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Introduction
Module title: Macroeconomics II
FOREIGN TRADE UNIVERSITY
Department of Macroeconomics Semester: II
Year 2019-2020
Level: Undergraduate

Macroeconomics II Module Convenor: Hoang Xuan Binh

Hoang Xuan Binh (Assoc. Prof. PhD)
Office hours: 8.00 -12.00 on Monday
Room: A206- Faculty of Cyber Education and
Professional Development
Foreign Trade University (Hanoi Campus)
Tel: 844-32595158 ext 228
Cellphone: 0912782608
Email:binhhx@ftu.edu.vn

*Objectives

* Text books: CHAPTER I

N. Gregory Mankiw, Macro economics INTRODUCTION
Dornbusch R., FischerS., Startz R., (2001), Macroeconomics,
8thEdition
David Begg, Stanley Fischer, Rudiger Dornbusch, Economics
Macro economics II, National economics University

•Assessment:
Class Participation: 10%; Assignment: 30%; Final Open book exam: 60%.

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Lecture 5 : AD and fiscal policy

I. AD in simple economy
I. Revision: macro economics I II. AD in closed economy with Government
III. AD in open economy
IV. Fiscal policy
Lecture 1: The Data of Macroeconomics

Lecture 2: Economic growth

Lecture 6: Money and monetary policy
I. Money
Lecture 3 : Savings, Investment and Financial system II. Money supply .
III. Money demand
Lecture 4 : Aggregate Demand and Aggregate Supply Interest rate
Monetary policy

Lecture 7 : Unemployment

I. Definition Lecture 9: Macroeconomics in open economy

II. Natural unemployment I. Balance of payments
III. Cyclic unemployment II. Nominal exchange rate and real exchange rate
IV. Impacts of unemployment III. Foreign exchange market
Lecture 8: Inflation IV. Exchange rate regime
V. Role of exchange rate for economy
I. Definition
II. Theories of inflation
In short -run:
In long - run:
III. Impacts of inflation:
Costs of inflation
Relationship between inflation and unemployment

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II. Introduction

Chapter 1: Revision macroeconomics I and introduction to

macroeconomics II

Chapter 2: IS-LM model and AD in close economy

CHAPTER TWO
Chapter3: Mundell-Fleming Model and AD in open economy AGGREGATE DEMAND
Chapter 4: AS and Phillips curve IN CLOSE ECONOMY AND IS-LM
Chapter 5: Consumption MODEL
Chapter 6: Neoclassical theory of fixed investment for doing
business*
Chapter 7: Theory of Money demand*

Chapter 8: Economic growth model

Chapter 9: Macroeconomic policy debates

I. Goods market and IS curve

• Content:
1. The Keynesian cross model (5/6/1883-21/4/1946)
– Analysis AD based on IS-LM model-(developed by Sir J.
Hicks, oxford, UK,1904-1989, nobel price in 1972 with Kenneth * Some main points:
J. Arrow), and developing from 1930s to explain well-known theory,
- APE -aggregate planned expenditure- Aggregate demand differ from
which was written by Keynes General theory of employment, interest
quantity or income Y
and money”
• IS-LM model is contructed by balancing in both goods market and
money market. -Close economy with 3 sectors
House hold=> Consumption=> C
Firm => I
Government=> Expenditure=> G

APE = C + I + G
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APE = C ( Y –T) + I ( r) + G Question: G increases, how does Y change?
APE and Income is positive relationship G = 1000 $, MPC=0.75 => GDP increases ?
At equilibrium point : APE = Y Production increases 1000$ =>Income increases 1000$=> C increases G
C 0,75*1 000 $ => Y increase MPC*1000$
APE APE= Y
=MPC*G
APE<Y G + MPC*G = (1+MPC)*G = 1,75*1000 $ Cons..
APE >Y E MPC*(MPC*G)= MPC*MPC*G
APE  Y = (1+MPC+MPC2 +MPC3 +…..)*G
=>  Y = (1/1-MPC)*G
Þ Multiflier of Consuption m = Y/G=1/1-MPC
Þ  Y = 4*1000=4000$

45o
Y

0 Y1 Y0 Y2

APE 2. IS model
APE= Y

2.1.Definition:
relationship (r, Y) where APE=Y; I=S
APE= C + I + G2

2.2. Derivation of IS Curve

G
APE= C + I + G1

Y

45o

0 Y
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r
E2
APE2 *Slope of IS curve: downward sloping IS curve
E1 APE1
2.3. Related Factors to slope of IS
45o * ………… I and r:
0 Y
r

E’1
r1
*Multiflier of consuption:
r2 E’2
IS
0 Y1 Y2 Y

II. Money market and LM curve r Ms

1. The Theory of Liquidity preference

* Equilibrium point in money market:

M/P = L (i,Y)<=> Ms = Md A
r0
•Real Money demand and Y…….
•Real Money demand and I
•Nominal interest rate…. ? L=L(r,Y)

•Real money demand belongs to nominal money supply, which is

exogenous variable, controlled by Central Bank Central Bank Real Money quantity
0

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2. LM curve r r Ms=M/
LM P
2.1. Definition:
r2 r2
Relationship ( r ,Y) Real MS = Real MD

<=> L ( Md) = M ( Ms) L2=L2(Y2,r2)

r1 r1

2.2. Deviration of LM curve L1=L1(Y1,r1)

Y1 Y2 Y 0 M/
P

2.3. Slope of LM curve: r r M1/P M2/P

LM1
an upward sloping LM curve LM2
E1 r1
r1

2.4. Situation of LM:

r2 r2
MS1=> LM1
MS2=> LM2 L1=L1(Y1,r1)

Y2 Y1 Y 0 M/
P

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III. Equilibrium point in both Goods market and Money market IV. Fiscal policy and IS curve

* Fiscal policy: G or/and T changes =>IS shift to leftwards or

IS: Y = C(Y-T) + I(r) + G
rightwards
r LM: M/P= L (Y, r)
LM -Expansionary fiscal policy G increases or/and T decreases =>IS shifts to
rightwards
E*
r* -Contractionary fiscal policy G decrease or T increases=>IS shifts to
leftwards

IS

0 Y
Y*
r Crowding-out Domestic Investment Effect
LM V. Monetary policy and LM curve

* Monetary policy
r2 E2

E’1 -Expansionary Monetary policy: Ms increases => LM shifts to

E1
r1 rightwards

IS -Contractionary Monetary policy: Ms decreases => LM shifts to

2 leftwards
IS
1

0 Y1 Y2 Y’1 Y
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MS increases => r decreases=> I increases =>APE
increases => Y increases
r
LM1 VI. Coordinate Fiscal policy and Monetary policy
LM2
E1
r1
1.Fiscal policy or monetary policy?
r2 E2

r’1
E’1 IS

0 Y
Y1 Y2

*Expansionary fiscal policy

IS steeper, LM flatter
r r
*Expansionary monetary policy:
IS flatter, LM steeper
IS steeper, LM flatter IS flatter, LM steeper
r r
LM
LM2 LM1 LM2

