MACROECONOMICS SUMMARY

BONDS
Types of issuers:
• Government bonds
• Corporate bonds
Types of bonds:
• Discount bonds
• Coupon bonds
Bonds differ by:
• Risk profile
o Default risk
o Price risk
• Maturity
o Price
o Interest rate (yield)

YIELD CURVE

YIELD (n-year interest rate) – int

Definition: the constant annual interest rate such that the price of a bond equals to the Present
Discounted Value (PDV) where n = the number of years to maturity

For example:
€100
€𝑃#$ =
(1 + 𝑖#$ )(1 + 𝑖#$ )
Where i2t = 2-year interest rate

0
𝑖.$ + 𝑖.$/.
𝑖#$ ≈
2
(the average of the interest rate today and the expected interest rate at time t+1 with NO RISK)

0
𝑖.$ + 𝑖.$/. +𝑥
𝑖#$ ≈
2
(the average of the interest rate today and the expected interest rate at time t+1 with RISK
PREMIUM)
YIELD CURVE WITH RISK VS. WITH NO RISK

Yield/Interest rate

1 2
Maturity (in years)

RISKY bond (constant interest rate)

NO RISK bond (constant interest rate)

DOWNWARD SLOPING YIELD CURVE

Yield/Interest rate

1 2
Maturity (in years)

NO RISK (expect lower interest rate in the future)

0
𝑖.$/. < 𝑖.$ ⟹ this occurs when the economy is going into a recession

EXPECTATIONS IN THE STOCK MARKET – EQUITY FINANCE

Equity finance: issuing stocks or shares that pay dividends

Variables:
0
• Ex-dividend price (price of the stock after the firm has distributed dividends) = €𝐷$/.
• Price of stock = €𝑄$
0
• Price of the stock if it is re-sold in the future = €𝑄$/.
Value of stock at time t+1:
0 0
€𝐷$/. + €𝑄$/.
€𝑄$

Indifference between stock and bond (with RISK):

0 0 0 0
€𝐷$/. + €𝑄$/. €𝐷$/. + €𝑄$/.
= (1 + 𝑖.$ + 𝑥 ) ⟹ €𝑄$ =
€𝑄$ (1 + 𝑖.$ + 𝑥 )

**N.B.** 𝐷$ is not considered in the equation because it has already been paid

In general:

In real terms:

RATIONAL BUBBLE
When the price of stocks increases because agents expect an increase in price therefore it is not a
realistic increase in price as all agents know that the stocks are being overvalued. The price usually
keeps increasing until a collapse creating uncertainty about the prospects of a firm.

CONSUMPTION AND EXPECTATIONS

𝐶 (𝑌9 ) = 𝐶$ (𝑌$ − 𝑇$ )
Consumption determinants: + +
• Wealth = 𝐶$
Wealth determinants:
• Financial and housing wealth = 𝑊𝐹𝐻$
• Human wealth (labour income or disposable income) = 𝑌9 = 𝑌$ − 𝑇$
• PDV of human wealth = 𝑌90 = 𝑌$/.
0 0
− 𝑇$/.
MICROFOUNDATION OF CONSUMERS AND EXPECTATIONS
Assumptions:
• 2 periods
o t
o t+1
• regular preferences (𝑈(𝐶$ , 𝐶$/. )
• access to banks ⟹ r = interest rate of loans
• 𝑊𝐹𝐻$ = 0

Individual Budget Constraint (IBC): 𝐻𝑊$

0 0
𝐶$/. 𝑌$/. − 𝑇$/.
𝐶$ + = (𝑌$ − 𝑇$ ) +
(1 + 𝑟) (1 + 𝑟)

Discounted value of Expected discounted value of

consumption at time t+1 human wealth at time t+1
(tomorrow) (tomorrow)

0- 0 𝐻𝑊$/.
⟹ 𝐶$/. = ( 𝑌$ − 𝑇$ )(1 + 𝑟) + (𝑌$/. − 𝑇$/. ) − (1 + 𝑟) ∙ 𝐶$

Slope of the equation = −(1 + 𝑟) = relative price of consumption today in relation to consumption
tomorrow ⟹ the opportunity cost of money
Y-intercept = (1 + 𝑟) ∙ 𝐻𝑊$
X-intercept = 𝐻𝑊$

