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Macroeconomics IA
Dr. T. V. de V. Cavalcanti, Michaelmas 2014
Email: tvdvc2@cam.ac.uk
Main Reading:
[R] Romer, D. (2001). Advanced Macroeconomics, 3rd edition, chs. 1, 2A.
Supplementary Readings:
[A] Acemoglu, D (2009). Introduction to Economic Growth, chs 1-5, 8, 11.
[BX] Barro, R.J. and X. Sala-i-Martin (1998). Economic Growth, chs 1-2.
[BF] Blanchard, O. and S. Fischer (1989). Lectures on Macroeconomics.
[J] Jones, C. (2002). Introduction to Economic Growth, 2nd edition.
[LS] L. Ljungqvist, and T. Sargent (2004). Recursive Macroeconomic Theory, 2nd edition.
[OR] M. Obstfeld and K. Rogoff (1996). Foundations of International Macroeconomics, MIT
Press.
Some articles:
Barro, R. (1991). Economic Growth in a Cross Section of Countries, Quarterly Journal of
Economics 106: 407-502.
Kaldor, N. (1961). Capital Accumulation and Economic Growth. In: The Theory of Capital.
ed. F. Lutz and D. Hague, St. Martins.
(*) Lucas, R. (1990). Why Doesnt Capital Flow From Rich to Poor Countries? American
Economic Review 80 (2): 92-6.
(*) Mankiw, N. G., D. Romer, and D. Weil (1992) A Contribution to the Empirics of Economic
Growth. Quarterly Journal of Economics 107: 407-37.
(*) Solow, Robert (1956). A Contribution to the Theory of Economic Growth. Quarterly
Journal of Economics 70: 65-94.
Swan, T. (1956). Economic Growth and Capital Accumulation. Economic Record 32.
Piketty, T. and G. Zucman (2014). Capital is Back: Wealth-Income Ratios in Rich Countries
Quarterly Journal of Economics: 12551310.
of Cambridge
M200: Macroeconomics
Cambridge
Michaelmas 2013
0.35
0.3
3. What are the policies that can change growth in the short and
long run?
Density of countries
1970
0.25
0.2
0.15
0.1
0.05
7
8
9
10
log of GDP per capita, PPP adjusted (US$, 2005)
11
12
0.35
0.35
0.3
0.3
1970
1990
Density of countries
Density of countries
2010
0.25
0.2
0.15
0.2
0.15
0.1
0.1
0.05
0.05
1990
1970
0.25
7
8
9
10
log of GDP per capita, PPP adjusted (US$, 2005)
11
12
7
8
9
10
log of GDP per capita, PPP adjusted (US$, 2005)
11
12
0.45
0.7
0.4
0.6
0.35
0.3
0.25
1970
0.2
0.15
0.1
1990
0.5
0.4
0.3
1970
0.2
0.1
0.05
7
8
9
10
log of GDP per capita, PPP adjusted (US$, 2005)
11
12
7
8
9
10
log of GDP per capita, PPP adjusted (US$, 2005)
11
12
1990
0.5
US
2010
0.6
= 20,435.85, 2005 US $)
0.7
0.4
0.3
1970
0.2
0.1
7
8
9
10
log of GDP per capita, PPP adjusted (US$, 2005)
11
12
1.5
CHE
1.25
US
AUT FRA
0.75
JPN
0.5
VNZ
ARG
0.25
BRA
0.25
0.5
0.75
1950 GDP per capita relative to the US level (GDP
1
1.25
= 13,069.2, 2005 US $)
1.5
US
1.5
2
2010 GDP per capita relative to the US level (GDPpcUS=41,365, 2005 US$)
US
=31,388.79, 2005 US $)
1.25
NOR
US
AUS
SGP
0.75
HKG
0.5
KOR
0.25
BWA
BRA
VNZ
ARG
0.25
0.5
0.75
1970 GDP per capita relative to the US level (GDP
1
1.25
=20435.85, 2005 US $)
US
1.5
1.8
1.6
1.4
SGP
NOR
1.2
1
HKG
US
GBR
0.8
KOR
0.6
0.4
CHN
0.2
BRAVNZ
0.2
0.4
0.6
0.8
1
1.2
1990 GDP per capita relative to the US level (GDPpc
1.4
1.6
1.8
=31,388.79, 2005 US$)
US
x xmin
Ii =
,
xmax xmin
1
3
1
3
1
3
0.9
Table : Real Income Growth by Groups, 1993-2010, Saez and Piketty (2012)
0.8
HDI
0.7
0.6
1993-2010
1993-2000
2000-2002
2002-2007
2007-2009
2009-2010
0.5
0.4
0.3
0.2
6
GNI per capita (US$), 2012
10
12
4
x 10
Average
Income
Real Growth
13.8%
31.5%
-11.7%
16.1%
-17.4%
2.3%
Top 1%
Incomes
Real Growth
58.0%
98.7%
-30.8%
61.8%
-36.3%
11.6%
Bottom 99%
Incomes
Real Growth
6.4%
20.3%
-6.5%
6.8%
-11.6%
0.2%
Fraction of
Total Growth (or loss)
Captured by the top 1%
52%
45%
57%
65%
49%
93%
1. Time is continuous
2. Demographics: Initially, there are L(0) people alive. Population
grows at a constant rate n:
L(t) = L0 ent = ent , normalizing L0 1.
Y = C + I + G + NX.
Assume for now no government G = 0 and start with a closed
economy NX = 0. Capital stock, K(t), depreciates at constant rate
> 0:
1. Capital stock:
Observe that
L(t)
= dL(t) .
= n, where L(t)
L(t)
dt
K(t)
= I(t) K(t).
K(t)
= sY(t) K(t).
Technology I
Technology II
Technology III
A
A
= g A(t) = A(0)egt .
Firms
F
2F
2F
F
> 0,
> 0,
< 0;
< 0.
K
K 2
L
L2
rK = FK (K, AL).
K0
L0
4. Example: Cobb-Douglas
F(K, L) = K (AL)1 , 0 < < 1.
Exercise: Verify that Cobb-Douglas satisfies the conditions of a
neoclassical production function.
(1)
K
w = AFL (K, AL) = AFL ( AL
, 1).
K
rK = FK (K, AL) = FK ( AL
, 1).
w
w
K
=const
AL
|{z}
gK + = sF(1,
CRS Assump.
AL
).
K
C = (1 s)Y,
C
= (1 s), gC = gY = gK = g + n.
Y
|{z}
w = AFL (
rK = FK (K, AL)
|{z}
rK = FK (
K
gw = g.
, 1) |{z}
AL
K
=const
AL
Homog of degree 0
AL
Y
= F(1,
) gY = gK = g + n.
K
K |{z}
K
, 1) |{z}
grK = 0.
AL
K
=const
AL
Homog of degree 0
F(K, AL)
K
Y
=
= F( , 1) f (k),
AL
AL
AL
Recall that: K = sY K.
Therefore:
Notice that:
K
AL
Y
K
= s AL
AL
=
K
AL
= sf (k) k, where k =
K
AL .
+ AL)K
d
A
KAL
(AL
L
K
k=k=
( + )k.
k =
2
dt
(AL)
AL
A L
K
L
K
A
= k + ( + )k
= k + (g + n)k.
AL
A L
AL
k + (n + g)k = sf (k) k
k = sf (k) (n + + g)k
| {z }
|
{z
}
investment
depreciation
y = f (k)
Observe that:
(n + + g)k
k = sf (k)
(g + n + )k
s y = sf (k)
k =
k(0)
1
1
= sF(1, ) (n + + g) k = sFL < 0.
k
k
k2
k
x 10
lim
"
#
#
sf (k)
sf (k)
sf (k)
sf (k)
] = , lim
]=0
=lim[
= lim[
k
k
k
k0 1
k 1
k =
= s f(kk) (n + + g)
k0
"
k
sf (k )
=0
= (n + g + ).
k
k
k < 0
K
AL
and k =
K
L.
k
A
k
= + = g + k = g.
k
A k
max c = (1 s)f (k ) = f (k ) (n + g + )k .
s
f (k ) k
k
c
=
(n + g + )
= 0,
s
s
k s
f (k )
k
c
=[
= 0 = f (kGR
(n + g + )]
) = n + g + .
s
s
k
Given k we can use sf (k ) = (n + g + )k to find sGR .
GR
GR
GR
c = (1 s)f (k )
k = sf (k) (n + g + )k.
1. If savings rate s increases, sf (k1 ) > (n + g + )k1 k > 0.
c
sGR
x 10
Linear Scale
x(t) = ex t x(0)
4. In new BGP, per capita variables K/L, Y/L, and C/L grow again
at rate g.
100
99
ln(x(t))
dln(x(t))
dt
x(t)
x(t)
= x
98
97
96
ln( K
L (t))
95
94
93
ln( YL (t))
92
t
Log of consumption per capita
90
ln( C
L (t))
91
Point: Use log scales to describe variables that are growing over time.
Conditional Convergence
(a ) Who le Sa mple
(b) O EC D C o untries
!$!(
19 60 -200 0
!$!'
