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M200: Macroeconomics

Macroeconomics IA
Dr. T. V. de V. Cavalcanti, Michaelmas 2014
Email: tvdvc2@cam.ac.uk

Office Hours: Monday 9:30-10:30 am, room 23, Economics Faculty.


Website: http://www.econ.cam.ac.uk/faculty/cavalcanti/teaching
Aims: This course introduces MPhil students to the theory of economic growth and business
cycles.
Objectives: Upon completion of this course, students should have acquired
Knowledge of the Solow economic growth model and the determinants of growth;
an understanding of the real business cycles model;
Knowledge of the determinants of consumption and investment.
Course Description: The purpose of this course is to introduce you to major questions and
theories in neoclassical economic growth. The goal is to develop the tools and tastes necessary
to understand the main models of economic growth. First, it discusses the Solow-Swan model
with exogenous technological progress and savings decision. We analyze the equilibrium of the
model and the comparative dynamics around the steady state. Second, we study the business
cycles phenomena and set up a simple model, which can generate some business cycle facts.
Then we study the micro-foundations of the consumption and investment theory.
Topics: There are 4 two-hour lectures + 1 hour lecture. The topics of the lectures are as
follows (main readings in parenthesis):
1. Solow growth model [R 1, BX 1, A 1, A 2]
2. Real business cycles model [R 4, A 17]
3. Micro-foundations of consumption [R 7]
4. Micro-foundations of investment [R 9, A7.8, OR 2.5]

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.

Lecture 1: Solow Growth Model


Dr. Tiago V. de V. Cavalcanti1
1 University

Part I: Questions and Empirical Evidence

of Cambridge

M200: Macroeconomics
Cambridge
Michaelmas 2013

Main problem in social science

Cross-Country Income Differences

The Problem of Economic Development


1. Why are there countries rich and poor?
2. Why do growth rates vary across countries and over time?

0.35

0.3

3. What are the policies that can change growth in the short and
long run?
Density of countries

4. Can all countries have the level of development of the rich


countries?

1970
0.25

0.2

0.15

0.1

Point: Questions similar to those raised by Adam Smith 240 years


ago!

0.05

7
8
9
10
log of GDP per capita, PPP adjusted (US$, 2005)

11

12

Cross-Country Income Differences

Cross-Country Income Differences

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

Cross-Country Income Differences: Pop. Weighted Density

7
8
9
10
log of GDP per capita, PPP adjusted (US$, 2005)

11

12

Cross-Country Income Differences: Pop. Weighted Density

0.45

0.7

0.4

Density of countries, weighted by population

Density of countries, weighted by population

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

Cross-Country Income Differences: Pop. Weighted Density

Lots of Movement Within the Distribution

1990

0.5

US

2010

1970 GDP per capita relative to the US level (GDP

Density of countries, weighted by population

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

Lots of Movement Within the Distribution

1.5

2
2010 GDP per capita relative to the US level (GDPpcUS=41,365, 2005 US$)

1990 GDP per capita relative to the US level (GDP

US

=31,388.79, 2005 US $)

Lots of Movement Within the Distribution

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

Income and welfare

Human Development Index

Is income per capita a sufficient statistic for the welfare of the


average citizen?
1. Differences in income per capita have strong implications for
differences in standards of living: nutrition, literacy, infant
mortality, life expectancy,...
- See gapminder: http://www.gapminder.org/

Implicit (subjective) weighting scheme.

One way (of many) to combine Implicit development indicators.


1. 2013: US rank (HDI=5, GNI=11) differential +6

Human Development Index. Three components to the index:


1. Life expectancy at birth;
2. Education, combine mean/expected years of schooling;
3. logarithm of GNI per capita.

x xmin
Ii =
,
xmax xmin
1
3

1
3

2. 2013: UK rank (HDI=14, GNI=27) differential +13


3. 2013: Kuwait rank (HDI=46, GNI=3) differential -43
4. 2013: Brazil rank (HDI=79, GNI=76) differential -3
5. 2013: China rank (HDI=91, GNI=88) differential -3
6. 2013: India rank (HDI=135, GNI=130) differential -5

1
3

HDI = ILife IEduc IIncome .

HDI versus GNI per capita

Does everyone benefit from economic growth?

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%

Robert M. Solow (1924-...), Nobel Prize Winner, 1987

Part II: Textbook Model of Economic Growth and Development

The Solow Model: Basic Structure

The Solow Model: Capital Stock


National income accounting

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

3. Households save constant fraction of income, i.e. exogenous


savings rate s(.) = s > 0.

K(t)
= I(t) K(t).

2. In equilibrium (closed economy): I(t) = S(t) = sY(t);


C(t) = (1 s)Y(t). Therefore,

K(t)
= sY(t) K(t).

Technology I

Technology II

Production function: Y(t) = Ft (K(t), L(t))

The production function is given by

Ft (., .) Change in production function: Technological Progress (TP)


1. Hicks-Neutral TP: Ft (K(t), L(t)) = B(t)F(K(t), L(t));
2. Labour augmenting TP: Ft (K(t), L(t)) = F(K(t), A(t)L(t));
3. Capital augmenting TP: Ft (K(t), L(t)) = F(C(t)K(t), L(t)).
For Cobb-Douglas, the three forms of TP are equivalent:
Ft (K, L) = BK L1 = K (AL)1 = (CK) L1 .
B = A1 = C .

Technology III

Y(t) = F [K(t), L(t), t] = F [K(t), A(t)L(t)]


1. A(t) corresponds to technological progress.

2. AL is called effective labour. (For the sake of space, lets now


omit the time descriptor.)
3.

A
A

= g A(t) = A(0)egt .

4. Technology must be labour-augmenting to ensure existence of


a Balanced Growth Path [proof: see Barro & Sala-i-Martin ch.1
appendix], or Cobb-Douglas.

Firms

Assumptions about the production function: Y = F(K, AL)


1. F(.) exhibits positive and diminishing returns w.r.t. each input:

Firms maximize profits (price takers, output is the numeraire):

F
2F
2F
F
> 0,
> 0,
< 0;
< 0.
K
K 2
L
L2

= max{F(K, AL) wL rK K}.


K,L

2. F(.) exhibits constant returns to scale (CRS):


F(K, AL) = F(K, AL), for all > 0.

w = AFL (K, AL).

rK = FK (K, AL).

3. It satisfies the Inada conditions:


lim (FK ) = lim (FL ) = ;

K0

L0

lim (FK ) = lim (FL ) = 0

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)

(Eulers Theorem) If F(K, AL) is homogenous of degree 1, then


Fi (K, AL), i = K, L is homogeneous of degree 0.

K
w = AFL (K, AL) = AFL ( AL
, 1).

K
rK = FK (K, AL) = FK ( AL
, 1).

Balanced Growth Path (BGP): Long-Run Equilibrium I


Definition: A BGP is an equilibrium path for K, Y, C, w, and rK such

that these variables grow at a constant rate: KK = gK ; YY = gY ; CC = gC ;


K

w
w

= gw ; rrK = grK . (Accurate characterization of most industrialized


economies)

Balanced Growth Path: Long-Run Equilibrium II


Along the BGP: gK = g + n
Y = F(K, AL)

K
=const
AL

Does a balanced growth path exist in the Solow model?


F(K, AL)
K
=s
,
K = sF(K, AL) K,
K
K

|{z}

gK + = sF(1,

CRS Assump.

AL
).
K

C = (1 s)Y,

w = AFL (K, AL)

Production Function in Intensive for Form

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

Along the BGP gK + is constant, therefore: AL


K = const.
Taking log of both sides and differentiating with respect to time:
A L K
ln(A)+ln(L)ln(K) = ln(const) + = 0 gK = g+n.
A L K

AL
Y
= F(1,
) gY = gK = g + n.
K
K |{z}

K
, 1) |{z}
grK = 0.
AL
K
=const
AL

Homog of degree 0

Dynamics to the BGP I


Does the economy converge to the BGP equilibrium?

Production function in intensive form:


y

F(K, AL)
K
Y
=
= F( , 1) f (k),
AL
AL
AL

where y, k denote output and capital per efficient unit of labor.


Use condition Y = ALf (k) and differentiate w.r.t K, L (verify
this!):
Y
= FK = f (k),
K
Y
= AFL = A[f (k) k f (k)].
L

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

Dynamics to the BGP II

Dynamics to the BGP III

y = f (k)

Observe that:

k = sf (k) (n + g + )k = k = s f (k) (n + + g).


k
k
k

(n + + g)k
k = sf (k)

(g + n + )k

By Constant Return to Scale, we have that

s y = sf (k)

k =

k(0)

1
1
= sF(1, ) (n + + g) k = sFL < 0.
k
k

k2
k

x 10

Dynamics to the BGP IV

Dynamics to the BGP V

Moreover, by lHopital rule:

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

"

Therefore, the model is global stable and there is a unique k , such


that:
k > 0

k
sf (k )
=0
= (n + g + ).

k
k

k < 0

Dynamics to the BGP VI

1. If k < k , saving/investment exceeds depreciation, thus k > 0.

Properties of the Balanced Growth Path I


1. In the BGP aggregate variables grow at rate (g + n), and per
capita variables grow at the rate g
Proof: k =

2. If k > k , saving/investment lower than depreciation, thus


k < 0.
3. By continuity and concavity and Inada conditions of f (k), there
must exist an unique k such that sf (k ) = (n + g + )k .
4. In the Balanced Growth Path (BGP) equilibrium,
k = y = c = 0!

K
AL

and k =

K = ALk log(K) = log(A) + log(L) + log(k).


Differentiate with respect to time:
k
K
A
L
= + + = g + n + k = g + n.
K
A L k
Similarly:
k = Ak

Properties of the Balanced Growth Path II

K
L.

k
A
k
= + = g + k = g.
k
A k

Golden Rule and Dynamic Inefficiency I


Definition: (Golden Rule) Saving rate that maximizes consumption
in the long run (BGP).

2. Changes in s, n, or will affect the levels of k , y , and c but not


the growth rates of these variables.

3. In the BGP, GDP per worker will be higher in countries where


the rate of investment is high and where the population growth
rate is low - but neither factor would have an impact on the long
run growth rate of these variables.

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

1. If s < sGR , then increases in s would increase c in the long run.


2. If s > sGR , then increases in s would decrease c in the long run
(Economy is dynamically Inefficient)

Golden Rule and Dynamic Inefficiency II

Policy change: Savings rate


Suppose initially that the economy is in its BGP equilibrium, k1 .
Recall the fundamental equation:

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

2. Capital stock k grows until it reaches new higher BGP.


3. Along transition, k and y, rises, but growth rate slows down.
(Can you show what happen with c in the transition?)

sGR

Parentheses: Linear versus log scales


43

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.

