DEC P5

Alle betekenissen
E= labour efficiency
g= grow rate of labour efficiency
n= toename van de labour force
L= Labour force
e=number of employed
u= number of unemployed
HC 1 explaining income inequality lecture kijken
Real return to capital= r/p
 Let κ denote the capital income share:
K r^
κ=
Y
where is capital stock, is real GDP, and is the real return to capital (r^ = r/p).
K Y r
^

Classical model with the assumption of flexible factor prices and good prices; it applies to the
medium and long run
 Production then equals production capacity:

Y =F ( K , L )
¿ K= K̄ Ȳ
¿ L= L̄ }
 In the medium run, labour L and capital K are fixed; they may change in the long run
 Also technology F is fixed in the medium run, but may change over time

 Cobb-Douglas function:
α β
Y =K L with α , β >0.

 Competitive firms maximizes profits. Profit is given by

Profit ¿ pF( K , L)−wL−rK
 The marginal product of labour is
∂F
MPL ¿ F ( K , L+ 1 )−F( K , L) or
∂L
and that of capital is
∂F
MPK ¿ F ( K +1 , L )−F( K , L) or
∂K
MPL decreases if L increases; MPK decreases if K increases ( factor demand curves are
declining

 Hiring an additional worker implies

∆profit = (p x MPL) – w
 Renting an additional unit of capital implies
∆profit = (p x MPK) – r
 Hence, profits are maximized when L and K are such that MPL = w/p and MPK
= r/p (= r^ )
 It follows that real income Y consists of
Lw
 labour income Y L= =L ∙ MPL
p
 Kr
 capital income Y K = =K ∙ MPK
p
 profit income Y −Y L −Y K
MPL = w/p
MPK = r/p (= r^ )
 Now, a theorem by Euler implies that if F has constant returns to
scale, then it must hold
F ( K , L )=K·MPK + L·MPL
Therefore, profit income Y −Y L −Y K =0

Bij een constant returns to scales productiefunctie is de winst 0.

De Cobb-Douglas productiefunctie is dus eigenlijk een heel beperkte

productiefunctie, met die σ =1.

 Combining the two results on the previous slide, we then find for the
change in the capital income share:
Δκ
=z ( r^ −g )
κ
Dat Δκ /κ=z ( r^ −g) geldt, mag je gewoon aannemen.
We vinden dus dat nu het kapitaal aandeel niet constant is, maar afhangt van de capital-
output ratio K/Y.
Dus zo vinden we Piketty’s resultaat dat het kapitaal aandeel groeit omdat r^ > g . (Herinner
σ −1
dat we hadden z= )
σ

A frequently used measure of income inequality is the Gini coefficient:

 rank households from lowest to highest income
 first calculate the fraction of total income earned by the poorest 1% of
households
 then calculate the fraction of total income earned by the 2% poorest
of households
 and so on, through 100%
graphing these data yields the Lorenz curve
Gini = A/(A+B)
t h e areabetween Lorenz curve∧line of perfect equality
Gini=
t h e areaunder t h e line of perfect equality

Kuznet curve: as a country develops, inequality will first rise then later fall.

Factoren income inequality

- different human capital (education and health)
- physical capital
- location
- skills
inequality arises
 people differ in economic characteristics
 different characteristics are rewarded with different levels of income

Economic mobility can be studied using a transition matrix, see next slide
 It shows the probability that an individual will move from one class to another
 Immobility is large, if the probabilities on the diagonal are large

 Promoting mobility supports economic growth:

 it improves the allocation of talented people over jobs
 it reduces social struggles about redistributing income
 Policy: improve access to education, improve democratic institutions that can
counter powerful interest groups, marry a poor guy or woman.
HC2

Labor force= number of employed + number of unemployed

Unemployment rate = (number of employed/labor force) x 100%
Labor force participation rate= (labor force/adult population) x 100%

Two types of unemployment:

 Short-run unemployment or cyclical unemployment; cf. the Keynesian model
 Long-run unemployment or natural unemployment; cf. the Classical model
Natural unemployment has two components:
 Frictional unemployment
 Structural unemployment

Constante niveau van werkeloosheid= statisch evenwicht

Voortdurende in en uitstroom= stationair evenwicht

Model 1: labour force is fixed

L= Labour force
E=number of employed
U= number of unemployed
L=E+U
Unemployment rate = U/L
This model keeps L fixed

s= how many employed people lose their job each month

f= how many unemployed people find a job each month
Change of unemploymend each month:
U= sE-fU

Steady state= unemployment rate (U/L)stays constant. Because L is fixed, this requires that
the number of unemployed stays constant.
 the steady-state unemployment rate follows as
U/L = s/(s + f)
It increases if s rises or f falls.
S= 3% -> 0.03
F= 40%-> 0.4
0.03/(0.03/0.4) x 100 = 6.97-> 7% steady state rate of unemployment
Model 2 changing labour force
B= how many people enter the labour force as new participants each month( birth rate)
R= how many people retire each month, and leave the work force ( rate of retirement)
Then the change of the labour force is:
L=bL-rL
 A steady state is a situation where the unemployment rate (U/L) stays constant.
Because L may change, this requires:
∆U/U = ∆L/L
 Now, we already know that
∆L/L = b – r,
what is ∆U/U ?

steady state rate of unemployment:

U/L= (b+s)/(b+s+f)
It increases if b rises, if b=o model 1 results holds (because labour force is fixed>
Retirement rate r spelt geen ril omdat wordt aangenomen dat werkelozen en werkenden op
hetzelfde moment met pensioen gaan.

In practice the natural rate of unemployment is always positive

Because quickly finding a job is difficult:
- Workers differ in skills while jobs differ in requirements -> it takes search time to
match workers and jobs
- Real wage rigidity -> too few jobs
Loonrigiditeit is een economische term die aangeeft dat lonen zich niet flexibel
aanpassen aan veranderende economische situaties. 

Frictional unemployment = the time it takes to match workers and jobs

Policies may reduce frictional employment

- Employment agencies (increase f)
- Retraining programs (increase f)
- Werkloosheidsuitkeringen aan de ene kant maken het zoeken naar een baan minder urgent,
aan de andere kant helpen iemand om een passende baan te vinden en dus beperken
toekomstig verloop.

Structural unemployment= the unemployment caused by downward real wage rigidity

Causes for too high real wages

 - Minimum- wages laws
- Monopoly power of labour unions
- Efficiency wages

In macroeconomics, rigidities are real prices and wages that fail to adjust to the level
indicated by equilibrium or if something holds one price or wage fixed to a relative value of
another.

Impact of minimum wages

 Because most workers earn more than minimum wages, they may apply only to
unskilled workers and those with little job experience.
 Minimum wage laws therefore seem to have the greatest impact on
unemployment of the youth.
 It follows that there seems to be an uncomfortable trade-off between youth
unemployment and youth wages – politics has to decide…
 Side effect: minimum wages could push up the salary structure

Wages are often the result of collective bargaining between employer (or employer
association) and employees
The bargaining process could lead to a too high wage, causing structural unemployment.
Als de lonen hoger zijn nemen de bedrijven minder mensen aan waardoor er meer
werkeloosheid ontstaat omdat er minder banen zijn.

The efficiency wage argument:

 The productivity of workers depends positively on the wage paid.
 Then firms weigh the costs of paying higher wages against the gain of having better
worker performance
 The optimal wage is called the efficiency wage
This wage may well be above the market-clearing level, thus causing unemployment

Stel bijvoorbeeld dat de efficiency van een werker E afhangt van loon w volgens E(w). Dus de
productiefunctie ziet er bijv. uit als f(K,EL) met E=E(w)

Why do higher wages promote better performance?