LM LM1
r IS2 r
r r

IS1 IS
IS2 IS1 IS

0 Y Y 0 Y Y 0 Y 0 Y Y
Effective Ineffective ineffective Effective

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2.Coordination Fiscal policy and Monetary policy 2.2.Contractionary fiscal policy and monetary policy Y increase, r unchanged,
with overheating AD
2.1. Expansionary fiscal policy and monetary policy:
r
Curbing crowding-out domestic investment LM2
LM1
r LM1
E2 E2
r2 LM2
r1 E1
E1
r1 E’1
IS2 IS1
IS1 IS2 Y
0 Y2 Y1
0 Y

2.3.Contractionary fiscal pol and expansionary monetary pol: Y unchanged, r 2.4.Expansionary fiscal pol and contractionary monetary pol: apply for
decreases=> apply for increasing I and C due to r decreases but Y unchanged decreasing I and C , but Y unchanged

r LM1 r
E1 LM2
LM2 E2
r1 LM1
r1
r’1
r’1 E’1
r2 E2
r1 E1
IS1
IS2
IS2
Y IS1
0 Y’1 Y1 Y
0 Y1 Y’1
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I. Mundell-Fleming model

-The M-F model was developed in the early 1960s. Mundell’s contribution are
CHAPTER THREE collected in Robert A. Mundell, International economics (NY,
Aggregate Demand in Open economy Macmillan,1968)
and Mundell –Fleming Model
- Standard open macro economy model explains how do
GDP,BP,exchange rate, interest...interact?

- Based on IS-LM model but with international trade and international

capital flows

- Some constrains of this model for developing or trans economies

3 basics of macroeconomics: 1. IS curve in open economy

-AD (IS curve, LM curve )
Y = (C + I + G) + ( X-M)
-AS ( production function & labour market)
Y= C(Y-T) + I(r*) +G + NX(e)
-Balance of payments (current and capital account)
Absorption + Trade balance

-AD-AS model: Domestic demand + Foreign Demand

-Mundell-Fleming model: AD vµ BP
Note: A real depreciation in domestic currency increase X and decrease M => trade
balance improve

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2. LM curve in open economy 3. Balance of payments (BP)

*Assumptions: Single currency

- Constant price level BP= T (current acc.)+ K (capital acc.)

Mundell_Fleming r unchanged, e changable - The balance of payments situation will depend on the type of foreign exchange rate
adopted (Flexible or fixed)

Equilibrium point in the M-F Model

i

Massive capital inflow L

M
i* BP
i* BP
Massive capital outflow

Y IS
0
0 Y
Ye

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II.Mundell-Fleming Model under Floating Exchange Rates 2. Equilibrium point
- IS, LM, BP-All three curves will intersect
1. Assumptions
-G, Ms, Y*, i*, P =>exogenous
-Monetary authority does not intervene in the foreign exchange market
-Y, i, => endogenous L
M
- Perfect capital mobility

i* BP
-Exchange rate expectation is static (today’s = future)

-Foreign interest rate (i*) equals to domestic interest rate (i) (i=i*)
IS
-Same inflation, real exchange rate is equal to nominal exchange rate, and r =i 0
Ye Y

3. Expansionary fiscal policy

-X decreases & M increases => Trade balance …………..
-G increases=>IS shift ………………
-An increase in G will shift IS ……………….. Domestic demand increases through fiscal spending,
-Pressure on domestic interest rate i>i* trade balance is reduced by exactly the same amount. Y is
…………………
This puts an upward pressure on domestic interest
rate i. (i>i*)

- Massive capital flows ……………….. To sum up: Under the Floating exchange rate and perfect
mobility, fiscal policy is ……………………..
-Nominal and real exchange rate …………………….

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4.Expansionary Monetary Policy
i 2 LM - Money supply increases, causing a rightward shift in
……..curve
1
i1 -Downward pressure on domestic interest rate (i<i*).

B
i* P -Massive capital flows…………

-…………………… in nominal and real exchange rate

IS2
IS1
-Trade Balance…………..
0 Y0 Y1 Y

-Depreciation leads to an ………… in trade balances i LM1

2
(net exports) so that it matches the initial increase in MS.
1
LM2

- Net exports t¨ng =>IS shift to rightwards=>IS1=>IS2

B
=>Y1=>Y2 & i1=>i* i* P

* To sum up: Under a floating exchange rate and i1

perfect capital mobility, monetary policy is IS
IS1
……………… 2
0 Y0 Y1 Y2 Y
Trade policy?

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III. Mundell -Fleming model under fixed foreign exchange rates 1. Expansionary fiscal policy

- G increases, it pushes up IS curve rightwards

-Interest rate increases, attractive a massive

*MS is endogenous variable to control exchange rates
capital …………
-Domestic currency ……………………..

-To prevent an appreciate of the domestic

currency, the central bank must ……. the dollars)

-This causes Ms to ……., thus shifting the LM

curve rightwards.)

-I =>i* and Y1 => Y2

* Conclusion: Under the fixed exchange rate regime and

perfect capital mobility, fiscal policy is ……….!!! 2. Expansionary monetary policy

-An increase in Ms (through the purchase of bonds on the

i LM1 open market operation), LM shifts rightwards.)
1
2
LM2 -This will lead to massive capital ……..
i
B -Depreciation in domestic currency,Government prevents by …….
i* P
-LM shift …………. again. Total of monetary base remains
unchanged
IS1 IS
- i and Y is ……………..
2
0 Y0 Y2 Y
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*Conclusion:Under fixed exchange rate regime, monetary policy is …………….

i LM1 ***Trade policy???

2 LM2

1
B
i* P
i

IS1
0 Y0 Y1 Y

IV. Mundell-Fleming model in (e-Y) The small Open Economy (capital IS* : Y = C (Y-T) +I ( r *) + G + NX (e)
mobility)
LM*: M/P= L (r*,Y)
1.Assumptions: e LM*
- i =i* ( i = r due to domestic inflation = Foreign inflation

-er = en e E
- r - exogenous by inter. financial market and only one income level to let
Md=Ms => The vertical LM* vertical.
IS*
- e increases=> domestic currency appreciates =>X decreases and M
increases=>NX decreases=>AD decreases => Y decreases => rel. e and Y
0
is negative =>IS* Ye Y

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2. Mundell-Fleming model in (e-Y) the Small, Open eonomy under *Expansionary Monetary policy
Floating Exchange Rates
-Ms increases => e
LM1 LM2
LM1=>LM2
*Expansionary Fiscal policy
e LM* 1
- G increase (sell bond) - r decreases
e2
-Outflow capital
-r increases
-Domestic curr.Depr. e1
-Inflow capital e1 E1
E
-Domestic curr. app IS2 -NX increases e2
-Y1=>Y2 IS1
-Y unchanged IS1
0 0
Y1 Y Y1 Y2 Y
=>Monetary policy is very effective
=>Exp. Fiscal policy is ineffective

* Trade policy: 3.M-F model in (e-Y), The small open economy under fixed exchange rates