The Solow Model: Change in savings rate


Log-Scale

100

99

ln(x(t))

dln(x(t))
dt

x(t)

x(t)

= x

98

Log of capital per capita

97

96

ln( K
L (t))

95

Log of output per capita

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

1. Countries converge to steady state determined by parameters


(s, n, g, );
Part III: Model Predictions and Empirical Evidence
2. Does model predict poorer countries grow faster (absolute
convergence)?

No! Conditional on having similar parameters (same steady


state), poorer countries predicted to grow faster (conditional
convergence)

The Lack of Convergence for the World I

(a ) Who le Sa mple

The Lack of Convergence for the World II. Source:


Sala-I-Martin

(b) O EC D C o untries

!$!(

19 60 -200 0

!$!'

Annual grow th rate o f

Annual g row th of

!$!&"

Y
L

!$!'

Y
L

196 0-20 00

!$!"

!$!&

!$!%

!$!#

!$!&

!$!%"

!$!%

!
!$!#"
!$!#
!$!#
!

"!!!

#!!!!
Y
L 60

#"!!!

"!!!

#!!!!
Y
L 60

#"!!!

Inequality Within Countries. Source: Sala-I-Martin

Speed of Convergence

Speed of Convergence I
For Cobb-Douglas k = sk (n + g + )k. Thus
k =

If rapid, we can focus on steady state,

If slow, transitional dynamics dominant.

Assume a Cobb-Douglas production function (see Romer


p.24 for more general setting)

Switch to original notation


k ln

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

Transition speed towards steady state important.

In the SS: se(1) (n + g + ) = 0. Using a first-order


Taylor approximation around the steady state implies:
(1 )se
| {z

= n+g+

(1 )(n + g + ) ( ) ( )

Coefficient (1 ) (n + g + ) determines the speed


of convergence from k to k

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 III

Speed of Convergence IV
ln y(t) ln y(0) = (1 et )(ln y ln y(0))

Define (t) = ln y(t):

d
dt

ln y = (ln y ln y ) = ( )

ln y(thalf ) ln y(0) =

Homogeneous solution: H (t) = Cet


Particular solution: P (t) =
General solution: (t) =
Notice that: (0) =

P (t)

so that: (1 ethalf ) =
H (t)

Cet

et ) ln y(t)

1
2

thalf =

+ C C = (0)

(t) = + ((0) )et = (1 et ) + (0)et


ln y(t) = (1

Speed of convergence. Define t thalf by:

1
2

ln y ln y(0)
2

= ethalf

ln 2
0.70

If = thalf , i.e. convergence is faster

How fast convergence depends also on the distance


between initial y and steady state

ln y(0)et

Steady-State Levels

Aggregate production function:

Yt = At F(Kt , Ht )

Yt
= yt = At F(kt , ht ) (Ht = ht Lt ).
Lt

Part IV: Explaining Differences in Income Levels


yt = TFPt F(Resourcest ).

TFPt : Total Factor Productivity;


Resourcest : Physical capital and human capital;

Early theories: Differences in income come from differences in


Resources. Mainly physical capital and human capital.

Development Accounting (PWT, 2011): Physical capital


2

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

Let the production function be represented by:


yit = Ait kit (hit )1 . Then,

(k_j/k_US)^0.4
1

Ratio of y = Ratio of factors Ratio of productivity.

.5

1
(y_j/y_US)
(k/k_US)^0.4

y/y_US

Development Accounting (PWT, 2011): Factors

(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

Development Accounting (PWT, 2011): Human capital

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

Development Accounting (PWT, 2011): TFP

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. Most of the empirical evidence suggests that about 1/3-1/2 of the


variation in output per capita remains unexplained by differences
in physical and human capital.

1
(y_j/y_US)
A/A_US

1.5

y/y_US

Differences in TFP

Point: Differences in physical and human capital still matter a


lot. However, TFP differences are also important.

Why does TFP differ across countries?


1. Homogeneous firms (or marginal productivity of factors are
equalized):
1.1 Technology differences: Countries use different technologies - But
unlikely, high rate of technological diffusion.
1.2 Efficiency in the use of the same technology: Countries use
technologies differently (e.g., Acemoglu and Zilibotti, 2001); technologies are invented in the North for a given skilled-unskilled
ratio. Not appropriate for the South.

2. Heterogenous firms (or marginal productivity of factors are Not


equalized):
2.1 Resources misallocation: Factors are not necessarily allocated in a
most productive way.

Part V: Thomas Piketty

Thomas Piketty (2014): Capital in the Twenty-First Century

Thomas Piketty(2014): Capital in the Twenty-First Century


1. Pikettys first law of capitalism: Capitals share of national
income is (definition)
K
K = r K .
Y
2. Pikettys second law of capitalism: In the long run the
capital-to-output ratio is (theory)
K
s
s
=
K = r K .
Y
g
g
Then, if technological progress decreases g 0, then K .
Point: If the economys growth rate declines to zero, then
capitals share of income would increase explosively.

Capital-to-Output Ratio: 1870-2010

Capital-to-Output Ratio: 1970-2010

Capital-to-Output Ratio: Type of Capital (UK)

Pikettys idea (weak version)


Consider a standard Solow model: C + I = Y, and I = sY,
Y = F(K, AL), and K = I K,
K
Y
= s .
K
K
Along a BGP equilibrium:

K
K

= gK = gA + n = g, then
K
s
=
.
Y
g+

As g 0, then KY , but there is a limit. If s = 0.24, g = 0 and


= 0.08 (0.06), then
 
0.24
K
=
= 3(4).
Y MAX
0.08

Pikettys idea (strong version) I


Consider a modified Solow model: C + I = Y,
Y = F(K, AL), and K = I K.
Assumption: I = sY = s(F(K, AL) K). Saving a constant fraction
of net income (not gross income).
But total investment is: I = I + K = sF(K, AL) + (1 s)K. Then:
K = sF(K, AL) + (1 s)K K = s(F(K, AL) K).
Along a BGP equilibrium:

K
K

Pikettys idea (strong version) II


Under this modified model, we have
C = Y I = F(K, AL) sF(K, AL) (1 s)K = (1 s)(Y K),
K
C
= (1 s)(1 )
Y
Y
Along a BGP equilibrium:

As g 0, then KY , but there is a limit. If s = 0.24, g = 0 and


= 0.08(0.06), then
 
1
K
=
= 12.5(16.67).
Y MAX
0.08

s
g+s

and

g
C
= (1 s)
.
Y
g + s

= gK = gA + n = g, then

s
K
=
.
Y
g + s

K
Y

Saving rate is: s =


s(g) =

YC
Y

= 1 CY , then:

s(g + )
s(1 )
, and s (g) =
< 0.
g + s
(g + s)2

As g 0, the saving rate increases, such that s(g 0) = 1 and

C
Y

0.

Pikettys idea (strong version) III

Saving rate, growth rate

Piketty goes even further and assume that = 0. This implies that:
s
s
K
K
=
=
lim = .
g0 Y
Y
g + s
g

Pikettys second law of capitalism:


s
s
K
=
K = r K .
Y
g
g

the reason why wealth today is not as unequally distributed as in the


past is simply that not enough time has passed since 1945

Saving rate, growth rate - Krusell and Smith (2014)

Concluding Remarks
1. The documentation of the historical data in Pikettys book is
impressive;
2. Inequality is indeed rising in many developed countries;

Even in egalitarian societies (e.g., Denmark and Sweden).

3. Theory: Dramatic rise in inequality through capital (or wealth)


accumulation (K = rK gs )

Wealth inequality implies inequality of opportunities - Not good


for economic efficiency.

4. Limitations in his theory: Saving behaviour does not seem to be


consistent with empirical evidence and = 0.
5. Still, inequality is a big topic - Related explanations based on
skill-biased technical change, educational institutions,...

Next time:

Real Business Cycles

Introduction

Lecture 2: Real Business Cycles

Definition: (Business Cycles) Recurrent fluctuations of output about


trend and the comovement among other aggregate time series
(consumption, employment, investment).

Dr. Tiago V. de V. Cavalcanti1


1 University

Some business cycle facts: UK and US.

of Cambridge

M200: Macroeconomics
Cambridge
Michaelmas 2014

You can do for other countries. Use the International Financial


Statistics (IMF).

Log of the UK Real GDP, 1957q1-2013q1. Source:


International Financial Statistics (IMF).

Cyclical component of the Log of the UK Real GDP,


1957q1-2013q1. Source: International Financial Statistics
(IMF).

0.06

Cyclical component of the log of the UK real GDP

Log of the UK real GDP, 2005

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

Cyclical component of the Log of the UK Real GDP and


Consumption, 1957q1-2013q1.

Cyclical component of the Log of the UK Real GDP,


Consumption and Invesment, 1957q1-2013q1.

0.08

0.2

Cyclical component of the log of the UK real GDP, C and I

Cyclical component of the log of the UK real GDP and C

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

Observation: Consumption includes households expenditures on


durable and non-durable goods. Usually, consumption of non-durable
goods is much less volatile

UK unemployment rate, 1992q2-2013q1. Source:


International Financial Statistics (IMF).

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

Observation: Consumption includes households expenditures on


durable and non-durable goods. Usually, consumption of non-durable
goods is much less volatile

Log of the US Real GDP, 1957q1-2010q2. Source:


International Financial Statistics (IMF).
9.8

11

9.6
10
9.4

9.2
log(Real US GDP, 2005)

UK unemployment rate (%)

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

Cyclical component of the Log of the US Real GDP,


1957q1-2010q2. Source: International Financial Statistics
(IMF).

US unemployment rate, 1957q1-2010q2. Source:


International Financial Statistics (IMF).
12

0.04
11
0.03
10

Unemployment rate (%)

Cyclical component of the US Real GDP

0.02

0.01

0.01

6
0.02
5
0.03
4
0.04
3
0.05

1960

1965

Business cycle facts

1970

1975

1980
1985
Quarters

1990

1995

2000

2005

1960

1965

2010

1970

1975

1980
1985
Quarters

1990

1995

2000

2005

2010

Some stylized facts


1. Consumption (of nondurables and services) fluctuates much less
than output.
2. Investment fluctuates much more than output.
3. The capital stock fluctuates much less than output and is largely
uncorrelated with output.
4. Productivity is slightly procyclical but varies considerably less
than output.
5. Wages vary less than productivity.

Some stylized facts

Shocks and Propagation Mechanisms:


1. Shocks

6. Employment fluctuates almost as much as output and hours of


work, while average weekly hours fluctuate considerably less.
7. Government expenditures are essentially uncorrelated with
output.
8. Imports are more strongly procyclical than export.

Overview of Business Cycle Theory

Technology shocks: internet; Oil price shocks;

Weather shocks and natural disasters.

Monetary and Fiscal policy shocks;

Political shocks;

Expectations shocks.

