MACROECONOMICS II

15 May 2024 13:46

What is macroeconomics A Two-Period Model – Consumption-Savings Decision and Credit Markets Credit Market Imperfections and frictions
- Two period model Credit market imperfections Firm Behaviour - Profit Maximization Chapter 5: A One-Period Mac
• Macroeconomics is the study of aggregate economic activity (the ○ A two-period macroeconomic model was constructed to understand the intertemporal consumption–savings decisions of consumers and the effects of - The intertemporal two period model shows how changes cause consumers to consumption smooth - Assumption Assumptions
behavior of large collections of economic agents – consumers, firms and fiscal policy choices concerning the timing of taxes and the quantity of government debt. - Their efforts to consumption smooth might be hindered by these ○ This is a static model (one period model) - important for the notion capital is fixed - Three different actors i
government), and is motivated by large issues that affect many people - there are many consumers, and each makes decisions over a two-period horizon where a consumer’s incomes in the two periods are given, and the consumer ○ Though aggregate consumption and income are qualitatively consistent with consumption-smoothing behavior, consumption is not quite smooth enough to tightly match the ○ Firms demand labor and supply consumption goods ○ Consumer
and many nations of the world pays lump-sum taxes in each period to the government. theory ○ The choices of the firms are determined by the available technology (production function) ○ Firm
• Microfounded macroeconomics is the approach that builds macroeconomic models based on individual agents' - Two periods - current period, future period  In the ricardian equviliance, the tax cut assumes the consumer saves 100 percent of the tax cut and that might not be true ○ Firms maximize their profits ○ Government
behavior and interactions, grounding the analysis in microeconomic principles. - Model - One of the most clear imperfection in the credit market is
○ A representative firm - The representative firm behaves competitively, that is, it takes as given the real wage - It is a closed economy
○ There are N consumers in this economy ○ The interest paid to lenders - Static model - one peri
○ Production function is constant returns to scale
○ Each consumer lives for two periods - the current period and the future period ○ The interest needed to be paid by borrowers
Behavior of the representative consumer and the representative firm in a one-period, or static, environment. - Production Function - Y=C+G
a single representative consumer, who acts as a stand-in for all of the consumers in the economy ○ Consumers do not make a work-leisure decision in either period, but simply receive exogenous incomes - meaning income is given  " consumers cannot borrow all they would like at the market interest rate market loan interest rate are typically higher than the interest rates at which consumers lend □ TOTAL DEMAND
○ The production function describes the technological possibilities for converting factor inputs into outputs
Assumptions ○ The goods consumer needs to worry about is current period consumption and future period consumption " ○ We can express this relationship as: Y = zF(K,N^d )
the representative consumer behaves competitively or they are price-takers We assume that there is no money in the ○ The credit market consists of risk free bonds and consumers trade bond directly, rather than through financial intermediaries - Assumption Consumer
 z is total factor productivity
economy, - ASSUMPTIONS ○ Assuming r1 < r2, - Consumers are endowe
 Y is output of consumption goods
the consumption good plays the role of numeraire ○ LEAVES OUT PRODUCTION AND INVESTMENTS  a consumer lends at real interest rate r1 - Consumers optimize: c
 K is the quantity of capital input
This is appropriate as this is a static model - Consumer in the two period model  a consumer borrows at real interest rate r2  N^d is the quantity of labor input - There a single represen
Consumers face the work-leisure choice ○ Need to consider consumer optimsiation across periods - NOTE - lifetime budget constraint gradient different for lenders and borrowers  F is a function consumption smoothin
choose to work harder and enjoy less leisure time, thus consume more goods ○ How consumers react to changes ○ If you are a lender, your savings will pay off with 1+r1 ○ Because one period model - no borrowing so K is fixed by N^d is a varaible factor of production
choose to work less and enjoy more leisure time, thus consumer fewer goods ○ Choice in two periods ○ If you are a borrower, you are paying 1+r2 ○ Constant returns to scale, multiply the inputs by x, output will multiply by x
Consumers are endowed with a fixed amount of time • Saving now, consume later: A consumer reduces current consumption to save, resulting in the future period to get (1+r) savings. ○ Because of this assumptoin, marginal product of labour and marginal product of capital is positive
Consumers optimize: consumers wish to make themselves as well off as possible given the constraints they face • Consume now, pay later: A consumer borrows now for more current consumption, reducing future consumption to repay (1+r) loan. ○ The two factor input are complementary to each other, as one Marginal product increase the other marginal product will increase
Constraint they face - Budget contraint ○ Consumers receive exogenous incomes:  The marginal product of labor increases as the quantity of the capital input increases, and similarly marginal product of capital increases as the
• y: real income in the current period ○
C = w(h−l) +π −T quantity of labor input increases -
NOTE h-l term is a substitude for labour supply - N^s, • y : real income in the future period - Marginal Production of Labour
As h is hours avaible, l is leasiure, N^s is hours worked ○ Each consumer pays lump-sum taxes: ○ Marginal product of labor is the additional output that can be produced with one additional unit of the labor input
Therefore h = N^s + l, N^s = h - l • t: tax in the current period ○ For lender
This is a time constraint • t : tax in the future period  If c< y-t, that means income - tax is greater than conusmption, so you have money left over to lend 
NOTE w(h-l), is labour income - Current Period Budget Constraint ○ For borrower
W = wage ○ c + s = y−t □ F2 signifies deriviative of the production function with respect to labour
 If c>y-t that means income - tax is negative, that means you are digging into your pocket and borrowing money Firms
Labour income = wN^s, subsituted • Consumption + savings = income - tax
NOTE pi is dividend income, T is lump sum tax □ NOTE - easier way of thinking is from the income I have, I give taxes, whatever is left, I either save or spend
NOTE - OVERALL THIS GIVES DISPOSABLE INCOME ® Hence
NOTE - when tax is proportional it is this - C=w(1−t)(h−l)+π ◊ Savings + spending = income - tax
BUDGET CONSTRAINT GRAPH ® Let's say I am in debt, my savings is negative, because I owe money, hence saving negative I am a borrower and give 1+r the loan in the
Two scenarios future period, reducing future consumption. Borrowers issue bonds.
Divdiend income less than tax - meaning you are living strictly on income ® If my savings > 0, that means I have my money in a risk free bond, I can lend out money and get 1+r the loan, increasing future
Dividend income more than tax - menaing you are living on income and some more consumption, I am a lender. Lenders buy bonds. - -
Dividend income less than tax ◊ Being a lender or a borrower is also contingent on the tangency of the indifference curve and budget constraint, ie indifference ○
curve between current and future consumption and lifetime budget constraint