Annual g row th of
!$!&"
Y
L
!$!'
Y
L
196 0-20 00
!$!"
!$!&
!$!%
!$!#
!$!&
!$!%"
!$!%
!
!$!#"
!$!#
!$!#
!
"!!!
#!!!!
Y
L 60
#"!!!
"!!!
#!!!!
Y
L 60
#"!!!
Speed of Convergence
Speed of Convergence I
For Cobb-Douglas k = sk (n + g + )k. Thus
k =
k
= sk(1) (n + g + ) =
k
ln k = se(1) ln k (n + g + ) = (let = ln k)
dt
= se(1) (n + g + )
Speed of Convergence II
= n+g+
(1 )(n + g + ) ( ) ( )
Note that:
(i)
(1)
} [ ] =
k
k
(ii)
y =
y
y
d
dt
ln y = dtd ln k = k
ln yy = ln kk
= ln( yy )
Thus: y = k ln kk
Capital and output per capita have the same speed of
convergence coefficient
Speed of Convergence IV
ln y(t) ln y(0) = (1 et )(ln y ln y(0))
d
dt
ln y = (ln y ln y ) = ( )
ln y(thalf ) ln y(0) =
P (t)
so that: (1 ethalf ) =
H (t)
Cet
et ) ln y(t)
1
2
thalf =
+ C C = (0)
1
2
ln y ln y(0)
2
= ethalf
ln 2
0.70
ln y(0)et
Steady-State Levels
Yt = At F(Kt , Ht )
Yt
= yt = At F(kt , ht ) (Ht = ht Lt ).
Lt
Development Accounting
kit
hit
Ait
yit
) = ( ) ( )1 ( ).
yjt
kjt
hjt
Ajt
ESP
ITA
BRNKWT
IRL
LUX
FBEL
RA
FIN
CYP
SGP
AUT
JPN
DNK
HKG
USA NOR
NLD
CHE
DEU
AUS
PRTMLT
OMN
KOR
SAU
GRC
ISL
LBNSVN
GBR
MAC
HRV
CAN
SWE
HUN
CZE
TWN
BHR
LVA
ESTSVK
ISR
ALB
ARG
SRB
LTU
NZL
MKD
BIH
MDV
ROU
TUR
TKM
SUR
IRN
GAB
MYS
RUS
MNE
JOR
POL
BHS BMU
CHL
VEN
URY
MEX
KAZ
BLR
PER
BGR
BWA
MNG
UKR
MUS
ECU
TUN
COL
BRA
SWZ
DOMPAN
BTN
SYR
THA
CHN
ZAF
GEO
MDA
GNQ
CPV
TTO
BRB
ARM
LKA
CRI
NAM
MAR
PHL
YEM
FJI
AZE
EGY
IDN
TJK
IRQ
JAM
DJI
PRY
MRT
VNM
LCA
BOL
LAO
VCT
PAK
UZB
AGO
BLZ
IND
HND
GTM
COG
LSO
BGD
STP
SEN
COM
GHA
GNB
NPL
KGZ
ZMB
CMR
KHM
SDN
BEN
NGA
GMB
KEN
MWI
NER
GIN
TZA
SLV
CIV
SLE
TCD
TGO
BFA
UGA
MDG
MLI
ETH
CAF
RWA
COD
LBR
MOZ
BDI
ZWE
.5
1.5
(k_j/k_US)^0.4
1
.5
1
(y_j/y_US)
(k/k_US)^0.4
y/y_US
(h_j/h_US)^0.6
1
1.5
(k_j/k_US)^0.4x(h_j/h_US)^0.6
.5
1
1.5
1.5
.5
USA NOR
NZLKOR CAN
AUS
CZE
DEU
EST
SVN
IRL
JPN
HUN
RUS
SWE
ISR
TWN
SVK
LKA
UKRALB
NLD
LTU
GRC
ISL
BEL
FRA
ARM
LVA
ESP
HKG
MLT
ROU
KAZ
CHL
MYS
FJI
CYP
LUX
DNK
FIN
CHE
BOL
POL
BGR
MDA
JAM
TTO
BHR
PAN
BLZ
BRB
BWA
AUT
ITA
GBR
ARG
TJK
JOR
SRB
SGP
MEX
HRV SAU
PHL
PER
CRI
KGZ
BRN
IRN
URY
PRY
ZAF
MNG
ECU
GAB PRT
CHN
MAC
SLV
MUS
COL
ZWE
SWZ
BRA
THA
DOM
HND
TUN
GHA
TUR
VEN
EGY
ZMB
KEN
LSO
VNM
KWT
COG
CMR
NAM
MDV
IRQ
IDN
BGD
TZA
TGO
PAK
UGA
SYR
IND
SEN
LAO
LBR
MAR
GTM
KHM
MWI
CIV
MRT
BEN
NPL
RWA
YEM
CAF
GMB
SLE
BDI
SDN
COD
MLI
NER
MOZ
TKM
NOR
ESP
BELLUX USA IRL
JPNFIN
FRA
ITA
NLD
CYP
AUS
HKG
DEU
BRN
DNK
AUT
KOR
SGP
CHE
SVN
GRC
MLT
ISLCAN
CZE
SWE
HUN
KWT
GBR
TWN
PRT
SAU
HRV
ESTSVK
MAC
LVA
BHR
ISR
NZL
ALB ARG
LTU
RUS
SRB
ROU
MYS
POL
IRN
JOR
CHL
GAB
KAZ
UKR
BGR
MEX
BWA
URY
PER
MDVTUR
VEN
MNG
ECU
PAN
MUS
COL
TUN
SWZ
BRA
MDA
CHN
LKA
DOM
ZAF
ARM
THA
TTO
BRB
CRI
FJI
SYR
PHL
JAM
TJK
NAM
PRY
BOL
EGY
BLZ
MAR
IDN
IRQ
VNM
HND
YEM
MRT
PAK
LAO
COG
LSO
IND
KGZ
BGD
GHA
GTM
SEN
ZMB
CMR
NPL
KEN
KHM
SLV
BEN
MWI
TZA
GMB
TGO
CIVSDN
UGA
SLE
NER
CAF
RWA
MLI
LBR
COD
ZWE
BDI
MOZ
TKM
.5
1
(y_j/y_US)
(h/h_US)^0.6
1.5
y/y_US
.5
1
(y_j/y_US)
Factors
1.5
y/y_US
Empirical Evidence
1.5
BRN
(A_j/A_US)
1
TTO
BRB
.5
TUR
SGP
LUX
CHE
GBR
SWE
HKG
TWN
CAN
SAU
AUT
NLD
FRA
DEU
BEL
MDV ISR ISL DNK
ITA
FIN
AUS
PAN POL
NZL CYP
ESP
SVK
GRC
JPN
GAB
HRV
BLZ
MLT
IRN
LTU
PRTKOR
MEX
RUS
VEN
SDNIRQDOM
ARG
EST
CHL
SVN
LVA
CZE
GTMCRI
ZAF
KAZ
ROUHUN
BGR
URY
EGY
SRB
BHR
MUS
MYS
SYR
PER
BWA
COL
BRA
ECUALB
TUN
INDARM
THA
UKR
TJK
MAR
PAK
NAM
LKA
JOR
IDN
MNG
JAM
PRY
CHN
BOL
MDA
FJI
MLI
COG
SWZ
YEM
KGZ
HND
PHL
KHM
MRT
CIV
VNM
GHA
RWA
ZMB
LAO
CMR
GMB
UGA
BGD
KEN
MOZ
BEN
NPL
SLE
TZA
SEN
LSO
NER
TGO
LBR
BDI
MWI
CAF
COD
SLV
.5
Summary:
NOR
IRL
USA
1
(y_j/y_US)
A/A_US
1.5
y/y_US
Differences in TFP
K
K
= gK = gA + n = g, then
K
s
=
.
Y
g+
K
K
s
g+s
and
g
C
= (1 s)
.
Y
g + s
= gK = gA + n = g, then
s
K
=
.
Y
g + s
K
Y
YC
Y
= 1 CY , then:
s(g + )
s(1 )
, and s (g) =
< 0.
g + s
(g + s)2
C
Y
0.
Piketty goes even further and assume that = 0. This implies that:
s
s
K
K
=
=
lim = .
g0 Y
Y
g + s
g
Concluding Remarks
1. The documentation of the historical data in Pikettys book is
impressive;
2. Inequality is indeed rising in many developed countries;
Next time:
Introduction
of Cambridge
M200: Macroeconomics
Cambridge
Michaelmas 2014
0.06
0.05
5.5
0.04
0.03
0.02
0.01
0.01
0.02
0.03
0.04
4.5
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
0.08
0.2
GDP
C
0.06
0.04
0.02
0.02
GDP
C
I
0.15
0.1
0.05
0.05
0.1
0.15
0.04
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
0.2
2010
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
11
9.6
10
9.4
9.2
log(Real US GDP, 2005)
8.8
8.6
8.4
6
8.2
5
4
1992
7.8
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
1960
1965
1970
1975
1980
1985
Quarters
1990
1995
2000
2005
2010
0.04
11
0.03
10
0.02
0.01
0.01
6
0.02
5
0.03
4
0.04
3
0.05
1960
1965
1970
1975
1980
1985
Quarters
1990
1995
2000
2005
1960
1965
2010
1970
1975
1980
1985
Quarters
1990
1995
2000
2005
2010
Political shocks;
Expectations shocks.