-Trade policy decreases M =>NX t¨ng=>IS shift => domestic

Under fixed exchange rate regime, Ms is endogenous, NHTW can’t control
currency =>appreciate=>e1=>e2 but Y unchanged Ms. e
LM1 LM2
=> ineffective * Exp. Fiscal policy:
e LM* - G increases=>IS1=>IS2 2
e2 -r increases=>inflow capital e2

e1 E2
e1 -Domestic curr. app E1
E
IS2 -Keep fixed ex.rate 1
IS2
=>buy $=>Ms t¨ng IS1
IS1 -LM1=>LM2:Y1=>Y2
0 0
Y1 Y =>Fiscal pol. is effective Y1 Y2 Y
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*Expansionary monetary policy * Trade policy

-Ms increases =>LM1=>LM2 Trade policy reduces M=>NX increases =>IS shift =>domes. curr appre.=>buy
$=>MS increases =>LM shift back=>Y unchanged
e
-r decreases=> outflowcapital LM1 LM2 e
LM1 LM2
1
-Domestic curr. Depre. 2
2 e2
-Keep fixed ex.rate
e1 E2
-Sell $=>Ms decreases E1 e1 E2
E1
e2 1
-LM2=>LM1: Y2=>Y1
IS1 IS2
IS1
0
Y1 Y2 0
=>Exp. Monetary pol. is ineffective Y1 Y2 Y

When we introduced the aggregate supply curve of chapter 9, we

established that aggregate supply behaves differently in the short run
than in the long run. In the long run, prices are flexible, and the
aggregate supply curve is vertical. When the aggregate supply curve is
CHAPTER FOUR vertical, shifts in the aggregate demand curve affect the price level, but
Aggregate Supply the output of the economy remains at its natural rate. By contrast, in
and Phillips curve the short run, prices are sticky, and the aggregate supply curve is not
vertical. In this case, shifts in aggregate demand do cause fluctuations
in output. In chapter 9, we took a simplified view of price stickiness
by drawing the short-run aggregate supply curve as a horizontal line,
representing the extreme situation in which all prices are fixed. So,
now we’ll refine our understanding of short-run aggregate supply.

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Let’s now examine three prominent models of aggregate supply, roughly

Y = Y + a (P-Pe) where a > 0
in the order of their development. In all the models, some market
Expected
imperfection causes the output of the economy to deviate from its
price level
classical benchmark. As a result, the short-run aggregate supply curve positive constant:
is upward sloping, rather than vertical, and shifts in the aggregate Output an indicator of
demand curve cause the level of output to deviate temporarily from Natural how much Actual price level
the natural rate. These temporary deviations represent the booms and rate of output output responds
busts of the business cycle. to unexpected
changes in the
Although each of the three models takes us down a different theoretical price level.
route, each route ends up in the same place. That final destination is a This equation states that output deviates from its natural rate when
short-run aggregate supply equation of the form… the price level deviates from the expected price level. The parameter
a indicates how much output responds to unexpected changes in the
price level, 1/a is the slope of the aggregate supply curve.

p p 2. Four models of aggregate supply in short-run

ASLR
ASSR

p1 + The Sticky-Wage Model

p1
+ The Worker –Misperception Model
p2 + The Imperfect- Information Model
p2
+ The Sticky-Price Model

0 Y* Y 0 Y2 Y1 Y

18

The sticky-wage model shows what a sticky nominal wage implies for
aggregate supply. To preview the model, consider what happens to the
amount of output produced when the price level rises:
1) When the nominal wage is stuck, a rise in the price level lowers the
real wage, making labor cheaper.
2) The lower real wage induces firms to hire more labor.
3) The additional labor hired produces more output.
This positive relationship between the price level and the amount of
output means the aggregate supply curve slopes upward during the time
when the nominal wage cannot adjust.
The workers and firms set the nominal wage W based on the target real
wage w and on their expectation of the price level Pe. The nominal wage
they set is:
W = w  Pe
Nominal Wage = Target Real Wage  Expected Price Level
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W/P = w  (Pe/P)
Real Wage=Target Real Wage (Expected Price Level/Actual Price Level)
This equation shows that the real wage deviates from its target if the
actual price level differs from the expected price level. When the actual
price level is greater than expected, the real wage is less than its target;
when the actual price level is less than expected, the real wage is greater
than its target.
The final assumption of the sticky-wage model is that employment is
determined by the quantity of labor that firms demand. In other words,
the bargain between the workers and the firms does not determine the
level of employment in advance; instead, the workers agree to provide
as much labor as the firms wish to buy at the predetermined wage. We
describe the firms’ hiring decisions by the labor demand function:
L = Ld (W/P),
which states that the lower the real wage, the more labor firms hire and
output is determined by the production function Y = F(L).

2.4.The Stricky –Price Model:

*Differences: Firms fixed price, some times prices are set by long-term contracts between
Income, Output, Y
real wage, W/P

firms and custumers. So Firms do not instantly adjust the price they charge in response to
Y = F(L) changes in demand

The firm’s desired price p depends on two macroeconomic variables:

L = Ld (W/P)
Labor, L Labor, L +The overall level of price: P increases=>firm’costs are higher=> firms need to increase
price
Price level, P

An increase in the price level, +T he level of aggregate income Y: Y increases=>Demand for firm’s products
Y=Y+a(P-Pe)
reduces the real wage for a given increases=>higher the firm’s desired price
nominal wage, which raises
employment and output and
income.
Firm’s desired price as : p = P + .(Y-Y)
Income, Output, Y
19

*Now assume that there are two types of firms
+Flexible prices, set prices according to this equation
p = Pe + a (Ye - Ye),
+Firms set fixed price according to this equation p=Pe
If s is fraction of firms with sticky prices and (1-s) the fraction of firms with
flexible prices, then
Overall price level is P=s.Pe + (1-s). [ P +a. (Y- Y)]
<=>P= s.Pe + (1-s).P +(1-s).a. (Y- Y)
=>P- (1-s).P = s.Pe + . (1-a). (Y- Y)
=>s.P = s. Pe +a. (1-s). (Y - Y)
Rearrangement puts this aggregate pricing equation in to more familiar form
Y= Y +.(P-Pe) ;  = s/[(1-s).a]
An upward sloping AS curve in short –run
IF s goes up and a goes down, AS is flatter, elasticity between Y and P
is high.
This model explains differences that Y is high which leads to P high. In
the past, P is high which leads to Y high. But both P,Y are endogenous
variables
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=>P= Pe + [a. (1-s)/s].(Y - Y)
*Conclusion:
-IF Y=Y =>P=Pe ( actual price level = expected price level) Firms with fixed price
set their prices at Pe, but Firms with flexible prices set their prices at actual price.
-AD high =>Y>Y=>actual price level (P) > expected price level (Pe).
When AD high, the demand for goods is high. Those firms with flexible prices set their
prices high, which leads to a high price level. The effect of output on the price level depends
on the proportion of firms with flexible prices. If proportion of firms with flexible prices is
high, Y won’t be higher than Ye. But firms with fixed prices will curb fluctuation of
prices
*Conclusions:
- Models 1,2 focus on labour market, Model 3,4 focus on goods market.
-Model 1,4 point out that fixed wages and prices keep supply and demand
balancing in the short- run.
-Model 2,3 emphasize that role of information for explaining fluctuation in
short-run. If Actual Price level is different from expected price level, Y can go
out of Ye
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inflation

II. Phillips curve:

1. Introduction: B

A
-2/1958: first paper of A.W.Phillips
Phillips curve

-1960 Samuelson & Robert Solow explained mentioned relationships 0 unemployment

with Phillips curve.