Government
○ Ignore the black lines
○ Focus on the endownment point
 Above lender, their money grows at 1+r1  Note the leveling off showing diminisnng retursn
◊
 Below borrower, they have to borrow at a higher interest rate ○ Showing the dininbibg reutnr another way
○ Note - as the budget constraints gradient will always be 1+r, borrower has a steeper gradient

To calculate point a, you take hours devoted to leasiure as 0, therefore l = 0, therefore the constraint
becomes c = w(h) + pi - T
Point b, you take consumptions as 0, and make leasiure the subject NOTE - drastic differen
C = w(h-l) + pi - T  tax it gets
0 = wh - wl + pi - T
Wl = wh + pi - T MARKETS TO CLEAR
L = ((wh) + pi - T)/w LABOUR MARKET : NS =
L = h + (pi - T)/w GOODS MARKET : Y = C
Dividend income more than tax Output = all cons
- Profit maximisng MEMORISE
FIRMS PUR
◊ SUPPLY LA
○ PRODUCE G
Side note - another imp

 Profit = production - cost of total labour demanded When labor market cle
 Profit = productoin function - wage * labour demanded Preface - labour marke
 Choose N ∗ to maximize the difference between total revenue zF(K,N d ) and the variable cost function WNd C = wNs +π −T
○ Profit maximinsing quantitiy = wNs +[Y −wNd
= wNs + Y - wNd
• NOTE - savings only in the current period because there is nothing about the future period so no savings  = wNs - wNd + Y
- future period Budget constraint
= w(Ns - Nd) + Y -
○ c = y −t + (1+r)s □ MPn is the benefit of hiring a new worker, w is the cost
As Ns = Nd
Key to note - using income is the slant, after income finished, just living on dividend, • My income + my savings from the past + interest that it garnered - taxes = what I can spend □ If you benefit of the hiring a new worker outweights cost of the new worker you will hire them
=Y−T
dividend doesn't matter on how much time you have ○ Consumption' = income' + savings(1+r) - taxes Consumers who cannot easily borrow at reasonable rates to smooth their consumption over time will prefer to spend more of the increased disposable income now rather than save it. This is ® MPn> w, hire more
=Y−G
As well off as possible - Lifetime Budget Constraint 1 because they can't rely on future borrowing to maintain their consumption when taxes rise later. □ If the benefit of hiring a new worker is less than the cost of new worker, you will not hire them
® MPN<w
Consumer's make themselves as well of as possible in two metrics In this example, the consumer is better off as a result of the tax change. The consumer consumers the entire tax cut in the current period and consumption increases In the Ricardian
equivalence theorem, the consumer save the entire tax cut and consumptions are unaffected □ Therefore it corrects itself to
Consumption good: C Production Possibilities Front
○ ® MPn = w
Leasiure: l - Converting the underst
 This is shown graphically
to have more consumption and less leisure, OR less consumption and more leisure - Production function
You can represent their prefence in a utilty function, which maps onto a indifference curve and have these TWO PERIOD BANKING MODEL ○ Y = zF(K,N)
○ In my lifetime, income now, income later - taxes now - taxes later = spending in total which is split up in consumption now and consumption later
properties like this - In the economy, there are many banks, in addition to the consumers and government in the baseline two-period model A bank is financial intermediary that borrows from one set of
○ The consumer’s problem is now to choose c and c to make himself as well off as possible, while satisfying the budget constraint and given r, y, y ,t and
More is always preferred to less individuals and lends to another set A bank borrows from its depositors in the current period, with a depositor receiving a real interest rate r1 The bank takes all of its deposits in the
t
The consume likes diversity in the consumption bundle current period, and make loans to borrowers at r2
- Lifetime wealth is equal to the present value of current and future consumption