 It may improve the nutrition of workers (e.g. in LDCs)
 It may reduce labour turnover (quits to other jobs)
 It may attract a higher quality of workers
 It may improve worker morale, inducing a higher work effort

Therefore, a key aspect of unemployment is the duration of unemployment:

 Is unemployment short-term for the jobless, or long-term?
 Short-term unemployment cannot be avoided – there is always some frictional
unemployment.
 Long-term unemployment tends to arise from real wage rigidity – it is probably
structural unemployment.
Therefore, public policy aimed at reducing the natural rate of unemployment should focus
on the long-term unemployed.
Unemployment variates across demographic groups:
- Age
- Gender
- Immigrant groups
- Regional disparities
Discouraged workers: giving up looking for a job or do not enter the labour force. They are
not unemployed, but they actually they are.
HC3

Short run
- Prices and factor prices (wages, rents) are sticky
- The labour force L and the stock of capital K are constant
- The production technology is given
Keynesiaanse model
Medium/long run
- Factor prices (wages, rents) are flexible
Klassieke model

Very long run

- Prices and factor prices are flexible
- The labour force L and the stock of capital K may change
- The production technology may change

Two factors of long-run economic growth:

- Accumulation of inputs needed for production
- Higher productivity which these inputs are used
Productivity can increase because of better
- Technology
- Efficiency

Solow model
Klassiek model voor in de long run.
- Labour force and technology are fixed
- L grows at a certain rate

Supply side
Aggregate production is given by a constant returns to scale production function:
Y=F(K,L)
 L is fixed (and also F), so Y can only change because of K

 Because of CRS, multiplying the inputs with 1/L yields

Y/L = F(K/L,1)
 Writing y = Y/L (labour productivity or output per worker) and k = K/L (capital per
worker) and F(k,1) = f(k), we have
  y=f (k)

MPK =f ( k +1)−f (k ) = f ' ( k )

Demand side
Er is maar 1 goed, het goed dat hier wordt geproduceerd, wordt of geconsumeerd door
huishoudens of geïnvesteerd.

National income: Y=C+I

 Or in per-worker terms (c = C/L and i = I/L):
y=c+i

households have a fixed consumption:

c = (1 - s)y

combining supply and demand

i = sf(k)
 Investment means expenditure on machines and equipment  it increases K
 Depreciation means the wearing out of old machines and equipment due to
production  it decreases K

From now on it is assumed that a fixed fraction δ of the existing capital stock K
depreciates every year

 When is there a steady state, or a state of rest? If the amount of capital per worker
stays constant over time, i.e., if
Δk = 0
 Hence, a steady state occurs if k is such that it solves

Let k = k* denote the solution of this equation; k* is called the steady-state level of capital
per worker. Capital tends to go to a steady state k= stays constant

Some important properties of this steady state (or long-run equilibrium):

 In a steady state, investment is just sufficient to replace old capital (net-investment is
zero)  K stays constant
 Whatever the initial level of capital per worker k, over time a steady state is reached
where k = k*.
 In a steady state, income per worker is constant and equal to y = f(k*) and
consumption per worker c = (1 – s) f(k*).
  Economic growth therefore is only temporary.
Zulke tijdelijke groei wordt ook wel ‘catching up growth’ genoemd

Calculate the steady state of capital k* for the following Cobb-Douglas function:
Y = K1/3L2/3
if the depreciation rate is 5 percent and the savings rate 40 percent
The higher s, the higher k* and therefore the higher steady-state income f(k*).

Hence, the model predicts that in the long run, countries with higher savings rates have
higher income per capita.
 Hence, the problem is to choose s such that the resulting value of k* yields the
highest value of c.
 Well, in a steady state (indicated by stars), we have:
 Maximizing the right-hand side with respect to k* and setting to 0, we find that c* is
the highest if k* is such that
Hence, it is the level of k for which MPK = δ ,
Mbt. 2e bullet: we weten dat c = y – i = f(k) – sf(k). In een steady state, geldt sf(k) = δ k. Daarom geldt
in een steady state: c = y – i = f(k) - δ k.

De 3e bullet geeft de eerste-orde voorwaarde voor een maximum. (Omdat f kromlijnig/concaaf is

hebben we inderdaad een maximum, en niet een minimum.)
¿
 This optimum level is called the golden-rule level of capital. It is denoted by k gold .
¿
 How do we determine the savings rate s that produces this k gold ?

 Well, we know that, in any steady state, k is such that

sf (k )=δk .
❑
Therefore, the golden-rule savings rate s gold for the

government is
¿
❑ δ k gold
s =
gold ¿
f ( k gold )
how to reach the optimal saving rate
too much capital: s has to fall
 A sudden drop of the savings rate to the appropriate level
 immediately increases c and decreases i, given y
 as investment decreases, k falls
 as k falls, y, c, and i decrease
 in the end, c must be higher than initially (we are in the golden state!), but because k
is lower, y and i are lower than initially.

Too little capital: s has to rise.

 A sudden rise of the savings rate to the appropriate level
 immediately decreases c and increases i, given y
 as investment increases, k rises
 as k rises, y, c, and i increase
 in the end, c must be higher than initially (we are in the golden state!); because k is
higher, y and i are also higher than initially.

When L grows at the rate n, in the steady state model where k* is going to be replaced with new
capital. Because also more workers enter the labour force, some additional investment is needed to
supply these new workers with capital.

Δk = kΔK/K – kn
 Because ΔK = I – δK, we have
ΔK/K = I/K – δ = i/k – δ
 Substituting this into the green equation, we find
Δk = kΔK/K – kn = i – k(δ + n)

With i = sf(k), we then arrive at our final result:

Δk = sf(k) – k(δ + n)
Interpretation: to keep capital per worker constant (Δk = 0), in addition to replacing old
capital, there is an amount of nk capital per worker needed to provide capital to new
entrants
 The steady-state level k* is implied by
sf(k*) = k*(δ + n)
 In a steady state net investments are now positive (equal to k*n)  K grows.
 Now there is sustained economic growth. Since a steady state has constant k, K must grow at
the same rate as L, viz. with rate n. Hence, because of CRS, income Y must grow at the rate n.
 However, income per capita stays constant, since both numerator and denominator of Y/L
grow at the same rate.

Het is belangrijk om in te zien dat in het standaardmodel met alleen depreciatie, er alleen groei
(of krimp) van nationaal inkomen Y plaatsvindt buiten de steady state. Eenmaal in de steady
state is Y constant. Dus dit standaardmodel kan alleen tijdelijke economische groei verklaren. Het
model uitgebreid met populatiegroei kan wél aanhoudende economische groei laten zien. De
economische groeivoet is dan gelijk aan die van de (arbeids)bevolking. Echter in welvaartstermen
schiet je er weinig mee op, omdat het inkomen per hoofd – net als in het standaardmodel –
constant blijft. Dus de belangrijke conclusie is hier: bevolkingsgroei doet de individuele welvaart
niet stijgen. Je zou wel kunnen stellen dat door economische groei door bevolkingsgroei de
(geopolitieke) invloed van het land doet toenemen.

Higher population growth lowers the steady-state level k*, lowers capital worker which lowers
the output per worker y and thus lowers the consumption per worker.

Countries with Higher population growth have lower living standards

HC 4
Solow model with technological and economical growth
E= labour efficiency
g= grow rate of labour efficiency
n= groei van de labour force
We say that technological progress is labour-augmenting: it is as if the labour force increases.
E= zou ook een verhoging van human capital kunnen zijn, door betere scholing wordt je productiever

Supply side
Y = F(K,L x E)
The term L x E indicates effective labour or the effective number of workers.
K
k e=
L∙E
so k e stands for capital per effective worker.

e Y
y=
L∙ E
for output per effective worker

∆ k =sf ( k )−(δ+ n+ g) k
e e e
Interpretation: to keep capital per effective worker constant, now there also is an amount of g k e
capital per effective worker needed to match the higher efficiency of the labour force.

The steady-state level k e* is implied by

sf ¿

 In a steady state net investments again are positive (equal to (n+ g)k e∗¿ ¿) 
K grows.
 Again there is sustained economic growth. Since a steady state has
constant k e, K must grow at the same rate as L x E, viz. with rate n + g.
Hence, because of CRS, income Y must grow at the rate n + g.
 However, income per capita now grows. Because the numerator grows with
n + g and the denominator with n, Y/L grows with g.
 Because C = (1 – s)Y, also consumption per capita c grows with g.