2. Propagation mechanisms

Consumption/investment decision;

Labour decisions;

Financial default

Getting Intuition: Static Labor/Leisure Choice


Consider the following optimization problem:
max{ln(c) + b ln(1 l)},

1. Keynesian

Fluctuations due to aggregate demand (monetary and fiscal


shocks, animal spirits).

Key ingredient: nominal rigidities.

Aggregate relations without microfoundations.

c,l

Subject to c = wl.
L = ln(c) + b ln(1 l) + [wl c],
FOCs:
1
= 0,
c

2. Real Business Cycles

Fluctuations due to aggregate supply (technology shocks).

Key ingredients: flexible prices, perfect markets.

General equilibrium with optimizing behavior.

b
+ w = 0,
1l
bc
= w.
1l

Getting Intuition: Static Labor/Leisure Choice

Combining first-order condition with budget constraint implies:


1
bl
=1 l=
.
1l
1+b

Getting Intuition: Intertemporal labour/leisure choice


Consider the following optimization problem:
max {ln(c1 ) + b ln(1 l1 ) + [ln(c2 ) + b ln(1 l2 )]},

c1 ,c2 ,l1 ,l2

Subject to
c1 +

Labor supply is independent of w.

Why? When individuals have no wealth and with logarithmic


utility, income and substitution effects cancel out.

Getting Intuition: Static Labor/Leisure Choice

w2 l2
c2
= w1 l1 +
.
1+r
1+r

L = ln(c1 ) + b ln(1 l1 ) + [ln(c2 ) + b ln(1 l2 )] + ...


c2
w2 l2
c1
].
+[w1 l1 +
1+r
1+r

Baseline Real-Business-Cycle model

FOCs:
Assumptions:
b
w2
b
= w1 and
=

1 l1
1 l2
1+r

large number of identical, price-taking firms;

large number of identical, price-taking infinitely-lived


households;

inputs in production are: capital (K), labour (L), and


technology (A);

output is divided among consumption (C), investment (I), and


government purchases (G);

a fraction of capital depreciates each period.

Therefore:
w1
1 l2
= (1 + r) .
1 l1
w2
w1
w2

work more today relative to tomorrow;

Implications:

Implications: r work more today relative to tomorrow.

Point: Shocks can be amplified by households decision to work and


to invest.

Production Technology:

The Household Sector

Cobb-Douglas production technology:


Yt = At Kt (Lt )1 ,

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 u(cs , 1 ls )Ns , (0, 1)

s=t

Kt+1 = Kt + It Kt

Population grows exogenously at rate n:

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

Nt+1 = (1 + n)Nt , N0 is given.


Time endowment is normalized to 1.

1

Household optimization under uncertainty I

Household optimization under uncertainty II

Assume households own capital. What is their budget constraint?


Nt ct + Kt+1 = wt lt Nt + (1 + rt )Kt .

max U = Et

kt+1 ,lt

s u(ws ls + (1 + rs )ks (1 + n)ks+1 , 1 ls )Ns

s=t

FOC w.r.t. kt+1 ?


Divide both sides by Nt :
ct +

t (1 + n)uc,t Nt + t+1 Et (1 + rt+1 )uc,t+1 Nt+1 = 0


Kt+1
Kt
= wt lt + (1 + rt ) .
Nt
Nt

Consider the following one-period utility function:


ut = ln ct + b ln(1 lt ),

Define kt =

Kt
Nt ,

b>0

and recall that Nt+1 = (1 + n)Nt . Then:


ct + (1 + n)kt+1 = wt lt + (1 + rt )kt .



1
1
= Et (1 + rt+1 )
ct
ct+1

Consumption and labour supply

Special case: Pencil and paper - Brock and Mirman (1972,


JET)
1. Full depreciation of capital: = 1;

FOC w.r.t. lt ?
wt uc,t ul,t = 0

2. One-period utility function: ut = ln ct Households do not


value leisure, so lt = 1 for all t.
3. No population growth: n = 0

wt
b
=
ct
1 lt

Equilibrium conditions:

Resource constraint:
Ct + It = Yt Ct + Kt+1 = At Kt .

bct
= wt
1 lt

Solving the model

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:

Yt+1 = At+1 Kt+1


= At+1 [Yt ] .

Taking ln of both sides and defining yt = ln(Yt ):

(1 ) = = (1 ), verifying the guess.

yt+1 = at+1 + ln() + yt .


Steady-state: y =

a+ ln()
.
1

Random walk Process

Dynamics of output with a random walk shock

Suppose that: at+1 = at + t+1 , t iidH(0, 2 ), and a0 = 0.


Then: y =

ln()
1 .

Therefore:

yt+1 = at+1 + ln() + yt yt+1 y = at+1 + (yt y).


How does output respond to a shock t+1 = 1, s = 0, s 6= t + 1?
yt+1 = y + 1,
yt+2 = y + 1 + ,
yt+3 = y + 1 + + 2 ,
yt+4 = y + 1 + + 2 + 3 .
yt+s = y +

1 s
.
1

White noise process

Dynamics of output with a white noise shock

Suppose that: at+1 = a + t+1 , t iidH(0, 2 ).


Then: y =

a+ ln()
.
1

Therefore:

yt+1 = a + t+1 + ln() + yt yt+1 y = t+1 + (yt y).


How does output respond to a shock t+1 = 1, s = 0, s 6= t + 1?
yt+1 = y + 1,
yt+2 = y + ,
yt+3 = y + 2 ,
yt+4 = y + 3 .
yt+s = y + s1 .

Dynamics of the full model after a technology shock I

Dynamics of the full model after a technology shock II

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

Dynamics of the full model after a technology shock III

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

Milton Friedman (1912-2006), Nobel Prize Winner, 1976

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;

2. Friedman (1957) Permanent Income Hypothesis:


Ct = t (Wt + Ht ), Wt is the market wealth; and Ht is the human
wealth;

Despite of international capital flow, savings and investment are


still highly correlated. Higher saving rate implies faster rate of
capital accumulation with long run impact on income per capita.

An important reform in the policy agenda of most countries is


the social security program reform

Essential component of IS (investment-saving) curve;


Ct = + Yt

Importance to Study Consumption and Saving

Proposes to replace the current income Yt by some weighted


average of current and lagged income Yt ;
Households consumption-saving decision is a forward-looking
and long horizon planning problem. Consumption should only
adjust to changes of the permanent component of income.
Also see Modigliani and Brumberg (1954) life cycle theory.

Social security reforms: pay-as-you-go, fully-funded, privatized,


diversified;

Tax reforms: elimination of death tax, elimination of capital


income tax, move towards consumption tax;

The economic impact of such policies can only be assessed


correctly by looking at how these reforms affect individuals
consumption-saving decision.

Discrete time model: Finite horizon case

Households Problem
The households problem is:

max

Time is discrete: t = 0, 1, ..., T;

{ct ,At+1 }Tt=0

[0, 1] : Time preference factor;

u () > 0, u () < 0;

at+1 + ct = yt + (1 + r)at , given a0 ,


aT+1
0, (no-Ponzi games).
(1 + r)T+1

Partial equilibrium: r and yt are given.

Present value budge constraint:


T
X
t=0

Solution to households problem I


L=

T
X

t u(ct ) +

t=0

T
X

t u(ct ),

t=0

Subject to:

Utility function: U = u(c0 ) + u(c1 ) + ... + T u(cT );

T
X

t=0

Solution to households problem II

t [yt + (1 + r)at ct at+1 ],

Euler equation:

t=0

First-order conditions:

u (ct )
= (1 + r)
u (ct+1 )

Complementary-slackness condition implies that:

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

Therefore, the present value budget constraint implies that:

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

Solution to households problem III


Let u(c) =

c1
1 ,

Solution to households problem IV

then the Euler equation becomes:


Notice that:

ct+1 = ((1 + r)) ct .

c1 = ((1 + r)) c0 , c2 = ((1 + r)) c1 ct = ((1 + r)) c0 .

Elasticity of substitution between consumption at two points in


time:
d ln(ct+1 /ct )
d(ct+1 /ct )/(ct+1 /ct )
1
=
EIS =
= .
d(1+r)
d ln(1 + r)

Using the present value budget constraint, we have that:


c0

t=0

(1+r)

When 0, then any change in r generates large effects on


ct+1
ct . Marginal utility of consumption is constant. (low
preferences for consumption smoothing).

If b =

1
[(1+r)]

(1+r)

t=0

< 1 < (1 + r)1 , then:


1

c0 =

When , then any change in r generates small effects on


ct+1
ct . Marginal utility of consumption is decreasing in c. (high
preferences for consumption smoothing).

Solution to households problem V

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

If 0 and r > postpone consumption;


If , then consume r of total wealth;

yt
].
(1 + r)t

t u(ct )}, subject to

t=0

at+1 + ct = (1 + r)at + yt t,
aT+1
0.
lim E0
T
(1 + r)T

If =

T
X

Savings under uncertainty I


max E0 {

)T+1

(1+r)

As T , then:

1
[(1+r)]

[(1 + r)a0 +

Assume: yt+1 is a random variable. At t the agent know yt .


L = E0 {

X
t=0

t u(ct ) +

t [(1 + r)at + yt ct at+1 ]},

t=0

L
= t u (ct ) t = 0,
ct
L
= t + Et [(1 + r)t+1 ] = 0,
at+1

Savings under uncertainty II

Savings under uncertainty III


Present value budget constraint:

Euler equation:

E0 [

u (ct ) = (1 + r)Et [u (ct+1 )].

If (1 + r) = 1 u (ct ) = Et [u (ct+1 )].

Quadratic utility function: u(c) = 1 c

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 .

By the law of iterated expectations: E0 [E1 ()] = E0 [], then:


c1 = E1 [c2 ] c0 = E0 [E1 (c2 )] = E0 [c2 ] ... c0 = E0 [ct ],

1 2 ct = Et [1 2 ct ] ct = Et [ct+1 ].

In this case, consumption follows a martingale and changes of


consumption cant be predicted:

c0 (1 +

X
1
1
1
+
+ ...) = a0 (1 + r) + E0 [
yt ].
2
(1 + r) (1 + r)
(1 + r)t
t=0

ct+1 = ct + t+1 , Et [t+1 ] = 0, Et [ct+1 ] = 0.

Savings under uncertainty IV

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

Savings under uncertainty V

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:

Consumption changes because new information arrives at date


t + 1;

The new information arrives between t and t + 1 is yt+1 ;

yt+1 can be decomposed into two parts:

If y increases but does not change the expected value, then ct


remains the same (Certainty Equivalence Principle). After some
algebra, we can show that:

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

Robert Halls (1978) random walk test

Basis of the test: Et (ct+1 ) = ct .

Conditioned on present consumption, no other variable should


help to predict future consumption.

Empirical Strategy: Run regression,


ct = 0 + 1 ct1 + 2 zt1 + t , where zt1 could be any lagged
variables.

Data: Aggregate consumption, GDP and others.