Consumption goods and leisure are normal goods 
Marginal rate of substitution of leisure for consumption, denoted MRSl,C, is how much consumption Credit market frictions
○ - Caused by
goods he is willing to give up for adding additional unit of leisure, such that his utility stays the same □
MRS is always MU,leasiure / MU,consumption ○ Asymmetric information
• Note the reason why lifetime wealth does not have savings because you already spend that in the future period, or if you spent in the current ○ Limited commitment
period, you paid it off in the future period, it is offset - Asymetric informaiton - As N can be written in
- Lifetime budget constraint 2 ○ In the credit market, borrower knows more about his own creditworthiness than do lenders ○ Y = zF(K, h - l)
 Borrowers know if they are a good loan or a bad loan than the people who lend them money
○ suppose that a fraction a of the borrowers in the economy are good borrowers who have positive income in the future period, while a fraction 1−a of borrowers are bad, will defualt
○ Banks cannot distinguish between good or bad
○ Loan of r2 is made to both bad and good borrowers, and qunaitity of loans made is L □ Point a is the maximisaiton point and production function is tangement to the wNd which as a gradient of wage
Note - bizarre that MRS is l and c, and U is C, l, just remember for weridness 
 R2 to make up for the losses they will make - Labour demand curve
PROPERTIES OF THE MRS - DIMINISHING
○ Banks risk diversificaiton
 minimizes risk by diversifying or lending to a large number of borrowers assuming a large majority will make up for the minority of bad loans
BANKS PROFIT FUNCTION
□ As le
○ - - Goods market
○ C=Y-G
○ Profit made = fraction of good borrowers * quantity of loans * principle and interest paid + fraction of bad borrowers * quanitity of loans * 0 - qunaity of loans * princieple and ○ C = zF(K,h−l)−G
interst - You get the relationshi
○ Profit made is the number of good loans and the principels and interst + all the bad loans made amounting to 0 - cost of loans in the form of principle and lower interet rate
○

As point a, as leaisure bcomes larger and larger, MRS becomes smaller and smaller
CONSUMER OPTIMISATOIN ○
The optimal consumption bundle is the point representing a consumption-leisure pair that gives the highest
utility (on the highest possible indifference curve) and is feasible (is on or inside the consumer’s budget
constraint).
-
 The cheaper the worker, the omore of them you want
○ When total factor productivity increases
- NOTE
○ Only production
○ Second graph an
- The PPF describes wha
goods and leisure
- The slope of the PPF is
- Profit = 0 becase - It is a rate at which one
- ○ The banking market is perfectly competitive, meaning many banks are competing for the same depositors and borrowers. This competition drives down the interest rate spread (the - Here, the MRT is the ra
difference between the interest rate charged on loans and the interest rate paid on deposits) . 
-
○ ALL THESE SLOPE

NOTE - THE GRADIENT OF INCOME - IE POINT A TO B - HAS THE GRADIENT OF w - wage
Therefore point h is tangent to the gradient of wage, where point h, has the MRS of the same
gradient - When a = 1 and there are no bad borrowers, we have r1 = r2 and there is no credit market imperfection When a decreases, given r1, r2 increases.
Therefore the optimal point of conusmer choice in a one period model is MRS = w - That is, the credit market imperfection becomes more severe as the fraction of bad borrowers in the population increases
- The difference r2 −r1 is the default premium.  The reason being when total factor productivity increases, you are getting more for the labour your input, knowing you can produce more with
MATHEMATICAL - This difference grows as the fraction of bad borrowers increase, or credit market imperfection becomes more severe more labour, your labour demand increases, it shifts to the right

