and what the government
expects people to expect)
2. Policymakers may do what is best for themselves
- Stay in power  political business cycles

How can we make policy makers to act in the best interest of people?
- Macroeconomists don’t know everything
- Macroeconomic policymakers don’t have all the knowledge, models give different
answers for how to solve a particular problem

Uncertainty should lead policy makers to be cautious and use less active policies
- Exception: severe recession and hyperinflation
- Energy crisis & covid
- But not engage in fine tuning, trying to achieve stable unemployment

Why are effects of macroeconomics policy uncertain

- Interaction between policy and private agents expectations!
- Politicians are elected, short term gains by misleading people, negative effects come
about later..

30 years ago: economy seen as a machine  methods of optimal control used to design
macroeconomic policy
But in reality: private agents try to anticipate what polocymakers will do
What people expect the government to do and what the government expects people to do

- Time inconsistency
- Difference between short term and long term
- People learn not to trust the initial announcement: credibility problem

People expect a certain price level:

An unexpected increase in inflation reduces inflation (inflation unemployment trade- off)
CB: 2 % inflation –> if people believe 2%, why not make it 3% to stimulate?
Next time you do this people will expect 3%
Time inconsistency:
Unexpected inflation -> lower real wages -> … powerpoint!!!!!!!!!!!

Politics and policy

Monetary and fiscal policy rules and constraints

Starting point: self- interest of politicians leads to suboptima

Monetary policy:
Consensus: high inflation disrupts economic activity
No consensus on 2 or 3%
Should be a stable inflation rate