2. Propagation mechanisms
Consumption/investment decision;
Labour decisions;
Financial default
1. Keynesian
c,l
Subject to c = wl.
L = ln(c) + b ln(1 l) + [wl c],
FOCs:
1
= 0,
c
b
+ w = 0,
1l
bc
= w.
1l
Subject to
c1 +
w2 l2
c2
= w1 l1 +
.
1+r
1+r
FOCs:
Assumptions:
b
w2
b
= w1 and
=
1 l1
1 l2
1+r
Therefore:
w1
1 l2
= (1 + r) .
1 l1
w2
w1
w2
Implications:
Production Technology:
0 < < 1.
The representative household maximizes the expected value of
+ gt + A
t, A
t = A A
t1 + , A (0, 1).
ln(At ) = A
At
U = Et
Capital adjustment:
s=t
Kt+1 = Kt + It Kt
Labour and capital are paid their marginal products. Real wage and
real interest rate in period t are:
wt = (1 )At Kt (Lt )
rK = rt + = At
Lt
Kt
1
max U = Et
kt+1 ,lt
s=t
Define kt =
Kt
Nt ,
b>0
1
1
= Et (1 + rt+1 )
ct
ct+1
FOC w.r.t. lt ?
wt uc,t ul,t = 0
wt
b
=
ct
1 lt
Equilibrium conditions:
Resource constraint:
Ct + It = Yt Ct + Kt+1 = At Kt .
bct
= wt
1 lt
Euler equation:
1
1
1
1 1
= Et (1 + rt+1 )
= Et At+1 Kt+1
.
ct
ct+1
ct
ct+1
Solution
ct = (1 )Yt , ct = (1 )At Kt ,
We will guess that the solution of this system satisfies a simple rule:
ct = Yt .
Verify: Kt+1 = Yt Ct Kt+1 = (1 )Yt . Moreover,
1
Yt+1 1
= Et
,
Yt
Kt+1 Yt+1
Yt
Yt+1
1 = Et
,
(1 )Yt Yt+1
1
,
1 = Et
(1 )
Kt+1 = Yt , Kt+1 = At Kt .
Taking ln of both sides and defining kt = ln(Kt ) and at = ln(At ):
kt+1 = ln() + at + kt .
Output:
a+ ln()
.
1
ln()
1 .
Therefore:
1 s
.
1
a+ ln()
.
1
Therefore:
1.2
1
Technology
Capital
Labour
Consumption
Output
0.9
0.8
0.8
0.7
0.6
0.6
0.4
0.5
0.4
0.2
0.3
0
0.2
0
0.2
10
15
20
25
30
35
0.1
40
10
15
20
Next time:
0.6
Wages
Interest rate
0.5
0.4
Micro-foundations of consumption
0.3
0.2
0.1
0.1
0
10
15
20
25
30
35
40
25
30
35
40
Lecture 3: Consumption
Tiago V. de V. Cavalcanti1
1 University
of Cambridge
M200: Macroeconomics
Cambridge
Michaelmas 2014
Historical development
1. Keynesian consumption function:
Yt is disposable income
is the marginal propensity to consume. Determines various
multipliers;
Households Problem
The households problem is:
max
u () > 0, u () < 0;
T
X
t u(ct ) +
t=0
T
X
t u(ct ),
t=0
Subject to:
T
X
t=0
Euler equation:
t=0
First-order conditions:
u (ct )
= (1 + r)
u (ct+1 )
L
= t u (ct ) t = 0,
ct
aT+1
= 0, guarantees no-Ponzi games
(1 + r)T
L
= t + (1 + r)t+1 = 0,
at+1
L
= T 0, aT+1 0,
aT+1
T
X
t=0
Then:
u (ct )
= (1 + r) t = 0, 1, 2, ..., T.
u (ct+1 )
X
aT+1
yt
ct
+
= (1 + r)a0 +
.
t
T
(1 + r)
(1 + r)
(1 + r)t
(Euler)
X
ct
yt
= a0 (1 + r) +
, a0 given.
t
(1 + r)
(1 + r)t
t=0
c1
1 ,
t=0
(1+r)
If b =
1
[(1+r)]
(1+r)
t=0
c0 =
1
T
T
X
X
[(1 + r)] t
yt
) = a0 (1 + r) +
(
,
(1 + r)
(1 + r)t
1
1(
[(1+r)]
(1+r)
1
[(1+r)]
at+1 ,ct
Financial wealth
z }| {
X
[(1 + r)]
yt
+
].
c0 = (1
)[ a0 (1 + r)
(1 + r)
(1 + r)t
t=0
{z
}
|
|
{z
}
Eat a fraction of
life-time income
1
1+ ,
then:
(1+r)
1 + 1 (r ) r,
1
c0 = (r (r ))[a0 (1 + r) +
t=0
yt
].
(1 + r)t
X
t=0
yt
].
(1 + r)t
t=0
at+1 + ct = (1 + r)at + yt t,
aT+1
0.
lim E0
T
(1 + r)T
If =
T
X
)T+1
(1+r)
As T , then:
1
[(1+r)]
[(1 + r)a0 +
X
t=0
t u(ct ) +
t=0
L
= t u (ct ) t = 0,
ct
L
= t + Et [(1 + r)t+1 ] = 0,
at+1
Euler equation:
E0 [
X
t=0
X
1
1
ct ] = a0 (1 + r) + E0 [
yt ].
t
(1 + r)
(1 + r)t
t=0
ct = Et [ct+1 ] c0 = E0 [c1 ],
2 2
2 c .
1 2 ct = Et [1 2 ct ] ct = Et [ct+1 ].
c0 (1 +
X
1
1
1
+
+ ...) = a0 (1 + r) + E0 [
yt ].
2
(1 + r) (1 + r)
(1 + r)t
t=0
c0 =
X
r
1
(at (1 + r) + Et [
yt+j ]),
1+r
(1 + r)j
j=0
ct = rat +
r
(Et [
1+r
t=0
1
yt ]),
(1 + r)t
At any period t:
ct =
r
(a0 (1 + r) + E0 [
1+r
X
j=0
1
yt+j ]),
(1 + r)j
ct+1 ct =
j=0
j=0
X
X
r
1
1
yt+1+j ]Et [
yt+j+1 ]}.
{Et+1 [
j
1+r
(1 + r)
(1 + r)j
Interpretation:
yt+1 =
Et [yt+1 ] +
y E [y ]
.
| {z }
|t+1 {z t t+1}
Forecast at t Shock: new information
Consumption should only react towards the new information
H0 : 1 = 1 and 2 = 0.
Empirical Strategy:
PIH H0 : 1 = 0 and 2 = 0;
Borrowing constraint
maxat+1 ,ct E0 {
t=0
t u(c )},
t
subject to
Next time:
t = (1 + rt )Et [c
t+1 ] ct .
Test: H0 : t = 0.
Result: t > 0. Liquidity constraint exists.
Micro-foundations of investment
T
X
ct
yt
aT +1
+
=
a
(1
+
r)
+
.
0
t
T
(1 + r)
(1 + r)
(1 + r)t
t=0
t=0
(1)
(2)
Analogously at t=1:
(3)
a3 y2 + c2
.
1+r
(4)
Therefore:
c0 +
c1
c2
a3
y1
y2
+
+
= (1 + r)a0 + y0 +
+
.
1 + r (1 + r)2 (1 + r)2
1 + r (1 + r)2
(5)
T
X
ct
aT +1
yt
+
= a0 (1 + r) +
.
t
T
(1
+
r)
(1
+
r)
(1
+
r)t
t=0
t=0
(6)
1 bT +1
.
1b
If b =
[(1+r)]
1+r
X
1
r
(at (1 + r) + Et [
yt+j ]),
1+r
(1 + r)j
j=0
X
X
r
1
1
{Et+1 [
y
]
E
[
yt+j+1 ]}.
t
j t+1+j
1+r
(1
+
r)
(1
+
r)j
j=0
j=0
ct+1 ct =
X
X
r
1
1
[at+1 (1+r)+Et+1 [
y
])(a
(1+r)+E
[
yt+j ])].
t
t
j t+1+j
1+r
(1
+
r)
(1
+
r)j
j=0
j=0
X
r
1
r
[(1 + r)((1 + r)at + yt ) (1 + r)
(at (1 + r) + Et [
ct+1 ct =
yt+j ])
1+r
(1 + r)
(1 + r)j
j=0
X
1
1
+Et+1 [
y
]) ((1 + r)at + Et [
yt+j ])].
j t+1+j
(1
+
r)
(1
+
r)j
j=0
j=0
X
X
1
r
1
ct+1 ct =
[Et+1 [
y
] + (1 + r)yt (1 + r)Et [
yt+j ]].
j t+1+j
1+r
(1
+
r)
(1
+
r)j
j=0
j=0
X
X
r
1
1
[Et+1 [
y
]
(1
+
r)E
[
yt+j ]].
t+1+j
t
j
1+r
(1 + r)
(1 + r)j
j=0
j=1
X
X
1
1
r
[Et+1 [
y
]
E
[
yt+1+j ]].
t+1+j
t
j
1+r
(1 + r)
(1 + r)j
j=0
j=0
Lecture 4: Investment
Tiago V. de V. Cavalcanti1
1 University
of Cambridge
M200: Macroeconomics
Cambridge
Michaelmas 2014
History of Thought
It = Yt rt .