H0 : 1 = 1 and 2 = 0.

Results: Null hypothesis is rejected

Flavins (1981) excess sensitivity test I

Assume that income process is a AR(q) process;

Under PIH, ct+1 ct = ct+1 = t+1 and ct+1 should not


react towards Et [yt+1 ]

Data: aggregate consumption and GDP

Empirical Strategy:

ct+1 = 0 + 1 yt+1 + 2 yt + t+1 + t

Frequent and short term income variations.

PIH H0 : 1 = 0 and 2 = 0;

Consumption should react only to unexpected change in income


6= 0.

Results: i 6= 0 and 1 = 0.355. Consumption reacts strongly


towards predicted income changes.
Campbell and Mankiw (1989) found that excess sensitivity exists
for many countries other than US.

1 and 2 excess sensitivity parameters.

Saving is a buffer to income variations

Run the consumption regression:


ct+1 = 0 + 1 yt+1 + 2 yt + t+1 + t

First run the income regression and get:


t+1 = yt+1 (1 yt + 2 yt1 + ... + q yt+1q )

consumption lagged more than one period and lagged income


have coefficients close to zero,
but lagged return on stocks has prediction power on current
consumption.

Flavins (1981) excess sensitivity test II

yt+1 = 1 yt + 2 yt1 + ... + q yt+1q + t+1 .


t+1 is the new information at time t + 1.

due to job loss, illness, or other unforeseen events;


Households usually build buffer stock in the form of saving
account in banks (more liquid) to prevent a dramatic fall in their
consumption when such an unfortunate event does occur. This is
precautionary motive of saving.

Earning variations during life-cycle; age-earning profile is


hump-shaped;

Over the life-cycle, consumption tracks income; excess


sensitivity;

With perfect credit market, i.e., without borrowing limit,


household consumption should be more less constant. We should
observe young households borrow.

That is not what we observe in the data. This suggests existence


of borrowing limits

What is wrong with this theory of consumption?

Life-time consumpt. and income (Carroll, 1997, QJE)

Borrowing constraint

maxat+1 ,ct E0 {

t=0

t u(c )},
t

subject to

at+1 + ct = (1 + r)at + yt t, at+1 , [0, ).

Zeldes (1989) test of existence of liquidity constraint

Euler eq. when at+1 > : u (ct ) = (1 + r)Et [u (ct+1 )].

Euler eq. when at+1 = : u (ct ) (1 + r)Et [u (ct+1 )].

Constrained household has lower consumption today and would


like to reduce future consumption to increase todays
consumption but cant.

Point: The consumption growth rate of constrained households is


on average higher than that of unconstrained households.

Next time:

Data: PSID (Panel Study of Income Dynamics). Split the sample


into three groups:

Constrained group has low wealth-to-income ratio;


Unconstrained group has high wealth-to-income ratio;
Omit the middle group.

Maintained hypothesis: the two groups are identical in every


other aspect other than one group is temporary short on cash.
Empirical Strategy:

estimate preference parameter and using data of


unconstrained group;
Use the estimates and data of constrained group to compute the
following:

t = (1 + rt )Et [c
t+1 ] ct .
Test: H0 : t = 0.
Result: t > 0. Liquidity constraint exists.

Micro-foundations of investment

Mathematical Appendix of Lecture 3


M200: Macroeconomics
Dr. Tiago Cavalcanti
Michaelmas 2014
1. Going to one-period budget constraint to the present value budget constraint:
at+1 + ct = (1 + r)at + yt , given a0 ,
T
X

T
X
ct
yt
aT +1
+
=
a
(1
+
r)
+
.
0
t
T
(1 + r)
(1 + r)
(1 + r)t
t=0
t=0

Start from t=0, we have


a1 = (1 + r)a0 + y0 c0 .

(1)

a2 = (1 + r)a1 + y1 c1 a2 = (1 + r)[(1 + r)a0 + y0 c0 ] + y1 c1 .

(2)

Analogously at t=1:

See also that this is the same as


c1
a2
y1
c0 +
+
= (1 + r)a0 + y0 +
.
1 + r (1 + r)
1+r

(3)

At t=2, we have that


a3 = (1 + r)a2 + y2 c2 or a2 =

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)

Keeping iterating on t implies that:


T
X

T
X
ct
aT +1
yt
+
= a0 (1 + r) +
.
t
T
(1
+
r)
(1
+
r)
(1
+
r)t
t=0
t=0

(6)

2. This is related to slide 10 in Lecture 3.


Let b < 1, then consider the following series:
S = 1 + b + b2 + ... + bT .
Notice that
bS = b + b2 + ... + bT +1 .
Therefore:
S bS = 1 bT +1 (1 b)S = 1 bT +1 S =

1 bT +1
.
1b

If b =

[(1+r)]
1+r

, the the result on the bottom of this slide derives.

3. This is related to slide 16: Savings under uncertainty V


Given that
ct =

X
1
r
(at (1 + r) + Et [
yt+j ]),
1+r
(1 + r)j
j=0

we have to show that:


ct+1 ct =

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

Proof: Notice that

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

Since at+1 = (1 + r)at + yt ct , this implies that

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

Aat can be canceled out, such that:

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

We can cancel the term (1 + r)yt , then:


ct+1 ct =

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

Another way to write the same equation is:


ct+1 ct =

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

This is a proof of our conjecture.

Why Study Investment?

Lecture 4: Investment

Tiago V. de V. Cavalcanti1

Although investment is much smaller as a fraction of GDP than


consumption, investment is much more volatile than
consumption.

1 University

of Cambridge

M200: Macroeconomics
Cambridge
Michaelmas 2014

Consumption and Investment in the US and in the UK

So fluctuations in investment spending account for a large


proportion of business-cycle frequency fluctuations in GDP.

In the long run, the average magnitude of investment spending


determines the size of the capital stock.

Volatility in Consumption and Investment

Volatility in Consumption and Investment

History of Thought

Keynes: I is determined by animal spirits which fluctuate


strongly;

The Samuelson Multiplier-Accelerator Model

It = Yt rt .

Aggregate economic fluctuation was driven by waves of


optimism or pessimism.

Samuelson (1939): The way we know investments from the


IS-LM framework.

Hall and Jorgenson (1967): Neoclassical model with no costs of


adjustment;

Tobin (1969)s Q model;

Abel (1981)-Hayashi (1982) marginal q model with smooth


convex costs of adjustment;

Hall and Jorgenson: Neoclassical Model without


Adjustment Costs
max{F(K, AL) rK K wL}.

(1)

When paired with equations determining consumption and


income, and with some lags added, the model generated the
classic Keynesian multiplier-accelerator framework.
In purely statistical terms, an equation like (1) performs
remarkably well in explaining investment spending.
But this is not very satisfactory because Y, I, and r are
presumably all determined by deeper underlying features of the
environment (Lucas Critique).

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.

Firms demand for capital is a smooth function of exogenous


variables (r, A, tax - if we had in the model);

There is no worries about the future, since firms can adjust the
capital stock to any change in the environment.

Point: Capital can be adjusted in a single period up to the point


where F1 (K, AL) = rK !

Q Models

Tobins Q

Tobins Q: Q =

Stock Market value of firm


replacement cost of capital .

Investment follows the following rule:



it > 0 if Q > 1,
it < 1 if Q < 1,

Firms which have a value greater than what it would cost to


reproduce their capital should be growing, while firms which are
not worth what it would cost to reproduce them should be
shrinking;

Tobins Q is now one of the basic tools of financial market


analysis.

Tobins Marginal q

Investment is subject to adjustment cost, c(I) =


and dismantled costs.

See: http://lexicon.ft.com/Term?term=Tobin%27s-q-ratio

Neoclassical Model with Adjustment Costs II


2
2I :

Installation
Value of the firm:

Adjustment cost is increasing in the absolute changes of


investment;
Adjustment cost is convex;
c(0) = 0 and c (0) = 0;

Assume a zero depreciation rate. Or investment is net of


depreciation.

Vt = max

Is ,Ks+1

X
s=t

)st [As f (KS ) Is Is2 ] subject to


(1 + r)
2
Ks+1 Ks = Is .

Lagrangian:
L=

X
s=t

)st [As f (Ks ) Is Is2 + qS (Is + Ks Ks+1 )].


(1 + r)
2

qS : Current shadow price of capital.

Neoclassical Model with Adjustment Costs II

Neoclassical Model with Adjustment Costs III

1
L=
(
)st [As f (Ks ) Is Is2 + qS (Is + Ks Ks+1 )].
(1
+
r)
2
s=t

Firms invest to the point where the market marginal value of


capital equals its marginal replacement cost:
qs = 1 + c (Is ) = 1 + Is .

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

When qs > 1 Is > 0;


When qs < 1 Is < 0;

Marginal qs : qs =

Marginal market value of capital


Marginal replacement cost of capital .

Investment Dynamics II

Let At+1 = A.

Two difference equations in state and co-state:


Kt+1 Kt =

Optimal investment plan is:

PV shadow price of K at period T

1
(qs 1).

1
(qt 1),

qt+1 qt = rqt Af (Kt +

Kt+1 Kt =

Kt+1 Kt = Kt+1 = 0 locus: combinations of (Kt , qt ) so that


Kt stays constant.

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;

qt > 1 implies that Kt+1 > 0;

r = Af (K).

qt < 1 implies that Kt+1 < 0.

Investment Dynamics III

Investment Dynamics IV

Kt+1 Kt = Kt+1 = 0 locus.


qt+1 qt = rqt Af (Kt +

1
(qt 1)).

qt+1 = 0 locus: combinations of (Kt , qt ) so that qt stays


constant.
Af (Kt + 1 (qt 1))
dq
=
<0
dKt
r A f (Kt + 1 (qt 1))
Locus is downward sloping: (Kt+1 = Kt + 1 (qt 1) > 0)

Investment Dynamics V
qt+1 = 0 locus

To the right of the locus, q increases;

To the left of the locus, q decreases;

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.

A permanent shock in productivity


and q = 1:
Suppose a firm with K = K

Kt+1 = 0 locus, i.e., q = 1 is not affected;

qt+1 = 0 locus shifts up; for the same K, AFK increases. q


needs to increase to keep the equality. Stock price goes up;
f (Kt + 1 (qt 1))
dq
>0
=
dA
r A f (Kt + 1 (qt 1))

A permanent shock in productivity

Capital stock cant adjust instantaneously.

If the shock is permanent, then the steady state capital increases


from E to E .

A temporary shock in productivity


and q = 1:
Suppose a firm with K = K

Kt+1 = 0 locus, i.e., q = 1 is not affected;

qt+1 = 0 locus shifts up temporarily; for the same K, AFK


increases.

Both q and investments jump immediately, but not as much as


before.

In the long run, the economy must be back on the OLD


saddle-path.

