RBC Model:

Changes from RCK model:

- Labour choice
- Labour is in the utility function
- Representative household
- Market economy with perfectly competitive labour, capital, and goods market
- Deviate from the RCK model, now nothing is for certain in the future
- Productivity shocks
- Before this productivity was constant
- Now this productivity depends on last periods productivity and the shocks

What is z?
Z is a productivity shock, it affects the output independent of k and l
- Even if you have the same labour and capital (same k and l) you will have different output
- If z are different = output is different

Zt+1 Equation:
- Tomorrows productivity is equal to today's productivity to the power of theta multiplied by a
variable epsilon
- Theta: Determines how persistent productivity will be
- Epsilon is going to be a variable that is distributed
- Nature drawing a value of epsilon
- Low = bad luck (miserable)
- High = good luck (back to normal)
Explain theta:
- If theta is equal to zero then today's productivity will have nothing to do with yesterdays
- If = 1 yesterday's productivity has to do a lot with today's productivity
- Theta can only be from -1 --> 1
- If theta = - 1 this means: todays productivity will be inversely correlated with
yesterday's productivity
- So if -1, when z is large zt+1 will be small
- When z is small,zt+1 is going to be large
- Not very realistic
- Productivity tends to be positively correlated
- Bottom line = measures persistence of the shock
Why is it important to define z this way?
- By defining z this way, we free ourselves from having to describe specific shocks
- Do not have to worry about the nature of a shock
- It is a statistical shock
- If epsilon is small, zt+1 will be small
- treat z as exogenous, something determined overtime
- Zt+1 also depends on last period
- If last period you had covid
- This year you are still affected by covid

Why do we need the expectation operator in the households problem

- Why do we need an expectation operator in the household problem?
- What is random?
- In eqbm the firm's demand for capital will be random because that depends on that
periods productivity
- So the equilibrium prices for capital and labour will also be random
- It is not the fact k and l will be random It is the wage and interest rate being
random because the demand will fluctuate as a result of productivity
- The prices will also fluctuate as a result
- As a household trying to figure out what consumption you will consume today and
capital you will have tomorrow will never be 100% sure about wt or rt
- Do not know future prices or future wages
- When you choose decisions all you can get Is the expected value, you can never
know the exact choices
- Why we have the expectation operator here
- We need the expectation operator when there is uncertainty in the world

Why do we have V(zt,kt)

- K and z
- K is not the only thing that matters for production anymore
- The productivity also matters
- Need to know productivity in addition to capital to make decisions

A negative shock will lead to…

- a lower labour supply
- Both z and l will decrease in the production function
- Change in labour supply amplifies the shock
- If you shock l it is an amplified shock because it also affects z

What do you do to lessen the effect of z:

** to lessen the effect of z, you want to prevent the labour market from becoming too worse
- By lessening the impact of the decrease of labour supply during a recession
- Encouraging firms to hire, by subsidizing the vacancies so then l does not decrease too much
- So if you cannot deal with z quickly (vaccine) you can try to avoid l from decreasing too much
DSGE Model:

Difference between DSGE model & RBC

- In RBC model, price = 1 because we are always measuring the price in terms of goods that we
consume, not in $
- Key feature of the New Keynesian model is that it looks at both real and nominal
- Do not measure our wages in goods
- Monopolistic competition
- Sticky prices

What are sticky prices

- Firms cannot adjust prices very frequently
- If you don’t assume this, it will essentially be the RBC model

What is the benefit of the DSGE model?

- With this model we can study aggregate price changes (inflation) as well as monetary

Define: Yhat = yt - yt^n

- What is the output gap
- yt^n is the natural output
- This would be the result when you do not make the assumption about sticky wages
- Idea: if firms cannot freely adjust prices then prices are not optimal, they are not maximizing
prices
- But if you give the economy enough time, eventually all firms will be able to adjust their prices
- Economy converges to a scenario where all firms adjust their prices
- Can adjust prices at least once, given enough time

What is the Phillips Curve?

● Representation between the relationship between inflation and output
○ Relationship and unemployment
■ Because output is with labour → Lower output = lower labour
■ Unemployment = ratio between number of people who want to work and
couldn’t find job vs total number of people who want to work (If you don’t want
to work = technically not unemployed because Not in the market for labour
○ Lower output = higher unemployment

Demand Shock
- Lower demand from households
- Friends produce less y<y^n
- Inflation decreases
- EX: Financial crisis

Supply Shock
 - Increase in prices lead to a decrease in productivity
- Firms want to produce less
- Households have same demand
- Yt>yt^n
- Increases inflation
- EX: Oil Crisis of the 70’s

Inflation tomorrow affect inflation today?

● if you believe prices will be higher tomorrow, you would want to increase the price
○ Why do you not just wait until tomorrow, you might not be able to change tomorrow =
sticky wages
■ If prices can adjust freely, then you can wait until tomorrow
■ In this environment, there is a chance you can't change price
■ So will be stuck at low price
■ Now, not maximizing profit, which is not profitable
■ Because they can't anticipate this they want to change the price today
incise they cannot tomorrow
● Model predicts, even when they think inflation will be higher, it will affect current inflation

Why are inflation expectations important for the central bank?