(1)
K,L
FOC:
F1 (K, AL) = rK , and AF2 (K, AL) = w.
K
rK
1
F11 (K,AL)
K
r ;
Notice that:
By arbitrage: r =
< 0.
There is no worries about the future, since firms can adjust the
capital stock to any change in the environment.
Q Models
Tobins Q
Tobins Q: Q =
Tobins Marginal q
See: http://lexicon.ft.com/Term?term=Tobin%27s-q-ratio
Installation
Value of the firm:
Vt = max
Is ,Ks+1
X
s=t
Lagrangian:
L=
X
s=t
1
L=
(
)st [As f (Ks ) Is Is2 + qS (Is + Ks Ks+1 )].
(1
+
r)
2
s=t
FOCs:
Is =
L
= 0 qs = 1 + c (Is ) = 1 + Is ,
Is
L
As+1 f (Ks+1 ) + qs+1
= 0.
= 0 qs +
Ks+1
1+r
1 T
(
TVC :
lim
) qT
T
1
+
r
| {z
}
KT+1 = 0.
Investment Dynamics I
Marginal qs : qs =
Investment Dynamics II
Let At+1 = A.
1
(qs 1).
1
(qt 1),
Kt+1 Kt =
1
(qt 1)).
1 T
Two boundary conditions: K0 , and limT ( 1+r
) qT KT+1 = 0.
Steady-state:
1
(qt 1),
Kt+1 = 0 qt = 1;
Kt+1 = 0 qt = 1;
r = Af (K).
Investment Dynamics IV
1
(qt 1)).
Investment Dynamics V
qt+1 = 0 locus
Investment Dynamics VI
Steady-state: q = 1 and AFK = r.
Saddle Path
Saddle path: the unique path that converges to the steady state, q = 1
and AFK = r.
Examples:
Tax policies.
Lagrangian:
L=
X
s=t
)st [As f (Ks )Is Is2 +qS (Is +Ks Ks+1 )+s (Is )].
(1 + r)
2
L=
X
s=t
)st [As f (Ks )Is Is2 +qS (Is +Ks Ks+1 )+s (Is )].
(1 + r)
2
FOCs:
L
= 0 qs = 1 + c (Is ) = 1 + Is + s ,
Is
L
As+1 f (Ks+1 ) + qs+1
= 0.
= 0 qs +
Ks+1
1+r
1 T
(
TVC :
lim
) qT
T
1
+
r
| {z
}
KT+1 = 0.
Let At+1 = A.
Investment decision:
Kt+1 =
Is =
1
s
(qs 1) .
1
1
(qt 1); qt+1 = rqt Af (Kt + (qt 1)).
If Kt+1 = , then
Kt+1 = ; qt+1 = rqt Af (Kt + ).
1 T
Two boundary conditions: K0 , and limT ( 1+r
) qT KT+1 = 0.
Steady-state:
Thank you!!!
r = Af (K).
Supplementary references (which are meant for those wishing to gain a deeper understanding of the material or write a dissertation on it) include:
- Benjamin Friedman and Michael Woodford (2011, eds.), Handbook of Monetary Economics, Vol. 3, Elsevier.
- Jordi Gal (2008), Monetary Policy, Inflation, and the Business Cycle, Princeton University Press.
- Gene Grossman and Kenneth Rogoff (1995, eds), Handbook of International Economics, Vol. 3 (Part 2), North-Holland.
- Peter Isard (1995), Exchange Rate Economics, Cambridge University Press.
- N. Gregory Mankiw and David Romer (1991, eds.), New Keynesian Economics, Vol.
I & II, MIT Press.
- Maurice Obstfeld and Kenneth Rogoff (1996), Foundations of International Macroeconomics, MIT Press.
- Lucio Sarno and Mark Taylor (2003), The Economics of Exchange Rates, Cambridge
University Press
- John B. Taylor and Michael Woodford (1999, eds.), Handbook of Macroeconomics,
Vol. 1 (Part 1, 5 and 6)
- Mark Taylor (1995), The Economics of Exchange Rates, Journal of Economic Literature 33.
- Carl Walsh (2010), Monetary Theory and Policy, MIT Press.
Organization
There are 5 two-hour lectures, meeting Monday at 11am in Lecture Block Room 6,
starting November 3, with a one-hour concluding lecture Monday December 1 at 2pm
in Lady Mitchell Hall. The topics for the lectures are as follows (with main readings in
parentheses):
1. Unemployment and real rigidities (Romer, ch 10)
2. Nominal rigidities (Romer, ch 6)
3. Monetary policy (Romer, ch 11)
4. Fiscal policy (Romer, ch 12)
5. Exchange rates
There are two problem sets for this course that are discussed in the classes, which are
taught by Jasmine Xiao. It is important to complete the problem set questions before
each class to get essential preparation for the exam.
Office hours are Tuesday 2:30-3:30 pm (during Full Term), or by appointment (Email:
Petra.Geraats@econ.cam.ac.uk), in Room 65, Austin Robinson building (Sidgwick Site).
The handouts for this course are available online at
http://www.econ.cam.ac.uk/faculty/geraats
Petra M. Geraats
Michaelmas 2014
Petra M. Geraats
Michaelmas 2014
Course Information
Lecture 1 Unemployment
- Outline
- Handouts available at www.econ.cam.ac.uk/faculty/geraats
Motivation
Unemployment
h<
2005
5.2
6.8
4.8
8.9
11.2
9.9
4.3
7.7
4.4
4.7
7.6
9.2
7.5
4.8
5.1
2009
4.8
8.3
6.0
9.1
7.7
9.6
12.0
7.8
5.1
3.4
9.4
17.9
8.3
4.2
7.6
9.3
2010
4.4
8.0
7.5
9.3
7.1
12.7
13.9
8.4
5.1
4.5
10.8
19.9
8.6
4.5
7.8
9.6
2011
4.1
7.5
7.6
9.2
5.9
17.9
14.6
8.4
4.6
4.4
12.7
21.4
7.8
4.0
8.0
9.0
2012
4.3
7.2
7.5
9.8
5.5
24.4
14.7
10.7
4.4
5.3
15.5
24.8
8.0
4.2
7.9
8.1
2013
4.9
7.1
7.0
9.9
5.3
27.5
13.0
12.2
4.0
6.7
16.2
26.1
8.1
4.4
7.5
7.4
Structural unemployment
Key ingredient: real rigidity [lec 1]
Unemployment due to minimum wage, efficiency wages, collective bargaining, etc
Frictional unemployment
Key ingredient: search and matching frictions [M210]
Unemployment due to optimal search decisions of firms and workers
2005
25
10
23
41
53
52
33
50
33
40
48
25
39
21
12
2009
21
8
10
35
46
41
29
44
29
25
44
24
13
30
25
16
2010
25
12
20
40
47
45
49
49
38
28
52
37
17
33
33
29
2011
26
14
24
42
48
50
59
52
39
34
48
42
18
39
33
31
Real Rigidities
2012
25
13
28
40
46
59
62
53
39
34
49
44
18
35
35
29
2013
24
13
26
40
45
68
61
57
41
36
56
50
17
33
36
26
Worker
Firm
e = e (w )
Key result
= Y wL
Production technology:
Y = F (eL)
with
F (.) >
0,
F (.) <
e (w ) w
=1
e (w )
0
Optimal wage
Market structure
e (w) = e (w) /w
(1)
Standard case with perfect competition in labor market: e = 1 and w = F L
e(w)
~
w
e(w)
~
w
w*
Derivation
Profits = F (e (w) L) wL
w
FOC wrt L: e (w) F (e (w) L) w = 0 F (e (w) L) = e(w)
Consider same model as before, but now suppose (following Summers, AER 1988)
det D 2 = e2F
on
!
eLF + eL 2 F eF + eeLF 1 2
o
e (w) =
eeL <
=
0 using eF = 1 (FOC wrt w)
w=w
(for close to w)
So w > implies L < L
ww
w
if w > w
otherwise
w
= (1 u) wm + uwm
1
Assuming symmetric equilibrium with w = wm yields
w=
u=
Derivation
w
, Solow condition e (w ) = e(w) yields
For e (w) = w
w
1 w
Hence, (3): w = 1
>w
.
Firm
1 ww
1 = 1 ww
w = w w
w
w
w
(2)
where wm market real wage, u unemployment rate, and replacement ratio (0 < < 1).
(3)
(4)
t = Y t w t L t
Production technology:
Note: Limiting case 0 yields outcome under perfect competition in labor market:
e = 1 and u = 0.
