2011 Highlight Notes

EC210 HIGHLIGHTS ! ∗ = !
"
(2) Measurement e should be expressed in foreign currency/unit of local

currency (e.g. $X/£). The Penn effect states that prices
Coconut producer Restaurant tend to be higher (correcting for currency exchange
Total revenue 20 Total revenue 30 rates) in wealthier countries
Wages 5 Coconut costs 12
(3) Microfoundations
Loan interest 0.5 Wages 4
Taxes 1.5 Taxes 3
Taxes and labor supply: Cutting lump sum tax
Consumer Government
increases leisure by pure income effect (reduces labor
Wage income 14.5 supply). Cutting proportional income tax reduces
Tax revenue 5.5
Interest income 0.5 leisure (increase labor supply)
Taxes 1
Wages 5.5
Producer profits 24 Time%constraint: ! + ! ! = ℎ ⟹ ! ! = −! + ℎ
Product (value-added) approach Budget'constraint'(BC): ! = !! ! + ! − !
Value added coconuts 20 20 BC#with#lump!sum$T:!! = −!" + !ℎ + ! − !

Value added restaurant 30 – 12 18
Value added government Wages 5.5 BC#with#proportional#T: ! = ! 1 − ! ℎ − ! + !
GDP 43.5
Lower lump sum tax Lower proportional tax
Expenditure approach C C
Consumption 30 + (20 – 12) 38

Investment 0 0
c’ c’
Government Wages 5.5 c c
Net exports 0 0
GDP 43.5
Income approach
l l
l l’ h l’ l h
Wage income 14.5 14.5
After-tax profits 13 + 11 24
Interest income 0.5 0.5 The labor supply curve (w against N) is upward
Taxes 1.5 + 3 4.5 sloping, ie. Assume that the substitution effect of an
GDP 43.5 increase in w is greater than the income effect (leisure
is “inferior”). A rise in real wages has the same effect
Implicit GDP price deflator as a fall in proportional tax
1 2 Neoclassical production function: (1) Constant returns

! !! !!
Laspeyres(quantity(index(!(!): !! = 1 1 to scale, (2) positive and diminishing marginal
! !! !!
products, (3) Inada conditions (MP goes to infinity as
2 2 input goes to zero, MP goes to zero as input goes to
! !! !!
Paasche'quantity'index'!(!): !! = 2 1
infinity)
! !! !!
! = !"(!, !)
Chain!weighted(ratio: !! = !! !!
Real%GDP2 = !1! !1! ×!!

!
2 2
Nominal(GDP ! !! !!
Implicit(GDP(deflator = = 1 1
Real%GDP ! !! !! ×!!
Consumer price index (CPI)
! !
! !! !!
Laspeyres(price(index!! ! : !"# = ! !
! !! !!
Purchasing power parity (PPP) ! = !" !, ! − !! !
EC210 (2012-13 syllabus), ivantwk@gmail.com 1

!" N’/N c
= !!! − ! = 0 ⟹ !!! = !
!" z2f(l)
B
g(c) c’ z1f(l)
Competitive equilibrium and Pareto efficiency: First
C B C
welfare theorem states that a competitive equilibrium 1 c*
A A
is Pareto optimal under certain conditions (no
externalities, perfect competititon etc.)
!"# = !"# = !!! = !

c l
c* c’ l*2 l*1
!"!Per$unit$tax = 1 − ! !
Increase in land supply: Quantity of land per worker
Pareto efficiency: Household utility is maximized u and MPL increase following an increase in land
subject to the aggregate resource constraints of an
supply. Workers become more productive and c
economy – there is no tradeoff of making some better
increases. Population growth rate increases until MPL
off without making others worse off. This means
fall back to original levels
equating MRS (rate at which leisure can be
substituted for consumption) with MRT (rate at which
N’/N c
technology converts one good into another)
Pareto efficiency and proportional tax: A proportional g(c) g(c)

r tax results in MPN being higher than the after-tax 1
C B
c’
c* C B
wage (MRS) received by the consumer. It would be A A
socially optimal to supply more labor, but the tax
scheme does not incentivize workers to do so. Labor
is undersupplied
c l
c* c’ l* l’
u (5) The Malthusian model
Malthusian theory: Long run standard of living is Population control: Lower population growth rate
determined solely by the population growth function
n increases supply of land per worker and MPL, raising
g. Improvements in the production function, such as per capita consumption in the long run
technology, have no effect. Population growth is
endogeneous and dependent on rising living N’/N c
standards. In the long run, population growth is zero,
and c is a constant – economic growth is zero g1(c) z1f(l)
c2*
A B g2(c) B
Neoclassical)production:!! = !" !, ! ⟹ ! = !"(!) 1 c1* A
Market'clearing: ! = ! = !"(!)
!!
Population*growth: = ! ! = ! !" ! c l
c1* c2* l*1 l*2
!
Steady'state: ! ! = ! ⟹ ! ! = !" !" ! (6) The Solow Model
At#the#steady#state,#! ! ∗ = 1 ⟹ ! ∗ = !"(! ∗ ) Basic Solow model: Unlike the Malthusian model

(fixed supply of land), capital is reproducible and can
u Increase in TFP and transitional dynamics: The
economy does not move to the new steady state
be accumulated endogenously. Population growth is
exogenous and independent of rising living standards.
immediately, as it takes time for the population to Due to the rival nature of capital as well as its
adjust to N’/N=g(c). c and N’/N temporarily rise above diminishing MPK (savings increase at a decreasing
their steady state levels. However, c subsequently rate) with constant effective depreciation, exogenous
falls (due to the fixed supply of land per worker and TFP shocks (technological progress) is necessary for
dwindling MPL) and converges to its initial level sustained increases in standard of living
Capital'accumulation: ! ! = 1−! ! + !"

Old$K$net$depreciation New$K
!! 1 − ! ! !" !! !!
= + ⟹ !× = 1 − ! ! + !"
! ! ! ! !
!! ! !!!
! ! 1 + ! = 1 − ! ! + !"
capital per worker will equal the growth rate of B
⟹ 1 + ! ! ! = 1 − ! ! + !"#(!) which is exogenous in the model
!!"!by#CRTS
ye
⟹ 1 + ! ! ! − ! = !"# ! − !" (n+d+g)k*
ye* sf(ke*)
⟹ 1 + ! ! ! − ! = !"# ! − ! + ! !
1 − ! ! !"# !
Steady'state: ! ! = ! ⟹ ! ! = +
1+! 1+!
ke
⟹ 1 + ! ! ∗ = 1 − ! ! ∗ + !"#(! ∗ ) ke*
⟹ ! + ! !∗ = !"#(! ∗ ) !
Effective(depreciation Replacement*of*k
! = !" !, ! = ! !, !" ⟹ !! = ! , 1 = !(!! )
!"
y !! 1 − ! ! !" ! ! !" !
(n+d)k* = + ⟹ × = 1 − ! !! + !!!
!" !" !" !" ! !"
y* szf(k*) !!!! !!! !!!
⟹ !!! 1 + ! 1 + ! = 1 − ! !! + !!!
≈!!!!!
⟹ 1 + ! + ! !!! − !! = !" !! − ! + ! + ! !!
k
k*
Long term growth rates: Because B is growing, if

Golden rule steady state: The savings rate that investment only covers depreciation, !! must be
maximizes steady state per-worker consumption falling. So investment must cover both depreciation
and growth in B for !! to remain constant
Solow with
Solow
technology
K per effective worker (ke) NA 0
Y per effective worker (ye) NA 0
K per worker (k) 0 g
Y per worker (y) 0 g
Labor (N) n n
Capital (K) n g+n
Output (Y) n g+n
(7) Beyond the Solow model

! = 1 − ! !" ! ∗ = !" ! ∗ − ! + ! ! ∗
!!"# ! ∗ !in#SS Solow model convergence: Rich and poor countries
with identical d, s, n and access to technology will
!" converge to the long run growth path, K and Y per
= !! ! ! ∗ − ! + ! = 0 ⟹ !"# = ! + !
!" worker. Poor countries will experience a ‘catch-up’
(accelerated growth) effect due to higher MPK due to
Change in population growth rate: Represented by a lower K endowment. The initial rich-poor gap
pivot of the effective depreciation line. Steady state attributed to higher capital held by the rich country
level of per worker output changes. Growth of output narrows and disappears in the long run. However, this
per worker changes temporarily, however long term may not be possible due to (1) unequal access to
growth rate of per worker output is 0 technology, (2) factors of production may be allocated
differently (e.g. inefficient firms due to corruption)
Change in total factor productivity (z): Represented by
a shift of the szF(k) curve. Steady state level of per
K endowments Y convergence Growth convergence
worker output changes. Growth of output per worker
changes temporarily, however long term growth rate
of per worker output is 0
Solow model with labor augmenting technology:

Diminishing MPK and constant effective depreciation
result in capital per effective worker converging to a
constant ke*. This implies that the growth rate of

Lucas (1990): Large differences in output per worker (1+n)(k’-k)
imply large differences in capital per worker and sAk(rich)
hence MPK – MPK should be higher in poor countries
given the negative relationship with y. Yet capital does
not flow from rich to poor countries. This may be sAk(poor)
attributed to (1) Missing capital (‘learning by doing’),
(2) R&D and technology adoption, (3) Institutions (d+n)k
(human capital)
k
!
! ! !
!= = !! ! ⟹ ! = ,!where!! = Capital'share
! ! If sA > d+n, then k is growing at a constant rate even
though A is constant. There is no steady state for k,
!!!
! ! ! !!! and growth persists in the long run. If sA < d+n, then k
!!!
!"# = !"! = !" = !! ! !!
is falling and converges to zero
!
Growth accounting: Measuring the growth in (8) Endogenous growth models

aggregate output accounted for by factor
accumulation and growth in TFP. If fast growth is due Learning by doing model: If the level of economy-wide
to high TFP growth (ie. g), growth in per worker output knowledge is not exogenous, differences in Y through
is sustainable (long run). If fast growth is due to high K differences in knowledge accumulation is due to
accumulation, short run growth exceeds steady state differences in savings. B is assumed to be a positive
growth but falls back due to diminishing MPK function of aggregate K due to knowledge spillovers.
Despite there being diminishing MPK at the firm level,
! = !! ! ! !!! positive externalities imply that the aggregate
production function displays no diminishing MPK
⟹ ln ! = ln ! + ! ln ! + 1 − ! ln !
! = ! !, !" = ! ! !" !!!
∆! ∆! ∆! ∆!
⟹ = +! + (1 − !) Positive(externality: ! = !", ! > 0
! ! ! !
TFP$growth Factor'accumulation
An#'AK ' model:!! = ! ! !"# !!!
= !!!! ! !!! !
Development accounting: Differences in the level of
technology are needed to account for large cross- Capital'accumulation: ! ! − ! = !" − !"
country income differences
! ! ! ! ! !" !"
! × − = − ⟹ ! ! 1 + ! − ! = !" − !"
! !!! !! ! ! ! !
!!∗ = Assume&n=0
!+!+!
⟹ ! ! − ! = !!!!! ! !!! ! − !"
!
! !!!
!∗ = ! !! − !
!+!+! ⟹ Growth'rate = = !!!!! ! !!! − ! = Constant
!
AK model: There is no steady state for k, and growth
If !!!!! ! !!! > !, there is constant and long run
persists in the long run
endogenous growth. Unlike the Solow model,
!!! technology parameters are not exogenous, savings
!
!"# = !" = !"! !!! rate affects both income and growth rate; scale
! effects are also present as N affects growth rate.
Differences in saving between rich and poor countries
In the Solow model, α<1, A is constant, then MPK falls can hence lead to divergence in incomes over time
as K/N rises – the incentive to accumulate K will
eventually disappear. However, if the fall in ! !!! is Human capital model: A tradeoff exists between
matched by a rise in A, MPK remains constant
producing goods and services in the present or
postponing production for future productivity gains by
If!! = 1, ! = !" ⟹ !"# = !
accumulating human capital (e.g. receiving education).
A highly skilled workforce can produce more output in
!! !! 1 − ! ! !"#
K"accumulation:! × = + the future as well as pass on skills to others. Unlike
! ! ! ! ! physical capital accumulation, knowledge is non-
rivalrous and is not faced with diminishing marginal
1 + ! ! ! − ! = !"# − ! + ! !
returns. Despite having different levels of initial human
capital, rich and poor countries have the same
⟹ 1 + ! ! ! − ! = ! !" − ! + !
consumption growth rates if b, z and u are identical –
convergence does not occur