 Therefore,the augmented Solow model predicts that only technological

progress can increase living standards of people.
 The golden-rule level of k e now follows from solving the equation:
f ( k ) −(δ +n+ g)=0
' e

or
MPK −δ =n+ g
Hence, we must use this criterion to establish whether the steady state has too
little or too much capital.

Solow model
1. The capital-output ratio K/Y should be constant.
The model predicts the real wage (= MPL) to grow at the same rate as
technological progress (g), while the real rental price of capital (= MPK) is
constant.
2. Solow model predicts that that economies converge over time. But this is
not the case.

Is a country saving enough To find out, apply the golden-rule criterion:

 If MPK −δ > n+g , savings rate s should increase
 If MPK −δ < n+g , savings rate s should decrease

1. a capital-output ratio equal to 4

2. depreciation of capital equal to 10% of GDP
3. capital income equal to 30% of GDP
4. GDP growth of 3% per year.
Does this country save too much or too little? Apply the golden-rule criterion.

Dan is K/Y = k/y = 4; δ K = 0.10Y of δ k = 0.10y; K.MPK = 0.3Y of k.MPK = 0.3y;

n + g = 0.02. Zo vind je dat het land te weinig spaart … (0.05 > 0.03)
changing the savings rate
The national savings rate is the sum of the private savings rate ( (Y – T – C)/Y)
and the public savings rate ((T – G )/Y). Hence, policies could
 reduce government budget deficit or increase government surplus
 increase incentives for private saving (e.g., lower taxes on capital, taxing
consumption instead of income

reallocating investment
 Three categories of investment:
 private capital stock,
 public capital stock (esp. infrastructure),
 human capital (the knowledge and skills that workers acquire
through education).
 The government should promote the type of investment with high MPK.

Private investments
1. Equalize tax treatment of all types of capital in all industries, then let the
market itself allocate investment to the type with the highest marginal
product.
2. Industrial policy: the gov’t actively encourages (through e.g. subsidies)
investment in certain industries that have positive externalities (by-
products) that private investors don’t consider.

Creating the right institutions

 Laws to protect property rights.
 Financial markets to help capital flow to the best investment projects.
 Fight corruption in the government, to promote competition, enforce
contracts, etc.

Achieving faster technological growth.

 Patent laws: encourage innovation by granting temporary monopolies to
inventors of new products
 Tax incentives for R&D
 Grants to fund research at universities
 Industrial policy: encourage specific industries that are key for rapid
technological progress
A one-sector model
∆ K =sAK −δK .
 This gives the final result:
Y K
  sA  
Y K
Income and capital changes over time
If sA> δ , then income per capita will grow forever, and investment is the “engine of
growth” rather than technology.
 Remark: the permanent growth rate depends on saving rate s. In the Solow
model, it does not (it’s g).
Hier wordt laten zien dat er meer wordt geinvesteerd om oud kapitaal te
vervangen. En zonder technologische ontwikkeling, kan het inkomen per hoofd
kan groeien, namelijk van de spaarquote s.

A two-sector model
 Two sectors:
 manufacturing firms produce goods
 research institutions produce knowledge
 Knowledge increases labour efficiency in manufacturing
 A fraction u of the labour force is employed in the research sector.
Final good sector: Y  F ( K , (1  u ) LE )
R & D sector: E  g (u ) E

where F has CRS and g is an increasing function of u.

Implications:
 If E is seen as capital (human capital!) just like K, then the MPK is
constant, unlike the Solow model.
 In this view, the previous one-sector model obtains with growth rates ΔY/Y
= ΔK/K = sA – δ where A positively depends on (1 – u )L. (This view
ignores the R & D sector.)

Om te zien dat MPK constant is, zet E = K en schrijf: Y = F(K,(1-u)LK). Omdat F

CRS heeft, geldt Y/K = F(1,(1-u)L
te schrijven als Y = KF(1,(1-u)L). Dus MPK = F(1,(1-u)L), een constante
onafhankelijk van K.

three sources of economic growth:

1. capital accumulation
2. population growth
3. technological progress
  We start with a general production function:
Y = AF(K,L)
where A indicates total factor productivity (TFP).
 An increase in A indicates technological progress.
 This implies that
ΔY = F·ΔA + A·( F K ∆ K + F L ∆ L )
Een verandering in TFP staat voor technologische ontwikkeling

HC 15 WEEK 4
Aggregate supply

Short run economic growh

Two aggregate supply curve:
We identified two Aggregate Supply curves:
 Long-Run AS: a vertical curve in a (Y,P) diagram at the
natural level of income (capacity income or steady-state
income) Y =Y .
 Short-Run AS: a horizontal line at the level of the (fixed)
prices P=P (see Section 10-4)
Then demand shocks or demand policies (i.e. shifts of AD) can only
affect Y (not P) in the short run, and only affect P (not Y) in the long run.

But recent studies say that the short term AS is not an horizontal line but
an upward-sloping curve

Phillips curve: the negative relation between inflation and unemployment

Recall the IS-LM mode

IS : Y = C(Y – T) + I(r) + G r↑→I↓→Y↓

LM: M/P = L(r, Y) Y↑→L↑→r↑

Monetary policy: shifts the LM-curve

Fiscal policy: shifts the IS-curve

 Hence, in reality, prices are also

somewhat flexible in the short run, being
responsive to changes in production.
 Consider the following form of the short-run AS-curve:

Y =Ȳ + α( P−Pe )
whereα >0 and Pe is the expected price level (Y is the natural level of
output (or capacity level)).
This is a positive relation between P and Y
Frictions between actual and expected prices cause deviations of Y from
its natural level Y

P is the price in the current period that is expected in a prior

e

period.

In the long run, P=P e :so then the vertical supply curve obtains

Mensen en bedrijven hebben verwachtingen omtrent het prijsniveau. Op

de korte termijn zijn die verwachtingen gegeven. Veronderstel
daarom bij de grafiek een zekere Pe (dwz. de prijs waarvan men op een
eerder moment dacht dat deze zich zou gaan voordoen). Nu weet je dat
je een positief verband hebt tussen P en Y. Voorts, als P = Pe dan is Y
gelijk aan het natural level. Als P hoger is, dan ook Y hoger; en als P
lager, dan ook Y lager. Dus dit verklaart verloop van curve. Merk op dat
als de verwachte prijs stijgt, de curve naar boven schuift. Economen
gaan ervan uit dat op de lange termijn, de verwachtingen van
mensen/instituties gemiddeld gezien uitkomen, dus dan geldt P = Pe. Dat
impliceert dat op lange termijn, Y gelijk is aan zijn natural level. En dat
klopt met de verticale supply curve!
Sticky wage model
Several explanations of the upward-sloping short-run AS obtain, below we consider
the sticky-wage explanation.
Assume:
 Nominal wages (say in euros) are sticky in the short run (e.g. because of
contracts, social norms, etc.).
 Workers and firms agree on a target real wage ω, which induces the setting of
a nominal wage W such that the expected real wage equals this target:
e
W/ P = ω

 Also assume actual employment depends on actual prices, according to the

firms’ demand for labour: L=L ( )
d W
P
Note that the setting of the nominal wage implies that expected employment is
e
L =L
( )
d W

P
e

De vraagfunctie naar arbeid is, als we een productiefunctie met alleen arbeid
hebben: Y = F(L), niets anders dan P.MPL = W omgeschreven als een relatie tussen
L en W/P.

W W
 If P< Pe , then > e ; so actual employment is less than expected
P P
employment: L< Le , and actual production less than expected production:
Y <Y e .
W W
 If P> Pe , then < e ; so actual employment is higher than expected
P P
employment: L> Le , and actual production higher than expected production:
Y >Y e .
W W
 If P=P e, then = e ; so actual employment equals expected employment:
P P
e e
L=L , and actual production equals expected production: Y =Y .