There are disinvestments: When productivity is high, investment


rises; but when it is low, investment decreases.

A temporary shock in productivity

You can check other policies

Examples:

Neoclassical Model with Adjustment Costs and Financial


Friction I

Interest rate policies;

Tax policies.

Neoclassical Model with Adjustment Costs and Financial


Friction II

Value of the firm:

)st [As f (KS ) Is Is2 ] subject to


Vt = max
(
Is ,Ks+1
(1
+
r)
2
s=t
Ks+1 Ks = Is ;
Is limit on leverage.

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
}

PV shadow price of K at period T

KT+1 = 0.

Neoclassical Model with Adjustment Costs III

Neoclassical Model with Adjustment Costs IV

Let At+1 = A.

If Kt+1 < , then

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 + ).

If Is < , then s = 0 and analysis is similar to before.


If Is = , then qs = 1 + + s > 0.

1 T
Two boundary conditions: K0 , and limT ( 1+r
) qT KT+1 = 0.

Steady-state:

Thank you!!!

Kt+1 = 0 It = 0 It < qt = 1 (t = 0);

r = Af (K).

Point: Financial constraint will limit firms growth (stock prices)


but not long-run equilibrium.

MPhil Module 200: Macroeconomics IB


Petra Geraats
Michaelmas 2014
Objectives
This course aims to provide an advanced overview of macroeconomics, focusing on
unemployment, real and nominal rigidities, fiscal and monetary policy and exchange
rates. It covers key theoretical and empirical contributions that help to analyze and
explain macroeconomic phenomena in these areas. Upon completion of this course,
students should have
a solid understanding of the main phenomena in macroeconomics.
the ability to analyze macroeconomic issues using theoretical models.
a sound understanding of the empirical relevance of macroeconomic models.
Course description
This course provides an overview of the main theory and evidence behind key macroeconomic phenomena, covering the following topics:
Unemployment and rigidities: real rigidities and efficiency wages (Solow condition; Shapiro-Stiglitz model); hysteresis in unemployment (insider-outsider model);
nominal rigidities (menu cost model)
Macroeconomic policy: central bank independence, conservativeness and reputation (Barro-Gordon model); optimal monetary policy (Taylor rule); high inflation (Cagan model); optimal fiscal policy (Ricardian equivalence; Barro taxsmoothing model)
Exchange rates: nominal exchange rates (flexible-price monetary model); exchange rate volatility (Dornbusch overshooting model); cross-country differences
in purchasing power and real exchange rate drift (Balassa-Samuelson effect).
Readings
The main textbook for this course is
* David Romer (2011), Advanced Macroeconomics, 4th edition, McGraw-Hill.

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

MPhil M200 Macroeconomics IB

MPhil M200 Macroeconomics IB

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

1. Unemployment: overview stylized facts and theory


2. Real rigidities: efficiency wages (Solow condition) and Shapiro-Stiglitz model

Motivation

3. Hysteresis: insider-outsider effects and Blanchard-Summers model

Economics is a science of thinking in terms of models


joined to the art of choosing models which are relevant to the contemporary world.
John Maynard Keynes (1938)

Main reading: Romer (2011), ch 10 (10.1-10.4, pp. 483-485, 10.8)


Supplementary references:
- Mankiw and Romer (1991), New Keynesian Economics, Vol. II, Part V
- Taylor and Woodford (1999), Handbook of Macroeconomics, Vol. 1, ch 17 and 18

Unemployment
h<

Key Stylized Facts

 Unemployment rate fluctuates over time countercyclically

 Unemployment rates differ substantially across countries

 Unemployment tends to be persistent

E ^ ^KE^

Unemployment rate (aged 15+; in percent)


Austria
Canada
Denmark
France
Germany
Greece
Ireland
Italy
Japan
Netherlands
Portugal
Spain
Sweden
Switzerland
United Kingdom
United States
Source: OECD Main Economic Indicators

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

Unemployment Theory Overview


Keynesian unemployment
Key ingredient: nominal rigidity [lec 2]
Fluctuations due to aggregate demand (monetary and fiscal shocks, animal spirits)

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

Long-term unemployment ( 12 months,


in percent of total unemployment)
Austria
Canada
Denmark
France
Germany
Greece
Ireland
Italy
Japan
Netherlands
Portugal
Spain
Sweden
Switzerland
United Kingdom
United States
Source: OECD

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

Real wage above market-clearing level:


Index-linked minimum wage set by government
Wage bargaining by unions [e.g. insider-outsider model]
or optimal contracting between firms and workers
Efficiency wages: higher wage increases productivity
+ improve nutrition/health
+ reduce labor turnover
+ attract better workers (less adverse selection)
+ prevent shirking (less moral hazard) [Shapiro-Stiglitz model]
higher wage helps to recruit, retain and motivate

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

Efficiency Wages and Solow Condition

Worker

Simple model (Solow, JMacro 1979)

Representative worker has inelastic labor supply L


Worker effort

Firm

e = e (w )

with e (.) > 0, e (.) < 0

Representative firm maximizes real profits

Key result

= Y wL

Efficiency wage w satisfies Solow condition:

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)

maximizes average effort per wage (e/w).


 


Standard case with perfect competition in labor market: e = 1 and w = F L

Perfect competition in goods market


Imperfect competition in labor market: firm determines labor input L and real wage w

Efficiency wage w and Solow condition: e (w) = e (w) /w

so unemployment (for w close to ).


If efficiency wage w > , then L < L
.
If w < , then w rises until L = L

Efficiency wage w and Solow condition: e (w) = e (w) /w

e(w)

~
w

e(w)

~
w

w*

 Derivation

Efficiency Wages with Reference Wage

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)

FOC wrt w: e (w) LF (e (w) L) L = 0 e (w) F (e (w) L) = 1


w = 1 e (w ) = e(w)
Combining yields (1): e (w) e(w)
w

Second order conditions:


2 = e2 F < 0
L2
n

det D 2 = e2F

on

with 0 < < 1 and reference wage

!



eLF + eL 2 F eF + eeLF 1 2
o

= e2F eLF > 0 using eF = 1 (FOC wrt w)


Hessian D 2 negative definite, so maximum at w.

Labor demand L (w) implied by FOC wrt L: eF (eL) w = 0


dL = e F +ee LF 1
Using implicit function theorem: dw
e2 F

dL
dw

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

Then Solow condition (1) implies efficiency wage


1
w

1
Assuming symmetric equilibrium with w = wm yields
w=

u=

 Derivation

Efficiency Wages and Shirking



w
, Solow condition e (w ) = e(w) yields
For e (w) = w
w

Shapiro-Stiglitz model (AER 1984) with imperfect worker monitoring

1 w
Hence, (3): w = 1
>w
.

Firm





1 ww
1 = 1 ww
w = w w
w

w
w

Rearranging, imposing symmetry w = wm and using (2):


w
= (1 ) wm = (1 u) wm + uwm (1 ) u =
Hence, (4): u = / (1 ) > 0 

(2)

where wm market real wage, u unemployment rate, and replacement ratio (0 < < 1).

(3)

(4)

Representative firm maximizes real profits

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 )

with F (.) > 0, F (.) < 0

Market structure
Perfect competition in goods market
Imperfect competition in labor market: firm chooses labor input L and real wage w

Worker

Results

Representative worker maximizes expected value of lifetime utility


U =

t=0 (1 + )

Firm sets real wage w to prevent shirking.

t vt

Expected value of lifetime utility of worker if

where intertemporal discount rate ( > 0) and instantaneous utility


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

e > 0 if not shirking


0
if shirking

Job market transitions (any period):


b probability of losing job exogenously
q probability of being fired due to shirking
a = a (u) probability of finding job, depending on unemployment rate u

Shapiro-Stiglitz model with NSC: w = e 1 + + ub 1q


h

1 [bV + (1 b) V ]
- employed and not shirking: VE = w e + 1+
U
E

 i

Ld

No-shirking condition: VE = VS , implying


"

w = e 1 + +

 #

b 1
u q

(NSC)

Shapiro-Stiglitz model with NSC: w = e 1 + + ub 1q


h

 i

Ld
NSC

Effect of rise in q in Shapiro-Stiglitz model on NSC: w = e 1 + + ub 1q


h

 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 ]

Labor demand determined by firms FOC wrt L: eF (


e L) = w
dL =
1
<0 
Using implicit function theorem: dw
e2 F (
eL)

Effect of rise in q in Shapiro-Stiglitz model on NSC: w = e 1 + + ub 1q


h

 i

Hysteresis

Hysteresis: persistence; path-dependence

Ld
NSC

Theoretical explanations of hysteresis in unemployment:

capacity scrapping [Rowthorn (1999)]

unemployment duration effects reducing re-employment probability [McGregor (1978)]


incl. depreciation human capital and discouraged worker effect

insider-outsider effects [Blanchard & Summers (1986); Lindbeck & Snower (1986)]
_

Insider-Outsider Effects

Workers

Insider-outsider model (Blanchard & Summers, NBER MA 1986)

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)

Representative firm maximizes real profits

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

First, insiders choose wt. Then t is realized.


Finally, firm sets Lt, hiring min {Lt, Nt} insiders and max {Lt Nt, 0} outsiders.

Market structure

Key result

Perfect competition in goods market

Hysteresis in employment as log employment follows random walk


ln Lt = ln Lt1 +

Imperfect competition in labor market: insiders set real wage w

 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

Insiders set wt such that E [ln Lt] = ln Nt


1 ln w = ln L
ln L0 1
t1
t
So, ln wt = (1 ) (ln L0 ln Lt1)
1 ln 
As a result, ln Lt = ln Lt1 + 1
t

,
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

MPhil M200 Macroeconomics IB

Petra M. Geraats
Michaelmas 2014

Nominal Rigidities

Nominal rigidities include sticky prices and (downwardly) rigid nominal wages.

Lecture 2 Nominal Rigidities

Sticky prices require imperfect competition (firms as price setters).

1. Nominal Rigidities: overview

Theoretical explanations of nominal rigidities:

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.


Second-order effect of sticky price Pi on profits i




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


Using optimality condition i Pi 0, difference in profit due to sticky price Pi


 

2
1
i Pi i (Pi) i (Pi) Pi Pi < 0
2

However, sticky prices have first-order macroeconomic consequences!

Pi*

Pi

Second-order effect of sticky price Pi on profits i

Menu Cost Model

Imperfect Competition with Flexible Prices


Basic textbook model
Firm
Representative firm i maximizes real profits

i =

W
Pi
Qi
Li
P
P

(1)

Q i = Li

(2)

Production technology for good i:


_
Pi

Pi*

Pi

Market structure

Demand

Monopolistic competition in goods market: firm has market power to set price Pi

Demand for good i:


Qi = Y

Perfect competition in labor market: agents take nominal wage W as given

Worker


Pi
P

>1

(5)

Aggregate demand:
Y =

Representative consumer i maximizes utility

1
U i = Ci L i

>1

(3)

subject to budget constraint


Ci = i +

W
Li
P

(4)

M
P

(6)

R
R
where Y = 01 Qidi aggregate output, P = 01 Pidi aggregate price, and M aggregate

demand (or money supply), with representative agent i [0, 1].

