Macro Part 2 Lecture Notes

Chapter 12 continued

 Experiment
o Suppose there are only two possible shocks that can hit an economy. Shock 1 is
permanent increase in the money supply. If this occurs we know that this only
increases prices and has no real effects
o W = wP
 Segmented Markets theory
o Firms who are in the market have already made their money allocation
 Locked into financial obligations
o Central bank increases the money supply
o Firms turn this into labour demand
o Our demand for labour goes up
 Real wage goes up
o Output supply curve shifts out
 Real interest rate falls
o Opp cost of leisures falls
 Supply of labour falls slightly
o Demand for money rises
o Money supply has not had time yet to shift right
 Cuz only the financial sector observes the increase and the majority of
money is in bank accounts from consumers who don’t know yet
 Central bank wants price stability
o They target the nominal interest rate (R = r + i)
o If there is a shock to money demand then this policy will work!
o If the demand for price is wobbly, then the price level is wobbly and this is bad
for the bank’s credibility
o If this is the case, the CB can change the overnight rate?
o CB increases the money supply to meet a rise in demand
 Price level stays constant
o When shocks are to money demand, bank can adjust supply according to
maintain current prices
o Where is the interest rate on this chart?
 If it is a real shock e.g. demand shock you have to give the economy more money than it
demands in order to maintain an interest rate target
 Bottom line: if the shock is real, bank must change its interest rate target
 CB will stifle the economy if they target an interest rate during a productivity increase
Chapter 13: Real Business Cycle
 People have differing views on which model to use
 DSGE = Dynamic Stochastic General Equilibrium model
 Comes from the supply side
o Real shocks to the economy from productivity
 Y=zf(K,N)
 Assume shocks are positive unless stated otherwise
 Effects of a persistent increase in TFP
o Firms want to hire more labour now
o Output supply increases
o Output demand increases, but less so than supply
 What will the central bank do?
 They will increase the money supply to hold the price level constant
 The money supply increased because firms demanded more money
o Called reserve causation
 Endogenous money
o Money created by the financial system
 Y = zK0.3N0.7
o Z=1
o K = 100
o N = 50
o = 61.6 = 1(1000.3)(500.7)
 Suppose only 95% of K is being used, and 90% N
 56.3 = 1(950.3)(450.7)
 Notice, z hasn’t changed
o People are still as effective, just not as much for them to do
 If you try to recalculate z, it will be 0.914 instead of 1
o 56.3= z(1000.3)(500.7)
o Z= 0.914
 Keynesian coordination failure model
 The Party Syndrome
o Strategic complementarities
o Works when everyone does it
 Upward sloping demand curve for labour
o It must be strongly steeper than the supply curve
o If interest rates rise, supply curve moves down(right) and labour supplied falls
 Multiple equilibria
o The low interest high income one is the good equilibrium
o High interest low income is bad equilibrium
 Sunspots
o Sunspots effected the agricultural output
 o Term for a variable that shouldn’t matter but if people believe it to be good/bad
it will be a self-fulfilling prophecy
 Government would like to stabilize the economy in the coordination failure model
o Reduce taxes, causes labour demand to shift to the left and labour supply to shift
to the right
 Increases their lifetime wealth, and they take more leisure
o Reach a single equilibrium
 CB gives banks money in exchange for T Bills
o They then reverse this trade a month (or however long) later
o Called repo
o Puts money into the economy
 Selling bonds during a recession will have good effects?
 New Monetarist Model review
o
 End of Chapter 13

Chapter 14:
You can use monetary policy to lower the interest rate and close the output gap
Chapter 12 review

 There are money demand shocks and productivity shocks

 Private sector economic agents cannot observe prod shocks but the CB can observe them
 How should they conduct policy?
 Usually they can see money demand shocks but not prod, its switched here
 W=wP
o People see nominal wage go up and down
o Cant see if its change in real wage or change in Prices
o If it’s a prod shock, it hits w
o Demand for labour actually increases
o People should work more
 If it’s just a change in Prices, people shouldn’t work any more or less
Textbook Notes
Chapter 13