○ NOTE - point e is endownment point where y'-t' = 0, and y - t = 0

• NOTE - below endownment point borrower, high current consumption, low future consumption
• NOTE - above endowmnet point lender, low current consumption, high future consumption
□ ○ NOTE - lifetime wealth on the futre consumption is 1+r because lifetime wealth is done through a present value calculation therefore in the future that
has to be multiplied by 1+r to get the future value
○ NOTE - current consumption it is we ○
- Preference for current and future consumption period Black line - production functi
® NOTE - langragian used ○ More is always better than less blue line - indifference curve
- AD - budget constraint
◊ They took the budget constraint and made it equal to 0 ○ The consumer likes diversity in his consumption bundle
○ Both current consumption and future consumption are normal goods When all of them are tangen
} C = w(h-l) + pi - T
} 0 = w(h-l) + pi - T - C - MRS AND Indifference curve
® L = U(C,l) + lamda (w(h-l) + pi - T - C)
® Taking deriviative with respect to C
croeconomic Model

in the one period model

iod

FOR GOODS IS ASSUMED TO BE FROM CONSUMERS AND GOVERNMENT AS FIRMS ONLY WANT LABOUR

ed with a fixed amount of time, and face the work-leisure choice

consumers wish to make themselves as well off as possible given the constraints they face
ntative consumer, who acts as a stand-in for all of the consumers in the economy - price taking behavior,
ng behavior

nce from intertemporal two period model because there is no borrowing for government it is strictly how much

= ND
C +G
sumption + government spending

RPOSE IS TO SUPPLY LABOUR AND PRODUCE GOODS

ABOUR - LABOUR MARKET
GOODS - GOODS MARKET
portant part is G = T

ears, goods market clears too:

et clearing means Nd = Ns, other condition G = T, pi = Y - Nd

]−T
-T
-T
-T
d, Ns - Nd = 0

tier
tanding of the production function into finding the optimal consumption bundle of leaiusre and consumption

terms of h - l

eisure increase, output decreases

ip between conusmption and leasiure in terms of productoin function

function has positive MPn slope, other graphs have negative

nd third graph is a subsutiton
at the technological possibilities are for the economy as a whole, in terms of the production of consumption

the marginal rate of transformation

e good can be converted technologically into another
ate at which leisure can be converted in the economy into consumption goods through work

ES MATCH

ion

nt, they are in compeittive equblirium, meaning that all of them have a gradient of wage
 • NOTE - above endowmnet point lender, low current consumption, high future consumption
□ ○ NOTE - lifetime wealth on the futre consumption is 1+r because lifetime wealth is done through a present value calculation therefore in the future that
has to be multiplied by 1+r to get the future value
○ NOTE - current consumption it is we ○
- Preference for current and future consumption period Black line - production functi
○ More is always better than less blue line - indifference curve
® NOTE - langragian used -
○ The consumer likes diversity in his consumption bundle AD - budget constraint
◊ They took the budget constraint and made it equal to 0
○ Both current consumption and future consumption are normal goods When all of them are tangen
} C = w(h-l) + pi - T
} 0 = w(h-l) + pi - T - C - MRS AND Indifference curve
® L = U(C,l) + lamda (w(h-l) + pi - T - C)
® Taking deriviative with respect to C
◊ MUc - lamda = 0
◊ MUl - w lamda = 0
○ Higher default premium, higher r2, that means steeper gradient
® ○ Financial Crisis
- During the financial crisis, there was an increase in interest rate spread, which made it harder to borrow, which lowered consumption, which impacts output and overall GDP
◊ As MRS = MU,leiasure / MU,consumption of goods
◊ MUc = lamda Intertemporal consumption model with assets
◊ MUl = w lamda - H - quantity of assets - asset illiquid, cannot be sold in current period
- pH - price per unit of the asset
◊ MUI / MUc = (w lamda) / lamda Initutivitely
- NOTE - savings is different from asset, asset is independent of income and tax
◊ MRS = w • MRS shows for how many current consumption good consumer wants, how many future consumption goods are they willing to give up - Current period budget constraint It is important for the a
○ Other things to think about □ How many of x they want and how many y they want to give up ○ c+s = y−t in the current period, consumption and lieas
 Change in dividend or tax transfomrationg compn
 Note the exclusion of asset as it is independent from everything
□ This causes an income change - hence an income effect takes place ○ - Future period budget constraint
○ c = y −t + (1+r)s + pH
TOTOAL FACTOR PRODUCTIV
• Indifference curve has to be tangent to the budget constraint  NOTE - price per unit of asset can be sold and consumed
- Z increase, production
• The lifetime budget constraint gradient is 1+r because at 0 future consumption, current consumption is we, and when current consumption is 0,
- Z increase, MPn increa
future consumption is we(1+r)
- CHANGE IN CURRENT PERIOD INCOME -
○ Change in current period income, y, will mean the lifetime wealth as increased, therefore the lifetime budget contraint will shift to the right. Moreover, if
® y increases, that means the endownment point as increased, but the future income stays the same, to be able to plot that you must shift the budget ○ pH has been done a presente value calculation as it can be consumed in the future
constraint to the right
- CONSUMPTION SMOOTHING BEHAVIOR Limited Commitment
○ When current income increases - Limit commitment refers to situations in which it is impossible for a market participant to commit in advance to some future action
• Because current and future consumption are normal goods, an increase in income leads to increases in both current and future consumption - As a result, lenders request collateral. When collateral is posted as part of a credit contract, the lenders have the right to seize the collateral in the event that the borrowers default on the -
goods if current income increases, the consumer wishes to spread this additional income over both periods and not consumer it all in the current loan
period. Thus, savings increase too This behavior arises because of the consumer’s desire to smooth consumption over time - The amount the borrower has to post up as collotoral can be a limiting factor how their overall consumption
- And a change in the value of collateral will matter for how much he can consumer in the present
® NOTE - the gradient does not change as wage does not change and the gradient is determined by - As a lender I will lend money if there is suffcieint collatoral, meaning the collortaral covers if I happen to lose money, therefore the only sufficeint condition for colloratal is
the wage - Because of limited commitment
® NOTE = moves from B to J because dividend changes, and dividend is not subject to how much ○ Current period budget constraint for borrowers
time I spend on it just a clean life up
® ONLY INCOME EFFECT BECAUSE INCOME CHANGES ○ Pay attention to
 Change in real wage  Because of
□ CAUSES A SUBSTUTION EFFECT AND INCOME EFFECT