Phillips curve point out the rule as folows: inf lation increases which let
unemployment decreases, there fore, policy maker have to trade off between
inflation and unemployment.

SRAS (Pe=P2) Y = Y + a (P-Pe) The Phillips curve in its modern form states that the inflation rate
P LRAS* Start at point A; the economy is at full employment Y and the
depends on three forces:
SRAS (Pe=P0)actual price level is P0. Here the actual price level equals the
P2 B expected price level. Now let’s suppose we increase the price 1) Expected inflation
level to P1.
P1 A' 2) The deviation of unemployment from the natural rate, called
Since P (the actual price level) is now greater than Pe (the
P0 expected price level) Y will rise above the natural rate, and we cyclical unemployment
A
AD' slide along the SRAS (Pe=P0) curve to A' . 3) Supply shocks
Remember that our new SRAS (Pe=P0) curve is defined by the
AD presence of fixed expectations (in this case at P0). So in terms
of the SRAS equation, when P rises to P1, holding Pe constant These three forces are expressed in the following equation:
Y Y' Output
p = pe - b(m-mn) + n
at P0, Y must rise.

Y = Y + a (P-Pe)
The “long-run” will be defined when the expected price level equals the actual price level. So, as price level
expectations adjust, PeÞP2, we’ll end up on a new short-run aggregate supply curve, SRAS (Pe=P2) at point
B. Expected
Hooray! We made it back to LRAS, a situation characterized by perfect information where the actual price Inflation
level (now P2) equals the expected price level (also, P2).
In terms of the SRAS equation, we can see that as Pe catches up with P, that entire “expectations gap” Inflation b  Cyclical Supply
disappears and we end up on the long run aggregate supply curve at full employment where Y = Y.
Unemployment Shock
Y = Y + a (P-Pe)
21

The Phillips-curve equation and the short-run aggregate supply equation
represent essentially the same macroeconomic ideas. Both equations
show a link between real and nominal variables that causes the
classical dichotomy (the theoretical separation of real and nominal
variables) to break down in the short run.
The Phillips curve and the aggregate supply curve are two sides of the
same coin. The aggregate supply curve is more convenient when
studying output and the price level, whereas the Phillips curve
is more convenient when studying unemployment and inflation.
The second and third terms in the Phillips-curve equation show the two
forces that can change the rate of inflation. The second term, b(u-un),
shows that cyclical unemployment exerts downward pressure on inflation.
Low unemployment pulls the inflation rate up. This is called
demand-pull inflation because high aggregate demand is responsible for
this type of inflation. High unemployment pulls the inflation rate down.
The parameter b measures how responsive inflation is to cyclical
unemployment. The third term, n shows that inflation also rises and falls
because of supply shocks. An adverse supply shock, such as the rise in
world oil prices in the 70’s, implies a positive value of n and causes
inflation to rise.
This is called cost-push inflation because adverse supply shocks are
typically events that push up the costs of production. A beneficial
supply shock, such as the oil glut that led to a fall in oil prices in the
80’s, makes n negative and causes inflation to fall.
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To make the Phillips curve useful for analyzing the choices facing
policymakers, we need to say what determines expected inflation. A
simple often plausible assumption is that people form their expectations
of inflation based on recently observed inflation. This assumption is
called adaptive expectations. So, expected inflation pe equals last year’s
inflation p-1. In this case, we can write the Phillips curve as:
p = p-1 - b(m-mn) + n
which states that inflation depends on past inflation, cyclical
unemployment, and a supply shock. When the Phillips curve is written in
this form, it is sometimes called the Non-Accelerating Inflation Rate of
Unemployment, or NAIRU.
The term p-1 implies that inflation has inertia-- meaning that it keeps going
until something acts to stop it. In the model of AD/AS, inflation inertia
is interpreted as persistent upward shifts in both the aggregate supply
curve and aggregate demand curve. Because the position of the SRAS
will shift upwards overtime, it will continue to shift upward until
something changes inflation expectations.
In the short run, inflation and unemployment
are negatively related. At any point in time, a
p policymaker who controls aggregate demand
can choose a combination of inflation and
unemployment on this short-run Phillips
curve.
pe + n
un Unemployment, u
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Let’s start at point A, a point of price stability (=0%) and full employment (u=un).
Remember, each short-run Phillips curve is defined by the presence of fixed expectations. Rational expectations make the assumption that people optimally use all
Suppose there is an increase in the rate of growth of the money supply causing LM and AD to shift out the available information about current government policies, to forecast
resulting in an unexpected increase in inflation. The Phillips curve equation  = e – b(u-un) + v implies
that the change in inflation misperceptions causes unemployment to decline. So, the economy moves to a the future. According to this theory, a change in monetary or fiscal
point above full employment at point B. policy will change expectations, and an evaluation of any policy change
As long as this inflation misperception exists, the economy will
 LRPC (u=un) remain below its natural rate un at u'. must incorporate this effect on expectations. If people do form their
When the economic agents realize the new level of inflation, they expectations rationally, then inflation may have less inertia than it first
10% D E will end up on a new short-run Phillips curve where expected
appears.
inflation equals the new rate of inflation (5%) at point C, where
actual inflation (5%) equals expected inflation (5%). Proponents of rational expectations argue that the short-run Phillips
If the monetary authorities opt to obtain a lower u again, curve does not accurately represent the options that policymakers have
then they will increase the money supply such that  is
5% B C 10%, for example. The economy moves to point D, where available. They believe that if policy makers are credibly committed to
actual inflation is 10% but, e is 5%. reducing inflation, rational people will understand the commitment and
When expectations adjust, the lower their expectations of inflation. Inflation can then come down
economy will land on a new SRPC, at
A SRPC (e=10%) point E, where both  and e equal without a rise in unemployment and fall in output.
u' 10%.
un SRPC (e=5%)
Unemployment, u
SRPC (e=0%)

Our entire discussion has been based on the natural rate hypothesis.
The hypothesis is summarized in the following statement:

Fluctuations in aggregate demand affect output and employment only

in the short run. In the long run, the economy returns to the levels of CHAPTER FIVE
output,employment, and unemployment described by the classical model.
Consumption
Recently, some economists have challenged the natural-rate hypothesis
by suggesting that aggregate demand may affect output and employment
even in the long run. They have pointed out a number of mechanisms
through which recessions might leave permanent scars on the economy
by altering the natural rate of unemployment. Hyteresis is the term
used to describe the long-lasting influence of history on the natural
rate.