Short time supply curve:

Y =Ȳ + α( P−Pe )
 Importantly, the new short-run AS curve introduces the role of expectations
into the AD-AS model.

So let us reconsider the effects of economic shocks and policy measures in this new
AD-AS model with building blocks:
 Aggregate demand:
IS: Y = C(Y – T) + I(r) + G & LM: M/P = L(r, Y)
 Short-run aggregate supply:
Y =Y + α (P−Pe )
 Long-run aggregate supply:
n
Y =F ( K̄ ,(1−u ) L)=Ȳ
  Demand shock – Changes in C, I, G
 Consumer confidence;
 Government spending changes;
 Money supply changes.
 Short-run supply shock – Changes in labor, capital
 Law and regulation;
 Energy prices;
 Price expectations.
 Long-run supply shocks – From the Solow model:
 Savings rate;
 Population shocks;
 Technology shocks (TFP);
 Depreciation shocks.

Om te voorkomen dat een economie verhit raakt, en door aanpassingen in verwachte

prijzen in een lange termijn evenwicht met hoge prijzen belandt, kan men AD
proberen af te remmen: 1) begrotingspolitiek, bijv T omhoog, G omlaag; 2) monetair
beleid: M omlaag. Dit schuift de rode AD-curve weer terug naar blauwe, en komt in
principe de economie weer terug naar A. De SRAS zal mee terugschuiven, want de
prijzen gaan dalen. Merk op dat als we al zitten in het hoogste snijpunt, dan
impliceert een terugschuiven vd AD curve dat er tijdelijk werkloosheid gaat ontstaan!.
Hier zie je al een voorbeeld van: als je inflatie wil terugbrengen, gaat werkloosheid
omhoog (zie verderop).
Om te voorkomen dat een economie verhit raakt, en door aanpassingen in verwachte
prijzen in een lange termijn evenwicht met hoge prijzen belandt, kan men AD
proberen af te remmen: 1) begrotingspolitiek, bijv T omhoog, G omlaag; 2) monetair
beleid: M omlaag. Dit schuift de rode AD-curve weer terug naar blauwe, en komt in
principe de economie weer terug naar A. De SRAS zal mee terugschuiven, want de
prijzen gaan dalen. Merk op dat als we al zitten in het hoogste snijpunt, dan
impliceert een terugschuiven vd AD curve dat er tijdelijk werkloosheid gaat ontstaan!.
Hier zie je al een voorbeeld van: als je inflatie wil terugbrengen, gaat werkloosheid
omhoog (zie verderop).

Stel de economie zit in A, en een virus slaat toe waardoor bedrijven opeens veel
moeilijker aan onderdelen kunnen komen. De productiekosten gaan stijgen. De
SRAS schuift hierdoor naar boven (hierna voegen we nog een ‘schok’ term toe aan
de vergelijking voor de SRAS, die dit effect kan weergeven), en de economie rijdt
een recessie in, naar punt B. Merk op dat het verwachte prijsniveau hoger is dan in
punt B (het eerste zit immers op niveau waar rode SRAS de LRAS snijdt), en dat is
hoger dan p2. Men zal daarom op termijn de prijsverwachtingen naar beneden
bijstellen, waardoor de economie weer terug kruipt naar A.
De economie laten terug kruipen van B naar A middels prijsverlagingen (verwachte
en gerealiseerde) kost vaak veel tijd. Een remedie is dan maar, als de economie in B
zit, de economie middels AD te stimuleren. Dat vermindert de recessie en
werkloosheid, maar verhoogt de prijzen verder, dus blaast de inflatie verder op
(situatie vd de jaren 1980s).

A stabilizing policy, in the short run, moves the economy along the short-run AS:
 It increases Y and reduces unemployment
 It increases P and thus creates inflation
Of course, this poses a dilemma for the government.
 The trade-off between inflation and unemployment is called the Phillips
curve.
 The short-run AS and the Phillips curve are essentially the same thing.

 The Phillips curve is specified as

 π=π e −β (u−un )+ υ
with
π = inflation
π e = expected inflation
β = a positive parameter
u = unemployment rate
 n
u = natural rate of unemployment
υ = an exogenous (positive or negative) supply shock
n
u−u is cyclical unemployment

short-run AS and Phillips curve are essentially the same thing

doordat de onverwachte prijs wordt afgeleid uit de capiciteit van de economie
en de onverwachte inflatie hangt af van de werkeloosheid.
En omdat de capeciteit van de economie gevolgen heeft voor de werkeloosheid
hangt dit samen.

 Recall The Phillips curve shows that short-run inflation can rise for three
reasons:
 expected inflation π eincreases
 actual unemployment u (or cyclical unemployment u−un) decreases
 this is called demand-pull inflation; it is typically caused by
expansionary monetary or fiscal policy (the size of the effect
depends on β )
 adverse supply shock υ >0
 this is called cost-push inflation.
Vb: stijging van de energie prijzen, nieuwe klimaatregels of problemen met
leveranciers.

In the long run, this link between real and nominal variables breaks down: the
classical dichotomy holds.
In the long run, expectations are assumed to be realized. Thus,
 regarding the Short-run-AS curve:
P=P , so output equals production capacity Ȳ
e

regarding Phillips curve:

π=π e , unemployment is at its natural rate un

Op de lange termijn hebben beleidsmakers dus (met fiscal of monetary policy) geen
effect op cyclische werkloosheid. Dit komt omdat mensen en bedrijven hun
verwachtingen omtrent prijzen aanpassen.

How do people form their expectations

- adaptive expectations: expectations of future inflation are based on recently
observed inflation, e.g. inflation in the previous quarter:
e
π =π−1
- Then the Phillips curve becomes
n
π=π −1 −β(u−u )+υ

 Adaptive expectations lead to inflation inertia:

 In the absence of supply shocks (υ=0 ¿ or cyclical unemployment (u=un
), inflation will continue indefinitely at its current rate.
 Trying to reduce unemployment below its natural rate will speed up
inflation and cause an inflation spiral.
 A temporary shock υ >0 causes a permanently higher level of inflation
Hogere inflatie zal leiden tot hogere looneisen. Die verhogen υ , en dus leiden tot verdere
inflatie: een loon-inflatie spiraal krijg een enorme werking als er sprake is van adaptieve
verwachtingen. En is moeilijk te doorbreken.

 Suppose a country is in a long-run equilibrium (u=un ¿ with high inflation. To reduce

the latter, policymakers can lower aggregate demand. But, moving along the Phillips
curve, this raises unemployment above the natural rate and lowers production below
its capacity. -> G omlaag of T omhoog
 The sacrifice ratio measures the percentage of a year’s real GDP that must be
foregone to reduce inflation by 1 percentage point.
 Estimates vary between 2 and 10.

 Instead of adaptive expectations, we could assume rational expectations:

 People base their expectations on all available information, including
information about current and prospective future policies.
 The better people are in forecasting inflation, the closer π e ≈ π , and thus the more the
short-run Phillips curve resembles the long-run one.
 And the lower the sacrifice ratio.
 But also: the less effective are demand policies to reduce unemployment.
Voorstanders van rational expectations geloven daarom dat des te transparanter en
geloofwaardiger de Centrale Bank inflatie wil terugdringen (en de overheid dat niet
tegenwerkt), des te minder dat aan GDP kost. Dit kan verklaren waarom sommige landen
veel lagere sacrifice ratio’s hebben dan andere

 The preceding analysis is in line with the natural rate hypothesis:

 Changes in AD affect output and employment in the short run;
 In the long run, the economy returns to the levels of output, employment, and
unemployment described by the classical model (Chapters 3-9)  the LRAS
does not move after a short-run shock or policy change
HC 6
 Instead of adaptive expectations, we could assume rational expectations:
 People base their expectations on all available information, including
information about current and prospective future policies.
 The better people are in forecasting inflation, the closer π e ≈ π , and thus the
more the short-run Phillips curve resembles the long-run one.
 And the lower the sacrifice ratio.
But also: the less effective are demand policies to reduce unemployment

π=π e −β (u−un )+ υ

A dynamic AD-AS model

1. The demand for goods & services
Y t =Y t −α (r t −ρ)+ ε t
Y t = natural level of output
r t = real interest rate
ε t = random demand shock (expectation E( ε ¿¿ t)=0 ¿)
ρ = natural level of real interest
α = positive parameter
Niet uit je hoofd!