□
®
- ○ When limited constraint is presented, it means that the overall consumption decreases as seen with the massive shift left and decrease in verticle intercept
○ This shift is imitated when price of per unit asset decreases, which rationally makes sense because the future consumption will be lower, because of consumption smoothing
behavior, current consumption also decreases
**Unconstrained Consumer:** Smoothly reduces consumption in both periods when asset prices drop.
◊ NOTE GRADIENT CHANGE ○ The substitution
} Also note H is the final point  Consumpti
**Constrained Consumer:** Experiences sharp, immediate reductions in current period consumption due to binding collateral constraints, illustrating the challenge of smoothing
} AB was before the change  Leisure dec
consumption with credit market imperfections.
} EB is after the real wage change ○ The income effec
 From the late 1990s until the peak in housing prices in the US in 2006, a significant fraction of consumer expenditure was financed by borrowing, through mortgages and
 Consumpti
} JK is the real wage change gradient matching orignal indifference curve - substution home equity loans, using housing as collateral With the decrease in housing prices in the US that began in 2006, the value of collateralizable wealth in the US economy fell,
 Leisure inc
effect and consumer spending also decrease by a large amount, fuelling the 2008-09 recession
} JK to EB that lift is income effect
} TOTAL EFFECT IS F TO H CONSUMER OPTIMISATOIN
○ LABOUR SUPPLY The consumer’s problem is to maximize his utility, given his lifetime budget constraint and collateral constraint
 Labor supply curve: how much labor the consumer wishes to supply given any real wage, ie. N s (w) = h−l The collateral constraint implies that the budget constraint is kinked
□ NOTE - l is dependent on wage, as wage increases, leasiure becomes more expensive due to opporuntity cost,
○ NOTE - future consumption endownment cooridinate is the same
however, one can argue, as wage increases, people will enjoy more leasiure as they can earn the same amount ○
doing less work. Therefore, the move is ambigious - If all consumers act to smooth their consumption relative to their income, then aggregate consumption should likewise be smooth relative to aggregate
 Therefore, we assume, when real wage changes, subsitution effect dominates over income effect meaning consumers income Indeed, this prediction of our theory is consistent with what we see in the data, that real aggregate consumption is less variable than is real GDP.
substitude more work in their consumption bundle and less leisure therefore as wage increases, people work more, - CHANGE IN FUTURE PERIOD INCOME
meaning labour supply is upward sloping ○ Due to consumption smoothing behavior
• Rather than spend all the increase in income in the future, the consumer saves less in the current period or borrows more in the current period so
that current consumption can increase. So saving decrease,
○ And as future period income increases overall lifetime wealth increases and lifetime budget increase because y' is a factor in lifetime budget contraint The effect of a change
Consumption inc
Leisure ambiguo
Employment amb
confusion
□ Output increases
Real wage increa
It suggests that if
aggregate outpu
Productivity (TFP