!= ! × ! × !! !!
Growth'rate'of'knowledge:!! = !=!
Real%wage Fraction)of)time)working Human&K&stock !
Cost%of%new%inventions
!!′ = ! × 1 − ! !!
Future&human&K Efficiency(of(human(K(accumulation Scale effects: Growth rate of knowledge depends on
the size of the population. This implies that countries
! = ! ×!! ! with larger populations have higher growth rates,
CRTS%in%human%K Marginal(product(of(efficiency(labor(units technology levels and are hence richer. It could also
be intepreted as an international technology transfer
! = ! − !"! ! = !"! ! − !"! ! = ! − ! !! !
An increase in labor share to R&D: Leads to a
Competitive equilibrium: The growth rate of permanent increase in the growth rate of knowledge.
consumption must equal the growth rate of human However, y falls temporarily as labor is reallocated
capital. Assuming no population nor technology from production into R&D
growth, growth occurs due to endogenous factors
determined by b and u. E.g. if b(1-u) > 1, human
lnA Productivity growth lny Output growth
capital and consumption increase forever
Market'clearing'condition:!! = ! × !"
!!! !! ! !!! !
!! !"! !
Growth'rate'of"consumption: −1= −1=⋯
! !"#
!! T T
Growth'rate'of'human'K ⟹ −1=! 1−! −1 T at which γA increases T at which γA increases
!
Decreasing u (e.g. increasing education): A decrease Research and development (Two country model)
in u increases the growth rate of consumption at the
expense of current consumption, because initial !! = !! 1 − !!,! ×!! , ! ∈ 1,2
human K is fixed. However, the government does not
have to incur any real resource costs. Depending on Technology*leader:!!!,! > !!,!
consumers’ patience, it is unclear if decreasing u will
be desirable Imitation costs: Copying costs are low if the difference
in productivity between the leader and follower are
lnC Decreasing u lnC = lnY No convergence large (ie. high A1/A2). Copying costs increase when
the leader-follower productivity gap narrows (ie. low
New consumption
Rich country
A1/A2). When both the leader and follower have the
same level of productivity, copying costs equal
inventing costs
Old consumption
Poor country
!Copy < !Invent ≡ !! < !!
!!
T T !! = !
!!
Increasing b (e.g. raising quality of education): μc Imitation costs Productivity growth

Increasing b raises growth rate of consumption
without the expense of current consumption.
μi
However, the government incurs real resource costs
Research and development (One country model):

Unlike the Solow model, knowledge accumulation is
non-rival and without diminishing MPK. Long-run c(A1/A2)
growth is endogenous, assuming !! remains constant A1/A2 A1/A2
1 1 (A1/A2)ss
!= !! + !! ⟹ !! + !! = 1
Workers'in'R&D Workers'in'production !!,! !!,! !!,! !!!!
Steady'state:! != ! ⟹ !! = !! = ! !!
!! !! !!,! !!
! = !!!
An increase in R&D in the leader (!!,! ): Shifts up !! ,
! !!! !! !!
!= = =! =! 1− = ! 1 − !! resulting in a higher steady state A1/A2, raising the
! ! ! ! growth rate of productivity per worker in the follower
as the cost of copying falls
Output growth Productivity growth Keynesian consumption function: Autonomous
Iny consumption plus consumption that varies with
y1 income
y2
! = ! + !"
! !
!"# = = +!
! !
T A1/A2 Modigliani’s life cycle theory: Income varies

1 1 (A1/A2)ss systemically over the consumer’s life cycle.
Consumers plan over their lifetime to smoothen
An increase in R&D in the follower (!!,! ): Shifts up !! , consumption (ie. borrow when young, save during
resulting in a lower steady state A1/A2. Growth rate in middle age and dissave during old age)
A increases temporarily, while growth rate in y falls
initially ! + !!×!Years&to&retirement&(!)
!= !
Remaining(life(span((!)
Productivity growth !
1 !
!= !+ !! ⇒ ! = !!" + !"!
! !
!
! !
!"# = =! + !!
! !
!
Explaining the consumption puzzle: In the short run,
A1/A2
wealth does not vary proportionately with income –
1 (A1/A2)new higher incomes correspond to lower APC. In the long
run, wealth grows in tandem with income, resulting in
Productivity growth Output growth a constant W/Y ratio and thus a constant APC
A lny
A1 y1 Friedman’s permanent income theory: While current

A2 income is the sum of transitory and permanent
y2
income, consumption only depends on permanent
income. If changes in current income are mainly
transitory, they have little impact on consumption.
Positive transitory shocks are translated into savings,
whereas negative shocks imply dissaving
T T
T at which γA2 increases T at which γA increases
! = !! + !!
Appropriate technology: Technologies developed in
! = !! !
the leader might not be appropriate to the follower.
E.g. the leader tends to have more physical and ! !! !
human capital !"# = = !
! ! + !!
y Neutral technological change y K-biased technological change

Explaining the consumption puzzle: In the short run,
y=A’f(k)
y=A’f(k)
fluctuations in income are dominated by transitory
y=Af(k) y=Af(k) income – high income should be met with low APC. In
the long run, variations in income arises from the
permanent component – and hence constant APC
Intertemporal model (Graphical)
Poor Rich Poor Rich Current'budget'constraint: ! + ! = ! − !

k k
Future&budget&constraint!(FV): ! ! = ! ! − ! ! + 1 + ! !
(9) Consumption
!!
Kuznets consumption puzzle: (1) APC was falling Lifetime'budget'constraint: !(!") = ! +
1+!
across households at a point in time (ie. short run
falling APC with current income), (2) APC within a !! − !! + 1 + ! !
country remains constant over time (ie. long run ⟹ !(!") = ! − ! − ! +
1+!
constant APC with current income)
!! !!
⟹ !(!") = ! + −!−
1+! 1+! Maximize(lifetime(utility(st.(lifetime(budget(constraint
c’
MRS = 1+r
! !, ! ! = ! ! + !" !(!" − !)
w(FV)=w(1+r)
!" !, ! !
Consumer is a lender = ! ! ! − !"! ! (! ! ) = 0 ⟹ ! ! ! = !"! ! (! ! )
!"
y’-t’
Endowment
Substitute(c(or(c ' !into%the%budget%constraint%and%solve
Consumer is a borrower
Slope: 1+r
c
!!! !′(!)
y-t w(PV) !"!!,! ! = = =! =1+!
!!!! ! !! ! (! ! )
Temporary and permanent increase in income: A
Consumption with borrowing (collateral) constraint
permanent increase in income has a larger effect on
(e.g. borrow against housing)
current consumption than a temporary increase. A
temporary income increase results in disproportionally ! ! − ! ! + !"
higher savings, so current consumption does not Unconstrained,BC:!! = ! − ! +
1+!
increase as much
Collateral(constraint:! − ! 1 + ! ≤ !"
c’
!"
Constrained+BC:!! ≤ ! − ! − ! ⟹ ! ≤ ! − ! +
1+!
c’
B
BC(perm)
BC(temp)
A c
c1 c2 c3 Temp increase
E
Permanent increase
Increase in real interest rates: Higher real interest rates

increase the relative price of current consumption, ie.
the budget constraint pivots at the endowment
c’ Lender c’ Borrower
c
w2(FV) w2(FV)
=w(1+r2) =w(1+r2)
B
w1(FV)
=w(1+r1)
Proportional tax cut (! < !, ! ! < ! ! ): Temporary
w1(FV) E
proportional tax cuts result in current consumption
=w(1+r1) A A being cheaper relative to future consumption. The
B
budget constraint pivots about future consumption.
E
By substitution effects, current consumption increases
c c
w2(PV) w1(PV) w2(PV) w1(PV) along the current IC. Positive income effects expand
the budget set, increasing both current and future
Lender Borrower consumption. Because income and substitution
Current C (c) ? Decrease effects work in opposite directions, the net effect on
Future C (c’) Increase ? future consumption is uncertain. Permanent cuts
Current savings (s) ? Decrease result in the budget set shifting outwards. There is no
substitution effect, as the relative price of current and
Intertemporal model (Mathematical analysis): Current future consumption remains unchanged – there is
consumption depends on lifetime wealth. The effect of hence no incentive to substitute to either one
changes in current income on current consumption
1 + !! !! 1 − !! !!
depends on how current income affects wealth !":! 1 + ! ! + = 1−! !+ = !"
1+! 1+!
0 < ! < 1:!Discounting*future*consumption
1+! 1+! 1+!
⟹ !! = !
!" − !
Lifetime'utility'function: ! !, ! ! = ! ! + !"(! ! ) 1+! 1 + !!
!! !!
Lifetime'budget'constraint: ! + = ! + = !"
1+! !
⟹ ! ! = !(!" − !)
c’ Temporary cut in VAT c’ Permanent cut in VAT c’ Non-binding c’ Binding
E E
c c c c
(10) Ricardian equivalence & credit market