Key results

 Derivation:
- Producer behavior with flexible prices

Firms engage in markup pricing due to imperfect competition:


Pi
W
=
P
1P

(7)

1
1

(8)

Market equilibrium Y under imperfect competition below socially optimal level


(Y = 1 under perfect competition) due to aggregate demand externality :
Reduction in prices Pi (and therefore P ) increases aggregate demand Y = M/P ,
leading to additional rise in demand Qi (Blanchard & Kiyotaki, AER 1987).

Effects of drop in aggregate demand with flexible prices (LHS) and fixed prices (RHS)
P

AD

AS

AD

FOC wrt Li (taking i as given): W


P Li
1
1

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

Macroeconomic equilibrium with sticky prices


Output determined by aggregate demand (6):

AD

Y =

Real wage affected by aggregate demand:

_
P

 1
W
M
=
P
P

Y
W
_
P

M
P

(9)

Y
W
_
P

 Derivation of labor market equilibrium with sticky prices


Labor supply still given by consumers FOC wrt Li: Ls = W
P
Note: with sticky prices, firms FOC wrt Pi no longer holds.
Instead, (2) and (6) give effective labor demand Le = Y = M
P


Ld

W
Labor market equilibrium: Le = M
P = P
L

Menu Costs

1
1

1
1

= Ls, yielding (9) 

Effect of drop in aggregate demand on profit function and ADJ F IX

Consider same imperfect competition model as before but now assume

Cost of changing goods price Pi: Z (menu cost)

Starting from flexible price equilibrium (Z = 0),


consider (unanticipated) change in aggregate demand from M0 to M1.
Sticky prices Pi = P0 are Nash equilibrium if
ADJ F IX < Z
where F IX profits if all firms keep prices fixed at P0,
and ADJ profits for firm that deviates and adjusts price to optimal level.
Note: ADJ F IX
P0

Pi

Effect of drop in aggregate demand on profit function and ADJ F IX

Effect of drop in aggregate demand on profit function and ADJ F IX

ADJ
FIX

Pi *

P0

Pi *

Pi

P0

Pi

Macroeconomic equilibrium with sticky prices

 Derivation of profit functions ADJ and F IX


Recall profit function:

Output determined by aggregate demand (6):

Pi W
Y

P
P
and equilibrium real wage with sticky prices:

Y =

i =

M
P

Real wage affected by aggregate demand:


M
W
=
P
P


1

(9)

Labor supply still given by consumers FOC wrt Li: Ls = W


P
Note: with sticky prices, firms FOC wrt Pi no longer holds.
Instead, (2) and (6) give effective labor demand Le = Y = M
P
W
Labor market equilibrium: Le = M
P = P

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 ():


 Derivation of labor market equilibrium with sticky prices




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 =

= Ls, yielding (9) 




1 1

M
P0

!(1)

(11)

Plausible parameter values require implausibly high menu costs


to sustain Nash equilibrium of sticky prices.

ADJ F IX with low price sensitivity profits and high real rigidity
i

Example

Take = 11 (inelastic labor supply Ls =

= 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

Small menu costs lead to nominal rigidity (i.e. small ADJ F IX )


if real rigidity high or price sensitivity profits low.

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

Menu Costs and Real Rigidities

ADJ F IX with low price sensitivity profits and high real rigidity

Adding real rigidity to model (Ball and Romer, REStu 1990)

Instead of perfect competition in labor market with (9):


ADJ

Assume real wage function (e.g. due to efficiency wages or wage bargaining):

FIX

W
= AY
P

>0

(12)

Real rigidity amplifies effect of nominal rigidity.


Nash equilibrium of sticky prices can be sustained with plausible parameter values.

Pi *

P0

Pi

 Derivation of profit functions F IX and ADJ


  
Pi
Recall profit function: i = PPi W
P Y P

=
AY
and real wage function (12): W
P
W
Optimal price still (7): PPi = 1
P


Plausible parameter values yield Nash equilibrium of sticky prices


as real rigidity amplifies effect of nominal rigidity.

( )

Example

Take = 0.1 (high real wage rigidity), A = 0.806 (output gap 5%)

and = 5 (markup factor 1


= 1.25)

- 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

Substituting into (13) and (14): (ADJ F IX ) /Yflex = 0.0000181


So, menu costs only need to be 0.002% of real revenue (output) for sticky prices
to be equilibrium. 

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)

2 = 0.388, s.e.e. = 0.215, standard errors in parentheses]


where x log nominal GDP [R
Significantly negative relation between
and (for
< 34%).
Microeconomic evidence on price adjustments
 Prices adjust about once per year (excl sales), though heterogeneity in frequency, size
and timing.
 Costs of price adjustment can be significant (e.g. 1% for supermarkets; Levy, Bergen,
Dutta and Venable, QJE 1997)

MPhil M200 Macroeconomics IB


Petra M. Geraats
Michaelmas 2014

Lecture 3 Monetary Policy

Monetary Policy Objectives

Objectives monetary policy:


Price stability or inflation stabilization around inflation target
Output stabilization
Consider (Lucas) aggregate supply equation with white noise supply shock st
yt = y + b ( t et) + st

1. Monetary policy objectives


2. Theory: inflation bias; monetary policy rules
3. Monetary policy in practice
Main reading: Romer (2011), chapter 11 (excl 11.5 and 11.9)
Supplementary references:

b>0

or expectations augmented Phillips curve (for = 1/b, t = st/b)


t = et + (yt y) + t
Systematic expansionary policy (yt > yt) requires t > et.
With adaptive expectations ( et = t1), this gives increasing inflation ( t > t1).
With rational expectations ( et = E [ t]), this is impossible (as E [yt] = y).

- Walsh (2010), ch 8, 10

Stabilization supply shocks st


possible, unless perfect foresight ( t = et),
and desirable, unless technology or preference shocks [recall RBC].

Costs and Benefits of Inflation

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.

- Friedman and Woodford (2011), Handbook of Monetary Economics, Vol. 3


- Taylor and Woodford (1999), Handbook of Macroeconomics, Vol. 1, ch 2, 3, 22, 23

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.

Monetary Policy Theory

Monetary policy game (Barro & Gordon, JPE 1983)


Monetary policymaker minimizes social welfare loss

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

where y natural rate of output, and s aggregate supply shock, with

(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

Note: For = , E [ ] > (dynamic inconsistency)


=

(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

Solutions to Inflation Bias


Commitment: Abandon discretion and adopt monetary policy rule.

Under commitment, optimal policy yields = and y = y + s


Compared to discretion, lower inflation loss, but higher output volatility loss
credibility-flexibility trade-off
 Derivation
Suppose policymaker commits to = C .
Then, rational expectations imply e = C .
y + s y )2
Substitute into (2) and (1): L = 12 a ( C )2 + 21 (
FOC wrt C : C =
2
a 2 = [L ]

)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

Problem: Commitment may not be feasible or credible.


Rules limit flexibility and cannot incorporate all contingencies.

Delegation: Delegate monetary policy to central banker (CB) with different preferences.

Recall monetary policy objectives: L = 21 a ( )2 + 12 (y y )2


b s
inflation: = + ab (y y) a+b
(4)
2
a
output: y = y + a+b2 s (5)

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.

Problem: Conservative central banker leads to credibility-flexibility trade-off.


Furthermore, central bankers preferences cannot be directly verified.

Inflation penalty to eliminate inflation bias: LI = L + b (y y)


 Derivation
Substituting (2):
LI = 12 a ( )2 + 21 (
y + b ( e) + s y )2 + b (y y)
FOC wrt : a ( ) + b (
y + b ( e) + s y ) + b (y y) = 0
Taking expectations using rational expectations ( e = E [ ]): e =
b s 
Substituting and rearranging: = a+b
2
Problem: Hard to translate into financial penalty or firing requirements.

Reputation: Repeated interaction makes policymaker behave better.

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.

Policymaker minimizes social welfare losses

Uncertainty about policymakers preferences and rational updating of e

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)

Economy described by aggregate supply equation (2): yt = y + b ( t et) + st


Public does not observe but has rational expectations with prior E [ ] =
Timing: each period t, public first forms et, then st observed and policymaker sets t

Key result
Reputation effect reduces inflation bias in first period:
1 = + (1 )

 Derivation

Transparency: Information disclosure improves central banks incentives.

People rationally use 1 to form e2.


Postulate updating: e2 = u0 + u1 1 (#)
Substitute into (7) and
 (6) using
 (2): h
i
L = 12 a ( 1 )2b 1 e1 s+ 21 a ( 2 )2 b ( 2 u0 u1 1) s
FOCs wrt 2 and 1 (given e1):
L/ 2 = [a ( 2 ) b] = 0 2 = + ab > (inflation bias)
L/ 1 = a ( 1 ) b + bu1 = 0 1 = + (1 u1) ab
Using rational expectations, e2 = E [ 2| 1]:
e2 = E [ | 1] + ab , where E [ | 1] = 1 (1 u1) ab
So, e2 = 1 + u1 ab
Matching coefficients with (#): u1 = 1 and u0 = ab
Hence, 1 = + (1 ) ab < + ab = 2 (reputation effect)
Note: E [y1] = E [y2] = y due to ratex ( et = E [ t])

b
b
< + = 2
a
a

Problem: Reputation not very effective for short-sighted policymakers.

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).

Monetary Policy Rules

Optimal monetary policy in simple dynamic backward-looking model [Svensson, EER


1997]

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 =

* Taylor (CRCSPP 1993): nominal interest rate rule


it = r + + 1.5 ( t ) + 0.5 (yt y)

s=t

stLs

t+2 = t+1 + (yt+1 y) + t+2

yt+1 y = (yt y) (rt r) + t+1




Optimal monetary policy described by Taylor rule:

Recall: t+2 = t+1 + (yt+1 y) + t+2 (9)


and yt+1 y = (yt y) (rt r) + t+1 (10)

it = r + + 1 +

"

1
1
( t ) + + (1 + ) (yt y)

satisfying Taylor principle (it/ t > 1)

(11)

0 < < 1, > 0




(10)

Timing: each period t, policymaker sets rt after observing yt and t

 Derivation

"

(9)

where r natural real interest rate, t i.i.d. 0, 2 and t i.i.d. 0, 2

Key result

Note: Using Fisher equation it = rt + Et [ t+1]


and t+1 = t + (yt y) + t+1 (9), so Et [ t+1] = t + (yt y),
yields Taylor rule for nominal interest rate:

>0

1
( t )2
2

and IS equation

Problem with instrument rules (Svensson, JEL 2003):


Design of optimal monetary policy rule complicated by uncertainty about structure of
economy.
Mechanical adoption of instrument rule not optimal for all contingencies.