 Change in TFP in the Real Business Cycle Model

o Increased output supply
o Increased demand for labour
o Increased output demand (but less so than supply)
 o Labour supply comes inwards a bit in response to lower r
o Demand for money increases
o Price level falls
 Money is neutral in RBC
 Money can be produced endogenously by banks
 Money can lead GDP for 2 reasons
o Banks reserves increase when they lend to firms who will produce later
o CB sees this and may pre-emptively conduct monetary expansion before GDP
grows
 Criticism
o No role for government stabilization policy
o Problem measuring TFP during a recession when workers/capital is under
utilized
 Keynesian Coordination Failure Model
o Production function has increasing returns to scale
 Rising marginal product of labour
 This implies labour demand curve is upward sloping
o Output supply is downward sloping because a rise in interest rates would
decrease Y and N
 Sunspots determine fluctuations in the business cycle
 Money is neutral in CFM
o It may appear non-neutral because it is a sunspot variable
o When it is high people are optimistic, self-fulfilling prophecy
 Policy implications
o Government should say encouraging things
o Government can decrease spending to shift Yd left and Ys right to create only 1
equilibrium
 Criticisms
o If no increasing returns to scale (which is hard to measure) it falls apart
o Model is based on expectations, which are hard to observe/quantify
 New Monetarist Model
o Money is neutral in the LONG run but not necessarily in the SHORT run
o Many attribute the non-neutrality to sticky wages and prices
o When there is a large quantity of financial assets, more transactions can occur
and GDP is higher
o When r is low, there is a higher stock of private liquid assets that can be used for
transactions
o When there is a negative shift in the k(r ) function, Yd falls causing r to fall which
shifts Ns left
o Money demand may either fall or rise
  Both real income and real interest rates fell
o Investment will fall and consumption could either rise or fall
o The proper CB response to a lack of liquidity is an open market sale
o Increasing the money supply, which fixes most other issues, would actually make
things worse, Yd will shift even further left and Md will increase, dropping prices
 Liquidity trap, interest rates are so low that bank rate = overnight rate
o CB’s open market purchases don’t do anything, switching M r for B leaves total of
reserves + bonds unchanged
o Different than conventional liquidity trap
o Bank should raise the interest rate on reserves
 Quantity of currency falls since now more attractive for banks to hold
reserves
 Chapter 14
 New Keynesian Economics: Sticky Prices
o Money is non neutral in the short run
o Money market clears but goods and labour markets do not
o CB lowers interest rate target, does this by increasing the M supply
 Output, employment, w, C, I, money demand all increase
o The CB could choose to do nothing, and the model will reach equilibrium in the
long run
 But if they don’t want to wait they can just reduce r/increase M to
achieve the results quicker
 Only difference would be a higher price level if they intervene rather than
wait
o Instead the government could increase G
 The key difference is that output needs to change more in response to
fiscal policy to restore efficiency, and that fiscal policy places a greater
emphasis on public spending relative to private spending than monetary
policy does
 No increase in C or I, only in G
o If there is a productivity shock, all that happens is employment falls because the
same output can be produced with less workers
 Nothing changes cuz sticky prices and fixed r
o Monetary policy is powerless if there is a liquidity trap here, but fiscal policy still
works
o Criticisms
 Does not explain why ALP is procyclical
 Poor underlying theory
 Does not fit all observed features of price setting
Chapter 15