Mathematical analysis example: The marginal effect of imperfections
a fall in housing prices on current consumption is
greater for credit constrained consumers than Ricardian equivalence: Assuming perfect, frictionless
unconstrained consumers capital markets and rational consumers, a change in
the timing of taxes by the government has no effect
! !, ! ! = ln ! + ! ln ! ! = ln ! + ! ln ! ! − ! on consumption. A tax cut in the current period will
shift endowment from E1 to E2, increasing the
!" !, ! ! 1 !" 1 !" capacity for current consumption from c1 to c2.
= − = − ! =0
!" ! ! !−! ! ! However, the consumer continues to consume at A –
the additional current consumption is saved to pay
! ! = !"# higher taxes in the future
!"# Government)current)BC: ! = ! + !
From%BC, ! = ! + = ! + !"
!
Government)future)BC: ! ! = ! ! − 1 + ! !
! !"#
!= !! =
1+! 1+! !! !! !!
!+ =!+ =! !+
1+! 1+! 1+!
!" !
Borrowing(constraint: ! ≤ ! − ! + ,! ≤ ! ! − !
! !! !!
Individual)wealth:!! = ! + − !+
! 1+! 1+!
Unconstrained,consumer ! = 1 + !
! !" :
≤!−!+ !"# !! 1 !!
1+! ! !! = ⟹!+ − !+
1+! 1+! ! 1+!
Constrained+consumer !"
! !" :! ! = ! − ! + ! c’
>!−!+
1+! ! !! = !! − !!
E1
!!Unconstrained 1 !!Constrained
= < 1=
!" 1+! !"
! ! E2
! ! A
Unconstrained,marginal,effect Constrained+marginal+effect
Credit rationing vs unlimited costly borrowing (r*>r)

c1 c2
c
c’ c’
Costly borrowing Credit rationing
preferred preferred
The Ricardian equivalence might not hold due to
E E
unequal tax burdens, distortionary effects (reducing
incentives to work) and credit market imperfections
such as intergenerational transfers (“You can lend to
the previous generation, but they will die before you
get your money back. Or you can lend to the next
generation, but they are not around yet”)
c c
Credit market imperfections: Due to asymmetric
information about default risk, lenders face a lower
Binding and non-binding borrowing constraints: See
interest rate than the one faced by borrowers (!! < !!
(10) Credit market imperfections
especially so during the financial crisis). A kink forms

at the endowment point. When there are no “good” budget set. Collateralizable wealth decreases, as the
borrowers, the BC will be vertical at the kink quantity of wealth that the consumer can borrow
against has fallen. Non-binding consumers will
!! ! ! − !′ smoothen consumption by reducing consumption in
Lender: !! = ! + =!−!+
1 + !! 1 + !! both periods, whereas binding consumers will reduce
current consumption, leaving future consumption
!! ! ! − !′ unchanged
Borrower: !! = ! + =!−!+
1 + !! 1 + !!
c’
c’ E
Borrower BC
E c
Lender BC
c Pay-as-you-go social security: Taxes on the working

population pay for social security transfers to retirees
in each period. Old consumers in time T enjoy b
Current lump-sum tax cuts: When borrowing is
additional units of future consumption at the cost of
constrained, a current lump-sum tax cut is equivalent
zero forgone consumption today (BC shifts up, current
to a loan from the government at below-market rates.
consumption remains unchanged). Young consumers
This enables the both the kink and binding IC to move
in time T enjoy b additional units of future
outwards – the credit-constrained consumer is hence
consumption at the cost of ! = ! 1 + ! units of
better off by spending the entire tax cut on current
consumption today (BC shifts up, but current
consumption
consumption decreases). All consumers are better off
c’ !!
Population*growth: =1+!
!
!
E1 Social'benefit'equals'taxes: !" = ! ! ! ⟹ ! =
1+!
E2 Higher'!,"lower"!
c’ c’
c Old in time T Young in time T
Consumption and asymmetric information:

Asymmetric information between lenders and E2 E2
borrowers can explain interest rate spreads if B B
borrowers have some private information that lenders A With SS A With SS
cannot observe (e.g. their probability of default). E1 No SS
E1 No SS
Lenders know this and so will charge an interest rate c c
higher than the cost of funding so as to compensate

them for the risk, hence !! < !!
Pay-as-you-go social security is only beneficial (ie. the
!= !" 1 + !! − ! 1 + !! =0 budget constraint shifts out) if the population growth
Interest'repayment'from'borrowers Payment(to(lenders rate (n) exceeds the real interest rate (r). This is so that
the rate of return of the social security system is
1 + !! higher than the rate of return in the private credit
1 + !! = market. This is possible because every pensioner has
!
1 + ! young people transferring benefits to him
⟹ When!! = 1!(ie.%all%borrowers%are%good):!!! = !!
! !! + ! !! ! !−!
!" = ! − + =!+ +
⟹ When!! = 0! ie.$all$borrowers$are$bad : 1 + !! → ∞ 1+! 1+! 1+! 1 + ! (1 + !)
Limited commitment with a borrowing (collateral) !! 1+!

constraint: See (9) Consumption with borrowing ⟹ Alternatively,!!!" = ! + + −1 !
1+! 1+!
(collateral) constraint. A fall in the price of collateral
(pH>p’H) is represented by an inward shift of the
When n<r, the present discounted value of b is
negative. Taxes paid by today required to fund the !"# ! !"! ! + 1 − !
From%(3), = −1 + =0
large old generation are higher than their expected !! ! 1+!
level of benefit b – intertemporal BC shifts inwards
⟹ !"! ! − ! = !
c’
n<r Tobin’s q theory of investment: Expected value of a
corporation divided by the value of its capital stock at
replacement cost. This gives the expected value of a
unit of capital relative to its current purchase price
A
Constant'returns'to'scale: ! ! = !"! ! ! ! + !"! ! !′
E2 B
E1
!"! ! = !′
With SS No SS
c
!! − ! !! ! + 1 − ! ! !
Market'value'of'installed!!:!
1+!
Fully-funded social security: The social security
system mandates a level of saving higher than the ! ! − !"! ! ×! ! + 1 − ! !′ !"! ! ! ! + 1 − ! !′
⟹ =
level chosen by the consumer in its absence. The 1+! 1+!
consumer is worse off, as he is now placed on a lower
indifference curve than before. However, a fully- Replacement*cost*of*installed!!: !′
funded social security system can solve a
commitment problem (ensuring that people have !"! ! ! ! + 1 − ! !′
Market'value 1+!
sufficient consumption in the future instead of relying != =
on the government). Yet a fully-funded system is not Replacement*cost !′
impervious to political interference and moral hazard
!"! ! + 1 − !
⟹ = 1
1+! Marginal(cost(of(investment
c’ Fully funded SS Marginal(benefit(of(investment
When q>1, MPK’>r+d, the stock market values the

profits flowing from a firm’s assets higher than the
B costs to acquire these assets. When q<1, the firm
A would be better off selling some of its assets as their
resale value exceeds expected profits in retention
y’ E
! > 1 ⟹ !!! ! + 1 − ! > 1 + ! ⟹ !"! ! > ! + !

y-c1 y
c
Investment and asymmetric information: A risk
premium/interest rate spread reflects the severity of
(11) Investment
the asymmetric information problem, reducing net
MPK given r. Risk premium increases as the
Intertemporal investment decisions
asymmetric information problem worsens
Current'profits:!! = ! − !" − ! … (1)
Risk%premium/interest%rate%spread:!! = !loan − !lending
! ! ! ! !
Future&profits:!! = ! − ! ! + 1−! ! … (2)
Disposal(of(leftover(K'
Invest'if!!"! ! > !lending + ! + !
Capital'accumulation: ! ! = 1 − ! ! + ! Current TFP and investment: Under perfect financial

markets, the investment decision is dependent on
!! MPK’. A current temporary TFP shock has no effect
!" ! = ! + … (3) on the investment decision. If credit market
1+!
imperfections exist (e.g. additional constraints), a
Investment,)I
!! − ! !! ! + 1 − ! ! ! change in current TFP can change profits and hence
⟹ ! − !" − ! ! − 1 − ! ! + investment. Alternatively, we can examine the effects
1+!
PV(Current*profits)
PV(Future)profits)
of current TFP change in dynamic macro models
(Keynesian model – no change in investment, RBC –
!" change in investment)
From%(1), = ! = !"#
!"
(12) Unemployment
!! !
From%(2), = ! ! = !"#′ Efficiency wage model: Firms will pay a real wage
!! !
higher than the competitively-determined wage to
induce employees to not shirk on the job. In interest rates. Assuming w* remains unchanged,
equilibrium, more workers than are employed would unemployment falls
like to work, hence unemployment. But the firm is
unwilling to offer the market-clearing wage, because w Labor market r Output market
this would reduce its profits given that workers exert Ns(r’) Ys Ys’
lower efforts. In overcoming the problems of moral Ns(r)
hazard and adverse selection, higher wages attract,
retain workers and increase the value workers attach w*
to their jobs. If the efficiency wage is lower than the
competitive wage, the competitive outcome is r
Nd’
sustained at zero unemployment r’
Nd Yd
! = ! !, ! = ! !, ! ! ! N Y
Nd Nd’ Ns’ Ns
! = ! !, ! ! ! − !"
Increase in effort monitoring: An improvement in effort
!" !" !" !" ! monitoring reduces the efficiency wages required to
=! ! −! ⟹! ! =!⟹ = induce all levels of effort. The effort curve shifts up,
!" !" !" !" ! !
and the efficiency wage falls. Unemployment falls and
!" !" !" output supply increases
= !! ! ! − ! ⟹ !! ! = 1 … (1)
!" !" !" e(w) Effort w Labor market r Output market
e’(w) Ys Ys’
Ns(r’) Ns(r)
Solow condition: Set w to maximize the effort from e(w)
each worker per unit of real wages paid w*
w*’
r
!" !! ! ! ! !
Sub! !into! 1 : = 1 ⟹ !! ! = Nd
r’
Yd
!" ! ! ! w N Y
w*’ w* Nd Nd’ Ns’ Ns
e(w)
e(w) Search model of unemployment: The change in
unemployment rate is due to the difference in the
inflow and outflow from unemployment. Unemployed
workers are faced with the choices of working for a
given wage or continue searching for work
Law$of$motion: !!!! − !! = ! 1 − !! − !! !" ! ∗

w
w* ∆Unemployment Job$separation Job$finding
Increase in government spending: Because firms are ! ×! = !× ! × !(! ∗ )

Finding&rate Pr(Offered(a(job) Pr(Job'pays'>! ∗ )
only willing to offer w*, quantity of labor demanded is
determined only by the labor demand curve. As a
! 1−! = !"
result, output supply is vertical (labor demand is not
Employed)losing)jobs Unemployed*finding*jobs
affected by r). An increase in G shifts output demand
to the right, raising r and labor supply as consumers !
substitute away from leisure to labor. Labor demand Steady'state'unemployment: ! =
!+!
remains unchanged – w* remains unchanged, and
unemployment increases Job finding rate: Unemployed workers who receive
offers will decide whether to accept or decline
w Labor market r Output market depending on their reservation wages. P represents
Ns(r) Ns’(r’)
Ys the fraction of unemployed workers receiving a job
offer, and H(w*) represents the fraction of offers
greater than the reservation wage w*
w* r’
Reservation+wage: !! ! ∗ ≥ !!
r
Yd’
Nd Yd Increase in unemployment benefits: An increase in
N Y unemployment benefits increases the welfare of the
Nd Ns Ns’
unemployed from !!! to!!!! and hence the reservation
wage. Workers can afford to be more picky about
Positive current TFP shock: A positive current TFP wages they accept. As ! ! ∗ is decreasing with w,
shock increases labor demand due to higher MPN. higher w results in !" pivoting downwards, assuming
Output supply shifts to the right and lowers real U and p remains constant. Unemployment increases