Suppose ( 𝑌$ − 𝑇$ ) ↑ ⟹ shift of the IBC outwards and ∆( 𝑌$ − 𝑇$ ) > ∆𝐶$

0 0
Suppose (𝑌$/. − 𝑇$/. ) ↑ ⟹ shift of the IBC outwards and ∆𝑌9 = 0
Suppose 𝑟 ↑ ⟹ 1 + 𝑟) ↑ ⟹ 𝐶$ ↓ and 𝐶$/. ↑ (substitution effect) ⟹ borrowers become poorer
(
and savers become richer (income effect)

Assumption:
• 𝑊𝐹𝐻$ ≠ 0
IBC:
0 0
𝐶$/. 𝑌$/. − 𝑇$/.
𝐶$ + = (𝑌$ − 𝑇$ ) + + 𝑊𝐹𝐻$
(1 + 𝑟) (1 + 𝑟 )

Determinants of 𝐶$ :
0 0
𝐶$ ( 𝑌$ − 𝑇$ ; 𝑌$/. − 𝑇$/. ; 𝑊𝐹𝐻$ )
+ + +
Determinants of 𝑊𝐹𝐻$ :
• Values of houses in time t
• 𝑃JKL9MN
• 𝑄$
Observations:
i. 𝐶$ responds less than proportional to changes in 𝑌9 ⟹ consumption today increases less
than the increase in disposable income today
ii. 𝐶$ changes even when ∆𝑌9 = 0 ⟹ income is not changing today but expected to increase
tomorrow causing increase in consumption today
iii. 𝐶$ changes more than predicted in response to changes in ∆𝑌9 ⟹ impact different from the
one expected, for example: ∆( 𝑌$ − 𝑇$ ) = ∆𝐶$
**N.B. ** this occurs when people are credit constrained and there is a transitory shock

INVESTMENT AND EXPECTATIONS

𝐼$ = 𝐼(𝑌$ ; 𝑟$ )
Where: + -
• 𝑌$ = level of sales at time t
• 𝑟$ = real interest rate (cost of buying bonds)

COST BENEFIT ANALYSIS

Definition: compare benefits (expected return) received from investment at time t+1 with the cost
of the investment at time t

Variables:
0
• Expected return of the investment per unit of capital = 𝜋$/.
• Depreciation rate = 𝛿 < 1

Present value of expected return (profits) for one unit of capital:

Today’s value of future expected profits corrected by depreciation:

Determinants of investment function:

When 𝑉 (𝜋𝑒𝑡 ) > 1 ⟹ invest

When 𝑉 (𝜋𝑒𝑡 ) < 1 ⟹ do not invest
When 𝑉 (𝜋𝑒𝑡 ) = 1 ⟹ indifferent between investing and not investing
SPECIAL CASE – static (constant) expectations and real interest rate

Today’s value of future expected profits corrected by depreciation:

Where 𝑟$ + 𝛿 = cost of borrowing (rental cost of capital) or shadow cost ⟹ opportunity cost of
investing that money

IS-LM WITH EXPECTATIONS

0 0
𝐶$ ( 𝑌$ − 𝑇$ ; 𝑌$/. − 𝑇$/. ; 𝑊𝐹𝐻$ )

𝐼$ = 𝐼(𝑌$ ; 𝑟$ )

𝑊𝐹𝐻$ determinants:
0
• 𝑃JKL9MN (𝑟$ ; 𝑟$/. )
0 0 0
• 𝑄$ (𝐷$/. 𝑜𝑟 𝑌$/. ; 𝑟$ ; 𝑟$/. )

Assumption:
• 2 periods
o t
o t+1
0 0 0 )
𝐼𝑆$ = 𝐴( 𝑌$ ; 𝑇$ ; 𝑟$ ; 𝑥; 𝑌$/. ; 𝑇$/. ; 𝑟$/. +𝐺
+ - - - + - -
0 0 0 )
𝐼𝑆$/. = 𝐴(𝑌$/. ; 𝑇$/. ; 𝑟$/. +𝐺
+ - -
Where 𝐴 = aggregate private spending (consumption and investment grouped together)

The IS equation with expectations has the same slope as the baseline model but the slope is
steeper as 𝑌$ depends on future expectation as well as the values at time t therefore sensitivity is
smaller so (𝑐. ) and (𝑐. − 𝑑. ) are smaller.

**N.B.** it is very important to differentiate between a TRANSITORY/TEMPORARY and a

PERMANENT policy as the latter causes expectations to change so it is necessary to use two graphs
(one representing period t and the other period t+1) to understand the effects of changes in
expectation today (at time t)

0 0
**N.B.** changes in 𝐺$/. do not cause a change in 𝐶$ whilst changes in 𝑇$/. cause changes in 𝐶$ as
it is found in the list of determinants of 𝐶$