Y t = F (e t Lt )
Market structure
Perfect competition in goods market
Imperfect competition in labor market: firm chooses labor input L and real wage w
Worker
Results
t=0 (1 + )
t vt
wt et if employed
0
if unemployed
1 [(b + q ) V + (1 b q ) V ]
- employed and shirking: VS = w + 1+
U
S
Employee effort
et =
1 [aV + (1 a) V ]
- unemployed: VU = 1+
E
U
1 [bV + (1 b) V ]
- employed and not shirking: VE = w e + 1+
U
E
i
Ld
w = e 1 + +
#
b 1
u q
(NSC)
i
Ld
NSC
Derivation
No-shirking condition: VE = VS
1 [bV + (1 b) V ] = w + 1 [(b + q ) V + (1 b q ) V ]
w e + 1+
U
E
U
E
1+
Simplifying yields VE VU = (1 + ) e/q ()
Note: VE > VU
Recall VE = w e +
1
1+ [(1 b) VE
i
Ld
NSC
+ bVU ]
1 [aV + (1 a) V ]
and VU = 1+
E
U
1 (1 b a) (V V )
So VE VU = w e + 1+
E
U
Substituting (): (1 + ) e/q = w e + (1 b a) e/q
Simplifying yields w = e + ( + a + b) e/q
In steady
state equilibrium (i.e. no shirkers):
L a = bL
bL = a L
LL
so a + b = b L = b/u as u = LL
LL
L
Hence (NSC): w = e [1 + ( + b/u) /q ]
i
Hysteresis
Ld
NSC
insider-outsider effects [Blanchard & Summers (1986); Lindbeck & Snower (1986)]
_
Insider-Outsider Effects
Workers
Workers are either insiders (if employed in previous period) or outsiders (if unemployed
in previous period), so insiders Nt = Lt1
Firm
Insiders set wt to achieve expected (log) full employment insiders (Lt = Nt)
Timing
t = Y t w t L t
Production technology: Yt = AtL
t
t where t i.i.d. with E [ln t] = 0
where 0 < < 1 and technology At = A
Market structure
Key result
Derivation
t L wt L t
Profits t = A
t
tL1 = wt
FOC wrt Lt: A
t
t 1/(1) w1/(1)
Labor demand Lt = A
t
1/(1)
1 ln w + 1 ln , where L = A
In logs, ln Lt = ln L0 1
t
0
t
1
,
Note: If insiders equal entire labor force Nt = L
+ 1 ln t, so no hysteresis.
then ln Lt = ln L
1
1
ln t
1
Petra M. Geraats
Michaelmas 2014
Nominal Rigidities
Nominal rigidities include sticky prices and (downwardly) rigid nominal wages.
2. Menu cost model: imperfect competition, menu costs and real rigidities
Menu costs: (typically small) costs of changing prices [Mankiw (QJE 1985)]
3. Empirical evidence
Near rationality : small deviations from optimizing behavior
[Akerlof & Yellen (QJE 1985)]
Main reading: Romer (2011), chapter 6B (excl 6.8-6.9) and pp. 337-340
Supplementary references:
- Friedman and Woodford (2011), Handbook of Monetary Economics, Vol. 3, ch 6
- Mankiw and Romer (1991), New Keynesian Economics, Vol. I, Part I and II
- Taylor and Woodford (1999), Handbook of Macroeconomics, Vol. 1, ch 15
In both cases, sticky price Pi has only second-order effect on firms profits.
For profit function i (Pi) with optimal price Pi satisfying i Pi 0 and i Pi < 0,
second-order Taylor approximation around optimal price Pi:
2
1
i Pi i (Pi) + i (Pi) Pi Pi + i (Pi) Pi Pi
2
Pi*
Pi
i =
W
Pi
Qi
Li
P
P
(1)
Q i = Li
(2)
Pi*
Pi
Market structure
Demand
Monopolistic competition in goods market: firm has market power to set price Pi
Worker
Pi
P
>1
(5)
Aggregate demand:
Y =
1
U i = Ci L i
>1
(3)
W
Li
P
(4)
M
P
(6)
R
R
where Y = 01 Qidi aggregate output, P = 01 Pidi aggregate price, and M aggregate
Key results
Derivation:
- Producer behavior with flexible prices
(7)
1
1
(8)
Effects of drop in aggregate demand with flexible prices (LHS) and fixed prices (RHS)
P
AD
AS
AD
1
1
1
1
AD
AS
AD
_
P
Ld
Effects of drop in aggregate demand with flexible prices (LHS) and fixed prices (RHS)
Y
W
_
P
= 0 Lsi = W
P
= 1
R1
where L = 0 Lidi so (2) implies Y = L.
1
1
As a result, aggregate supply (8): Y s = 1
<1
Pi
W
Note: under perfect competition, P = P = 1 so Y = 1
Labor market equilibrium: L = W
P
Y
L
- Consumer behavior
1
Substituting (4) into (3): Ui = i + W
P Li Li
_
P
W
_
P
1
In symmetric equilibrium, Pi = P , so W
P = <1
Note: price above MC and real wage below MPL due to imperfect competition
With flexible prices, output determined by aggregate supply and money M neutral:
Yflex =
Pi
()
Substitute (2) and (5) into (1): i = PPi W
P Y P
1
Pi
Pi
Pi
Y
W
Y
FOC wrt Pi: P P
P P P P
= 0 PPi = PPi W
P
W
W
Rearranging reveals markup pricing (7): PPi = 1
P > P
W
_
P
Y
W
_
P
Ld
Effects of drop in aggregate demand with flexible prices (LHS) and fixed prices (RHS)
P
AD
AS
AD
Y =
_
P
1
W
M
=
P
P
Y
W
_
P
M
P
(9)
Y
W
_
P
Ld
W
Labor market equilibrium: Le = M
P = P
L
Menu Costs
1
1
1
1
Pi
ADJ
FIX
Pi *
P0
Pi *
Pi
P0
Pi
Pi W
Y
P
P
and equilibrium real wage with sticky prices:
Y =
i =
M
P
1
(9)
1
1
Pi
P
M 1
W
=
P
P
- For firms that keep price Pi fixed at P0, markup pricing (7) fails.
Substitute Pi = P0 = P , (6) and (9) into ():
F IX =
1
1
M
M
P0
P0
()
(9)
(10)
W
- For firm that adjusts price, plug PPi = 1
P (7), (9), (6) and P = P0 into ():
ADJ =
1 1
M
P0
!(1)
(11)
ADJ F IX with low price sensitivity profits and high real rigidity
i
Example
= 1.25)
and = 5 (markup factor 1
1
W 1
P
1 = 0.1)
with 1
ADJ
FIX
1
Start from flex-price outcome (8): Yflex = 1
= 0.978
M = 0.97 M0 = 0.97Y
using
(6)
Consider 3% drop in M : P
flex
P0
0
Substituting into (10) and (11): (ADJ F IX ) /Yflex = 0.258
So, menu costs of more than 25% of real revenue (output) needed for fixed
prices to be Nash equilibrium.
1 amounts to high real wage flexibility ( W = Y 1 ).
Low elasticity of labor supply 1
P
Pi *
ADJ F IX with low price sensitivity profits and high real rigidity
ADJ
ADJ
FIX
FIX
P0
Pi
Pi
ADJ F IX with low price sensitivity profits and high real rigidity
Pi *
P0
Pi *
P0
Pi
ADJ F IX with low price sensitivity profits and high real rigidity
Assume real wage function (e.g. due to efficiency wages or wage bargaining):
FIX
W
= AY
P
>0
(12)
Pi *
P0
Pi
=
AY
and real wage function (12): W
P
W
Optimal price still (7): PPi = 1
P
( )
Example
Take = 0.1 (high real wage rigidity), A = 0.806 (output gap 5%)
- For firms that keep price Pi fixed, markup pricing (7) fails.
Substitute Pi = P0 = P , (6) and (12) into ():
F IX =
M
M
A
P0
P0
!1+
(13)
1
1 1
M
P0
!1+
1W
- Flexible price outcome with real rigidity: Yflex = A
P
using (12), (7) and Pi = P .
- For firm that adjusts price Pi, substitute (7), (12), (6) and P = P0 into ():
ADJ = A1
1
1 1 = 0.928.
Start from flex-price outcome: Yflex = A
M0
M
Consider 3% drop in M : P = 0.97 P = 0.97Yflex
1
1 1
= A
(14)
1
As a result, small microeconomic nominal friction with some real rigidity could generate
substantial aggregate nominal rigidity.
Empirical Evidence
Testable implication menu cost model (Ball, Mankiw and Romer, BPEA 1988)
When average inflation
is higher, aggregate demand shocks x have smaller effect on
output y because prices are adjusted more often.
yt = c + t + xt + yt1
i = 0.600 4.835
i + 7.118
2i
(0.079)
(1.074)
(2.088)
(Time series)
(Cross section)
b>0
- Walsh (2010), ch 8, 10
Benefits of inflation
Costs of inflation
+ Reduction of real wage rigidity when nominal wages are downwardly rigid (inflation
greases the wheels of the labor market).