 International growth of trade has happened for two reasons

o Cost of transporting goods across borders has fallen
o Government imposed barriers have been relaxed
 A Two Good Model of a Small Open Economy (SOE)
o Economic activity in this country doesn’t affect rest of world
o TOTab is the terms of trade, price of good a in terms of good b
o MRTab+ is the marginal rate of transformation, amount of b given up to produce a
unit of a
o MRSab = MRTab
o Representative consumer sets MRSab = pab (price of a relative to b)
o When the SOE can trade with the rest of the world, optimization now occurs at
MRTab = TOTab
o Rep consumers budget constraint will now be
 TOTabqa + qb = TOTaba1 + b1 **Ask about this
 Written in terms of good b
 Right hand side is consumers income in terms of good b
 Left side is consumer expenditure on goods a and b, in terms of good b
 CA = b1 – b2 – TOTab(a2 – a1)
 In terms of good b, value of exports – imports
 CA = 0 in this model because it is one period, therefore no
lending/borrowing
o Patterns of trade are affected by comparative advantage, and consumer
preferences
 As MRSab increases, the slope of indifference curves get steeper
 More likely to export b and import a
o Increase in terms of trade when good a is imported
 Value of imports = Quantity of imports x TOTab
 Consumption of a must decrease, b could either increase or decrease
o Increase in terms of trade when good b is imported
 Consumption of b will rise, a could either increase or decrease
 Effect on value of imports and exports is ambiguous, but CA will = 0
o Shocks to terms of trade can be important cause of business cycles
 A Two Period Small Open Economy Model
o Rep consumer has same budget constraint as chapter 9
 C + C’/1 + r = Y – T + Y’ –T’ / 1 + r
 SP = Y – T – C = Y – T – C’
 G + G’/1 + r = T + T’/1 + r
 SG = T – G
 No investment in this economy
  So CA = S – I
 =Y–C–G
o Various factors affect the current account surplus
 Current period income
 Increase consumption in both periods
 Save more by lending abroad, CA rises
 Current gov spending
 Decreases consumer lifetime wealth
 Decrease consumption in both periods
 CA surplus decreases
 Taxes
 No change in CA
 Ricardian equivalence
 The real interest rate
 Depends on if net borrower or lender
 Usually if income effects aren’t too big, increase in r causes
decrease in C and increase in CA
 Production, Investment, and the Current Account
o Increase in World Real Interest Rate
 Yd shifts right
 CA increases
 I falls, C is ambiguous
 This could happen if world factor productivity fell for example
o Temporary Increase in Government Expenditure
 When economy is open, some of the increase in output dissipates
 Lifetime wealth decrease ,more labour supplied, Ys shifts right
 G causes Yd shift right
 Output increases and CA falls
 Some of the G’s demand is satisfied from imports
 R does not change, C falls, I doesn’t change
o Increase in Current Factor Productivity
 Workers are more productive, Ys shifts right
 CA increases, shifting Yd right
 C increases, I is same
 Real interest rate is global, so it doesn’t move
o Increase in FUTURE Factor Productivity
 C and I rise, but CA falls
 Y remains fixed at Y1
 Demand for C and I shift it right, but Ca shifts it back
 CA deficit isn’t always bad
 o Can use to smooth consumption
o Can use it to invest in future productivity
 This might eliminate the deficit in the future
 In future, Yd and Ys will shift right cuz of more capital
Chapter 16: Money in the Open Economy