Interpretation (remember Y = C + I): dit wel weten!!

 higher interest r t reduces borrowing and raises saving, causing C and I to fall;
r t is the key variable in the economy;
 changes in Y t stand for economic growth, which increases C and I;
 ρ is the natural rate of interest (if r t =ρ , then in the long run Y t =Y t );
 changes in ε t could stand for waves of pessimism or optimism or unexpected
fiscal policy changes;
 2. the Fisher equation
r t =i t −Et π t +1
r t = real interest rate
i t = nominal interest rate
Et π t +1 = the expectation one has on time t about the
inflation in the coming period t + 1

Dus i t is de nominale interest die commerciële banken vragen voor een lening. Die
interest is gebaseerd op de verwachte inflatie in de komende periode, want als de
lening wordt terug betaald (of een deel wordt afgelost) wil men weten wat de
koopkracht is van dat bedrag. De reële rente r t staat voor het rendement wat banken
verwachten op tijdstip t als ze de lening maken. Banken willen een zeker rendement
om de concurrentie te overleven: des te hoger de verwachte inflatie, des te hoger zij
de nominale rente zullen zetten om hun rendement te waarborgen.

3. The supply side of the economy --- Phillips curve

π t =Et −1 π t + ϕ(Y t −Y t )+ v t
where
Et −1 π t = the expectation one had on time t – 1 about the inflation in the
current period t
v t = random supply shock (expectation E( v ¿¿ t)=0¿ )
ϕ = positive parameter
n
 Note that Y t −Y t is assumed to be proportional to ( 1−ut ) −( 1−u nt )=u t −ut
 −β becomes + ϕ

4. Adaptive expectations
Et π t +1=π t
where
Et π t +1 = the expectation one has on time t about the
inflation in the coming period t + 1
 5. The monetary policy rule
Recall
M
=L(i , Y ) with i=r + π e
P
 By changing M it can also influence i and so r , which is key for the demand for
goods and services.
 The monetary policy rule sets a target i ¿ and implicitly adjusts M to achieve
this target.

¿
i t =π t + ρ+θ π (π t −π t )+θY (Y t −Y t )
¿
 π t = the Central Bank’s target for the inflation rate
 θ π , θY = positive key policy parameters
 ρ = the natural rate of real interest (a constant)

Interpretation:
 The goal of the Central Bank is to achieve a certain nominal interest i t .
 The equation states how the Central Bank will respond to a deviation from the
¿
inflation target ( π t −π t ) and a deviation from the natural output level (Y t −Y t ).
 The policy parameters θ π and θY measure the size of these responses.

Remember that the real interest rate r t is the key variable in an

economy (see (1)). Combining (2) and (4), we obtain r t =it −π t.
Therefore:
 The CB can influence the real interest rate.
¿
 If π t =π t and Y t =Y t , we have r t =ρ .
¿
 If π t > π t or Y t > Y t , we have r t > ρ (an overheated economy)
¿
 If π t < π t or Y t < Y t , we have r t < ρ (an under-performing economy)

 Computing the long-run equilibrium gives

Y t =Ȳ t
r t =ρ
π t =π ¿t
Et π t +1=π ¿t
¿
i t =ρ+π t

 a dynamic Aggregate Supply curve (DAS)

 a dynamic Aggregate Demand curve (DAD)
DAS: π t =π t−1 +ϕ (Y t −Y t )+ v t
Its position depends on past inflation π t−1.
DAS slopes upward: high levels of output go with high inflation. It shifts in response
to changes in the natural level of output, previous inflation, and supply shocks.

DAD is given by
Y t = A−B π t
where
¿ B
A=Ȳ t + B π t + ε
α θπ t
α θπ
B=¿
1+ α θY
 A downward-sloping curve that does not depend on past inflation.
 A rise of θ π decreases and of θY ∈¿creases the slope of inverse demand
A 1
πt= − Y t.
B B

DAD shifts in response to changes in the natural level of output, the inflation target, and
demand shocks (e.g. changes in G or T)

Why is DAD downward-sloping?

 When inflation rises, the CB increases the nominal interest (see (5)).
 The increase is larger than the rise of inflation, so the real interest increases
also.
Then, according to (1), income Y t falls.

Op lange termijn is op elk niveau van inflatie het inkomen gelijk aan Y t =Ȳ t , verticale
lijn.
Op lange termijn is de inflatie= target inflatie

the short-run equilibrium depends on past inflation π t−1

adverse supply shock= v t ↑

positive demand shock= stijging van ε t

een aanpassing van het monetair beleid in principe een verandering in de infaltion
¿
target π t . Krimpend monetair beleid betekent een lagere target, dus een lagere A
DAD verschuift parallel naar links. We komen in een recessie, de reden is dat de
lagere target nominale en reële rente verlaagt, en daarom demand. De inflatie is
lager waardoor de past-inflation in DAS lager waardoor het naar beneden verschuift
tot we weer op het lange termijn evenwicht zitten.

Als de DAD curve vlakker is θπ is high or θY is low -> minder inflatie

geeft de CB relatief veel gewicht aan bestrijding inflatie. Als er een negatieve
aanbodschok is, reageert de bank met een hogere nominale interest die de reele
rente flink doet stijgen, waar door vraag sterk daalt en zo een grote outputdaling
En als de DAD curve steiler is θπ is low or θY is high -> minder output verandering
geeft de CB relatief veel gewicht aan bestrijding van productieschommelingen. Als er
een negatieve aanbodschok is, reageert de bank met slechts een stijging van de
nominale interest die de reele rente minder doet stijgen, waar door vraag maar
weinig daalt en zo een kleine outputdaling.

 Compared to the Fed, the ECB seems to give more weight to fighting inflation
and less to stabilizing production.

HC 7 Government policy & debt

Opponents:
- It takes time for a policy to be implemented
- Due to these lags, policy may end up destabilizing the ecocnomy

Two types of lags:

Inside lags= time between shock and policy response
Outside lags= time between policy response and impact

Regarding fiscal policy:

Inside lags are relatively short for tax policy, but long for government spending;
outside lags are long

Regarding monetary policy:

Inside lags are shorter, but outside lags are generally longer as compared with fiscal
policy.

No lags in automatic stabilizers (a passive policy), such as unemployment benefits

and income taxes.

Because of these lags, accurate economic forecasts are crucial, but this is hard.

??Lucas critique: policy alters expectations in a way that the fundamental

relationships between variables in the model (built on history) may not hold anymore.

Should policy be conducted by rule or discretion

By rule: policy makers announce in advance how policy will respond in various
events, and commit themselves to following through.

By discretion: as events occur and circumstances change, policymakers use their

judgement and apply whatever policies seem appropriate at the time
Why commit to a policy rule, if discretion is more flexible? Two basic reasons:
1. Distrust of politicians and the political process
 Lack of knowledge and misinformed.
 Conflict of interests – society vs. party.
 Political budget cycles.
2. Time inconsistency problem.
policy makers have an incentive to renege on a previously announced policy once
others have acted on that announcement.

if the public is rational enough (you cannot fool them all the time), the best thing is to
take away the policy maker’s discretion and let policy be conducted by fixed rules.

What is the best rule for monetary policy

1. A constant money supply growth rate
advocated by monetarists (believe that fluctuations in money supply are responsible
for large fluctuations in nominal GDP)
stabilizes aggregate demand only if income velocity is stable

2. Money supply depends on actual versus target growth rate of

nominal GDP
Stabilizes aggregate demand also if income velocity is unstable
Veranderingen in nominale inkomen kunnen ook door veranderingen in
omloopsnelheid van geld komen.