● Important for the central banks to MANAGE people's expectations
○ You would see high inflation immediately if they think next years inflation will be high

Dynamic IS curve:
- Output gap decreases because consumption decreases with an increased interest rate (people are
buying more bonds)
- Buy bonds = less demand = decrease output
- High interest rates decrease the output gap
- Decrease in output gap = increase in inflation

Monetary Policy: Taylor Rule

- Specific to DSGE
● Reacts to inflation rate and output gap
○ Depending on these values, the central bank will set the interest rate
○ The circle with a line through it: policy variables --> they measure how strong the central
bank will react to inflation and output gap

By targeting the interest rate, what does to central bank have the ability to control
- They can control through the interest rate, employment and inflation
- So it is important to figure out how to design this policy to manage the output gap
- Changing the nominal interest rate, the central bank can change the inflation and output gap
- Want to lessen the impact of the shocks
- Interest rate policy prescription is going to be VERY different whether it is a demand shock or a
supply shock
What is the DSGE model limited to?
- Its ability to match data
- Can match the direction but NOT the volatility
Basic Job Search Model
** add class 20 notes

What is reservation wage

- the wage above wage (lowest wage) you will accept while being unemployed in order to accept a
job offer

What does reservation wage depend on?

- Depends on two things
1. b --> unemployment benefits: payoff per period from being unemployed
1. The higher the b the higher the reservation wage
2. When you think about accepting a job offer or not, if you get the job you will be in the job forever
(in this model there is no way to quit the job) --> what do you consider? If you get a better job
offer than this one
1. You are giving up the possibility of getting a better job offer if you choose to stay
unemployed
Labour market tightness
- If u/v is very small
● The ratio of unemployed workers over vacancy is called labour market tightness
○ Tight labour market: there is a lot of demand for goods and services = firms are hiring an
lot of people
■ There is little unemployed workers but lots of vacancies
■ So in this case = labour market is tight because firms are competing for very few
workers

What if u/v is very large?

- If u/v is very large there is a lot of unemployed workers , then it will be very difficult to find a job
because you are competing with many other people

Let's make unemployment benefits very generous. What are the consequences?
1. Wages are higher when you are employed
2. At the same time, people will experience longer unemployment
1. Because there will be fewer vacancies posted relative to the number of unemployed
workers
2. Prolong unemployment
1. Because benefit is greater
2. And harder to get a job
Simple Monetary Search Models

Model
● Idea is same as labour search model
○ The labour search model is a way to improve the DSGE and RBC model in a sense that
they do not have a frictional labour market
○ We model explicitly the frictions in the labour market

Credit as Payment

What is the key assumption?

- Agents do NOT want to consume their own output
- Because if you want to consume your own output there is really no trade to talk about

α
- Agents meet each other with probability alpha
δ
- Once agents meet, the probability delta is that both agents like each others output
σ
- With probability sigma, one agent likes the other agents output but not vice versa
- (σ > δ)
Autarky
- you do not trade with anyone
- Could be used as a punishment
- What is the value of not trading with anyone?
- 0

-
- You do not get any payoff doing this because you don’t like your output
Barter
- If you meet someone whose output you like and someone also at the same time also likes your
output - you trade with each other
- I give you my output, you give me your output
- Both are happy

-
Credit System
- Can produce something for someone and they can produce something for someone else who then
can produce that for you
- Does not require that any pair of the two like each other if we can establish a circle
- For this to happen, we only need one party to like the other party's good
- We do not need both directions
● Assume that an agent will always produce for other agents so long as other agents like our output

Compare Vc with Vb
- it is very clear Vc is larger
● The probability that you can get something and produce something is much larger
○ If Vb you have to meet someone who likes your output and you like their output
○ Now it is possible with only one party liking the others output

What do you need in order for the credit system to work?

- We need to specify a “punishment”
- Assume that if someone defaults (their time to produce, they choose not too), they will receive the
V^b

For the credit system 2 work there are 2 conditions which need to be satisfied
1. For credit system to work we R = the discount rate. If this B = 0.9 this means that the utility in the
need r to be sufficiently future is only 90% of what it is today so the r = 10% less today.
small We need r to be sufficiently small so you put more value in
tomorrow's value = you care a lot about the future --> we don’t
want people to discount future heavily since the punishment
would be future lower utility = they don’t really care .
Punishment wouldn't be useful = convincing

2. For credit system to work Need to be high enough so people do not always default. If it is
we need mew (weird u ) to small, cost of defaulting will be small so they will want to default
be sufficiently large because there is a large probability they will not be caught = need
 enforcement to be sufficiently strong for the credit system to
work
Asset as Payment

What is Tau 0
- Let T0 (tau) indicate whether a seller of goods is willing to accept the asset as payment
- (t0 = 1 if yes) (t0=0 if not)
What is Tau 1
- Let T1 (tau) indicate whether a buyer is willing to use the asset as payment
- T1=1 if yes and T1 =0 if not
What is Mew
- The probability of being detected by the system

When does monetary trade happen?

- Monetary trade happens if T0 = 1 and T1 = 1
● If both types of agents
● Sellers willing to sell for money
● Buyers willing to give money for goods
● Then money is used
^^ for money trade to happen BOTH HAVE TO BE WILLING TO USE MONEY
Due to the exchange you get utility u and now you become someone without and asset (V0)and lose your
asset (V1 - status of someone who has asset)

1 - A > mew
If 1 - A > mew, money is used
= if r photo is not satisfied
● The discount rate is too high so you do not care about future - do not care about future
punishment so credit system won't work
● When 1 - A > there is a chance that when credit doesn’t hold this new r may hold
○ So money can become the payment when credit is not feasible but for this to happen mew
cannot be too large
If mew = 1?
- then money is not used wherever credit is not feasible
● Money cannot improve the situation
○ 1 - A can never be bigger than one
○ If credit cannot be used when enforcement is perfect then money cannot be used
either
Fiat money can only be used when
- when the monitoring and detection of default is not perfect