Ve(w) Inflow, outflow
Ve(w)
Ve(w)
Vu2
Vu2
Vu1
Vu1
w w
w1* w2* U1 U2
w w
w1* w2* U2 U1
Increase in taxes on wage income: An increase in

taxes on wage income decreases the welfare of being Efficiency wage vs search model: Frictions in the job
employed from !!! to !!! and raises the reservation market lead to unemployment. In the efficiency wage
wage. Workers become more picky, and the fraction model, informational frictions within jobs (e.g.
of workers receiving wage offers who accept these unobservable efforts) demand higher wages so that
offers fall. As ! ! ∗ is decreasing with w, higher w workers will exert good efforts. In the search model,
results in !" pivoting downwards, assuming U and p frictions matching workers and firm outside jobs (ie.
remains constant. Unemployment increases matching and separating) result in slow market
clearing. So unemployment is always positive
(14) Measuring macroeconomic fluctuations
Ve(w)1
Business cycle facts
Ve(w)2
Vu1 Var Mvt Time Vol Explanation
P Ctr Coincident Lower Increasing
cyclicality in recent
w w times – unclear
w1* w2* U1 U2
I Pro Coincident Higher Investment plans

Positive current TFP shock: A positive current TFP are easy to adjust
shock raises MPN and wages offered by all firms. – no smoothening
There is a higher fraction of wage offers that are
higher than ! ∗ for all wage levels – ! ! shifts C Pro Coincident Lower Low volatility due
outwards, causing !" to pivot upwards. At the same to consumption
time, the welfare of the unemployed increases from !!! smoothening
to !!! . Workers on average can afford to reject a wage
offer in anticipation of one higher, resulting in a higher APN Pro Coincident Lower Increasing counter
reservation wage. Changes in unemployment is cyclicality in recent
uncertain – net unemployment is reduced if the effect times – unclear
of the former dominates the latter
Labor hoarding:
Ve(w) Inflow, outflow H(w)
Hiring in
Ve(w) anticipation of
Vu2 recovery
Vu1 H’(w)
H(w)
TFP shocks:
w w w
Business cycles
w1* w2* U2 U1
due to exogenous
changes in
Increase in job offer rate (p): A higher p raises the productivity
welfare of the unemployed from !!! to!!!! and hence
the reservation wage. This is because workers can Increasing returns:
afford to be more picky, as they do not have to wait Returns to labor
for as long for another wage offer if the current one is are not necessarily
rejected. As ! ! ∗ is decreasing with w, higher w diminishing
results in !" pivoting downwards. At the same time, a
higher p results in !" pivoting upwards due to higher N Pro Lagging Lower
likelihood of matching unemployed workers with hiring Ms Pro Leading Lower Increasing counter
firms. Changes in unemployment is uncertain – net cyclicality in recent
unemployment is reduced if the effect of the latter times – unclear
dominates the former. Net effect on welfare is also
uncertain given resources expended in raising p
w Pro Unclear Lower !! − ! !! ! + 1 − ! ! !
! = ! − !" − ! +
1+!
Additional business cycle facts
!!! = !
Variable Mvt Time Vol
G A N/A Lower !!!! = ! + !
Real interest (r) Ctr Leading Lower
Current account Ctr N/A N/A Government budget constraint
X Pro Coincident Higher
!! !!
Capacity utilization Pro Coincident Higher !+ =!+
C (Durables) Pro Coincident Higher 1+! 1+!
Solow residual Pro Coincident Lower
Complete macroeconomic model: Substitution effects
C (Non-durables) Pro Coincident Lower
are highlighted in blue, wealth effects are highlighted
Inflation (i) Pro Lagging Lower in red
Nominal interest (R) Pro Unclear Unclear
Temporary increase in G
Consumption volatility: Volatility of consumption of
durables > nondurables > services. This is because Labor market Output market Investment market
nondurables and services provide immediate utility, w r r
the latter of which cannot be stored. Marginal utility to Ns

Ns’
Ys
Ys’
consume is hence high even when prices are high, Ns’(r’)
indicating insensitivity to price fluctuations. Durables r’ r’

Yd’
provide utility spread over a long time period, and so w r r
price changes do not translate into large changes in w’

Nd Yd MPK-d
utility in the short run as consumption is postponed N N’

N
Y Y’
Y
I I’
Id
Labor hoarding: In the absence of TFP shocks, APN is Permanent increase in G (see Chapter 20)
countercyclical as the gradient of the ray from the
origin to the production function falls with higher Labor market Output market Investment market
output. However, if firms hoard their workers during w r r
recessions, actual productive employment may be Ns

Ns’
Ys
Ys’
lower than the measured level of employment. APN

may hence be procyclical
w r r
Yd’
w’
Y Countercyclical APN Y Procyclical APN Nd Yd r’ MPK-d
With labor hoarding N Y Id

N N’ Y Y’ I
Y=zF(K,N) Y=zF(K,N)
Y_hi Y_hi
Increase in future G
Y_lo Y_lo
Labor market Output market Investment market
w r r
Ns’(r’) Ns Ys
Ns’
Ys’
N_lo (actual) N_hi

N N_lo (measured) N_hi
N
w’
w r r
(15) A dynamic macroeconomic model Nd r’

Yd’
Yd r’ MPK-d
N Y Id
N’ N Y’ Y I I’
Household preferences
Temporary increase in TFP/current TFP shock
!! ! ! ℎ − !! + ! ! − ! !
!":!! + =! ℎ−! +!−!+
1+! 1+! Labor market Output market Investment market
w Ns(r’) r r
!"!!,! = ! !"!!!,! ! = ! ! Ns Ys
Ys’
w’
!"!!,! ! = 1 + !
Nd’
w r r
r’ r’
1+! ! Nd Yd MPK-d
!"!!,!! = N Y Id
!! N N’ Y Y’ I I’
Firm preferences Persistent increase in TFP: Higher Y, r, N than in the

temporary case

Labor market Output market Investment market q
w r r
Ns’(r’) Ns Ys
Ys’
Xs(q)
If q>R, put all
wealth in bonds
w’
Xd=0, Md=PY
Nd’ r
MPK’-d
w r R
r’ Yd’
Nd Yd MPK-d Xd If q<R, put all
wealth in credit
N Y Id
N N’ Y Y’ I I’ Xd=Y, Md=0
X
X* Y
Increase /permanent increase in future TFP
Labor market Output market Investment market Proportional credit card taxes
w r Ys’ r
Ns
Ns’ Ys
New$credit$fees:!! = ! + ! ! > !"
Ns’(r’)
r’
r’
Yd’ r Credit facilities market Money market

MPK’-d
w r q P
w’
Ms
Nd Yd MPK-d Md=P(Y-X)
Xs(q)
N Y Id
N N’ Y Y’ I I’
P
Fall in capital stock Xd Md=P(Y-X’)
R
Labor market Output market Investment market

Xd’ P’
w r Ys’ r R-t
Ns Ys
Ns’(r’)
X M
X’ X Y
r’
r
MPK’-d
w r Yd’
Money demand equation: Money demand is positively
w’
Nd’
Nd Yd MPK-d
related to Y and negatively related to R
N Y Id
N’ N Y’ Y I I’
Money&demand&eqn: ! ! = ! ! − ! ∗ ! ≡ !×! !, !
Increase in credit market risk
!
!
Labor market Output market Investment market Demand'for'real'money'balances: = ! !, !
w r r
!
Ns’(r’)
Ns
Ys
P Increase in Y P Increase in r
Ms Ms
w’ r Md=PL(Y,r) Md=PL(Y,r’)
w r MPK-d
r’
Nd Yd MPK’-d
Yd’ P Md=PL(Y’,r)
P’
Md=PL(Y,r)
N Y Id
N’ N Y’ Y I’ I
P’ P
(16) Money
Fisher equation Md Md
1+! Money neutrality: Real variables are independent of

1+! = ⟹! ≈!−!
1+! one-off unexpected changes to the money supply.
Nominal variables simply change in proportion to the
Credit card balances (! ! ): Y determines the real value money supply. The dynamic macro model predicts
of transactions (higher Y, higher number of neutrality because the equilibrium for real variables
transactions), whereas P determines the monetary depends only on relative prices
value of transactions
Money superneutrality: Real variables are independent
Transactions*constraint:!! ! = !" − !! ! = ! ! − ! ! of predictable changes in the future growth rate of
money supply. Predictable differences in the money
Credit'or'money'decision: ! − ! ! supply growth rate will change i, which has
distortionary effects on real variables because of the
transactions constraint requiring cash to be held in
advance of purchases
Transaction constraints and MRS (wage explanation):

It is too early to spend money wages received in the
next period in the current period due to the Future&BC:!! ! ! ! + 1 + ! ! = ! ! ! ! + ! ! − !
transactions constraint. It is also too late to invest in
bonds, so this money earns zero R. Holding money !!! ! − !!! ! + !! − !
⟹!= … 2
reduces the effective value of real wages by R – the 1+!
opportunity cost of not holding bonds. Substituting
!"!!,! ! , we obtain the following result for!!"!!,! Sub$(2)$into$(1):!! − !
!! + 1 + !! !! ! 1
=− + 1−
!" ! ! 1+!
!"!!,! ! ! ! ! !! ! !
!"!!,! = = ! = = + !! − !! + !
!"!!,! ! 1 + ! 1+! 1+! 1+! ! 1+! !
Transactions constraints and MRS (credit facilities !! 1 + !! ! ! + !! !! !

explanation): When workers finance their current !+ + !
=!+ + !
1+! 1+! 1+! 1+!
consumption using costly credit facilities, they must !"!! !"!Debt !"!Tax Interest'saved
pay a fee of q for each unit spent when money wages
are received in the next period. After settling the bill Household lifetime budget constraint
(assuming no default), leftover income is ! 1 + ! .
Workers will therefore supply labor optimally up to !! 1 + ! ! ! ! + !! !! − !! !
!+ = + ! − ! + − !
where !"!!,! is equal to leftover income, where ! = ! 1+! 1 + !! 1+! 1+!
for agents to be indifferent between holding both
money and credit Increase in seigniorage-funded government spending:
A one-time, unexpected growth in money supply
! ! ! ! result in unchanged inflationary expectations. Interest
!"!!,! = = = = saved and savings due to lowered debt value is used
1+! 1+! ! 1+! 1+!
to finance additional G
Higher inflation/money growth rate: With higher
! − !!
expected inflation, R is higher for every r. Given that ∆! = ⟹ ! = ! ! + !∆!
consumption is subject to a transactions constraint !
and labor income is not immediately available, higher Labor market Output market Money market
R increases the opportunity cost of holding cash and w r P
Ms Ms’
decreases the returns to working. !"!!,! falls Ns
Ns’
Ys Md=PL(Y,R)
Ys’
Ns’(r’)
Let!! ! = !, ! = ! ! , ! = ! ! P’ Md=PL(Y’,r’)
r’ Yd’ P
w r
!! !!! ! !, ! ! + ! ! !! w’
= ⟹1+! ≈ =1+!
Nd Yd
! !" !, ! + ! ! N N’
N
Y Y’
Y
M M’
M
Labor market Output market Increase in government spending funded by