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The consumption function was central to Keynes’ theory of economic

fluctuations presented in The General Theory in 1936.
C
• Keynes conjectured that the marginal propensity to consume-- the
amount consumed out of an additional dollar of income-- is between
C = C + MPC. Y
cY
zero and one. He claimed that the fundamental law is that out of +
=C
every dollar of earned income, people will consume part of it and save C
the rest. consumption Marginal income
depends
• Keynes also proposed the average propensity to consume-- the ratio of spending by on Propensity to C
consumption to income-- falls as income rises. households consume (MPC)
Y
• Keynes also held that income is the primary determinant of Autonomous
consumption and that the interest rate does not have an important role. consumption The slope of the consumption function
is the MPC.

APC = C/Y = C/Y + MPC This consumption function

exhibits three properties that
Keynes conjectured. First, To understand the marginal propensity to
C consume (MPC) consider a shopping scenario. A
the marginal propensity to
consume c is between zero person who loves to shop probably has a large
and one. Second, the average MPC, let’s say (.99). This means that for every
APC1 propensity to consume falls extra dollar he or she earns after tax deductions,
C APC2 as income rises. Third,
11 consumption is determined by
he or she spends $.99 of it. The MPC measures
current income. the sensitivity of the change in one variable (C)
Y
with respect to a change in the other variable (Y).
As Y rises, C/Y falls, and so the average propensity to consume C/Y
falls. Notice that the interest rate is not included in this function.

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The failure of the secular-stagnation hypothesis and the findings of

Kuznets both indicated that the average propensity to consume is fairly
During World War II, on the basis of Keynes’ consumption function,
constant over time. This presented a puzzle: why did Keynes’
economists predicted that the economy would experience what they
conjectures hold up well in the studies of household data and in the
called secular stagnation-- a long depression of infinite duration--
studies of short time-series, but fail when long time series were
unless fiscal policy was used to stimulate aggregate demand. It turned out
examined?
that the end of the war did not throw the U.S. into another depression, but
it did suggest that Keynes’ conjecture that the average propensity to Long-run Studies of household data and short
consume would fall as income rose appeared not to hold. C consumption time-series found a relationship
function between consumption and income
Simon Kuznets constructed new aggregate data on consumption and (constant APC) similar to the one Keynes conjectured--
investment dating back to 1869 and whose work would later earn a Short-run this is called the short-run consumption
Nobel Prize. He discovered that the ratio of consumption to income was consumption function. But, studies using long time-
stable over time, despite large increases in income; again, Keynes’ function series found that the APC did not vary
conjecture was called into question. (falling APC) systematically with income--this
Y relationship is called the long-run
This brings us to the puzzle… consumption function.

Here is an interpretation of the consumer’s budget constraint:

The consumer’s budget constraint implies that if the interest
The economist Irving Fisher developed the model
rate is zero, the budget constraint shows that total
with which economists analyze how rational,
consumption in the two periods equals total income
forward-looking consumers make intertemporal
in the two periods. In the usual case in which the
choices-- that is, choices involving different periods
interest rate is greater than zero, future consumption and future income
of time. The model illuminates the constraints
are discounted by a factor of 1 + r. This discounting arises from the
consumers face, the preferences they have, and how
interest earned on savings. Because the consumer earns interest on
these constraints and preferences together determine
current income that is saved, future income is worth less than current
their choices about consumption and saving.
income. Also, because future consumption is paid for out of savings
that have earned interest, future consumption costs less than current
When consumers are deciding how much to consume
consumption. The factor 1/(1+r) is the price of second-period
today versus how much to consume
consumption measured in terms of first-period consumption; it is the
in the future, they face an intertemporal
amount of first-period consumption that the consumer must forgo to
budget constraint, which measures the total
obtain 1 unit of second-period consumption.
resources available for consumption today and in the
future.

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Here are the combinations of first-period and second-period consumption

the consumer can choose. If he chooses a point between A and B, he
The consumer’s preferences regarding consumption in the
consumes less than his income in the first period and saves the rest for
two periods can be represented by indifference curves. An
the second period. If he chooses between A and C, he consumes more that
indifference curve shows the combination of first-period and
his income in the first period and borrows to make up the difference.
second-period consumption that makes the consumer equally
happy. The slope at any point on the indifference curve
Consumer’s budget constraint
consumption

shows how much second-period consumption the consumer

B requires in order to be compensated for a 1-unit reduction in
Saving
Second-

Vertical intercept is first-period consumption. This slope is the marginal rate of

period

(1+r)Y1 + Y2 substitution between first-period consumption and second-

A Borrowing period consumption. It tells us the rate at which the
Y2 consumer is willing to substitute second-period consumption
Horizontal intercept is
C for first-period consumption.
Y1 + Y2/(1+r)
Y1
First-period consumption
consumption

consumption
Second-

Second-
period

period
Y Z
X IC2 IC3
W IC1 IC2
IC1
First-period consumption First-period consumption
Indifference curves represent the consumer’s preferences over first-
period and second-period consumption. An indifference curve gives the The consumer achieves his highest (or optimal) level of satisfaction
combinations of consumption in the two periods that make the consumer by choosing the point on the budget constraint that is on the highest
equally happy. Higher indifferences curves such as IC2 are preferred to indifference curve. At the optimum, the indifference curve is tangent
lower ones such as IC1. The consumer is equally happy at points W, X, to the budget constraint.
and Y, but prefers Z to all the others-- Point Z is on a higher indifference
curve and is therefore not equally preferred to W, X and Y.
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Economists decompose the impact of an increase in the real interest

rate on consumption into two effects: an income effect and a

consumption
substitution effect. The income effect is the change in consumption
Second- that results from the movement to a higher indifference curve. The
period
O
substitution effect is the change in consumption that results from the
IC2 change in the relative price of consumption in the two periods.
IC1
New budget An increase in the interest rate

consumption
First-period consumption rotates the budget constraint
constraint
An increase in either first-period income or second-period income around the point C, where C is

Second-
B

period
shifts the budget constraint outward. If consumption in period one and Old budget (Y1, Y2). The higher interest rate
consumption in period two are both normal goods-- those that are constraint reduces first period consumption
A
demanded more as income rises, this increase in income raises Y2 C IC2 (move to point A) and raises
consumption in both periods. IC1 second-period consumption
Y1 (move to point B).
First-period consumption

The inability to borrow prevents current consumption from exceeding

current income. A constraint on borrowing can therefore be expressed
as C1 < Y1.
This inequality states that consumption in period one must be less than
or equal to income in period one. This additional constraint on the
consumer is called a borrowing constraint, or sometimes, a liquidity
constraint.
The analysis of borrowing leads us to conclude that there are two
consumption functions. For some consumers, the borrowing
constraint is not binding, and consumption in both periods depends
on the present value of lifetime income. For other consumers, the
borrowing constraint binds. Hence, for those consumers who would
like to borrow but cannot, consumption depends only on current income.
In the 1950’s, Franco Modigliani, Ando and Brumberg used Fisher’s
model of consumer behavior to study the consumption function. One of
their goals was to study the consumption puzzle. According to Fisher’s
model, consumption depends on a person’s lifetime income.
Modigliani emphasized that income varies systematically over people’s
lives and that saving allows consumers to move income from those
times in life when income is high to those times when income is low.
This interpretation of consumer behavior formed the basis of his
life-cycle hypothesis.
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In 1957, Milton Friedman proposed the permanent-income hypothesis

to explain consumer behavior. Its essence is that current consumption is
proportional to permanent income. Friedman’s permanent-income
hypothesis complements Modigliani’s life-cycle hypothesis: both use CHAPTER SIX
Fisher’s theory of the consumer to argue that consumption should not
depend on current income alone. But unlike the life-cycle hypothesis,
INVESTMENT
which emphasizes that income follows a regular pattern over a person’s
lifetime, the permanent-income hypothesis emphasizes that people
experience random and temporary changes in their incomes from year
to year.