+ Expansionary monetary policy less constrained by zero lower bound on nominal interest
rate.
+ Government revenues from printing money (seignorage) allow for reduction of distortionary taxes.
Shoe-leather costs due to reduction of real money holdings caused by higher opportunity
cost of money (i = r + e) [Friedman rule: = r ]
Menu costs associated with adjusting nominal prices and wages
[up to 1% of retail revenues (Levy, Bergen, Dutta & Venable, 1997)]
Distortion of relative prices due to infrequent price adjustments
Inflation distortions induced by tax system
[cost about 1% of GDP for inflation of 2% vs 0% (Feldstein, 1997)]
Inconvenience of changing value unit of account and errors in financial planning
In addition, higher inflation tends to be more variable and unpredictable.
For unanticipated inflation,
unintended redistribution of wealth in nominal assets
greater uncertainty welfare reducing under risk aversion
Conclusion
Optimal rate of inflation likely to be positive, but small.
Inflation Bias
No inflation-output trade-off in long run (AS curve vertical).
But empirically, inflation often higher than socially desirable (inflation bias).
Explanation (Kydland and Prescott, JPE 1977):
Discretionary low-inflation monetary policy is dynamically inconsistent.
1
1
L = a ( )2 + (y y )2
a>0
2
2
where socially optimal inflation, and y socially optimal output, with y > y
(due to distortions or market imperfections).
Economy described by aggregate supply equation
y = y + b ( e) + s
b>0
(2)
Key results
Socially optimal inflation = dynamically inconsistent under discretion.
Discretionary monetary policy gives rise to inflation bias
b
(y y) >
a
with aggregate output on average equal to natural rate
E [ ] = +
E [y ] = y
This outcome is dynamically consistent (subgame-perfect Nash equilibrium).
s i.i.d. 0, 2s
N Dynamic inconsistency
Multi-period decision {xt}T
t=0 optimal at time 0
no longer so at some future time 0 < t < T
(in game theory, equilibrium not subgame-perfect)
(1)
Timing
1. Public rationally forms inflation expectations: e = E [ ]
2. Aggregate supply shock s realized
3. Monetary policymaker sets
Derivation
Use backward induction.
3. Substitute (2) into (1): L = 21 a ( )2 + 21 (
y + b ( e ) + s y )2
FOC wrt (given e): a ( ) + b (
y + b ( e ) + s y ) = 0
Rearranging:
b2
b
b
a
+
e +
(y y)
s
a + b2
a + b2
a + b2
a + b2
e
(3)
a + b e + b (y y
1. Rational expectations: e = E [ ] = a+b
)
2
a+b2
a+b2
Rearranging: e = + ab (y y) > (inflation bias)
Substituting into (3) and simplifying:
b
b
(y y)
s
a
a + b2
e
e
Substituting (4) and into (2): y = y + b ( ) + s
a
s
y = y +
a + b2
= +
1 a+b2
(4)
(5)
a 2
Note: Substitute (4) and (5) into (1): E [LD ] = 2 a (y y)2 + 12 a+b
2 s
)2 + 21 a+b
Note: E [LC ] = 21 (y y)2 + 21 2s < 12 a+b
E D
2 s
a (y y
b 2 2 < b2 (y y
if a+b
)2
2 s
a
Delegation: Delegate monetary policy to central banker (CB) with different preferences.
Incentive contracts: Give central banker personal incentives to prevent inflation bias
(Walsh, AER 1995; Persson and Tabellini, CRCPP 1993).
(1)
Conservative, inflation-averse central banker with aCB > a (Rogoff, QJE 1985)
reduces inflation bias, but also stabilization of supply shocks.
Central banker with conservative inflation target CB = ab (y y)
(Svensson, AER 1997) eliminates inflation bias, without affecting output stabilization.
=y
Responsible central banker with output target yCB
(Blinder, JEP 1997)
eliminates inflation bias, without affecting output stabilization.
Two-period monetary policy game with reputation [Geraats, EJ 2002, sec 1.2]
Trigger strategies with higher e as punishment after inflation bias (Barro & Gordon,
JME 1983).
Problem: Multiple equilibria; trigger strategy arbitrary and hard to coordinate.
makes inflationprone policymakers mimic low-inflation types (Backus & Driffill, AER 1985; Barro, JME
1986).
L = l1 + l2
1
lt = a ( t )2 (yt y)
2
0<<1
a>0
(6)
(7)
Key result
Reputation effect reduces inflation bias in first period:
1 = + (1 )
Derivation
b
b
< + = 2
a
a
Publication of central bank forecasts allows private sector to infer central banks intentions
from monetary policy actions/outcomes and adjust private sector inflation expectations
accordingly, which imposes discipline on central bank (Geraats, EJ 2002).
Prominent examples
Monetary policymaker minimizes expected value social welfare loss
t = k
* Friedman (1960, AER 1968): constant money growth M
Activist monetary policy undesirable because of uncertainty about economy and
propensity to overreact due to policy lags.
L t = Et
Lt =
s=t
stLs
it = r + + 1 +
"
1
1
( t ) + + (1 + ) (yt y)
(11)
(10)
Derivation
"
(9)
Key result
>0
1
( t )2
2
and IS equation
1
1
( t ) + (1 + ) (yt y)
(8)
rt = r +
0<<1
Substitute
i
hP(9) and (10) into (8):
st 1 ( )2
L t = Et
s
s=t
2
= Et
FOC wrt
st 1 (
) (rs2 r) + s1} + s )2
s1 + { (ys2 y
s=t
2
h
i
rt: Et 2 ( t+2 ) = 0 Et [ t+2] =
hP
4/2008
22
29
130
11
192
in,t =
Petra M. Geraats
Michaelmas 2014
Gt + rBt = Tt + Dt + St
Main reading: Romer (2011), chapter 11.9 and 12 (excl 12.5-8 and 12.10)
Supplementary references:
- Fischer, Sahay and V
egh (2002), Modern Hyper- and High Inflations, JEL 40(3)
- Taylor and Woodford (1999), Handbook of Macroeconomics, Vol. 1, ch 22, 25, 26
(1)
Seignorage
Gs
s=t (1 + r )
st
Ts
s=t (1 + r )
st
Ss
s=t (1 + r )
st
(2)
Derivation
Rearranging (1) and iterating forward:
1 (T + S G + B
Bt = 1+r
t
t
t
t+1 )
t =
1 (T
1
Tt + St Gt + 1+r
= 1+r
t+1 + St+1 Gt+1 + Bt+2 )
1 PT
1
1
= 1+r
(
T
+
Ss G s ) +
s
st
T +1t BT +1
s=t
(1+r)
Pt Pt1 Mt1
Mt1 Mt1
=
Pt1
Pt
Pt
Pt1
M
1
T +1t BT +1 = 0 (transversality
T (1+r)
1
condition lim
T +1t BT +1 0
T (1+r)
Mt
t1
t1
t1
t
Relation seignorage and inflation tax: St = M
Pt Pt1 + Pt1 Pt = Pt + t
(1+r)
condition).
M
M
M
In continuous time, S = M
dd xt .
P = M P and = P , where x
Cagan model
Money market equilibrium with Cagan (1956) money demand (b > 0):
ln
M
= a bi + ln Y
P
(3)
0.1
Fisher equation:
0.08
i = r + e
(4)
where i nominal interest rate, r real interest rate and e expected inflation.
0.06
Superneutrality (i.e. change in money growth has no effect on real resource allocation):
Y = Y , r = r
0.04
Sss
Perfect foresight: e =
0.02
Key result
0
M
Inflation tax Laffer curve leads to limit on seignorage S = M
M P in steady state
/M raises tax rate but erodes tax base M/P .
as increase in money growth M
Derivation
gM
10
855
Seigniorage
10
10
/M constant and gM = = e
In steady state: gM M
M
M
M
bgM
Steady state seignorage: Sss = M
P = M P = gM P = gM Ce
1
bgM = 0 g
ss
FOC: dd S
M = b
gM = (1 bgM ) Ce
2S
SOC: d 2ss = bCebgM b (1 bgM ) CebgM < 0 for gM = 1b
d gM
0.2
0.4
0.6
LN(1 + Inflation/100)
0.8
0
1.2
Hyperinflation
Derivation
Hyperinflation: inflation over 50% per month (12, 875% per annum)
m = [ln m ln m] (6)
Recall: m = Ceb (5), and d ln
dt
m = 1 dm = m
Note that d ln
m dt
m and substitute (5) into (6):
dt
Hyperinflation model
= [ln C b ln m] = [b ss (m) b ]
m
(5)
d ln m (t)
= [ln m (t) ln m (t)]
dt
where
M (t)
m (t) P (t)
(6)
Key result
Hyperinflation arises if seignorage needs exceed maximum steady state seignorage S .
848
m
= 0 so b (m) ln C ln m.
since in steady state with constant m, m
ss
Then, m
= b [ ss (m) m m] = b [Sss (m) (S m
)]
recalling = gM in steady state and S = gM m, so Sss (m) = ss (m) m,
m
M
=Sm
.
and using m P , so m = gM and m = gM m m
Rearranging,
b
m
=
[Sss (m) S ]
1 b
Let S maxm Sss (m) maximum steady state seignorage.