w Ns’(r)
r Ys’ permanent growth in money supply: A permanent
Ns Ys growth in money supply raises inflationary
expectations. Counteracting forces in the labor market
nullifies the seigniorage scenario to some extent –
higher inflation raises R, lowers !"!!,! and reduces
w’ labor supplied, whereas an erosion of wealth
w r
incentivizes more labor to be supplied. In the goods
Nd Yd market, lower consumption demand nullfies the
Yd’
Y
rightward ∆! shift to some extent. Money demand
N
N’ N Y’ Y and supply moves to a smaller extent, as seigniorage
gains are spread out over multiple time periods
Money supply and government current BC: Assuming
that ! ! + 1 + ! ! ! ! > !, the CB can increase Labor market Output market Money market
w r P
revenue by increasing ! which acts like an inflation Ns
Ys Ys’
Ms Ms’
Md=PL(Y,R)
tax. This is done by expanding ! ! . Alternatively, the Ns(r’) Md=PL(Y’’,R’’)
government can raise taxes

r’’ Md=PL(Y’,r’)
Yd’ P
+ 1 + !! !! = + ! − !!
w r
!" !" + ! w’
Nd Yd
Nominal(G Old$debt Tax$revenue New$debt ∆Money&supply
N Y M
N N’ Y Y’’ M M’
! ! !! + 1 + !! !!
⟹!−! = + − … 1 Friedman rule (MRS, MRT explanation): When ! = 0,
! ! !
the opportunity cost of holding money is zero, and
Government lifetime budget constraint there are no disadvantages of holding money over
bonds. A cash-in-advance constraint in the labor
market means that households must set aside cash (B) New Keynesian sticky price model: Nominal
(foregoing interest R) or resort to costly credit facilities rigidities result in markets not clearing continuously
to pay for consumption. Because income cannot be and prices not adjusting immediately. In the sticky
drawn upon until it is earned in the next period, Pareto price model, firms have market power and are able to
o
efficiency requires !"!!,! = !"!!,! = !!! , and this fix prices above marginal costs ie. !!! > !. As firms
requires ! = 0. If ! > 0, !"!!,! < !"!!,! , leisure is make positive profits on each unit sold (unlike perfect
overconsumed. Households are better off giving up competition where profits are zero), they sell as much
leisure for consumption as is demanded at the prevailing sticky price.
Furthermore, we assume that there is a cost of
! = ! +! =0 changing prices (e.g. menu costs), such that the
Nominal(return(on($ Real%return%on%$!!! benefit of a small price change will be below cost. No
optimization takes place (if prices are flexible,
o
! !!! !!"! = !. However since prices are sticky, the
Cash!in!advance'constraint:!!"!!,! = =
1+! 1+! effective labor demand curve is vertical at the N
required to supply the demand-determined level of
Friedman rule (credit market explanation): Because output) over the level of employment required to
cash and credit are perfect substitutes in financing supply that output, and the output supply curve is
consumption, Pareto efficiency requires that the social irrelevant as soon as prices are fixed
cost of each payment method be equal. Money has
zero MC of production, whereas credit has positive ! ! !" −1
and increasing MC – efficiency thus requires ! ! = 0. Imperfect)competition:!! = − =
! !" ! ! !"(!)
Households will only hold money at ! = 0, where the ! ! !"
private costs of holding money is zero. In the market
for credit facilities, ! = 0 means that ! ! = 0, and ! !" ! 1
there is no need for households to incur credit cost !, ⟹ = − ,!where! ! < 1
! ! !" !
implying further gains to efficiency
! !" !
o
(17) Theories of business cycles Perfect'competition: !!! 1 + =!
! ! !"
!"!!
(A) Real business cycle (RBC) theory: Business cycles
represent the economy’s efficient response to TFP 1
shocks (exogenous, large with business-cycle ⟹ !"!! = !!! 1− < !!!!(Perfect(competition)
!
frequency, persistent) that vary its ability to produce
goods and services Comparing real changes under imperfect competition
with sticky and flexible prices: With sticky prices,
Positive TFP shock money is non-neutral, and the CB’s choice of nominal
rates determines the real interest rate. By lowering the
Labor market Output market Money market
w r P real interest rate, the CB can stimulate consumption
Ms
Ns(r’) Ns(r)
Ys and investment demand by increasing production and
PL(Y,r)
employment
Ys’
w’ p
PL(Y’,r’)
Nd’
w r Labor market Output market Money market
r’ Yd’ p’
w r P
Nd Yd Ms PL(Yf,rf) Ms
N Y Ms,Md Ysf
N N’ Y Y’ M
PL(Ys,rs)
Ns(rf) rs CB
ps
rf
wf Ns(rs)
RBC model and business cycle facts MRP

ws Yd or IS
Nds
N Y Ms,Md
Variable Data RBC Ns Nf Ys Yf
C Procyclical Procyclical
I Procyclical Procyclical IS curve: Investment equals saving at every point on
P Countercyclical Countercyclical the IS (output demand) curve. This is possible
Ms Procyclical - because output is demand determined – the increase
N Procyclical Procyclical in investment and reduction in savings (due to higher
w Procyclical Procyclical consumption demand) is met by an increase in output.
APN Procyclical Procyclical The IS curve slopes downwards due to intertemporal
substitution effects on consumption and investment
RBC limitations: (1) Lack of direct evidence for large
!": ! = ! − ! − ! + !−! =!
and frequent TFP/technology shocks, (2) Cannot
Private(savings Public'savings
explain negative TFP growth, (3) Reverse causality of
output affecting TFP, (4) TFP may not be exogenous
Real interest rate cut/monetary shock: An interest rate
(labor hoarding and variable capital utilization)
cut stimulates consumption and investment demand

while keeping prices sticky. This is welfare-improving,
because employment is expanded when the economy Keynesian model limitations: (1) Not all business cycle
is at a point where the MRS is below MPN facts are matched, (2) High cost of price adjustment
assumption may not hold, (3) Lack of empirical
w Labor market r Output market P Money market evidence to suggest that prices are indeed sticky
Ms Ms’
PL(Y,r)
MPN
PL(Y’,r’)
(C) Imperfect information model: Imperfect information
Ns(r’)
w’
Ns(r)
r CB p
may contribute to nominal rigidities, resulting in
MRPN’
r’ CB’
markets not clearing continuously and prices not
w
Nd Nd’
MRPN
Yd or IS adjusting immediately. Households do not observe the
N N’
N
Y Y’
Y Ms,Md
price level at the time their labor supply decision is
made. While the money wage is known, real wages
Future positive TFP shock/investment shock: Real must be inferred from expectations about prices
interest rate is acyclical
! ! ! ! 1+! 1+!
!! = !
= !
= !
=!
w Labor market r Output market P Money market ! !! ! 1+! 1 + !!
Ms Ms’
PL(Y,r)
Ns’(r)
PL(Y’,r)
Phillips curve: Workers who only observe their money
w’
Ns(r)
r CB p wage may believe that their real wage is higher than it
MRPN’
Yd’ really is when there is a positive inflation surprise (ie.
when ! > ! ! ). As such, they are willing to supply more
w
MRPN Yd
Ns
Nd
Nf
Nd’
N
Y Y’
Y Ms,Md labor at every real wage level – output hence
increases when inflation is above expectations, vice
Current positive TFP shock: A current positive TFP versa. Expectations are correct in the long run – the
shock shifts up the production function, boosting long run Phillips curve is vertical, and there is no
MPN. Now that workers are more productive, fewer scope for monetary policy intervention. In the short
workers are required to produce the same level of run, monetary policy has a role in stabilizing the
output than before – employment falls. This is economy only to the extent that the central bank has
because output is demand determined and remains access to better information about the economy that
constant in this case has not already been factored into household inflation
expectations
w Labor market r Output market P Money market
Ms
PL(Y,r)
! − !! = ! ! − !! ⟹ ! = !! + ! ! − !!
Ns(r)
r CB p
w Labor market i Phillips curve
w MRPN’
Ns(i<ie)
w’
MRPN Yd
Ns(i=ie)
Nd’ Nd
N Y Ms,Md i>ie
N’ N Y
w’’
Ns(i>ie) i=ie
w
LM curve: The set of real interest rates and output i<ie
w’
combinations that are consistent with the money
market equilibrium if the central bank chooses to fix Nd
the money supply instead of real interest rates in an

N Y
environment with sticky prices. A higher Y implies N’’ N N’ Y’’ YT Y’
higher demand for money to fuel more transactions

Holding prices and money supply constant, scarcer Lowering inflation with adaptive expectations: The
money bids up the nominal interest rate. The LM curve v central bank implements a contractionary monetary
shifts rightwards when money supply increases, when policy to lower inflation. This reduces labor supply, as
money demand decreases or when price level falls workers mistakingly perceive a fall in their real wage,
hence cutting output. In the next period, inflationary
Keynesian sticky price model and business cycle expectations are realigned at ! ∗ and the economy
u facts: The model can be made consistent if firms are achieves the targeted level of output
assumed to hoard labor (ie. output falls by more than
employment during recession – productivity falls)
Variable Data Keynesian

C Procyclical Procyclical
I Procyclical Procyclical
P Countercyclical Acyclical
Ms Procyclical Procyclical
N Procyclical Procyclical
w Procyclical Procyclical
APN Procyclical Countercyclical
!!!
Ns’ Desired'! ! :!! =
PC1
1 + !!
Ns=Ns’’ A PC2
i’ Unspent'cash + Unspent'credit + ∆!
w’
B Effective(! ! :!!
w i* !
C
Anticipated increase in money supply (e.g. credible
Nd central bank): If agents anticipate an increase in the
money supply, they will react to it in advance by
N Y financing their consumption with a lower quantity of
N’ N=N’’ Y’ YT
money. Market segmentation is now irrelevant, as
both active and inactive agents share the same
Lowering inflation with rational expectations: With
information. Money is once again neutral
rational expectations, the economy does not have to
endure an output loss to reduce inflation. Forward-
looking workers correctly anticipate the fall in inflation, w No change
r No change
P
and labor supply remains efficient Ns Ys
Ms Ms’
Md=PL(Y,R)
P’

P
w r
PC1
Ns
A PC2
Nd Yd
i’ N Y M
N Y M M’
w i*
B Unanticipated increase in money supply (e.g. weak
central bank)/open market operations: The central
Nd bank boosts money supply by buying bonds in the
bond market. This slackens the wages-in-advance
N Y
N YT constraint as firms can sell more bonds, shifting firms’
effective labor demand rightwards, as they now have
more funds to employ more workers. Open market
(D) Segmented markets/limited participation model:
The segmentation of bond markets into active (firms operations also lower the nominal interest rates ! ! ,
causing desired labor demand to shift rightwards due
and the central bank) and inactive markets
to lower borrowing costs which reduce the costs of
(households) leads to frictions in household savings
hiring workers. Output supply increases with the
being channeled to firms
higher labor input. Total money supply has increased,
Households’ transactions constraints: (1) Under the but the money held by households cannot change due
to limited participation in bond markets. Open market
cash-in-advance constraint, households set aside
operations could move the economy closer to the
money balances and credit facilities for consumption.
Credit limits are fixed at the beginning of period, (2) efficient level of output, which satisfies !"!!,! = !!!
Households participate in bond markets and fix their (ie. the highest possible desired labor curve, ! ! = 0)
bond holdings only at the beginning of the period prior
to any shocks and monetary policy decisions. Bond w Labor market r Output market
market segmentation also means that money created Ns(r’)
Ns(r) Ys
Ys’
in open market operations do not immediately reach
households (to firms first), and the money supply
curve does not shift for any unexpected changes
w’ Desired Nd’
Firms’ transactions constraints: (1) Firms are required w Nd’ r

to pay wages using existing money holdings or credit r’
facilities under the wages-in-advance constraint. N N’
Nd
Y Y’
Yd
Credit limits are fixed at the beginning of period. There N Y

r^a Bond market P Money market
is now a higher opportunity cost to hiring workers, as Bd Bd’
cash can be invested in bonds to yield returns of Ms PL(Y,r)
1 + ! ! , (2) Firms participate in bond markets only at
the beginning of the period and after shocks and r_a p
monetary policy have been realized, (3) Firms can only PL(Y’,r’)
borrow money from others in the active segment –

r_a’
employment is hence constrained by the demand for p’
bonds that active agents sell. This defines a Bs
downward-sloping effective labor demand function B^a M