3. Money supply depends on actual versus target inflation rate

Many countries’ central banks now practice inflation targeting, but allow
themselves a little discretion.
The Taylor Rule is related to this rule: the target short-term interest rate
is based on gap between actual and target inflation & gap between
actual and capacity GDP

Should a central bank be politically independent

- Policy rules announced will only work when they are credible
- Credibility depends in part on degree of independence of the CB
- Independent CBs score better on inflation without hurtinf employment and real
income

How do we measure government debt

 When government spending exceeds tax revenues, it runs a budget deficit.
 Budget deficits are financed by borrowing from the private sector or from
foreign governments.
 The accumulation of past borrowing minus repayment is government debt.
Problems in measuring the budget deficit
1) Correction for inflation
Because the focus is on the government’s real debt, the budget deficit should be
expressed in real terms – but it’s done in nominal terms.
 Example: U.S. in 1979,
nominal budget deficit = $28 billion
inflation = 8.6%
debt = $495 billion
D = 0.086  $495b = $43b
real deficit = $28b  $43b = $15b surplus
correctie is vooral van belang als de inflatie hoog is

2) Correction for capital assets

The current focus only is on liabilities, better is capital budgeting:

deficit = (change in debt)  (change in assets)

3) Counting all liabilities

Current measure of deficit omits important liabilities of the government: e.g. future pension
payments to public servants, future payments through social security system.
It is often hard to attach a monetary value when the future outcomes are uncertain.

4) Correction for business cycle

Dit wordt het structureel saldo genoemd: het feitelijke overheidstekort geschoond
voor invloeden van de economische conjunctuur
 Solution: construct a cyclically adjusted budget deficit

How bas are government debts

Views:
 The traditional view
If the government cuts taxes or spends more and runs a budget deficit,
 aggregate demand increases in the short run (the Keynesian model);
 it crowds out private investment (Classic model) and reduces capital
accumulation (Solow model) in the medium and long run.

 The Ricardian equivalence view

Because consumers are forward-looking, they understand that government
borrowing today means higher taxes in the future. Therefore, if the government cuts
taxes or spends more and runs a budget deficit,
 consumers start to save for meeting their future tax burden;
 no effect on aggregate demand & no crowding out.
Hence, future taxes are equivalent to current taxes.

- Not all consumers look so far ahead

- Some consumers are not able to borrow enough to achieve their optimal
consumption, and would therefore spend a tax cut.
- Future generations
  The balanced-budget view
E.g., Eurozone countries are not allowed to run budget deficits of more than
3% of GDP in any given year, and no deficit in the long run.
 Many economists object yearly zero-deficit goals, arguing that deficits
should be used to
 stabilize output & employment;
 smooth taxes in the face of fluctuating income;
 redistribute income across generations when appropriate.

Het CPB schat het prudente niveau op 70% van nationaal inkomen. Het stabiliteitspact van
EU eist 60%.

 The budget deficit B includes interest payments: where G−T is called the
primary budget deficit.
 The budget deficit increases nominal debt:
B= ΔD
 A constant debt-to-GDP level requires that D/Y (here Y is nominal income)
remains constant over time. So with inflation π and real growth rate g, this
holds if

Hence, for fiscal sustainability, the primary budget as a percentage must be equal to
(or lower than) the excess of real growth over real interest times the prudent debt-to
GDP level.

 The EU Stabilization Pact requires maximum 3% deficit, which includes

interest payments.
 The prudent debt-to-GDP level is 60% of GDP.
HC8
 The money supply equals currency (C) plus demand deposits (D):
M = C + D
CB cannot directly control the amount of money
- That households hold as deposits in banks
- That banks lend to households

 To understand the interaction between C and D, and what the CB can do,
three scenario’s:
(1) no commercial banking;
(2) 100% reserve banking (all deposits as reserves);
(3) fractional reserve banking (a fraction of deposits as reserves, the rest to make
loans).
 Suppose C = € 1000
Ad (1): With no banks, D = 0 and M = C + D = € 1000.

Ad (2) 100% reserve banking

 Not-lent-out deposits are called reserves, or R.
 The balance sheet of a bank looks like
 Now C = 0 and D = € 1000, so M = C + D = € 1000
 Hence, the banking system does not affect money supply.

Ad (3): Fractional reserve banking, say 20%

 The reserve-deposit ratio is denoted by rr. So rr = R/D = 0.20.
 The balance sheet of several banks looks like

If loans are deposited at another bank, there is creation of money supply:

If it goes on infinitely, the sum of deposits (D) equals
C
C + ( 1−rr )C + ( 1−rr )2C + … =
rr
In the end, we find C = 0 and D = € 1000/0.2 =
€ 5000, so M = C + D = € 5000
Hence, the commercial banking system creates money (if r r <1).
Liabilities and
Assets
equity

Reserves 200 Deposits 750

Loans 500 Debt 200

Capital
Securities 300 50
(owners’ equity)

Liabilities bestaan uit vreemd vermogen (debts and deposits) en eigen vermogen (equity).
Voorbeelden van securities zijn staatsobligaties waarin de bank belegt. Debt staat voor
schulden die de bank heeft aangegaan middels leningen bijv. van andere banken of de CB.
By using borrowed money (deposits and debts) banks can increase the leverage of their
capital.
Leverage ratio = assets/capital
= (200 + 500 + 300)/50 = 20
However, banks with high leverage are vulnerable.
The CB imposes capital requirements to avoid risky behavior: a minimum amount of capital,
higher for banks that hold more risky assets.

Being highly leveraged makes banks vulnerable. Example: Suppose a recession causes our bank’s
assets to fall by 5%, to 950. Then, capital = assets – liabilities = 950 – 950 = 0. The bank has lost its
capital. Depositors may fear that they will not be paid out, it may cause a bank run.

How can the CB influence money supply

 Consider a model of money supply under fractional reserve banking. Definitions:
 Monetary base, B = C + R
It is directly controlled by the CB.
 Reserve-deposit ratio, rr = R/D
It depends on CB-regulations & bank policies.
 Currency-deposit ratio, cr = C/D
It depends on households’ preferences.

cr +1
Money multiplier: M = × B=m× B
cr +rr
 If rr <1 , then m>1 .
 If the monetary base changes by B, then M = m  B.
 m measures the increase in the money supply resulting from a one-dollar increase in the
monetary base.
The CB can change money supply by changing the monetary base B (= C + R) through
 open market operations
 buying and selling bonds
 buying bonds is also called quantitative easing
 adjusting the refinancing (or discount) rate
 it is the interest rate the CB charges on short-run loans to banks
 e.g., a lower refinancing rate encourages banks to borrow more
reserves R, thus increasing the monetary base.
A third instrument:
 adjusting reserve requirements
 regulations that impose a minimum amount of reserves that banks
must hold against deposits
 e.g. a higher minimum may raise rr , thus lowering the money
multiplier – though not necessarily because Banks often hold excess
reserves

Repo rate: de rente die een bank de CB moet betalen voor een tijdelijke lening in ruil voor
tussentijds afstaan van obligaties als onderpand

Pros and cons of a single currency

Benefits:
- lower transition costs in international trade
- less price discrimination among countries
- elimination of exchange rate uncertainty
costs
- loss of independent monetary policy
what if shocks are asymmetric
- less room for national fiscal policy

theory of optimum currency areas

 The theory formulates criteria for a group of countries such that, if the criteria are
satisfied, it would be optimal for the countries to share the same currency.

Factors that reduce the cost of losing an independent monetary policy:

 flexible real wages
 high labour mobility between member states (see next slide…)
 high capital mobility between member states
 symmetric shocks.
A major factor that increases the benefits of a single currency:
 high international trade volumes.
Is the Eurozone an optimum currency area?
Five tests to tick:
 Trade integration (+)
 High labour mobility (-)
 Financial integration (+/-)
 Flexibility of real wages (-)
Synchronisation of demand shocks (+)

 One aim of the Stability & Growth Pact is to solve the free-rider problem in a
common currency area:
 Suppose a country runs large budget deficits, then defaulting becomes
attractive.
 Investors respond by charging risk premia.
 This causes higher borrowing rates for other euro countries as well: a
negative externality.
 It also causes expectations of bailout by the other countries and the ECB.
 The effect is that the first country can continue borrowing at lower rates.