With proportional income ta

- Changes in the model
○ Wage = w(1-t)(h-
 1 - t afterta
○ ○ Productoin funct
 Y = zNd
□ Smo
- Same
○ G=T

The elasticity of labor supply measures how sensitive the quantity of labor supplied is to changes in the wage rate. A
relatively large elasticity of labor supply indicates that small changes in wages lead to significant changes in the quantity of -
labor supplied.
When the elasticity of labor supply is large, the substitution effect dominates. This means that workers are highly responsive
to changes in wages, choosing to work more when wages increase and less when wages decrease.
In the context of proportional income taxation, if the substitution effect is large (elasticity of labor supply is large), then an Consumers who cannot easily borrow at reasonable rates to smooth their consumption over time will prefer to spend more of the increased disposable income now rather than save it. This is ○ Consumer - wage
increase in the income tax rate can have a substantial disincentive effect on the hours of work. This is because a higher tax because they can't rely on future borrowing to maintain their consumption when taxes rise later.  Maximum
rate reduces the effective real wage received by the worker, making leisure relatively more attractive compared to working. □ MRS
• Endownment point rationale also follows
As a result, workers may choose to work fewer hours in response to higher income tax rates. In this example, the consumer is better off as a result of the tax change. The consumer consumers the entire tax cut in the current period and consumption increases In the Ricardian □ From
- CHANGE IN INTEREST RATES
Therefore, when a government aims to redistribute income through labor taxation, it becomes crucial to understand the equivalence theorem, the consumer save the entire tax cut and consumptions are unaffected □ MRS
○ Interest rates is the gradient of the lifetime budget constraint, therefore, if interest rate increases, slope will be steeper, it will pivot around the
magnitude of the elasticity of labor supply. A higher elasticity implies that tax policy changes will have a more pronounced endowment point. They still have to pay the tax?
impact on labor supply decisions, potentially affecting the effectiveness of income redistribution efforts. ○ Rational is if interest rate rise, the savings in the present will be worth more in the future, hence it will have a higher vertical intercept, if interest rate 
rise, people will be incentivised to save more, therefore consumption will decrease, on top of that, because lifetime wealth (we) is measured by doing
the present value calculation of the future disposable income (y'-t')/1+r it will be smaller because r term larger ○ Firm
This behavior is the basis for constructing a macroeconomic model that we can work with in Chapter 5. • The representative  π = Y −wNd
consumer stands in for the large number of consumers that exist in the economy as a whole, and the representative firm □ As Y
stands in for a large number of firms. • The representative consumer’s goal is to choose consumption and leisure to make  Pi = zNd - w
 Pi = (z−w)N
himself or herself as well off as possible while respecting his or her budget constraint. • The consumer’s preferences have
 FIRMS PRO
the properties that more is always preferred to less and that there is preference for diversity in consumption and leisure. The
□ FIRM
consumer is a price-taker in that he or she treats the market real wage as given, and his or her real disposable income is real □ FOR
wage income plus real dividend income, minus real taxes. • Graphically, the representative consumer optimizes by choosing ®
the consumption bundle where an indifference curve is tangent to the budget constraint or, what is the same thing, the ®
marginal rate of substitution of leisure for consumption is equal to the real wage. • Under the assumption that consumption
and leisure are normal goods, an increase in the representative consumer’s income leads to an increase in consumption and -
an increase in leisure, implying that labor supply goes down. • An increase in the real wage leads to an increase in ○
consumption, but it may cause leisure to rise or fall, because there are opposing income and substitution effects. The ○ Government = ta
consumer’s labor supply, therefore, may increase or decrease when the real wage increases. • The representative firm ○ As z = w
chooses the quantity of labor to hire so as to maximize profits, with the quantity of capital fixed in this one-period
environment. • The firm’s production technology is captured by the production function, which has constant returns to scale, 
a diminishing marginal product of labor, and a diminishing marginal product of capital. Further, the marginal products of WHY IS SAVINGS NEGATIVE
labor and capital are positive, and the marginal product of labor increases with the quantity of capital. • An increase in total
factor productivity increases the quantity of output that can be produced with any quantities of labor and capital, and it
increases the marginal product of labor. • When the firm optimizes, it sets the marginal product of labor equal to the real
-
wage. This implies that the firm’s marginal product of labor schedule is its demand curve for labor.
○ When interest rate rise ○ Labour market an
• For a lender, a higher interest rate implies that the return on saving is higher
• For a borrower, to repay the loan the consumer has to forgo more future consumption goods With a credit market imperfection, modeled as a situation where the lending interest rate is less than the borrowing interest rate, Ricardian equivalence does not hold. A current tax cut Social planner problem
○ Substiution and income effect that just changes the timing of taxes, with no effect on lifetime wealth, will increase current consumption and have no effect on savings. • One credit market imperfection is asymmetric - No choices from individ
• For lenders information, under which lenders cannot perfectly observe the creditworthiness of would-be borrowers. In a credit market with good and bad borrowers, the lending interest rate is less - The social planner face
□ Substitution effects: current consumption decreases and future consumption increases, as future consumption becomes cheaper than the borrowing interest rate, reflecting a default premium on the loan interest rate. An increase in the fraction of bad borrowers in the market increases the default premium and - Purpose -The social pla
® Future consumption is cheaper because they are wealthier in the future reduces the quantity of lending. • A second credit market imperfection is limited commitment—borrowers have an incentive to default on their debts. Lenders give borrowers the consumer as well of as
□ Income effects: both current and future consumption increases incentive to repay by requiring that borrowers post collateral. However, when borrowers are collateral-constrained, a decrease in the price of collateralizable wealth reduces lending and - For this model, the com
□ Therefore, future consumption increases, and the effects on current consumption are ambiguous. consumption. • Social security programs can be rationalized by a credit market failure—the inability of the unborn to trade with those currently alive. There are two types of government-
® As they can save more, or knowing they will be wealthier in the future, spend more provided social security programs—pay-as-you-go programs and fully funded programs. • Pay-as-you-go social security, which funds retirement benefits from taxes on the working-age
• For borrowers population, increases welfare for everyone if the real interest rate is less than the rate of growth in the population. • Fully funded social security at best has no effect, and at worst
□ Substitution effects: current consumption decreases and future consumption increases, as future consumption becomes cheaper constrains retirement savings in ways that make consumers worse off. • Even if the population growth rate is low, social security can be justified if we think that the government is unable
® Because they are saving more to commit to providing social assistance to destitute senior citizens. In that event, pay-as-you-go systems may in fact be less costly than fully funded systems.
□ Confusion
○ Interest rates, income effect and aggregate consumption
• there are potentially confounding income effects in determining the effect of an increase in interest rate on current consumption Thus, there is no
theoretical guarantee that aggregate consumption will fall when interest rate rises
- Government -
○ Current period budget constraint
• G=T+B
□ Government Spending = Taxes - value bonds issued
ion