B B’ M
Wages!in!advance:!!!! = 1 + ! ! !
Current positive TFP shock: Due to transactions Segmented markets/limited participation model
constraints faced by firms, a current positive TFP limitations: (1) Segmentation may not be possible
shock leads to no changes in effective labor demand given the extent of financial connectedness, (2)
as there is no change in the amount of funds available. Wages-in-advance constraints may not be relevant
Even though effective demand does not shift
rightwards, output supply shifts rightwards (but to a (E) Coordination failure model: Setup identical to the
smaller extent) due to gains in productivity. R fall in RBC model except firms’ production functions, on
line with fall in r, shifting up firms’ desired labor aggregate, have increasing returns to scale. This is
demand, but this is irrelevant since the only relevant attributed to positive production externalities from
labor demand curve is effective labor demand average employment and output to the productivity of
each firm – aggregate !!! need not be diminishing
Labor market Output market Money market with higher employment (labor demand curve can be
w r P
Ns(r’)
Ns(r)
Ys
Ms upward sloping if increasing returns are sufficiently
Ys’ PL(Y,r)
strong) even though individual !!! remain decreasing
PL(Y’,r’)
Multiple equilibria: Taking account of the spillover, and

r that all firms make the same employment decisions in
w’ p’
Desired Nd
w r
r’ Yd’
Nd Yd
N Y Ms,Md
equilibrium, the aggregate labor demand curve can be
upward-sloping. If the spillover is sufficiently strong to
N’ N Y Y’ M
make the aggregate labor demand curve steeper than

u Tightening of firms’ wage-in-advance constraint (e.g.
reduction in banking services for making wage
the labor supply curve, output supply becomes
downward-sloping. There may hence be multiple
payments): A tightening of firms’ wage-in-advance intersections and equilibria in the output market –
constraint shifts labor demand to the left, as firms can each of which is attributed to strategic
no longer afford to employ as many workers as before complementarity (ie. firms would like to take actions
due to limited money holdings. Expansionary similar to those of other firms). Sunspots reveal no
monetary policy is effective and desirable in restoring information about the economy, but serve as
effective labor demand and output supply back to coordination devices for agents to make choices
their original positions consistent with the same equilibrium at the same time
w r Ys’
P w r P
Ms Md=PL(Y’,R’)
Ns Ys Md=PL(Y,R) Nd Ms PL(Y_lo,r_lo)
Ns(r’)
Ns(r_hi) Ys
P’ PL(Y_hi,r_hi)
r_lo
w_hi p_lo
Ns(r_lo)
r’ P
w r w_lo p_hi
r_hi
w’ Nd Yd Yd
Nd’
N Y M N Y Ms,Md
N_lo N_hi Y_lo Y_hi
N’ N Y’ Y M M’
Money non-neutrality: A surprise increase in the Moving from the bad to good equilibrium: On its own,
v money supply puts money in the hands of the active each of these equilibria are consistent with utility-
maximization by households and profit-maximization
firm participants in the bond market. There is no way
for this money to find its way to households by firms. There is no fundamental reason for the
immediately if households are not actively economy to be at one equilibrium rather than the
participating in financial markets. Firms must hence other. Higher perceived MPN due to optimistic
spend more by hiring more workers, slackening the expectations may cause labor demand to shift
wages-in-advance constraint. This shifts effective rightwards, leading to increased output (and
labor demand and output supply rightwards – corresponding demand). Real interest rates fall to r_hi,
changing real variables where consumption and investment demand
increases and labor supply falls due to intertemporal
Segmented markets/limited participation model and substitution. In the labor market, a fall in r to r_hi
business cycle facts reduces labor supply, raising w and N, confirming the
initial shifts of expectations
Variable Data Segmented
C Procyclical Procyclical w r P
MPN1 MPN2
Nd Ms PL(Y_lo,r_lo)
Ns(r_hi) Ys
P Countercyclical Countercyclical r_lo

PL(Y_hi,r_hi)
Ms Procyclical Procyclical w_hi

Ns(r_lo)
p_lo
N Procyclical Procyclical w_lo p_hi
w Procyclical Procyclical r_hi

Yd
N Y Ms,Md
APN Procyclical Countercyclical N_lo N_hi Y_lo Y_hi

Temporary increase in government spending: A rise in !"!! = !" ⟹ ! = !!!
government spending moves the two equilibria apart Early&withdrawals Liquidated)projects)early
(A to C, B to D). In the good equilibrium, real interest
rate falls slightly and output increases more than ∆!, ! 1 − ! !! = 1−! ! 1+!
implying a government spending multiplier > 1. This Late%withdrawals Projects)liquidated)at)maturity
shows that fiscal policy can yield very different results
depending on agents’ expectations – while output can Rearrange ⟹ 1 − ! !! = 1 − !!! 1 + !
be raised when agents are optimistic, it can also
decline in a phase of pessimism 1+! 1+!
Feasible(deposit(contracts: !! = − !!
1−! 1−! !
w
Nd
r P
Ms
PL(Y_lo2,r_lo2) Outcome A (good equilibrium): The risk averse
D
C
consumer will choose a deposit contract on the
Ns(r_hi)2 PL(Y_lo,r_lo)
w_hi2 Ns(r_hi) Ys D
r_lo2 p_lo2
bank’s zero profit line that is tangent to the highest

Ns(r_lo) PL(Y_hi,r_hi)
A Ns(r_lo2)
w_hi
B
p_lo
B
r_lo
B
A PL(Y_hi2,r_hi2)
possible indifference curve (outcome A). This is
w_lo
r_hi
C p_hi
because the (risk-sharing) optimal deposit contract
w_lo2 r_hi2 A Yd’
provides insurance by allowing the consumer to enjoy

p_hi2
C
D Y_lo2 Y_lo Y_hi Y_hi2
Yd
N Y Ms,Md
N_lo N_hi
some project returns even in the event that he turns
out to be an early type. Since the investment project
Coordination failure model and business cycle facts has a positive return (r > 0), the zero-profit line is
steeper than the IC when it passes through the 45
Variable Data Coordination degree line. This implies that the tangency point must
C Procyclical Procyclical lie above the 45 degree line
!"!!!
P Countercyclical Countercyclical !"!Point&C = −
Ms Procyclical Procyclical 1 − ! !!!!
N Procyclical Procyclical
! 1 + ! !!!!
w Procyclical Procyclical !"!Point&A = −
APN Procyclical Procyclical 1 − ! !!!!
Coordination failure model limitations: (1) Empirical c2

evidence does not support increasing returns to scale
claim, (2) Source of confidence driving the business
cycle is unexplained 1+r
B A
c_2*
(18) Financial markets and banking
C
Yields expectations hypothesis: Assuming no
arbitrage, the return from purchasing one long-term c1
1 c_1*
bond must equate the expected return of purchasing
several short-period bonds. Long term interest rates
reflect current and future expected short term interest Outcome B (outcome with no banks): Consumers are
rates. Upward sloping yield curves suggest that unable to smooth consumption via risk-pooling
financial markets expect spot rates to be higher in the (increasing early type payouts at the expense of late
future, vice versa types). They will either liquidate their projects early
(earning 1), or liquidate their projects at maturity
1 + !!! !
≈ 1 + !!! !
1 + !!!!! (earning 1 + !). This outcome lies on a lower
Yield&to&maturity Spot Forward indifference curve
1 1 Bank run outcome: The bank commits to pay !! > 1 if

!!! ≈
2
!
!! + !!!! !
⟹ !!! ≈ !! + !!!!
3
!
+ !!!! …
u early consumers withdraw early. However, banks
cannot distinguish between early and late types due
Diamond-Dybvig banking model: Assuming perfect to private information and are unable to stop late
n competition, all banks will offer contracts on the locus types from withdrawing early if they fear the bank will
of feasible deposit contracts. Otherwise new players collapse. If a late type consumer believes that all other
will enter the market to compete for market share consumers of both types will withdraw early, they will
too. This is because there will be nothing left for
Early&type&consumers! !" : !! > 1 withdrawal in the late period, and some probability of
receiving !! is prefered to nothing
Late%type%consumers! ! − !" : !! > !! > 1
! − 1 !! > !
Bank!invests'in'projects: 1 + ! > !! > !! > 1 Early&withdrawals&for!!!! All#projects#liquidated#early

(19) International macroeconomics ! = !+!+! + !"
Domestic)demand Current'account,'foreign'demand
Equilibrium with no trade: Produce at A, consume at A
⟹ ! − ! − ! = ! + !"
!"!!,! = !!,! = !"!!,! Savings
Advantages of running CA deficits: (1) In light of

B
Slope=p_AB
temporary negative shocks to current TFP, production
may fall below demand. This can be offset by
purchasing more imports (CA falls into deficit) and
paying back with exports in the future, spreading the
Slope=MRT_AB
loss in consumption over time. Consumption
A
qB smoothening is preferred to volatile consumption and
Slope=MRS_AB
stable CA, (2) CA deficit may be caused by a surplus
in the capital account. A boost in productivity-
A enhancing investment (e.g. FDI) can increase the
qA
future output of the economy, generating higher
productivity and CA surpluses in the future
Equilibrium with trade: Produce at B, consume at C by
exporting B and importing A. Trade is similar to a Increase in ! ∗ : There is excess demand in the world
“technology” transforming one good into another output market; domestic producers should meet this
without diminishing returns, allowing consumers to demand by consuming less and exporting more to
attain a higher level of utility corresponding to a higher raise GDP. Capital flows out of the domestic
indifference curve economy, causing the capital account to fall. Current
account surplus rises
!"!!,! = !"!!,! = !"!!,!
w r
Good A is imported Good B is imported
Ns(r*1) Ys
Ns(r*2)
B B
C
Slope=TOT_AB qB2
B
qB1
r*2
C A
qB2 w r*1 Yd’
A w’
Excess demand
qB1 B Nd
CA
Yd
N Y
N N’ Y Y’
A A
qA1 qA2 qA2 qA1
Temporary increase in government spending: Unlike