If seignorage needs S > S , then S > Sss (m) so m
< 0.
m
(hyperinflation!)
While m 0, gM = S/m and = gM m
LN(1 + inflation/100)
853
Seigniorage
1.2
1.2
10
10
1
8
0.8
0.8
0.6
0.6
4
0.4
0.4
0.2
0.2
4
2
2
0.2
0.4
0.6
LN(1 + M2 Growth)
0.8
0
1.2
2
15
Growth1
10
0
5
Fiscal Balance/GDP
10
15
of regression line is 1.115 with a t-statistic of 12.13; 94 countries in total, each with 10 or more observations.
1 Slope
of regression line is 0.152 with a t-statistic of 2.30; 94 countries in total, each with 10 or more observations.
0
20
Ricardian Equivalence
Ricardian experiment
Assumptions:
Constant (present value) government purchases
(1+r)n T
Consumer saves current tax cut to pay for higher future taxes.
Lump-sum taxes
Superneutrality
M
Mt
= (1 + r) Bt + t1 + Yt
Ct + Tt + Bt+1 +
Pt
Pt
Intertemporal budget constraint representative consumer:
Cs
s=t (1 + r )
st
Ts
s=t (1 + r )
st
Ss
s=t (1 + r )
st
= (1 + r) Bt +
(7)
Ys
s=t (1 + r )
st
(8)
1 (C
1
Ct + Tt + St Yt + 1+r
= 1+r
t+1 + Tt+1 + St+1 Yt+1 + Bt+2 )
1 PT
1
1
= 1+r
(
C
+
T
+
S
Ys ) +
s
s
s
st
T +1t BT +1
s=t
(1+r)
1
T +1t BT +1
T (1+r)
st
Ts
s=t (1 + r )
st
Ss
s=t (1 + r )
Ys
s=t (1 + r )
st
Cs
s=t (1 + r )
st
Ts
s=t (1 + r )
st
Gs
(1+r)
= 0 (transversality condition)
st
Derivation
s=t (1 + r )
Ys
s=t (1 + r )
st
Cs
s=t (1 + r )
st
to get (8).
Empirically, Ricardian equivalence often fails.
Gs
s=t (1 + r )
st
Ss
s=t (1 + r )
st
Tax Smoothing
Key result
( t) = Et ( t+1)
where (0) = 0,
( .) >
0 and
s=t (1 + r )
st ( s ) Ys
Special cases:
(.) > 0.
Without uncertainty,
t = t+1
(1 + r) Bt +
Gs
s=t (1 + r )
st
s Ys
s=t (1 + r )
(9)
st
Derivation
P
1
Lagrangian: L = Et
s=t (1+r)st ( s ) Ys
P
P
s Ys
Gs
+ (1 + r) Bt +
s=t (1+r)st s=t (1+r)st
FOC wrt t:
t ) Yt Yt
=0
( t )
(1 + r) Bt +
t =
=
Y
1
t+n
FOC wrt : (1 + r) Bt +
P
P
s Ys
Gs
s=t (1+r)st = s=t (1+r)st
Combining FOCs:
h
( t) = Et ( t+n)
Special cases:
Without uncertainty, ( t) = ( t+n). Hence, t = t+n.
For quadratic cost ( ) = 12 2, ( ) = . Hence, t = Et [ t+n].
P
P Et[ s]Ys
P
t Ys
Et [Gs ]
s=t (1+r)st = s=t (1+r)st = s=t (1+r)st
Et [Gs ]
s=t (1+r)st
Ys
s=t (1+r)st
(1+r)Bt +
P
Petra M. Geraats
Michaelmas 2014
Forward exchange rate Ft: domestic price at time t for foreign currency at time t + 1
Main reading: Sarno and Taylor (2003), ch 2.0-2.1, 3.0-3.2, 3.5, 3.7, 4.1.2-4.1.3, 4.3-4.4
Supplementary references:
1 + it = (1 + it )
Ft
St
(CIP)
1 + it = (1 + it ) Et
"
St+1
St
Empirical evidence
- CIP holds for advanced economies without capital controls, but UIP fails.
- Nominal exchange rate very volatile and hard to predict.
Meese and Rogoff (JIE 1983):
For short forecast horizons (1-12 months), random walk outperforms macro models,
even if structural forecasts are based on actual realization of explanatory variables.
For longer forecast horizons (2-3 years), macro models do outperform random walk.
(LOP)
(UIP)
(PPP)
- Large and persistent deviations from law of one price (potential explanations: transport
costs, tariffs and other trade barriers, imperfect competition with pricing to market)
- Real exchange rate close to random walk. However, for long sample periods and/or
large deviations from PPP, mean reversion occurs.
PPP puzzle: Assuming deviations from PPP caused by nominal rigidities, convergence to
PPP should be fast. However, half-life of PPP deviations appears 3-5 years, suggesting
convergence extremely slow.
- Real exchange rate increasing in per capita income ( Balassa 1964)
Key result
Nominal exchange rate is asset price which depends on expected discounted value of
future fundamentals:
t
1 X
st =
(4)
Et [k ]
1 + =t 1 +
mt pt = yt it
, > 0
(1)
Derivation
pt = st + pt
(2)
it = it + Et [st+1] st
(3)
1 k +
Rearranging: st = 1+
t
1+ Et [st+1]
using ln (1 + i) i and ln
S
Et St+1
t
i
Et ln
St+1
St
i
St+1
St
Forward substitution:
2
1 k + 1
st = 1+
t
1+ 1+ Et [kt+1 ] + 1+ Et [st+2 ]
T
t
T t+1
1 P
= 1+
Et [k ] + 1+
Et sT +1
1+
=t
T t+1
Et sT +1 = 0 yields (4)
for all : s = k
t k
1
into (4): s = 1 P
= 1
Substitute k = k
1+
1+
1+ 1 k = k
=t
1+
=0
T +1
P
1
a = 1a
a = 1a
1a and for |a| < 1,
=0
TP
1
st = 1+
1+
=t
t
T t
t k
+ 1 P
k
1+
1+
=T
1 1+
1
T t
+ 1
= k
+ T t k
k
k
1 k
= 1+
1+ 1+
1+
1
1
1+
1+
, > 0
(5)
>0
(6)
Aggregate demand
y = (s + p p) + u
(7)
Key results
Steady state nominal exchange rate determined by
(m
real exchange rate q = 1 (
yu
) and fundamentals k
) (
y y):
m
s = q + k
and p = p + k
.
with short-run saddle point dynamics around s = q+ k
In short run, exchange rate overshooting possible: s s > s s
Derivation
In steady state: s = p = 0
Using q s + p p, s = q + p p = q + k
Given exogenous variables m = m
, u = u
and p = p,
using (8) and (6): p = (y y) = (s s) (p p)
In addition, using (7), = i, m p = y i (5), and (6):
s = i i = i = 1 [(p p) + (y y)]
= 1 [(p p) + {(s s) (p p)}] = 1 (s s) + 1 (1 ) (p p)
>0
(8)
In matrix form:
s
p
"
|
1 (1 ) 1
{z
A
s s
p p
s = 1 (s s) + (1 ) 1 (p p)
p = (s s)
(p p)
s = 1 (s s) + (1 ) 1 (p p)
p = (s s)
(p p)
p=0
s=0
_
p
s=0
_
s
p=0
s=0
_
s
_
p
s=0
p=0
_
s
p=0
s=0
_
p
_
p
_
s
_
s
p=0
s = 1 (s s) + (1 ) 1 (p p)
p = (s s)
(p p)
p=0
s=0
s=0
_
p
s = 1 (s s) + (1 ) 1 (p p)
p = (s s)
(p p)
_
p
_
p
_
s
p=0
s=0
p=0
_
p
_
s
_
s
s = 1 (s s) + (1 ) 1 (p p)
p = (s s)
(p p)
s = 1 (s s) + (1 ) 1 (p p)
p = (s s)
(p p)
p=0
s=0
_
p
s=0
_
s
s = 1 (s s) + (1 ) 1 (p p)
p = (s s)
(p p)
_
p
s=0
p=0
_
s
_
s
p=0
s=0
_
p
_
s
p=0
_
p
_
p
_
s
s=0
p=0
s=0
p=0
s=0
_
p
_
p
_
s
p=0
_
s
p=0
s=0
_
p
p=0
s=0
_
p
_
s
_
s
_
s
_
s
s=0
p=0
p=0
s=0
_
p
_
p
_
s
_
s s
s=0
p=0
_
p
p=0
s=0
_
p
_
s
_
s
_
s
_
ss
Note: Exchange rate overshooting if (i) < 1, but undershooting if (ii) > 1
Harrod-Balassa-Samuelson Effect
Two-sector model
Production function for tradables (T) and nontradables (N):
1 i
Y i = A i L i i Ki
i = T, N
(9)
Derivation
X
t h
i
1
Pi, Yi, W Li, Ii,
i,t =
=t 1 + R
(10)
Profit maximization
Substituting (9) and (11) into (10):
(11)
X
t h
i
1
i
1
Pi, Ai, Li,
Ki, i W Li, Ki, +1 Ki,
=t 1 + R
FOCs wrt Ki,t+1 and Li,t:
i,t =
1
i
i +1 = 0
1 + 1+R
(1 i) Pi,t+1Ai,t+1Li,t+1
Ki,t+1
iPi,tAi,tLi,ti
1 i
Ki,t
Wt = 0
and P = P
Small open economy: R = R
T
T
(1 T ) AT (KT /LT )T = R
T AT (KT /LT )1T = W
(1 N ) PN AN (KN /LN )N = R
Harrod-Balassa-Samuelson effect: countries with higher productivity in tradables compared to nontradables tend to have higher aggregate price levels.