nt, they are in compeittive equblirium, meaning that all of them have a gradient of wage

assumptoin of representative firm and consumer because of the price taking behvaioru of wage being given, and
sure choices are based off of that, which decides the optimal slope for the marginal rate of transformation,
nents into productive outpout

VITY INCREASE
functoin Nd substutede for h - l , PPF increase
ase Nd increase, wage increase

the convergance
f this

effect: the movement from A to D

ion increases
creases
ct: the movement from D to B
ion increases
creases

in total factor productivity:

creases
ous - if substiution effect dominates, leasure decreases, if income effect dominates, lieasure increases
biguous, as N = h−l , due to ambigous shift in leisure
s, as Y = C +G
ases
f we prioritize substitution effects over income effects, an increase in a variable denoted as zzzleads to higher
ut, increased consumption, and increased employment. Therefore, the statement concludes that Total Factor
P) shocks could indeed be a significant driver of business cycles.

ax

-l)
ax
tion

ooth brain bullshit

e per hour after tax * hours worked + dividend

utiltiy condition
S = real wage ie w (1-t)
m firms you understand z = w
S = z(1-t)

d
= zNd
wNd
Nd
OFIT CONDITION
MS PROFIT CONDITION IS PROFIT = 0
PROFIT TO EQUAL 0
(z-w) term has to be 0
Therefore z = w is a condition