Change in TOT: When good A becomes more the closed economy, an increase in government
expensive, an A-importer may be incentivized to spending does not lead to higher real interest rates.
export instead. An A-exporter may export more This is because excess demand is met by a rise in
imports, and the output demand curve shifts to the
Good A is imported Good B is imported left. Crowding out only takes place in the export
Consume: B -> E
Produce: A -> D
Consume: B -> E
Produce: A -> D
market (domestic consumption and investments are
B B not crowded out), and current account surplus falls
C E
qB2
A C qB1
B Closed economy Open economy
qB2
E B A
qB1 r r
D
D Ys Ys
Ys’ Ys’
IE
IE SE SE
A A
qA2 qA1 qA1 qA2
r’ r’
Yd’
Yd’
International dynamic macroeconomic model: There is r r*
u
Excess demand
only one prevailing interest rate for the small open Yd’’
Yd
economy – the world interest rate. If ! > ! ∗ , capital Y
CA Yd
Y
flows in; if ! < ! ∗ , capital flows out. Output demand Y Y’ Y Y’
always shifts to intersect output supply at ! ∗ if

domestic demand does not match up to domestic Current domestic positive TFP shock: Unlike the
supply closed economy, a positive temporary TFP shock in
the domestic market does not lead to lower real
interest rates. Consumption increases due to higher
real incomes, but investment does not change. The Increase in domestic money supply: A one-off
output demand curve shifs to the right to mitigate the unexpected rise in the domestic money supply results
excess supply; exports increase, and the current in depreciation and an increase in the local price level
account surplus rises (inflation). Money is neutral and has no effect on real
variables – an instance of money neutrality in world
Closed economy Open economy markets
r r Goods market World money market Domestic money market

Ys Ys No change Money neutrality Money neutrality
r e P
Ys’ Ys’
Ys Ms Ms’ Ms Ms’
eP*L(Y,r*) PL(Y,r*)
e’ P’
r* e P
Excess supply
r r* Yd
r’ Yd’’
r’ Yd’ Y M M
Yd’ Y
Yd CA Yd
Y Y
Y’
Y Y’ Y
Increase in foreign price level, P*: Inflation in foreign
markets shifts money demand to the right – domestic
Future domestic positive TFP shock: Assuming no currency appreciates. Prices in the domestic market
wealth effects, a future positive TFP shock in the remain unchanged
domestic market has no effect on labor supply, as real
interest rates do not change (no substitution for more Goods market World money market Domestic money market
labor). An increase in investment demand shifts output r
No change
e
Money neutrality
P No change
demand to the right, at the expense of higher Ys Ms Ms
borrowing (through imports) which shifts output eP*L(Y,r*) PL(Y,r*)
demand back to its original position. Current account eP*’L(Y,r*)
surplus falls. However, if capital stock rises in the r* e P
future, current account surplus may be recovered Yd

e’
(same as a current positive domestic TFP shock) Y

Y M M
Closed economy Open economy

Increase in world interest rates: Assuming output
r r effects dominate real interest rate effects, domestic
Ys’ Ys Ys currency appreciates, and the domestic price level
falls
Goods market World money market Domestic money market

r’ r’ Current account surplus Appreciation Price level falls
r e P
Ys
Yd’ Yd’ Ms Ms
r r*
Excess demand eP*L(Y,r*) PL(Y,r)
Yd CA Yd=Yd’’
r’ eP*L(Y’,r’) PL(Y’,r’)
Y Y
Y Y’ Y=Y’ r Yd’’ e P
e’ P’
CA Yd
Y M M
Real exchange rates: PPP suggests that the real Y Y’
exchange rate is equal to 1. When e increases, the

domestic currency depreciates
Fixed nominal exchange rates: The government can
∗ intervene in world money markets by buying and
Home/foreign+currency×Foreign(price !!
!= = selling the domestic currency in a bid to keep nominal
Home%price ! exchange rates constant. Domestic prices are no
longer insulated from changes in foreign price levels;
Purchasing+power+parity:!!! ∗ = ! ⟹ ! = 1 they are however, insulated from changes in world
real interest rates – subject of course, to the extent to
!Index < !Actual = Currency(is(undervalued
Indices:! which governments can intervene in world money
!Index > !Actual = Currency(is(overvalued
markets
Money&demand: ! ! = !" !, ! ∗ = !! ∗ ! !, ! ∗
Buy domestic currency Sell domestic currency
Currency appreciation Currency depreciation
Flexible nominal exchange rates: With flexible nominal
Running down reserves Accumulating reserves
exchange rates, domestic prices are insulated from
Money supply falls Money supply rises
changes in foreign price levels but not from changes
in world real interest rates
Increase in foreign price level, P*: To keep nominal
exchange rates fixed, the government intervenes in
the money market by selling domestic currency. In Goods market World money market Domestic money market
doing so, the government raises money supply and r e P
“imports inflation”
Ys’
Ms eP*L(Y2,r*) Ms PL(Y2,r*)
Ys
eP*L(Y3,r’) PL(Y3,r’)
e2 B P2 B
C
Goods market World money market Domestic money market eP*L(Y1,r*) PL(Y1,r*)
r’
e3 P3
Domestic inflation A C C
r e P r*
Yd
Ys e1 P1
Ms Ms’ Ms Ms’ B A A
Yd’
eP*L(Y,r*) PL(Y,r*) Y M M
Y2 Y3 Y1
P’
eP*’L(Y,r*)
r* e* P
Yd
Capital controls with fixed nominal exchange rates
Y
Y M M and negative TFP shocks: The government can put up
with a smaller reduction in money supply and foreign
reserves when fixing the nominal exchange rate with
Increase in world interest rates: In keeping nominal capital controls
exchange rates fixed, the government insulates the
domestic price level from any increases in the world Goods market World money market Domestic money market
real interest rate r e

Ms2 Ms3 Ms1
P
Ms2 Ms3 Ms1
Ys’
eP*L(Y2,r*) PL(Y2,r*)
Ys
eP*L(Y3,r’) PL(Y3,r’)
Goods market World money market Domestic money market
C
r e P eP*L(Y1,r*) PL(Y1,r*)
r’
Ys
Ms Ms’ Ms Ms’ A B B
Yd
r* e* P*
A A
C C
i eP*L(Y,r) PL(Y,r) B
Yd’
Y M M
Y2 Y3 Y1
r’ eP*L(Y’,r’)
PL(Y’,r’)
r Yd’ e* P
Yd
Y Y’
Y M M (20) Monetary and fiscal policy
Central bank’s problems: (1) Output demand shock,

Exchange rate regimes and negative TFP shocks: (2) Output supply shock, (3) Money demand shock
With flexible nominal exchange rates, the economy
moves from A to B (domestic currency depreciates). Central bank’s objectives: (1) Price stability and low
With fixed exchange rates, the government buys inflation, (2) Stabilizing output and employment
domestic currency in the money market and lowers
the money supply, keeping exchange rates and price Monetary policy
levels fixed (outcome A to C)
Policy Evaluation
Goods market World money market Domestic money market Fix money Undesirable price fluctuations
r e P supply
Ys’
Ys
Ms’ Ms
eP*L(Y2,r*)
Ms’ Ms
PL(Y2,r*)
Undesirable output fluctuations
e’ B P’ B
when prices are sticky (active
eP*L(Y1,r*) PL(Y1,r*)
central bank intervention in setting
A C C
r*
Yd e*
A
P*
A real interest rates, a la Keynesian
B
Yd’ model)
Y M M
Y2 Y1
Money neutral otherwise – no

change in real variables
Capital controls with flexible nominal exchange rates
and negative TFP shocks: Limitations on capital Fix nominal Price stability in the event of money
inflows or outflows mean that real interest rates in the interest rate market shocks: Fixed nominal
domestic economy can differ from that in world interest rates are consistent with
markets, dampening the effects of macroeconomic zero inflation – money supply
shocks, as output demand does not shift, creating adjusts to accommodate change in
smaller changes in output and exchange rates (the money demand. When prices are
economy moves from outcome A to C instead of sticky, fixing R results in no output
outcome A to B – changes in nominal exchange rate fluctuations
and domestic price level is less pronounced)
But real interest rate may be
unknown: Price stability can only
be achieved if the central bank
knows the output market-clearing
real interest rate and sets the
nominal interest target accordingly

price drop in the short run may induce negative
Liquidity trap: Because money can be stored inflationary expectations. Real interest rates increase
costlessly, savers will never accept a negative nominal (by the Fisher equation), and a reduction in investment
interest rate. Nominal interest rates are hence subject demand shifts IS to the left, further cutting output
to a zero lower bound. Here, lowering interest rates
and manipulating money supply cannot stimulate the R
economy; agents are indifferent between holding their
wealth as money or bonds IS’ IS LM
Transactions*constraint*slack:!! ! ≥ ! ! − ! ! = !"
!!
Liquidity trap in the Keynesian model: At R = 0,

0 Y
nominal interest rates cannot be cut further. There is Y’ Y
no opportunity cost of holding money compared to

bonds. The transactions constraint need not bind, so Monetary policy: The central bank minimizes its loss
agents can hold on to more money than needed. Any function subject to an inflation constraint imposed by
increment in money supply may merely shift the the Phillips curve. This is because monetary policy
money supply curve further into the region of can influence output in the short run with its
acceptable money demands without any changes in corresponding level of inflation
output as the private sector may hoard cash without
altering its choices (money demand would usually min ! !, ! = ! − ! ∗ !
+ ! ! − !∗ !
adjust to meet this new money supply, raising output).

This need not be inflationary, because there is no subject(to(Phillips(curve:!! = ! ! + ! ! − ! !
incentive to try to avoid holding the extra money. The
policy may still be effective in stimulating demand if ⟹ min ! = ! ! + ! ! − ! ! − ! ∗ !
+ ! ! − !∗ !
!
the central bank buys non-substitute assets, such as
risky assets
Loss function: The parameter b represents the
importance the central bank attributes to achieving its
Goods market Money market output target. In equilibrium, it can achieve this target
r P by increasing inflation above the level expected by
Ys
agents. But this would raise inflationary expectations,
Ms Ms’
which requires the central bank to create even more
PL(Y,0) inflation to achieve its goal. Inflation increases until the
Excess supply central bank’s dislike of higher inflation offsets its
0
PL(Y’,r’)
desire to achieve its output target
r’ P*
Monetary policy choice and time-inconsistency: If the
Yd central bank takes the level of inflationary
Y M expectations corresponding to PC1 as stable (ie.
Y Y’
! ∗ = ! ! at point A), output in the economy will be the
target output YT. However, it has an incentive to
deviate ex-post so as to minimize its loss function –
Limit to monetary expansion: If the central bank fixes creating extra output at the expense of
money supply, the LM curve will be horizontal additional/surprise inflation (point B). Knowing this,
(perfectly elastic) when nominal interest rates equal agents (with rational expectations) will expect some
zero and increasing for output above some threshold. inflation !!! > ! ∗ , and the equilibrium outcome is the
Any increase in money supply shifts LM to the right, tangency point C – a worse outcome than when the
but output cannot expand beyond Y’ as the output central bank could commit to ! ∗ , as inflation is higher
threshold is now higher than before without any output gains (inflation bias)
Interest and money demand Goods market Limit to monetary expansion
R R R i PC2
Y>Y’>Y’’
Ms
Md(Y’’) Md(Y’) Md(Y) IS LM IS LM LM’ LM’’
C
ie’
R R PC1
B
R’ R’ R’
A
0 M 0
Y’’ Y’ Y
Y0
Y’’ Y’
Y i* Y
YT Y1
Liquidity trap and deflation: In the long run, prices are

not sticky and are expected to fall in response to
excess output supply. However, anticipation of this
Monetary policy effectiveness: Due to Labor market Goods market
Temporary rise in G
Goods market
Permanent rise in G
market/information frictions, monetary policy can r P P
influence output in the short run. However, money