 P = domestic price
 P* = foreign price
 e = nominal exchange rate
o one unit of foreign goods will cost eP* in units of domestic currency
 Real exchange rate = eP* / P
o If eP* > P, it would be cheaper to buy goods domestically than abroad
o Foreigners would buy our goods and P would rise
 With no transport costs, and no trade barriers we expect P = eP*
o Called the law of one price, or purchasing power parity
o Holds for goods than can easily be traded (oil) but not for things that cant
(haircuts)
 A hard peg can be implemented in three ways
o Dollarization: using the currency of another country as national medium of
exchange
 Disadvantage is that the gov cant print money to finance G spending
o Currency Board: a central institution holds interest bearing assets denominated
in the currency of a country against which the nominal exchange rate is fixed
 CB is now ready to exchange at a specified rate, does this by
buying/selling interest bearing assets
o Agreement among countries to a common currency: e.g. Euro, controlled by
European Central Bank
 Soft peg is just a somewhat commitment to stay within a range in the short term
o Usually collapse and change to other systems
 IMF plays important role in exchange rate determination
o Also acts as a lender of last resort
 SOE model with FLEXIBLE exchange rate
o M = eP*L(Y,r*)
o If Ms increases, e depreciates proportionately
 No effect on real variables though
o Nominal shock from abroad: P* rises
 Money demand curve shifts rightwards, e appreciates
 No change in domestic price
 Flexible e has insulated the domestic economy
 Under flexible rates, foreign monetary policy don’t affect us
 o A real shock to the domestic economy from abroad: increase in world r
 CA increases, shifting Yd right to meet higher r*
 I falls, C ambiguous
 Total absorption may rise or fall
 Increase r causes Md to fall, but increase in output causes Md to rise
 Assume Md more responsive to output than interest rates
 Md rises, e appreciates
 PPP holds, P = eP* therefore P falls with e
 Flexible e cannot insulate domestic economy from foreign real shocks
 To stabilize, would have to increase Ms in response
 SOE Model with FIXED exchange rate
o We will consider a type of soft peg where they fix for extended periods of time
but might revalue the currency at times
o The gov must through CB stand ready to support the fixed rate
o Government can’t change the money supply when they set a fixed rate, market
will undo any monetary action by CB
o Nominal Foreign Shock: Foreign Prices increase
 Demand for money shifts right
 Puts downward pressure on e
 Gov exchanges domestic currency for foreign
 Leads to increase in M
 P = eP*, therefore domestic P must rise in proportion to P*
 Under fixed rate, CB must adopt world’s inflation rate domestically
o Real Foreign Shock: world interest rate increases
 Domestic output increases, Yd shift right
 Output effect dominates, Md increases
 Ms must rise under fixed e
 Domestic price level doesn’t change
 Fixed rate insulates the domestic economy from real shocks abroad
 Same result can be achieved under flexible, but it requires CB to act, here
it is automatic
o Exchange Rate Devaluation
 Under fixed rate, gov might want to devalue domestic currency in
response to a shock
 Suppose temporary negative shock to TFP
 Ys shifts left
 CA falls, shifting Yd left to keep constant r
 C and absorption fall
 Md falls cuz of fall in income
  If gov were to still support the fixed rate, they would have to buy
up domestic currency to prevent depreciation
o Implies Ms would contract
 What if gov doesn’t want to, or doesn’t have enough foreign
exchange reserves?
 Gov can let their currency depreciate and Ms will stay at M1
 Note: devaluation doesn’t affect the Current Account, trying to
make a real change through nominal means
 Flexible vs Fixed exchange rates
o Depends on whether or not they think nominal or real shocks are important to
be insulated from
 Flexible for nominal
 Fixed for real
o Flexible allows CB to have independent monetary policy
 Capital Controls
o Can help reduce nominal shock’s affect under flexible and can reduce
fluctuations in foreign reserves under fixed
o In general they are undesirable, create inefficiencies
o BP = KA + CA (balance of payments = capital account + current account)
o BP must be zero, so KA = - CA
o Temporary negative shock to domestic productivity under flexible rate
 Ys shifts leftward
 Implies CA decreases and Yd shifts left
 Md shifts left, and e depreciates
 Now what if gov prohibits all capital inflows and outflows
 Ys shifts left but Yd doesn’t
o R is allowed to rise to r1
 Income falls but less than before
 Md falls but less than before
 E depreciates, but less than before
 If country is worried about effects of fluctuating nominal e under flexible,
capital controls will dampen the effects
o Under a fixed rate, output market acts the same but money market is different
 E is fixed so when Md falls, Ms must be decreased
 Capital controls make Ms fall by less

Midterm on parts of 12, all of 13 and 14

Chapter 15: Trade (not on midterm 1)
  MRS x,y = Px / Py
 S = Sp + Sg
 =Y - C- G
 4 cases
 1. Change in current income (default is an increase)
o Non labour income is up
 Exchange rates
 0.08 CAD = 1 Yen
 $1.50 = a coffee = 400 yen
 eP*
o exchange rate x amount of foreign currency
o 0.08(400) = 3.20/1.50
o = 2.14
 The real exchange rate
 *
RER = eP / P
 P = eP*
 Flexible SOE
o Perfect Capital Mobility
 Countries with high inflation have poor exchange rates because no one wants that
money
 Flexible exchange rates:
 Appreciation = e is going down, we pay less
 Depreciation = e is going up, we pay more for their currency
Chapter 16: International Finance