As a result,
PN = N A
T AN
T
=R
yields ln (1 T ) + ln AT T (ln KT ln LT ) = ln R
Totally differentiating gives (12): d ln AT T (d ln KT d ln LT ) = 0]
T T K
T L
T
A
= 0
T + (1 T ) K
T L
T = W
A
N L
N = 0
N N K
PN + A
N L
N
N + (1 N ) K
PN + A
= W
T L
T , K
N L
N , W
and PN using (12)-(15):
To solve for K
T L
T = W
"
and substitute PN :
P = (1 ) PN = (1 ) N A
T AN
T
(13)
T > A
N implies P > 0.
Using N T , A
(14)
Consider two countries Home and Foreign (denoted by *) that are identical,
i.
except for productivity growth A
P (use S = 1/P
as PT = SP = 1):
Log-differentiate real exchange rate SP
T
T
(15)
"
= P P = (1 ) N A
T AT A N AN
T
T A
> A
N A
, leads to
So, productivity growth advantage in tradables, A
T
N
real appreciation
>0
SECTION A
A.1 Consider the following consumption-savings problem of the representative household
1
X
t
max1
u(ct ) subject to
fct ;at+1 gt=0
t=0
ct + at+1
at+1
(1 + rt )at + yt
where ct , at , rt and yt denote consumption, assets, the real interest rate, and
income in period t, respectively. The initial asset level, a0 , and the entire sequence
of income and the real interest rate fyt ; rt g1
t=0 are taken as given. The utility
0
00
function satises u ( ) > 0, u ( ) < 0, limc!0 u0 (c) = 1, and 2 (0; 1) is the
subjective discount factor. The parameter
0 denes a borrowing limit for this
representative household.
Derive the rst-order conditions associated with this problem and explain the
intuition behind them.
A.2 Consider the following continuous-time Solow growth model. Suppose that the
production function is:
Y (t) = K(t) T (t) [A (t) L(t)]1
where Y (t) corresponds to output, K(t) is the capital stock, T (t) is land used
in production, L(t) is labour, which grows at a constant rate n, and A(t) is a
productivity factor which grows at an exogenous rate g. Assume that the technology parameters satisfy ; 2 (0; 1) and + < 1. Economic agents save a
fraction s 2 (0; 1) of income. The amount of land is xed such that T (t)
T.
The economy is closed and capital evolves according to the following equation of
motion:
_
K(t)
= I(t)
K(t)
where I(t) denotes investment and is the depreciation rate, with > 0.
Explain whether this economy has a balanced growth path along which output
per worker has a positive growth rate.
mt
p t = st + p t
p t = y t it
it = it + Et [st+1 ]
st
where p denotes the log aggregate price level, s the log nominal exchange rate,
dened as the domestic price of foreign currency, m the log money supply, y log
aggregate output, and i the nominal interest rate. Foreign variables are indicated
by an asterisk and subscripts indicate the time period.
Solve for the nominal exchange rate st in terms of expected future fundamentals.
Explain the eect on the nominal exchange rate st of a sudden drop in expected
Home output in period t + 1 by 4%.
SECTION B
B.1 Hyperination
Consider the following continuous-time model of an economy in which peoples
desired level of real money holdings m M=P is given by
1
i
2
ln m = ln Y
where M denotes the money supply, P the aggregate price level, and Y aggregate
output. The nominal interest rate i satises the Fisher equation
i=r+
where r denotes the real interest rate and e the expected (instantaneous) rate of
ination. Assume perfect foresight and superneutrality, with Y = Y and r = r.
In addition, assume initially that people are able to instantaneously adjust their
real money holdings m to their desired level.
(a) Derive the maximum amount of seignorage that can be obtained in the steady
state, and the corresponding (instantaneous) growth rate of prices . Interpret the latter and explain whether it corresponds to hyperination.
(b) Using the denition of seignorage and the equation for real money holdings,
derive an expression for the steady state level of seignorage in terms of real
money holdings, Sss (m). Use this to derive the maximum amount of steadystate seignorage and the corresponding level of real money holdings m, and
compare it to your answer to part (a).
(c) Assume now that adjustment of real money holdings to their desired level is
gradual such that
d ln m (t)
= ln m (t) ln m (t)
dt
Show that m
_ = [Sss (m) S], where is a constant parameter. Explain
carefully how hyperination could arise.
(d) Suppose that there is a decline in the real interest rate r. Explain how this
aects the maximum amount of steady-state seignorage and the possibility
of hyperination occurring.
1
X
[ln(ct ) + ln(1
lt )]
t=0
END OF EXAM
SECTION A
A.1 Solow Growth Model with Capitalists
Consider the continuous time Solow model without technical progress and without
population growth. Firms produce output Y (t) using the production function
Y (t) = K(t) L(t)1
2 (0; 1);
where K(t) denotes the capital stock, which depreciates at constant rate , and
L(t) is labour. The equation of motion of the capital stock is:
_
K(t)
= I(t)
K(t);
where I(t) corresponds to investment and the initial capital stock, K(0) > 0,
is given. The economy is closed and all markets are competitive. Assume that
besides rms, there are two types of agents: (i) capitalists, who own the capital
stock K (t) that is rented to rms for the production of output; and (ii) workers,
who supply labour L to rms and earn a real wage w, so their income is wL.
As in Kaldor (1957), suppose that capitalists save a fraction sK 2 (0; 1) of their
income, while workers save a fraction sL 2 (0; 1) of their income. Derive the level
of capital per worker in the steady state. What is the capitalistssaving rate sK
that maximises consumption per worker in the long run? Explain.
1))
where r denotes the real interest rate, with 1 + r > 0; the production function
is given by Yt = AF (Kt ), with F 0 ( ) > 0 and F 00 ( ) < 0, where A is a positive
productivity parameter; and is a positive parameter related to investment adjustment costs. The initial capital stock K0 > 0 is given and the transversality
1 T
) qT KT +1 = 0.
condition is limT !1 ( 1+r
Draw the phase diagram and explain the dynamics implied by this model. Suppose
that secular stagnationleads to a sudden permanent decline in the productivity
parameter A. Carefully explain how Kt+1 and qt are aected over time using a
phase diagram and provide an intuitive explanation for the eect on investment.
wL
where w denotes the real wage, and the parameter 2 (0; 1). The rm and a
union bargain over the wage before the rm decides on its level of employment.
The union maximises its objective function
U = (w
w)
1
X
s=t
1
(1 + r)s
1
2
2
s Ys
1
X
s=t
Gs
(1 + r)s
1
X
s=t
s Ys
s t
(1 + r)
where Bt denotes government debt at the start of period t and Gs denotes government purchases in period s. Assume that initially, Bt = 0, Ys = Y and Gs = G
for s = t; t + 1; :::.
Suppose now that the government plans to implement austerity measures in period
t that will reduce G to (1
) G for T periods, where 2 (0; 1). Explain how
this would aect the income tax s and the primary government budget decit
Ds Gs
s Ys over time.
SECTION B
B.1 Equilibrium with Heterogenous Consumers
Consider an economy in which each agent maximises her lifetime utility:
U=
1
X
ln(ct );
t=0
1
(
2
)2
1 2
y
2
+ y+s
. Give
(b) Derive private sector ination expectations e , and solve for the policy rate
r, the output gap y and ination . Provide an economic interpretation of
their properties.
Now suppose the central bank faces uncertainty about the shocks s and d. In
particular, it does not observe these shocks when it sets the policy rate r, but it
has access to sta forecasts, fs for the cost-push shock s and fd for the aggregate
demand shock d. These forecasts satisfy s = fs + "s and d = fd + "d , where "s and
"d are white noise forecast errors that are unknown to the central bank. Assume
that "s , "d , fs and fd are all uncorrelated with each other. The forecast errors have
variance Var ["s ] = s 2s and Var ["d ] = d 2d , where the parameters s 2 (0; 1) and
d 2 (0; 1) reect the degree of uncertainty faced by the central bank.
(c) Derive the policy rate r set by the central bank for a given level of e . Compare the result to part (a) and explain how greater uncertainty aects the
variability of the policy rate, Var [r].
(d) Derive private sector ination expectations e , and solve for the policy rate
r, output gap y and ination . Carefully compare the results to part (b).
(e) Explain how the central banks uncertainty aects macroeconomic volatility,
Var [y] and Var [ ]. Could greater uncertainty s or d be benecial?
END OF PAPER
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