Ns(r) Ys Ys
Ns(r’) Ys’
remains neutral in the long run. This is because

monetary surprises cannot be sustained indefinitely. A r’
constant increase in the money supply will only lead to w

w’
r
∆G Yd’
r
∆G Yd’
higher inflation Nd ∆Y Yd ∆Y
Yd
Y M M
N N’ Y Y’ Y Y’
Model Short-run Long-run

Keynesian The CB is able to Prices are flexible, Announced decrease in government spending:
control r via R - i and r clears Yd
due to sticky and Ys Temporary increase in government spending with
prices. This sticky prices: With sticky prices, the central bank can
affects Yd accommodate fiscal policy by holding real interest
rates constant when government spending increases
Segmented The CB is able to Firms adjust their temporarily. ∆! = ∆!. Spending multiplier = 1
slacken liquidity liquidity holdings
constraints by Labor market Output market
increasing money. w r
This affects Nd
Information The CB can Workers form

create surprise rational Ns(r)
r
∆G
CB
inflation to expectations w’
mislead workers !! = ! r’ Yd’
into accepting w
Yd
lower w. This ∆Y
Nd Nd’
affects Ns N Y
Ns Nf Y Y’
Coordination The CB can There can be no

Temporary increase in government spending with
influence
expectations that
improvement
once the v strategic complementarity: When strategic
select between economy is at the complementarity in output is observed, the downward
multiple equilibria good equilibrium sloping output supply curve results in interest rates
falling with higher government spending – the
opposite of crowding out effect. ∆! > ∆!. Spending
Fiscal policy multiplier > 1
u Temporary increase in government spending: Wealth Labor market Output market
effects and shifts in output supply when government w r
spending increases temporarily are negligible. Nd
Crowding out effects caused by a higher real interest
rate reduces consumption and investment demand. Ns
As such ∆! < ∆!. Spending multiplier < 1 r

∆G
r’ Ys
Permanent increase in government spending (see Yd’
w
Chapter 15): When government spending increases Yd
permanently, wealth effects shift output supply to the ∆Y
right as workers demand less leisure for all wage N Y
N Y Y’
levels. And yet wealth effects also lower consumption
demand due to permanently higher tax burdens.
Because C falls and N rises by equal amounts in both Perfectly substitutable government spending: When
periods, the relative desire to smooth consumption government spending provides the same utility as
(!"!!,! ! = 1 + !) remains unchanged. Investment private consumption, an increase in G must be
spending is not crowded out, as real interest rates matched by an increase in T – this reduces C by the
remain unchanged. ∆! < ∆!. Spending multiplier < 1 same magnitude. ∆! = 0 < ∆!. Spending multiplier
equals zero
No#change:! ! − ∆! + ! + ∆! = ! + !

Labor market Goods market ⟹ ∆! ! = !"#∆! ! + ∆! ! + ∆!
∆! ! !!
r P
Ns(r) Ys ∆!
⟹ ∆! ! = > ∆!!if!!"# < 1
1 − !"#
Demand for goods r

r’ 45 deg
C2(r) + I(r) + G2
∆G Yd’
w r
Y2
∆G
C1(r) + I(r) + G1 r
Nd Yd = Yd’’ ∆Y
Y M Yd2
N Y=Y’’ Y’ Y1
Yd1
Current income Y
Perfectly complementary government spending: Y1 Y2 Y1 Y2
Further private consumption will yield positive utility if

and only if government spending increases in tandem.
An increase in government spending lowers the MRS
between leisure and consumption, incentivizing
consumers to substitute away from leisure towards
consumption. Consumption demand increases,
shifting output demand further to the right. ∆! ≥ ∆!.
Spending multiplier may be more than or equal to 1
Labor market Goods market
r P
Ns(r) Ys Ys’
Ns’(r)
Ns’(r’)
∆G ∆C
r’
Yd’’
w r
Yd’
w’
Nd ∆Y Yd
Y M
N N’ Y Y’
Keynesian multiplier and credit market imperfections:

An increase in output has multiplied feedback effects
through increased consumption. Households which
are credit constrained have an MPC of 1 (ie. extra
marginal income is spent; none is saved).
Unconstrained households have an MPC of 0 (ie.
reduce current consumption in anticipation of higher
taxes in the future). The higher the proportion of
constrained households, the higher the MPC
c’
Future income falls

due to tax increase E1 E2
c
All extra disposable
income is consumed
Keynesian multiplier and the Keynesian cross: The

multiplier effect depicted in the Keynesian cross
shows that ∆! > ∆!
! ! = ! ! ! ! , ! + !! ! + !

Growth model summary
Malthusian Solow LBD Human K R&D

! = !"# = !"# = !
! = !!!
!!
! !∗ = 1 = ! = !!!! ! !!! ! !! = ! 1 − ! ! = !" 1 − !!
Key ! !" !!
equations = ! + ! + ! !! !!
! = !" !! !!
! ∗ = !" ! ∗ =! 1−! = != ×! = !
! ! !
Long-run growth is Long-run growth is Long-run growth is Long-run growth is Long-run growth is
exogenously exogenously constant and constant and constant and
determined by determined by TFP endogenously endogenously endogenously
changes to the growth rates determined by level determined by ! and determined by !!
Economic population growth of savings !. Decreasing ! and !. Increasing !!
growth function would increase the would increase the
growth rate at the growth rate of
expense of current knowledge at the
consumption expense of current
output
Exogenous and Endogenously Endogenously Human K is Knowledge is
fixed supply of land. accumulated and accumulated and endogenously endogenously
MPL is diminishing reproduced. MPK is reproduced. MPK is accumulated by accumulated by the
diminishing, diminishing at the postponing current size of the labor
converging to a firm level, but not production for future force as well as !! .
Relevant
steady state ke* diminishing at the productivity gains. Knowledge is non-
“capital”
aggregate level due Knowledge is non- rivalrous and does
to positive rivalrous and does not have diminishing
externalities not have diminishing MPK
marginal returns
Endogenous and Exogenous and Exogenous and Exogenous and Exogenous and
positively related to independent of independent of independent of independent of
consumption. In the living standards living standards (for living standards (for living standards (for
Population
steady state, simplicity, assume simplicity, assume simplicity, assume
growth
population growth is zero) zero) zero)
zero
Exogenous with only Exogenous, Endogenous, Exogenous and Exogenous and

short-run effects on sustained increases assumed to be a independent of independent of
consumption, which drive long-run positive function of living standards (for living standards (for
eventually falls back output growth. One- aggregate K due to simplicity, assume simplicity, assume
Technology
to steady state off changes in TFP knowledge zero) zero)
and TFP
governed by the only change output spillovers
growth
population growth growth temporarily,
function eventually falling
back to zero
Comparing dynamic macro models
Variable Data RBC Keynesian Segmented Coordination

Consumption Procyclical Procyclical Procyclical Procyclical Procyclical
Investment Procyclical Procyclical Procyclical Procyclical Procyclical
Prices Countercyclical Countercyclical Acyclical Countercyclical Countercyclical
Money supply Procyclical - Procyclical Procyclical Procyclical
Employment Procyclical Procyclical Procyclical Procyclical Procyclical
Real wages Procyclical Procyclical Procyclical Procyclical Procyclical
APN Procyclical Procyclical Countercyclical Countercyclical Procyclical

2011 Highlight Notes

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EC210 HIGHLIGHTS ! ∗ = !

(2) Measurement e should be expressed in foreign currency/unit of local

Product (value-added) approach Budget'constraint'(BC): ! = !! ! + ! − !

Value added coconuts 20 20 BC#with#lump!sum$T:!! = −!" + !ℎ + ! − !

Consumption 30 + (20 – 12) 38

1 2 Neoclassical production function: (1) Constant returns

Real%GDP2 = !1! !1! ×!!

Consumer price index (CPI)

Purchasing power parity (PPP) ! = !" !, ! − !! !

EC210 (2012-13 syllabus), ivantwk@gmail.com 1

!"# = !"# = !!! = !

Pareto efficiency and proportional tax: A proportional g(c) g(c)

Steady'state: ! ! = ! ⟹ ! ! = !" !" ! (6) The Solow Model

At#the#steady#state,#! ! ∗ = 1 ⟹ ! ∗ = !"(! ∗ ) Basic Solow model: Unlike the Malthusian model

Capital'accumulation: ! ! = 1−! ! + !"

Long term growth rates: Because B is growing, if

(7) Beyond the Solow model

Solow model with labor augmenting technology:

EC210 (2012-13 syllabus), ivantwk@gmail.com 3

Growth accounting: Measuring the growth in (8) Endogenous growth models

EC210 (2012-13 syllabus), ivantwk@gmail.com 4

Increasing b (e.g. raising quality of education): μc Imitation costs Productivity growth

Research and development (One country model):

T A1/A2 Modigliani’s life cycle theory: Income varies

A1 y1 Friedman’s permanent income theory: While current

y Neutral technological change y K-biased technological change

Intertemporal model (Graphical)

Poor Rich Poor Rich Current'budget'constraint: ! + ! = ! − !

Increase in real interest rates: Higher real interest rates

(10) Ricardian equivalence & credit market

Credit rationing vs unlimited costly borrowing (r*>r)

EC210 (2012-13 syllabus), ivantwk@gmail.com 8

c Pay-as-you-go social security: Taxes on the working

Consumption and asymmetric information:

higher than the cost of funding so as to compensate

Limited commitment with a borrowing (collateral) !! 1+!

When q>1, MPK’>r+d, the stock market values the

! > 1 ⟹ !!! ! + 1 − ! > 1 + ! ⟹ !"! ! > ! + !

Capital'accumulation: ! ! = 1 − ! ! + ! Current TFP and investment: Under perfect financial

Law$of$motion: !!!! − !! = ! 1 − !! − !! !" ! ∗

Increase in government spending: Because firms are ! ×! = !× ! × !(! ∗ )

EC210 (2012-13 syllabus), ivantwk@gmail.com 11

Increase in taxes on wage income: An increase in

I Pro Coincident Higher Investment plans

the latter of which cannot be stored. Marginal utility to Ns

consume is hence high even when prices are high, Ns’(r’)

indicating insensitivity to price fluctuations. Durables r’ r’

price changes do not translate into large changes in w’

utility in the short run as consumption is postponed N N’

recessions, actual productive employment may be Ns

lower than the measured level of employment. APN

With labor hoarding N Y Id

N_lo (actual) N_hi

(15) A dynamic macroeconomic model Nd r’

Firm preferences Persistent increase in TFP: Higher Y, r, N than in the

EC210 (2012-13 syllabus), ivantwk@gmail.com 13

Yd’ r Credit facilities market Money market

Labor market Output market Investment market

1+! Money neutrality: Real variables are independent of

Transaction constraints and MRS (wage explanation):

Transactions constraints and MRS (credit facilities !! 1 + !! ! ! + !! !! !

Labor market Output market Increase in government spending funded by

tax. This is done by expanding ! ! . Alternatively, the Ns(r’) Md=PL(Y’’,R’’)

borrowing (through imports) which shifts output ePL(Y,r) PL(Y,r*)

demand back to its original position. Current account eP’L(Y,r)