1
1
( t ) + (1 + ) (yt y)

(8)

Economy described by Phillips curve

satisfying Taylor principle it/ t > 1.


Corresponds to (approximately) optimal monetary policy for several models.

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

Substitute (9): Et [ t+1] + (Et [yt+1] y) =


Substitute (9) for t + 1 and (10):
[ t + (yt y)] + [ (yt y) (rt r)] =
1 ( ) + 1 (1 + ) (y y
Rearrange to get Taylor rule (11): rt = r +
)
t
t

Monetary Policy in Practice

Price stability requires nominal anchor, depending on monetary policy regime.


Common monetary policy frameworks (see Mishkin, JME 1999)
as nominal anchor and policy instrument
Monetary targeting: money growth M
Inflation targeting: explicit inflation target as nominal anchor;
nominal interest rate as policy instrument,
set by independent, transparent and accountable central bank

Monetary policy framework


Monetary targeting
Inflation targeting
Exchange rate targeting
Other
Total
Source: IMF

4/2008
22
29
130
11
192

Exchange rate targeting: exchange rate target e as nominal anchor;


interest rate and/or exchange rate interventions as policy instrument,
to maintain target zone, fixed exchange rate or currency board

Prevalent monetary policy instrument is short-term nominal interest rate,


except for exchange rate targeters

Monetary policy in practice

Monetary policy needs to be forward-looking

Solution to inflation bias:


Delegate monetary policy to independent, transparent central bank
and appoint responsible central bankers with long overlapping tenures
and explicit inflation target.

Optimal policy under inflation targeting implies inflation-forecast targeting:


Et [ t+2] = (Svensson, EER 1997)

Monetary policy rules:


Taylor rules reasonable description of actual monetary policy,
but no adoption of mechanical rules (besides exchange rate pegs).

Monetary policy requires management of expectations:


monetary policy instrument is short-term interest rate,
but economy affected by longer-term interest rates.
Assuming expectations theory of the term structure,
long-term interest rate is average of expected future short-term interest rates:
h
i
h
i
1
i1,t + E t i1,t+1 + ... + E t i1,t+n1
n
where in nominal interest rate (yield to maturity) for n-period bond.
Importance of central bank communications as additional policy tool
to affect private sector expectations of future policy rates.

in,t =

MPhil M200 Macroeconomics IB

Petra M. Geraats
Michaelmas 2014

Fiscal Policy Overview

Sources of government financing:


Taxation (lump-sum or distortionary)

Lecture 4 Fiscal Policy

Government debt (run budget deficit)

1. Fiscal policy: overview

Seignorage (print money)

2. Theory: seignorage [Cagan model]; Ricardian equivalence; tax smoothing [Barro]

Government budget constraint:

3. Fiscal policy in practice

Gt + rBt = Tt + Dt + St

Main reading: Romer (2011), chapter 11.9 and 12 (excl 12.5-8 and 12.10)

where Gt government purchases, Tt tax revenue,


Bt real government bonds at start of period t, r real interest rate,
Dt Bt+1 Bt government budget deficit (and debt issue),
M M
St t P t1 seignorage in period t

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

Government budget constraint:


Gt + rBt = Tt + (Bt+1 Bt) + St

(1)

Seignorage

Intertemporal government budget constraint:


(1 + r) Bt +

Gs

s=t (1 + r )

st

Fiscal Policy Theory

Ts

s=t (1 + r )

st

Ss

s=t (1 + r )

st

(2)

Seignorage: real government revenues from printing money M


Mt Mt1
Mt Mt1 Mt
=
Pt
Mt
Pt
Inflation tax: capital loss on real money balances due to inflation
St =

 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)

To get (2), let T and lim


Note: no-Ponzi-game

condition).

M
M
M
In continuous time, S = M
dd xt .
P = M P and = P , where x

Cagan model

Inflation tax Laffer curve


0.12

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

Fischer, Sahay, and Vgh: Modern Hyper- and High Inflations

 Derivation

gM

10

855

Seigniorage

and substitute (4):


Write ln M
P = a bi + ln eY (3) in levels
M = eabi Y = eab(
r+ ) Y
= Ceb e , where C eabr Y > 0
P

(Change in high powered money in percent of GDP)

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

Maximum steady-state seignorage at gM = 1/b yields S = C/be. 


According to Cagans money demand estimations, 31 < b < 12 .
So, maximum seignorage for (continuous) growth rate = gM = 1/b of 2 to 3
(using M (t) = egM tM (0), which implies growth factor M (1) /M (0) = egM ,
this amounts to annual inflation growth factor of e2 = 7. 4 to e3 = 20).
Empirically, maximum seignorage about 10% of GDP.

0.2

0.4

0.6
LN(1 + Inflation/100)

0.8

0
1.2

Figure 4. Seigniorage and Inflation1


196095 averages
Regression line is 0.806 + 9.563LN(1 + inflation/100) 4.691(LN(1 + inflation/100)^2; t-statistics on the coefficients are 2.65
and 1.31 respectively; 94 countries in total, each with ten or more observations.

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

Desired real money holdings:


m (t) Ceb(t)

(5)

Gradual loglinear adjustment of real money holdings:

d ln m (t)
= [ln m (t) ln m (t)]
dt
where

M (t)
m (t) P (t)

(6)

real money holdings, and 0 < < 1/b.

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

Journal of Economic Literature, Vol. XL (September 2002)

Fischer, Sahay, and Vgh: Modern Hyper- and High Inflations

LN(1 + inflation/100)

853

Seigniorage

1.2

1.2

(Change in high powered money in percent of GDP)

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)

Figure 2. Inflation and Money (M2)


196095 averages
1 Slope

0.8

0
1.2
2
15

Growth1

10

0
5
Fiscal Balance/GDP

10

15

Figure 3. Seigniorage and Fiscal Balance1


196095 averages

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

Recall government budget constraint: Gt + rBt = Tt + Dt + St

Ricardian equivalence: financing of government expenditure


by raising taxes or issuing government bonds has same effect.

Ricardian experiment

Consider tax cut T < 0 financed by increase in debt, so D = T > 0.

tax financing debt financing

Servicing and paying off higher government debt B = T


requires raising taxes by (1 + r)n T after n periods.

Assumptions:
Constant (present value) government purchases

(1+r)n T

Present value of taxes changes by T (1+r)n = 0,


so consumers intertemporal budget constraint not affected and consumption unchanged.

Representative agent with infinite horizon


Perfect capital markets

Consumer saves current tax cut to pay for higher future taxes.

Lump-sum taxes

Superneutrality

Budget constraint representative consumer:

 Proof Ricardian equivalence

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)

Recall intertemporal government budget constraint (2):


(1 + r) Bt +

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

Substitute (2) into (8):

Rearranging (7) and iterating forward:


1 (C + T + S Y + B
Bt = 1+r
t
t
t
t
t+1 )

Let T and lim

Gs

(1+r)

= 0 (transversality condition)

st

and intertemporal budget constraint representative consumer (8):


(1 + r) Bt +

 Derivation

s=t (1 + r )

Ys

s=t (1 + r )

st

Cs

s=t (1 + r )

st

Government bonds Bt are not net wealth to consumer!

to get (8). 
Empirically, Ricardian equivalence often fails.

Gs

s=t (1 + r )

st

Ss

s=t (1 + r )

st

Tax Smoothing

Key result

Tax-smoothing model [Barro (JPE 1979)]

Government engages in tax-rate smoothing:


h

( t) = Et ( t+1)

Government minimizes expected value deadweight losses due to distortionary taxes :


Lt =

where (0) = 0,

( .) >

0 and

s=t (1 + r )

st ( s ) Ys

Special cases:

(.) > 0.

Without uncertainty,
t = t+1

Intertemporal government budget constraint with income taxes:

(1 + r) Bt +

Gs

s=t (1 + r )

st

s Ys

s=t (1 + r )

(9)

st

For quadratic cost ( ) = 21 2,


t = Et [ t+1]

Assume income Ys exogenous and government expenditure Gs stochastic.

 Derivation

Note: Taking expected value of (9) and substituting t = Et [ t+n]





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 t+n: (1+r)


= 0 Et ( t+n) =
n Et ( t+n ) Yt+n
(1+r)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

Fiscal Policy in Practice

* For some developing countries, seignorage important (and inflation high),


but in advanced economies, seignorage limited by independent central bank
with low inflation target.
* Ricardian equivalence typically fails,
although consumers may act Ricardian
for short-term tax cuts aimed at stimulating economy.
* Tax smoothing contributes to countercyclical fiscal policy,
but fiscal policy typically driven by political influences.

MPhil M200 Macroeconomics IB

Petra M. Geraats
Michaelmas 2014

Exchange Rates Overview

Nominal exchange rate


Spot exchange rate St: domestic price of foreign currency at time t
Note: Home nominal appreciation S (depreciation S )

Lecture 5 Exchange Rates

Forward exchange rate Ft: domestic price at time t for foreign currency at time t + 1

1. Exchange rates: overview


2. Exchange rate theory: Flexible-price monetary model; Dornbusch overshooting model;
Harrod-Balassa-Samuelson effect

Assuming international capital mobility, risk neutrality and rational expectations,


arbitrage ensures:
Covered interest parity

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)

Uncovered interest parity

Dornbusch (JPE 1976)


Grossman and Rogoff (1995), Handbook of International Economics, Vol 3, ch 32, 33, 38
Isard (1995), incl ch 4, 7, 8; Obstfeld and Rogoff (1996), ch 4.1-4.4, 8-9; Taylor (JEL 1995)

1 + it = (1 + it ) Et

"

St+1
St

Real exchange rate

Empirical evidence

Real exchange rate P/SP : relative price of home vs foreign goods


Note: Home real appreciation (depreciation )

- 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.