Friedman suggested that we view current income Y as the sum of two

components, permanent income YP and transitory income YT.

n why
In this chapter, we’ll explai • Business fixed investment includes the equipment and
lated to
investment is negatively re structures that businesses buy to use in production.
es the
the interest rate, what caus
and • Residential investment includes the new housing that
investment function to shift people buy to live in and that landlords buy to rent out.
ga
why investment rises durin
cession.
boom and falls during a re • Inventory investment includes those goods that businesses
put aside in storage, including materials and supplies, work
in progress, and finished goods.

28

The standard model of business fixed investment is called the
neoclassical model of investment. It examines the benefits and costs of
owning capital goods. Here are three variables that shift investment:
1) the marginal product of capital
2) the interest rate
3) tax rules
To develop the model, imagine that there are two kinds of
firms: production firms that produce goods and services
using the capital that they rent and rental firms that make
all the investments in the economy.
The marginal product of capital for the Cobb-Douglas production
function is MPK = aA(L/K)1-a. Because the real rental price equals
the marginal product of capital in equilibrium,
we can write R/P = aA(L/K)1-a . This expression identifies the
variables that determine the real rental price. It shows the
following:
• the lower the stock of capital, the higher the real rental price of
capital
• the greater the amount of labor employed, the higher the real
rental price of capitals
• the better the technology, the higher the real rental price of capital.
Events that reduce the capital stock, or raise employment, or
improve
the technology, raise the equilibrium real rental price of capital.
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To see what variables influence the equilibrium rental price, let’s
consider the Cobb-Douglas production function as a good approximation
of how the actual economy turns capital and labor into goods and
services. The Cobb-Douglas production function is: Y = AKaL1-a ,
where Y is output, K capital, L labor, and a a parameter measuring the
level of technology, and a a parameter between 0 and 1 that measures
capital’s share of output. The real rental price of capital adjusts to
equilibrate the demand for capital and the fixed supply.
Capital supply
Real rental
price, R/P
Capital demand (MPK)
K Capital stock, K
Let’s consider the benefit and cost of owning capital.
For each period of time that a firm rents out a unit of capital, the rental
firm bears three costs:
1) Interest on their loans, which equals the purchase price of a unit of
capital PK times the interest rate, i, so i PK.
2) The cost of the loss or gain on the price of capital denoted as -DPK .
3) Depreciation d defined as the fraction of value lost per period
because of the wear and tear, so d PK .
Therefore the total cost of capital = i PK - DPK + dPK or
= PK (i - D PK/ PK + d)
Finally, we want to express the cost of capital relative to other goods in
the economy. The real cost of capital-- the cost of buying and renting
out a unit of capital measured in terms of the economy’s output is:
The Real Cost of Capital = (PK / P )(r + d), where r is the real interest
rate and PK / P equals the relative price of capital. To derive this equation,
we assume that the rate of increase of the price of goods in general is
equal to the rate of inflation.
29

Now consider a rental firm’s decision about whether to increase or
decrease its capital stock. For each unit of capital, the firm earns real
revenue R/P and bears the real cost (PK / P )(r + d).
The real profit per unit of capital is
Profit rate = Revenue - Cost
= R/P - (PK / P )(r + d).
Because the real rental price equals the marginal product of capital, we
can write the profit rate as
Profit rate = MPK - (PK / P )(r + d).
The change in the capital stock, called net investment depends on the
difference between the MPK and the cost of capital. If the MPK exceeds
the cost of capital, firms will add to their capital stock. If the MPK
falls short of the cost of capital, they let their capital stock shrink, thus:
DK = In [MPK - (PK / P )(r + d)],
where In ( ) is the function showing how much net investment responds
to the incentive to invest.
Notice that business fixed investment increases when the interest rate
falls-- hence the downward slope of the investment function. Also,
an outward shift in the investment function may be a result of an
increase in the marginal product of capital.
Real interest
rate, r
Investment, I
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We can now derive the investment function in the neoclassical model of
investment. Total spending on business fixed investment is the sum of
net investment and the replacement of depreciated capital.
The investment function is:
I = In [MPK - (PK / P )(r + d)] + dK.
the cost of capital
depends on amount of depreciation
investment marginal product of capital
This model shows why investment depends on the real
interest rate. A decrease in the real interest rate lowers the
cost of capital.
Finally, we consider what happens as this adjustment of the capital
stock continues over time. If the marginal product begins above the
cost of capital, the capital stock will rise and the marginal product will
fall. If the marginal product of capital begins below the cost of capital,
the capital stock will fall and the marginal product will rise.
Eventually, as the capital stock adjusts, the MPK approaches the cost
of capital. When the capital stock reaches a steady state level,
we can write:
MPK = (PK / P )(r + d).
Thus, in the long run, the MPK equals the real cost of capital. The
speed of adjustment toward the steady state depends on how quickly
firms adjust their capital stock, which in turn depends on how costly
it is to build, deliver and install new capital.
30

The term stock refers to the shares in the ownership of corporations, and
the stock market is the market in which these shares are traded.
The Nobel-Prize-winning economist James Tobin proposed that firms
base their investment decisions on the following ratio, which is now
called Tobin’s q:
q = Market Value of Installed Capital
Replacement Cost of Installed Capital
1) Higher interest rates increase the cost of capital and reduce business
fixed investment.
2) Improvements in technology and tax policies such as the corporate
income tax and investment tax credit shift the business fixed
investment function.
3) During booms higher employment increases the MPK and therefore,
increases business fixed investment.
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The numerator of Tobin’s q is the value of the
economy’s capital as determined by the stock
market. The denominator is the price of capital as if
it were purchased today. Tobin conveyed that net
investment should depend on whether q is greater
or less than 1. If q >1, then firms can raise the value
of their stock by increasing capital, and if q < 1, the
stock market values capital at less than its
replacement cost and thus, firms will not replace
their capital stock as it wears out. Tobin’s q
measures the expected future profitability as
well as the current profitability.
We will now consider the determinants of
residential investment by looking at a simple
model of the housing market. Residential
investment includes the purchase of new
housing both by people who plan to live in
it themselves and by landlords who plan to rent
it to others.
There are two parts to the model:
1) the market for the existing stock of houses determines the
equilibrium housing price
2) the housing price determines the flow of residential
investment.
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The relative price of housing adjusts to equilibrate supply and demand When the demand for housing shifts, the equilibrium price of housing
for the existing stock of housing capital. The relative price then changes, and this change in turn affects residential investment.
determines residential investment, the flow of new housing that An increase in housing demand, perhaps due to a fall in the interest
construction firms build. rate, raises housing prices and residential investment.