De negative externaliteit onstaat omdat investors een depreciatie van euro verwachten, en
dus een hogere interest vragen aan alle euro landen die obligaties uitgeven.

 To solve the free-rider problem

 member states have signed a no-bailout agreement and the Stability &
Growth Pact;
 also the ECB’s constitution does not allow for bailout of member state.
Problem:
 not perceived as credible if large country were to run into problems;
 no credible ways to enforce sanctions against those who violate the Pact.
HC 9
 It is important to know what determines consumption and savings of households:
 Short run: consumption is part of Aggregate Demand
 Long run: saving is the key determinant of capital accumulation and economic
growth

Six views on what determines household consumption:

 Keynes: the role of current income
 Fisher: the role of future income – intertemporal choice
 Modigliani: the Life-Cycle Hypothesis
 Friedman: the Permanent Income Hypothesis
 Hall: the Random-Walk Hypothesis
 Laibson: the pull of instant gratification

Keynes view
Three conjectures:
∆C
 The marginal propensity to consume ( ∆ Y ) lies between zero and one:
0< MPC <1
C Δ APC
 The average propensity to consume ( Y ) falls as income rises: ΔY <0
 Current income determines consumption; no role for interest
- The predicted stagnation did not occur
- Long-run studies by Kuznets found that APC remains fairly constant as
income rises.

Fisher
Consumer’s choices are subject to an intertemporal budget constraint.
1 1
C 1+ C =Y 1 + Y
1+r 2 1+ r 2
present value of lifetime consumption present value of lifetime
income
1
is the relative price of future consumption
1+ r
the intertemporal budget constraint

The slope of the budget line equals -(1+r):

To increase C1 by one unit, the consumer must sacrifice (1+r) units of C2.

An indifference curve shows all combinations of C1 and C2 that make the

consumer equally happy
Higher indifference curves represent higher levels of utility.
Preferences are formally presented by a utility function U ¿)
Marginal rate of substitution (MRS ): the amount of C2 a consumer would be
willing to substitute for one unit of C1.
The slope of an indifference curve at any point equals the MRS at that point.
So -dC 2/dC 1

The optimal (C1,C2) is where the budget line just touches the highest
indifference curve.
Having the optimal C 1 , we know savings S=Y 1−C1
At the optimal point, MRS = 1+r

Het spreiden van de consumptie over de tijd ten gevolge van een
inkomensverandering nu of in de toekomst heet consumption smoothing.

 According to Keynes, current consumption depends only on current

income.
 According to Fisher, current consumption depends only on (the present
value of) lifetime income.
 The timing of income is irrelevant because the consumer can
borrow or lend between periods.

How C responds to changes in r

An increase in r pivots the budget line around the point (Y1,Y2 ).

As depicted here, C1 falls and C2 rises. However, it could turn out differently…
De relatieve prijs van huidige consumptive is 1 + r, d.i. de helling van budgetlijn.
Als r stijgt, wordt deze helling dus groter én het draaipunt moet rond punt
(Y(1), Y(2)) zijn.

A rise of r induces two familiar effects:

 An income effect
If the consumer is a saver, lifetime income increases, which increases
consumption in both periods in the case of normal goods.
 A substitution effect
The opportunity cost of current consumption increases, which reduces C1
and raises C2.
Taken together: C2 ; C1 can go both ways.

Als het een lener is met een hogere r is de lifetime inkomen lager. En draait de
budgetline naar binnen toe.
A borrowing constraint takes the form:
C1  Y1

III Modigliani’s Life-Cycle Hypothesis

 Just like in Fisher’s model, people try to achieve a smooth consumption
pattern over their lives.
 Because income varies over the life cycle, people save and dissave over
the phases of their lives in order to smooth their consumption.
 Essentially the Fisher model is simplified by assuming that real interest r
is zero and that people care as much for present as future consumption
(no time preference).
 However, there is initial wealth W, which increases by saving and
decreases by dissaving.

Suppose
W = initial wealth
Y = annual income until retirement (a constant)
R = number of years until retirement
T = remaining lifetime in years
Then lifetime resources are W + RY
 To achieve smooth consumption, consumer divides resources equally
over time:
C = (W + RY )/T
Or rewritten:
C = aW + bY
where
a = (1/T) is the marginal propensity to consume out of wealth
b = (R/T) is the marginal propensity to consume out of income
 The role of wealth enables the life-cycle hypothesis to solve the
consumption puzzle:
 In the short run, wealth W is constant, so we have the familiar
linear consumption function in income Y

 Regarding the long run, observe that the APC is

C/Y =α(W/Y ) + β
and recall that long-run studies find that APC is fairly constant.
 Now, because of saving, wealth grows over time. Indeed, wealth and
income typically grow together, causing W/Y to be fairly stable.
 E.g, if W/Y = a (a is a constant), C/Y = αa + β is constant.
The LCH implies that saving varies systematically over a person’s lifetime.

Friedman’s Permanent-Income Hypothesis

 Just like in Fisher’s model and Modigliani’s, people try to smooth
consumption over their lives.
 Unlike Modigliani’s model, income does regularly grow over the working
life, but has unexpected temporary variations
 Consumption depends on permanent income: the part of income that
people expect to be persistent.

Y = YP + YT
where Y = current income, and
Y P = permanent income
average income, which people expect to persist into the future
Y T = transitory income
temporary deviations from average income (expectation E(Y T) = 0)

 The consumption function is

C = aY P
where a is the fraction of permanent income that people consume per
year.

The consumption puzzle is solved as follows:

 In the short run, transitory income Y T is constant (<>0), so we have the
familiar linear consumption function in income Y by rewriting C = aY P = -
aY T +aY.
 Regarding the long run, note that the average propensity to consume is
APC = C/Y = aY P/Y
Higher or lower transitory income changes APC in the short run, but in the long
run the effect disappears (recall E(Y T) = 0).
Hence, in the long run, APC is stable.
Hall’s Random-Walk Hypothesis
 If the permanent-income hypothesis holds and consumers have rational
expectations, then actual consumption should follow a random walk:
changes in consumption should be unpredictable.
 A change in income or wealth that was anticipated has already
been factored into expected permanent income, so it will not
change consumption.
 Only unanticipated changes in income or wealth that alter
expected permanent income will change consumption.

Dus consumptie hangt af van het verwachte permanente inkomen over de life
cycle, conform Friedman. In geval van rationele verwachtingen zijn
consumenten forward looking en nemen alle informatie tot zich om zo goed
mogelijk hun toekomstig inkomen te kunnen voorspellen. Dan kan hun
verwachte permanente inkomen alleen maar op een toekomstig moment
worden bijgesteld als er een onverwachte gebeurtenis is. Die bijstelling van
verwachte permanente inkomen leidt tot ander consumptieniveau. Maar die
wijziging in consumptieniveau is geheel toevallig.

Some implications:
 Policy changes (e.g., a tax cut aimed at increasing AD) will affect
consumption only if they are unanticipated.
If an unexpected policy or event implies an income change in (say) next year,
consumption changes today

Laibson’s instant gratification hypothesis

 Recent studies in behavioural economics show that consumers are not that rational.
 E.g., in one US survey, 76% said they were not saving enough for retirement.
 The “pull of instant gratification” explains why people don’t save as much as a
perfectly rational lifetime utility maximizer would save.
 People are not consistent over time: they are more patient in the long run than in
the short run.
HC 10
 Investment is the most volatile component of GDP. Studying investment therefore is
crucial to understand the business cycle.
 The interest lies in the spending effect of investment, not the capacity effect.
 Three types of (private) investment:
 Business fixed investment
 Residential investment
Inventory investment

Met capacity effect wordt bedoeld het effect op de stock K: I leidt tot hoger K, vgl Solow
model. We kijken alleen naar de investeringen van de private sector, niet van de overheid

Business fixed investment:

businesses’ spending on equipment and structures for use in production
Residential investment:
purchases of new housing units
(either by occupants or landlords)
Inventory investment: (is niet fixed, maar flexible)
the value of the change in inventories
of finished goods, materials and supplies, and work in progress.