Terms of trade: relative price of exports in terms of imports

Assuming no barriers to international trade, goods market arbitrage ensures:


Law of one price
Pi = SPi

(LOP)

Purchasing power parity (PPP)


absolute PPP: = 1
P = SP

relative PPP: constant, so P = S + P S =


d ln X = X
where X
X
dt

(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)

Exchange Rate Theory

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 +

Flexible Price Monetary Model


Money market equilibrium:

where k (m m ) (y y ) (inverse) measure of macroeconomic fundamentals.

mt pt = yt it

, > 0

(1)

Purchasing power parity:

 Derivation
pt = st + pt

(2)

Using pt = st + pt (2), mt pt = yt it (1), and it = it + Et [st+1] st (3):


st = pt pt = (mt mt ) (yt yt) + (it it ) = kt + (Et [st+1] st)

it = it + Et [st+1] st

(3)

1 k +
Rearranging: st = 1+
t
1+ Et [st+1]

Uncovered interest parity:

where x ln X with X {M, P, Y, S}


Note: (3) approximation of UIP: 1 + it = (1 + it ) Et

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

Assuming no-bubble condition limT 1+

T t+1

Et sT +1 = 0 yields (4) 

Recall: pt = st + pt (2), it = it + Et [st+1] st (3) and s = k

for all : s = k

In steady state with k = k


 Derivation



t k
1
into (4): s = 1 P

= 1
Substitute k = k
1+
1+
1+ 1 k = k 
=t
1+

Fixed exchange rate s = s


restricts monetary policy: k = s
effectively imports monetary policy from abroad: i = i and =

N Sum of geometrically declining series


T
P

=0

T +1
P
1 
a = 1a
a = 1a
1a and for |a| < 1,
=0

Anticipated change in fundamentals k has immediate effect on nominal exchange rate s.


to k

Unexpected announcement at t = 0 of permanent change at t = T from k




1 P
t
Substitute into (4), st = 1+
Et [k ], and simplify (0 t < T ):
1+
=t

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+

Note: International capital mobility requires macroeconomic policy choice


either fixed exchange rate
or independent domestic monetary policy
International macroeconomic policy trilemma

Dornbusch Overshooting Model


Dornbusch (JPE 1976) model [for = , = , = and = = 0]
Money market equilibrium
m p = y i

, > 0

(5)

>0

(6)

Aggregate demand
y = (s + p p) + u

where (log) real exchange rate q s + p p


Uncovered interest parity under perfect foresight
i = i + s

(7)

Predetermined price p with price adjustment (Phillips curve)


p = (y y)

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

s = 0 and (7) gives i = i, so (5) yields p p = (m


m
) (
y y) k
p = 0 and (8) gives y = y, so y = q + u (6) yields q = 1 (
yu
)

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)

Recall short run dynamics:


s = 1 (s s) + 1 (1 ) (p p)
p = (s s)
(p p)

In matrix form:
s
p

"
|

1 (1 ) 1

{z
A

s s
p p

where det A = 1 (1 ) 1 = 1 < 0


Hence, saddle point dynamics.
Note: In phase diagram
(s s
s = 0 (p p) = 1
)
p = 0 (p p) = (s s)
Cases:
< 0 so s = 0 downward sloping
(i) For 0 < < 1, 1

= > 1 so s = 0 upward sloping


(ii) For > 1, 1
1


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

Consider unanticipated permanent increase in m


.
and p = p + k
, where k
(m
Recall: s = q + k
m
) (
y y)

p=0

s=0

_
p

_
p

_
s

p=0

_
s

Consider unanticipated permanent increase in m


.
and p = p + k
, where k
(m
Recall: s = q + k
m
) (
y y)

Consider unanticipated permanent increase in m


.
and p = p + k
, where k
(m
Recall: s = q + k
m
) (
y y)

p=0

s=0

_
p

p=0

s=0

_
p

_
s

_
s

_
s

Consider unanticipated permanent increase in m


.
and p = p + k
, where k
(m
Recall: s = q + k
m
) (
y y)

_
s

s=0

p=0

p=0

s=0

_
p

_
p
_
s

Note: Exchange rate overshooting if (i) < 1


_
s

_
s s

s=0

p=0

_
p

p=0

s=0

_
p

_
s

_
s

Note: Exchange rate overshooting if (i) < 1

_
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

where 0 < i < 1 and N T


Two factors of production
- Labor L mobile between sectors: L = LT + LN and WT = WN = W
- Capital K mobile between sectors and countries: RT = RN = R
where W real wage and R real interest rate (in terms of tradables)
Perfect competition in goods and factor markets

Aggregate price index: P = PT PN , where 0 < < 1


Let tradables be num
eraire (PT = 1)

(9)

Firms maximize present value of real profits (in terms of tradables):

 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):

Ki,t+1 = Ki,t + Ii,t

(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 =

Capital accumulation (from tradables) reversible and no depreciation:

where Ki,t > 0 and investment Ii,t R.

1
i
i +1 = 0
1 + 1+R
(1 i) Pi,t+1Ai,t+1Li,t+1
Ki,t+1

Law of one price for tradables: PT = SPT

iPi,tAi,tLi,ti

1 i

Ki,t

Wt = 0

This yields optimality conditions for tradables and nontradables sector:

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.

N PN AN (KN /LN )1N = W

Log-differentiating (i.e. taking logs and totally differentiating),


d ln X = d X/X :
denoting X
T

As a result,

PN = N A
T AN
T

=R

[For example, taking logs of (1 T ) AT (KT /LT )

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

Subtract (12) from (13): K


T + (1 T ) W
=W
W
=A
T / T
Substitute this into (13): A
N L
N = W
=A
T /T
Subtract (14) from (15): K
N + (1 N ) A
T / T = A
T / T
Substitute this into (15): PN + A

Log-differentiate aggregate price index P = PN


(12)

"

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.

A.3 Consider the following insider-outsider model. The representative rm maximizes


p
real prots t = Yt wt Lt , subject to the production technology Yt = At Lt ,
where Yt is output, Lt labour, and At = A t , where t is an i.i.d. shock with
E [ln t ] = 0. There is perfect competition in the goods market. The real wage wt
is set at the end of period t 1 by the workers who are employed in that period
(insiders) such that they expect to maintain their log employment: E [ln Lt ] =
ln Lt 1 . After the shock t has been realized, the rm decides whether to hire
additional workers (Lt > Lt 1 ) or re workers (Lt < Lt 1 ) in period t.
Suppose there is a positive shock t < 0 such that At temporarily rises 1% above
A in period t. Explain the eect of this on employment Lt and the real wage wt
from period t onwards.
A.4 Consider the following exible price monetary model based on purchasing power
parity, money market equilibrium and uncovered interest parity, respectively:

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.

B.2 Real Business Cycles


Consider the following two-period economy. There is a continuum of measure
one of identical individuals i 2 [0; 1]. A representative individual maximises the
following utility function:
U=

1
X

[ln(ct ) + ln(1

lt )]

t=0

where ct denotes consumption, lt labour supply, the subscript t = 0; 1 the time


period, and 2 (0; 1) and > 0 are constant parameters. The time endowment
is equal to one in each period. Assume that individuals start with no initial assets
(b0 = 0) and cannot die with a debt. Individuals supply labour to rms at a real
wage rate wt per unit of labour. The consumption good is the numraire.
There is also a continuum of measure one of identical, prot maximising rms. The
production technology of the representative rm is represented by the following
function:
Y t = At L t
where Yt is output, Lt is labour used in production, and At > 0 is an exogenous productivity factor. There is perfect competition in the product and labour
market. There is no government and the real interest rate is r.
(a) Formulate the problem of the representative rm and take the rst-order
condition. Give an economic interpretation of the result.
(b) Formulate the problem of a representative individual and take the rst-order
conditions associated with this problem. Give an economic interpretation of
the conditions which characterise the trade-os of this problem.
(c) Derive the optimal levels of consumption c0 and c1 , labour supply l0 and l1
and assets b1 , for given w0 , w1 and r.
(d) Suppose that this is a small open economy so that the real interest rate r is
given. Explain how an increase in future productivity A1 aects the optimal
levels of consumption c0 and c1 , labour supply l0 and l1 , and assets b1 .
(e) Suppose now instead that the economy is closed. Derive the equilibrium real
interest rate r. Explain the eect of an increase in future productivity A1 on
the real interest rate r, consumption c0 and c1 , and labour supply l0 and l1 .

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.

A.2 Investment and Secular Stagnation


Consider a q-theory model with the following dynamics for the capital stock Kt
and the shadow price of capital qt :
Kt+1 =
(qt 1)
qt+1 = rqt AF 0 (Kt + (qt

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.

A.3 Wage Bargaining


Suppose a rm chooses employment L to maximise real prots
=

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)

where w > 0 denotes the minimum wage, and the parameter


2 (0; 1]. The
1
bargained wage w maximizes U
, with parameter 2 (0; 1). Assume that
> .
Derive the level of the bargained wage w. Explain how it depends on w and .

A.4 Fiscal Policy and Austerity


Suppose the government sets the income tax
pected value of the following loss function:
Lt =

1
X
s=t

1
(1 + r)s

1
2

each period to minimise the ex-

2
s Ys

where Ys denotes aggregate output in period s, r is the constant real interest


rate, and is a positive parameter. The intertemporal budget constraint of the
government is given by
(1 + r) Bt +

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

where ct corresponds to her consumption in period t and 2 (0; 1) is her subjective


discount factor. Assume that the agent can borrow or lend at a given sequence
of real interest rates frt g1
t=0 and that the agent receives a deterministic sequence
of perishable endowment fyt g1
t=0 . Let bt be the asset position of the agent at the
start of period t and assume that b0 = 0. The one-period budget constraint of the
agent is
ct + bt+1 = yt + (1 + rt )bt :
There is no possibility of a Ponzi scheme.
(a) Set up the maximisation problem of the agent and derive the Euler equation.
Give an economic interpretation of your result.
(b) Solve for consumption in period t = 0. Comment on your result.
Now assume that this economy has a total of N agents and that there are two
types of agents, A and B, which are indicated by a superscript. Half of agents are
of type A and have the following endowment prole:
ytA = f1; 0; 1; 0; 1; 0; :::g:
The other agents are of type B and have the endowment prole
ytB = f0; 1; 0; 1; 0; 1; :::g:
Therefore, type-A agents have one unit of the endowment good in even periods,
while type-B agents have one unit of the endowment good in odd periods.
(c) Write down the market clearing condition for the goods market in each period
B
and use it to get an equilibrium condition between cA
t and ct for even periods
and for odd periods.
(d) Use the equilibrium condition for the goods market and the Euler equation
to derive the equilibrium real interest rate in each period. Solve for the levels
B
of consumption cA
t and ct in equilibrium. Interpret your results.
(e) Explain how the levels of lifetime utility U A and U B compare in equilibrium.

B.2 Monetary Policy, Uncertainty and Macroeconomic Volatility


Suppose the central bank maximises the expected value of the objective function
W =

1
(
2

)2

1 2
y
2

where is ination, y the output gap,


the ination target, and the parameter
> 0. The economy is described by the Phillips curve
e

+ y+s

where e denotes private sector ination expectations, s is an i.i.d. white noise


cost-push shock with variance 2s , and the parameter > 0. Aggregate demand is
given by
y=
(r r) + d
where r is the real interest rate, r the natural real interest rate, d an i.i.d. white
noise aggregate demand shock with variance 2d , and the parameter > 0. The
timing is as follows. First, the private sector rationally forms its ination expectations e . Next, the shocks s and d are realized and observed by the central bank.
Subsequently, the central bank sets its monetary policy instrument r.
(a) Derive the policy rate r set by the central bank for a given level of
an intuitive explanation of the result.

. 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
5

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