PH/P PH/P
of housing PH/P

of housing PH/P
Relative Price

Relative Price
Demand'
Demand Demand
Stock of housing capital, KH Flow of residential investment, IH Stock of housing capital, KH Flow of residential investment, IH

32

When sales are high, the firm produces less that it sells
and it takes the goods out of inventory. This is called
production smoothing. Holding inventory may allow
firms to operate more efficiently. Thus, we can view
inventories as a factor of production. Also, firms don’t
want to run out of goods when sales are unexpectedly
high. This is called stock-out avoidance. Lastly, if a
product is only partially completed, the components are
still counted in inventory, and are called, work in
process.
The accelerator model predicts that inventory investment is
proportional to the change in output.
• When output rises, firms want to hold a larger stock of
inventory, so inventory investment is high.
• When output falls, firms want to hold a smaller stock of
inventory, so they allow their inventory to run down, and
inventory investment is negative.
The model says that inventory investment depends on whether
the economy is speeding up or slowing down.
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The accelerator model assumes that firms hold a stock of
inventories that is proportional to the firm’s level of output. Thus, if
N is the economy’s stock of inventories and Y is output, then
N=bY
where b is a parameter reflecting how much inventory firms wish to
hold as a proportion of output. Inventory investment I is the change in
the stock of inventories DN. Therefore, I = DN = b DY.
Like other components of investment, inventory investment
depends on the real interest rate. When a firm holds a good in
inventory and sells it tomorrow rather than selling it today, it
gives up the interest it could have earned between today and
tomorrow. Thus, the real interest rate measures the opportunity
cost of holding inventories.
When the interest rate rises, holding inventories becomes more
costly, so rational firms try to reduce their stock. Therefore, an
increase in the real interest rate depresses inventory investment.
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CHAPTER SEVEN
Economic Growth

-Harrod – Domar Model: based on Keynesian theory: Capital

1.Sources of economic growth accumulation

+ Human capital
-Neo-classical Model: Solow-Swan Model – exogenous economic
+Capital accumulation
growth model. Capital accumulation => short-run economic growth but
+Natural resource techonological knowledge leads to long-run economic growth.
+Technological knowledge
2. Theories of economic growth
-Endogenous growth model, F. Romer-Lucas in 1980s.
-Classical theory: AdamSmith & Mathus: Land

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1. Assumptions
The Solow Growth Model is designed to show how
growth in the capital stock, growth in the labor force, *Production
and advances in technology interact in an economy, and
how they affect a nation’s total output of -Single goods: - Y or GDP of economy
goods and services.

Let’s now examine how the

-Constant return to technology in production. There are only two inputs, K
model treats the accumulation
of capital. and L in production

-Production function Cobb-Douglas: (diminishing returns to K and L): -Population and labour supply: constant population, population is equal to
Y = A. Ka . L1-a ; (0 <a<1); labour force (Assu.).

-Factors of production : production with only two inputs: K and L -No technological progress: relax later

+MPk, MPl: K and L have been calculated by MPk and MPl,

(simplify MPk - r, MPl - wage)
*Market structure
-Perfect competition):

+Diminishing returns to capital and labour -Normal profit (zero profit): Firms have normal profit. Output will belongs
to owner of capital (i) & L (w).

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2. Solow Model
2.1. Capital accumulation
-Solow Model explains economic growth through capital accumulation by two
relationships as follows:

+Per capita capital & capita output

+Accumulation & output

a 1- a Y AK a L1-a
Y  AK L Þ  Þ y  Ak a
L L
=>per capita production function

Let’s analyze the supply and demand for goods, and

see how much output is produced at any given time
and how this output is allocated among alternative uses.

The Production Function This assumption lets us analyze all quantities relative to the size of
the labor force. Set z = 1/L.
The production function represents the Y/ L = F ( K / L , 1 )
transformation of inputs (labor (L), capital (K),
production technology) into outputs (final goods the amount of
Output is some function of
and services for a certain time period). capital per worker
Per worker
The algebraic representation is: Constant returns to scale imply that the size of the economy as
zY = F (zK ,zL ) measured by the number of workers does not affect the relationship
between output per worker and capital per worker. So, from now on,
let’s denote all quantities in per worker terms in lower case letters.
Income is some function of our given inputs
Here is our production function: y = f ( k ) , where f(k)=F(k,1).
Key Assumption: The Production Function has constant returns to scale.
36
 10/28/2021
y=A3k1
*Source of growth yt yt

-Increases in Capital per Worker: => increases sources of production but y=Aka y3 y=A2k1a
(A2>A1)
diminishing returns to capital=>addition to Y is diminishing (Grapth a) y2 y2
y=A1k1a
y1
y1

-Improvement in the state of technology: more per-capita output can be

produced for any given level of capital per worker, (APF shift, Grapth b)
k1 k2 kt k1 kt

Grapth a Grapth b

*The Relation Between Output and Capital Accumulation): Based on relationship -Private Savings Proportional to Income:
between I and Y, then I and capital accumulation. S = s. Y ( 0 <s<1)

-Equilibrium Investment Spending at time t :

- Relationship between I and Y: 3 assumptions
It = St = s.Yt
+ Closed economy: no International trade

+Private Savings = Public Savings =>I = S + (T-G)

-Per-Capita Investment and the Savings Curve:
+No Government sector: (T-G)=0 <=> I = S (I = private savings)
It Y a
 s t  sAk t
L L

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 10/28/2021

Savings *Relationship between I and capital accumulation:

y=Aka
-Capital stock and capital flows
s1Aka (s1>s)
-Capital depreciation: d, 0 < d < 1
sAka
=>Capital depreciation in one year d.Kt

=>Capital depreciation per worker: d.Kt/L = d.kt

H×nh c kt

-Depreciation curve: *Capital accumulation:

K t1  K t  I t - dK t

dk It = s.Yt; yt = A.kt
d1k (d1>d)
dk K K Y K
Kt1 Kt sYt -dKt Þ t1  t s t -d t Þkt1 kt syt -dkt
L L L L
a
k t  1  k t  sAk t - dkt
kt
0

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1 a
-The Equilibrium in the Solow Model: the Dynamics of Capital *a  sA  1-a * a  sA  1-a
sAkt  dkt Þ sAk
a
- dk  0 Þ k   
* *
y  Ak *  A  
d  d 

yt
a
Dkt 1  kt 1 - kt  sAkt - dkt y=Aka
changein capital investmentin yeart depreciation in year t
from year t toyear t1 dk
sAka
-Steady-State Capital and Output: capital and output per capital are
constant at steady state. At that point, investment is equal to depreciation:
sAk0a
Growth in per capita
dk 0 capital stock
sA k ta - d k t  0 Þ sAk ta  dk
t k0 k1 k* kt
investment depreciati on
steady state
capital stock