 They demand our currency because they demand our goods

 If you have a flexible exchange rate, you aren’t not insulated from real shocks only from
nominal shocks
 With fixed rate, you lose control of the money supply
 Inflation is imported from the rest of the world
 Williamson assumptions is that elasticity of our model, change in L/change in Y > change
in L/change in r
o The elasticity measure on the demand for money for the change in GDP is higher
than it is on interest rates
o GDP affects demand for money more than interest rates do
 Under fixed exchange rate, when a real shock hits the price level wont change
 Capital Control: Central bank says they won’t give people foreign currency that will leave
the country
 KA = capital account
 CA + KA = 0
  CA = - KA
 |These controls aren’t a great idea
o Only do it when they’ve been hit hard and have tons of inflation
o Bad for foreign investment cuz they cant take their money out
o Countries would use it temporarily when needed
 If a fixed rate with capital controls, you don’t lose as much money supply fighting the
change
 Assume capital mobility unless they say there are controls

Chapter 17

 Money in everyday life we use is Fiat

o Money that has value because it is decreed to by government
o Issued by monetary authority
o Backed by “faith of government”
 Our money supply is currency + bank deposits
 Commodity Money
o Actually using the commodity e.g. gold coins/bars
 Commodity-backed Money
o US dollar used to be gold backed
o $35 = 1 gold oz
o In theory/law, it was convertible to gold
o US printed a bunch of money but didn’t increase gold as well
o Nixon changed it
 Won’t get technical about M1 and M2
 Inflation is a monetary phenomenon
 Money in advance model
o Must decide how much cash to hold at beginning of period
 MIDTERM 2 STOP
 Will review on Tuesday
 Marginal Condition
o MRS I, C’ = Pw / P’
o MRS l, C = w / 1 + R
 The Friedman Rule
o Friedman says you gonna get nominal interest rate to zero to have economic
efficiency
o X = -r
Inflation and the Central Bank
Unemployment

 Q is labour force
 N is working age population
 N–Q
o Consumers who decide not to work
 k is the cost of posting a vacancy
 A = active firms
 Matching function
o M = em(Q,A)
 # of matches is a function of people who want to work, and number of
active firms
 e is the equivalent of z in the production function
 it is the efficiency with which matches can be made within the labour
market
o em(Q,A) / A
 Pc = em(1,A/Q)
 Pc = em(1,j)
 J = labour market tightness
 1 – Pc = 1 – em(1,j)
o Probability of being unemployed, while searching
 V(Q) = Pc w + (1 – Pc)b
o b are unemployment benefits
 V(Q) = em(1,j) w + [1- em(1,j)]b
o = b + em(1,j)(w – b)
 V(Q) is the supply curve of labour
 The probability that a girm with a vacancy finds a worker to fill the job is
o Pf = em(1/j, 1)
 Z – w is the profit for the firm
 K = em(1/j,1)(z-w)
o K is the cost of matching
o Basically MR = MC
 k/(z-w) = em(1/j , 1)
 Nash Bargaining
o W = az + (1 – a)b
o A = worker’s share of total surplus (bargaining power)
 Experiments
 1. Increase in UI benefit b
o
  2. Increase in productivity
 3. Decrease in matching efficiency

Endogenous Growth

 Solow model uses total factor productivity, labour force growth rate, saving rate
 Why are there barriers to technology/tfp?

Exam info:

 Please note Money Surprise model – Friedman Lucas Model and Segmented Markets
model are all the same operationally. They work because some sector of the economy
perceives money as having real effects and therefore output and employment rise –
albeit temporarily
 55 – 60 Q’s
 Chpt 12,13,14 = 12 – 14 q
 Cpt 15,16 = 8 – 10 q
 Cpt 17,18 = 14- 16q
 Chpt 6 = 9 – 11q
 Chpt 8 = 5 – 8q