Business fixed investment

 The spending on equipment and factories for use in production.
 The standard explanation of fixed investment is the neoclassical model of
investment.
 It shows how investment depends on MPK (the return) and the real interest
(the cost).
 The model assumes a competitive economy with two types of firms:
production firms that rent capital;
rental firms that buy capital (invest) and rent it out.
Hier is MPK de marginal product of capital.

First production firms: how much capital will they rent:

If P is the price of output and R the rental price of capital, the optimal K is such that
R
=MPK
P

1. De winst van een production firm is gegeven met: profit = PF(K,L) – KR – LW (loonkosten).
De maximale winst vind je in principe door deze uitdrukking naar L en K te differentiëren en
dan dit gelijk aan nul te stellen. Dit geeft: P.MPK = R en P.MPL = W, waarbij MPK = dF/dK en
MPL = dF/dL. Dus ook hebben we de twee condities: MPK=R/P en MPL = W/P. Hierboven
gaan we alleen verder met de conditie voor kapitaal.
2. Aan het plaatje kun je zien, dat als K stijgt, dan real rental price daalt; Als de vraag stijgt,
gaat deze juist omhoog. De vraag stijgt als MPK stijgt, bijvoorbeeld omdat er meer arbeid is
(dan wordt K gecombineerd met meer L) of omdat er technologische vooruitgang is.
Next, rental firms. They buy new capital (invest) as long as the marginal benefit of a unit of
capital exceeds the marginal cost of a unit of capital.
 The marginal benefit arises from renting out capital, so this is R/P.
 There are three components that make up the marginal cost of a unit of capital.
If PK is the nominal price of a unit of capital (the capital good), these are
 interest cost: i PK,
where i = nominal interest rate
 depreciation cost:  PK,
where  = rate of depreciation
 capital loss or gain:  PK
The total cost of a unit of capital is the sum:
i PK +  PK  PK =
PK (i +   PK / PK ) =
PK (i +   π) =
PK (r +  )

π is inflation rate
r is real interest

Het verlies aan kapitaal staat voor de waardevermindering die optreedt als je de
aangeschafte (zeg) machine weer ongebruikt zou verkopen. Er kan ook sprake zijn van een
capital gain, de prijs van je kapitaalgoederen stijgen (bijv. igv een klassieke auto)., dan is PK
>0.

 In sum,
 cost of (a unit of) capital = PK (r +  )
 real cost of capital = (PK /P)(r +  )
 Recalling that the marginal benefit of capital for a rental firm is R/P, capital is bought
as long as R/P > (PK /P)(r +  ).
 Now, also recall that production firms will rent capital unitil it holds MPK = R/P.
 Taken together, the equilibrium amount of capital K* that is bought by rental firms
and rented out to production firms is such that

MPK = (PK /P)(r +  )

Capital supply shifts to the right as long as long as R/P > (PK /P)(r +  ).

MPK = (PK /P)(r +  )

 Now, optimal K* increases (so ΔK > 0) if
 P rises (higher product price)
 PK falls (e.g., cheaper machine)
 r falls (cheaper to finance capital or lower opp. costs)
 δ falls (less depreciation of e.g. a machine)
(since higher K reduces MPK)
 MPK rises for given K (e.g., technically better machines, a larger labour force)
  Observe that ΔK > 0 means that the capital stock increases, so net investment is
positive.
 Denoting this by In, we know
 In > 0, if MPK > (PK /P)(r +  )
 In = 0, if MPK = (PK /P)(r +  )
 In < 0, if MPK < (PK /P)(r +  )
 This defines In as an increasing function of MPK - (PK /P)(r +  ):
In = In[MPK - (PK /P)(r +  )]

 Adding the replacement of depreciated capital, we arrive at the (gross) investment

function:
I = In +  K = In[MPK - (PK /P)(r +  )] +  K
- + - + +/- +
= I(r; MPK, PK , P, , K)

An increase in MPK
or decrease in PK/P
• increases the profit rate
• increases investment at any given interest rate
• shifts I curve to the right.

an alternative explanation of fixed investment is James Tobin’s

q theory:
- it shows how investment depends on stock prices
- firms base their investment decisions on Tobin’s q

Market value of installed capital
q=
Replacement cost of installed capital
numerator: the stock market value of the economy’s capital stock;
denominator: the actual cost to replace the capital goods that were purchased when the
stock was issued.

 If q > 1, net investment increases

 firms in the economy buy more capital to raise the market value of their firms
 If q < 1, net (and gross) investment is zero
 firms do not replace capital as it wears out.

Actually, q theory and neoclassical theory are closely related:

 First note that the stock market value of capital depends on current and expected
future profits from capital.
 If MPK rises above the cost of capital, then the profit rate increases; it drives up the
stock market value of the firms, yielding a higher value of q.
 If MPK falls below the cost of capital, then the profit rate decreases and losses may
arise; it reduces the stock market value of the firms, causing a lower values of q.
Stock market crash → q falls → I falls → AD falls →Y falls a recession
The figure shows that the stock market and GDP tend to move together, but the association
is far from precise.
Een forse daling van de aandelenkoersen vermindert ook het vermogen (wealth) van
huishoudens, hetgeen een daling van C veroorzaakt -- hierdoor daalt AD ook.

 The efficient-markets hypothesis:

The market price of a company’s stock is the fully rational valuation of the company, given
current information about business prospects.
 Stock market is informationally efficient: each stock price reflects all available
information.
 So stock prices follow a random walk (are unpredictable) and only only
change as new information arrives.

Keynes’s view emphasises irrationality

Stock prices especially reflect what people think about what other people think that will
happen to stock prices.
Stock prices reflect irrational waves of pessimism & optimism (“animal spirits”).
The best investors are those who understand mass psychology and the signs of the time.
The irrational movements in stock prices are one source for the short-run fluctuations of AD.

Residential investment
A simple model:
- Suppose all housing is owner-occupied (no renting).
- In the market of housing, the relative price of a house PH /P is determined by supply and -
demand, where supply is the existing stock of houses, KH .
- This relative price PH /P in turn determines the flow of residential investment, IH = ΔKH .

An increase of housing demand raises the relative price PH /P and thereby residential investment, IH .
Sources of increased demand:
- Increase of national income Y
- Population growth
- A fall of the real interest r (cheaper borrowing)
- Improved access to credit availability.
Hence, investment responds indirectly to these changes through the effect on PH /P .

Inventory investment
 A small (only about 1% of GDP) but very volatile component of Aggregate Demand.
 In a typical recession, more than half of the fall in spending is due to a fall in
inventory investment.
 Motives for holding inventories:
 To smooth production (when sales < > production)
 To support production & sales (e.g. having spare parts)
 To avoid out-of-stocks
 For work in progress.
The accelerator model is a simple theory that explains inventory investment (ignoring a
particular motive).
 Suppose stocks N are proportional to production:
N = βY ( β > 0)
 Because investment implies a change of stock, it follows
I = ΔN = βΔY
where ΔY < > 0.

Implications:
 If the economy grows, ΔY > 0, there is an additional positive effect on Aggregate
Demand because inventory investment becomes positive I > 0, thus accelerating
economic growth.
 If the economy shrinks, ΔY < 0, there is an additional negative effect on Aggregate
Demand because inventory investment becomes negative I < 0, thus accelerating
the recession.
 Observe the interaction between I and Y:
 I  Y: the multiplier effect
 Y  I : the accelerator effect

Note that inventory investment also depends on the real interest rate:
 There is an opportunity cost of holding goods in inventory: the interest that could
have been earned on the revenue from selling those goods.
 The higher the interest, the lower inventory investment.
Indeed, we have found that all three types of investment depend negatively on the real
interest rate.