2. The role of savings for economic growth: -S increases =>sAka shifts =>I increases =>k and y increases at
new steady state
I, D
d.k
-Solow concluded that S plays an important role in level of k and y at
s2Aka steady state but economic gorwth still face with steady state, S =>short
run growth.
s1Aka
3. The role of population for economic growth

-Population rate: n, fluctuation of capital at t as follows:

Dkt+1 = s.A.kat -d.kt - n.kt = 0

k <=> s.A.kat = (n+ d).kt
0 k1* k2*
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 10/28/2021
(n2+d).k (n1+d).k 4. Conclusions
I,D
-Exogenous Long-Run Growth Rate: capital acc with diminishing
y=Aka returns to cap. Acc => short run growth.
s1Aka
-Long run growth is exogenous, which doesn’t depend on economic variable
such as savings rate. Thus Government cant intervene in long-run economic
growth.

-Growth doesn’t depend on s, thus policy aim at increasing the saving rate
=>short run growth

0 k -Convergence and speed of growth

k2* k1*

5.Augmented Solow model -State of technological progress: T helps Y increase at initial capital level:
-Basic Solow Model point out that long-run economic growth is exogenous
Techonology (manna from heaven), however, tuy nhiªn augmented Solow
model explain that T makes productivity changeable
-Production function Y = f(K,AL) = Ka.(A.L)1- a

+Constant return to scale

-Dimensions of Technology progress:
+Diminishing return to K and L
+larger quantities of output for given quantities of capital and labour
+AL: effective labour
+better products, new products
+A: technological progress
+larger variety of products
-Assumption; technological progress increases at gA gA=DA/A

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*The Equilibrium in the Augmented Solow Model:the Dynamics of Capital
Y Ka ( AL)1-a Y K
a
Y  K ( AL) 1-a
Þ   yˆ  kˆa yˆ  andkˆ 
AL AL AL AL
*Relationship between I and K: kˆ t  1 - kˆ t  s kˆ ta - dˆk t - g A kˆ t
change in capital investment in year t depreciati on in year t increase in efficiency
from year t to year t  1

- Investment = Private Savings : I= S = s.Y (0<s<1)

* Steady-State Capital and Output:
-Depreciation rate d vµ 0< d <1

-Capital accumulation: skˆta -dkˆt - g Akˆt  0 Þ skˆta  dkˆt  g Akˆt

investment depreciati
on increasedproductivi
ty
Kt1  Kt  It -dKt - gAKt  Kt  sYt -dKt - gAKt 1 a
*a  s 1-a  s  1-a
skˆta dkˆt  gAkˆt Þskˆ -dkˆ* - gAkˆ*  0 Þk*  
a
 yˆ *  kˆ*   
K t 1 K sY dK t g A K t d  gA  d  g A 
 t  t - - Þ kˆt 1  kˆt  skˆta - dkˆt - g A kˆt
At L At L At L At L At L

*Note: population increases at fixed rate gL=n, increasing rate of T is

*Conclusions: gA, and depreciation rate is d, we have:

-gA have impacts on short-run and long- run economic growth rate. At
steady state, we have: kˆt 1  kˆt  s kˆta - d kˆt - n kˆt
+Output and capital per effective worker are constant
+Output and capital per effective worker increases at gA level kˆt 1 - kˆt  skˆta - dkˆt - gAkˆt - nkˆt  0
+Output and capital increases at gA level
1
 s  1 - a
kˆ *
  
 d  g A  n 

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Summary of impacts of population and technological progress

6. The policies to promote economic growth

*Improving savings rate:

Po. =0 L=0 K k=K/ Y/L
Y const const - S increases => C decreases =>choose reasonable S and C for now and
const. L const future
L K Y
D/ increases : increases:
k=K/ increases
Y/L
L const Const
s=n n n :n
-S and C is trading off between short- run and long –run benefits.
D/s=n L increases:n K k=K/AL -
Y increases:
Y/L
increases n n +g
T=g AL increases n+g +g const increases: g

-S=private +public savings: S public increases => decreases budget deficit.

IF G increases=>S decreases and happen - crowding out private
investment=> k level is low.

*Investment: 3 types of investment

+Fixed investment CHAPTER EIGHT
MACROEconomIC policy DEBATES
+Fixed investment supplied by Government
+Human capital
Note: Infrastructure and human capital spur economics growth.

*Improving technological progress:

-No tax for R&D, suppor for basic research,copy right, know-how,
patent…
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I. Should Policy Be Active or Passive?: *Lags in the Implementation and Effects of policies
* Stabilization policy’s views
-Keynes=>P and w=> fixed=>G have more room to intervene in economy
-Classical views: Flexible price and wage => Allocation all resources effectively=>
but some economists of New Keynes wonder about lag of policies.
no need stabilization policy

-Lags come from:

-AD-AS model=>AD changes to keep economy stable, but many economists
didn’t support for this view.
+Time lags for Forcasting and issuing policies:inside lags
+ Time lags from issuing policies to implement policies effectively=>outside lags
=>In order to issue good stabilization policy, economists have better information of
=>Lags can reduce effectiveness of policies
shocks than other individuals in economy.

-Lags make forcating of econmists become difficult =>using econometric model

only forecasts key economic variables but exogenous hard influence seems hard II.Should Policy Be conducted by Rule or by Discretion?
to forcast.

-Flexible policies help economists react freely fluctuations of economy.

*R.Lucas Critique
-Econometric model or classical model is less effective.
-Policies, which are conducted by Rule, is total of engagement of reaction of
-Focus on private expectation Government

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* Why should policy be conducted by Rule: II.Rules for Fiscal Policy and Monetary Policy:

-Distrust of Policymarkers and the Political Process 1. Rules for Fiscal Policy

+ineffective policies due to lack of information -No budget deficit

-Budget deficit can derive from stabilization tools
+Economic policies derives from advantages of polictics,
+Recession=> T decreases=>all types of tax reduce=>spur AD. Government
spending on social problems increases=> G increases=>AD increases
-The time inconsistency of Discreationary Policy:

2. Rules for Monetary Policy:

+Budget deficit or budget surplus let Government adjust taxrate=>G face
with budgetdeficit in recession with low level of Y or in War time -Rule 1: Friedman “Stable money supply”

+Budget deficit can be used to transfer tax from now to future.

-Rule 2: set nominal GDP targeting
+IF GDPn < Objective =>Central Bank increases Money supply to
spur AD
+Good point: let monetary policy adjust according to fluctuations of money
supply.

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-Rule 3: Price targeting.

Central Bank set price targeting. If real price is different from price
targeting, Ms will be adjusted to achieve at that price. T his rule is
reasonable when price is considered as objective of monetary policy.

The end!

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