axed wage per hour worked * hours worked

nd goods market have to clear

duals or firms, social planner does everything

es resource constraint
anner’s problem is to choose C and l, given the technology for converting l into C, to make the representative
s possible
mpetitive equilibrium is identical to the Pareto optimum, or the competitive equilibrium is Pareto optimal
 • For borrowers population, increases welfare for everyone if the real interest rate is less than the rate of growth in the population. • Fully funded social security at best has no effect, and at worst
□ Substitution effects: current consumption decreases and future consumption increases, as future consumption becomes cheaper constrains retirement savings in ways that make consumers worse off. • Even if the population growth rate is low, social security can be justified if we think that the government is unable
® Because they are saving more to commit to providing social assistance to destitute senior citizens. In that event, pay-as-you-go systems may in fact be less costly than fully funded systems.
□ Confusion
○ Interest rates, income effect and aggregate consumption
• there are potentially confounding income effects in determining the effect of an increase in interest rate on current consumption Thus, there is no
theoretical guarantee that aggregate consumption will fall when interest rate rises
- Government -
○ Current period budget constraint
• G=T+B
□ Government Spending = Taxes - value bonds issued
□ Government can spend what they get in taxes and what they can borrow
○ Future period budget constraint
• G' + B(1+r) = T'
□ Future taxes should support government spending and principle and interest on the bonds
○ Present value budget constraint
○ Subject to the go
• ○ NOTE - MU,lesiur
- FOR PROPORITIONAL T
□ NOTE THE EXCLUSION OF BORROWING BECAUSE THEY CANCEL OUT AND dividing by 1+r off sets the interest rates ○ Social planner m
- Exogenous and endogenous  Y=C+G
○ The exogenous variables are:  C=Y-G
• G, G , B government expenditure and deficit □ As di
• y, y income  C = zNd - G
○ The endogenous variables are: □ As N
 C = z (h - l)
• c, c , s consumption and saving
 C +G = z(h−
• t,t tax
• r real interest rate
□ Remembering
® Current consumption and future consumption, subject to t'he rates ○
- Competitive equilibrium
○ Competitive: all agents are price-takers
○ Equilibrium: demand equals to supply in all markets (markets clear)
- Markets to consider
○ Credit Market
○ Goods market
○ If one clear, the other one does too - Walrus' Law
- Credit Market
○ Credit Market
• consumers and the government can borrow and lend
○ Credit Market Clearning Condition ○
• The credit market clears when the net quantity that consumers want to lend in the current period is equal to the quantity that the government
wants to borrow
• S^p = B
□ Aggregate quanitity of private savings = government borrwoing needs
○ Interest rate adjusts such the credit market clears
• Demand is determined by government’s wish to borrow money, B = G−T, independent of interest rate
• Supply is determined by consumers’ wish to lend money. We assume that when interest rate increases, consumers want to save more, so that
supply curve is upward sloping  AB is the re
□ This implies with interest rate goes up, aggregate quantity private savings goes up  DF is when
- GOODS MARKET  E is parto o
 H is not pa

What could cause a competit

economy: externalities, disto

- CONSUMER OPTIMSATION PROBLEM

○ FIRST PART - max utility given constraint of income and tax, representative of consumption now and future - remember the goods are current
consumption and future consumption The budget constraint gets sh
○ Second part - langragian method, note budget constrained made equal to 0 and taken the current and future consumption to the other side The effects of an increase in
○ Third part - taking derivaitive with respect to c and c' which gives the results Consumption decrease
- INTERTEMPORAL MARGINAL RATE OF SUBSITUITON The PPF, the bud
○ As MRS is MU1/MU2 - MU,current consumption / MU,future conusmption Leisure decreases
○ MU,current consumption = u1(c,c') - lamda = 0 The budget cons
• Leading to Employment increases
□ u1(c,c') - lamda = 0 Because leasiure
□ u1(c,c') = lamda Output increases,
○ MU,future conusmption = u2(c,c') - lamda/1+r = 0 Because more em
• Leading to since the model contradicts t
□ u2(c,c') - lamda/1+r = 0 seem to be a plausible cause
□ u2(c,c') = lamda/1+r
○ Therefore you have lamda / (lamda/1+r ) as Y = zF(K,N) Real wag

Exogenous and endggenous v

○

- Equlibirum Interest Rate

○ From each consumer’s optimization problem, we can derive c and c from the intertemporal condition and the budget constraint.
○ The optimal consumption bundle is a function of interest rate r: c(r) and c (r)
○ Then, the savings is: s(r) = y−t −c(r), which is also a function of interest rate
○ We aggregate savings from all consumers and get total private saving: S(r) or the supply of loanable funds in the credit market S^p
○ Government demand for loanable funds is given by B = G−T In the credit market, from supply and demand of loanable funds, we can solve for the
equilibrium interest rate
- Ricardian equivalence theorem
○ Condition studying
• If present taxes decrease by certain amount, which future tax is adjusted for what is the impact

□ Exogenous
Government Zap
Endgonous
○ Ricardian equivalence theorem states that it has no effect on the interest rate or on the consumption of individual consumers. That is, the timing of Watch CNN, You
taxation does not matter or government budget deficit does not matter. Competitive equlibrium
○ Short of it, when this type of change is made, everything is offset, that is why governmetn present value budget constraint stays the same, and Competitive: all consum
consumer's lifetime budget stays the same. So the goods market component does not change demand equals to supp

PROBLEM
- PURPOSE OF PPF
○ he slope of the P
○ It is a rate at whi
○ Here, the MRT is
- WHY LEISURE BEING CO
○

• CHANGE IS OFFSET BY CANCELING OUT AND 1+r dividing away

○ This is true for every consumer, so aggregate consumption is the same Aggregate income does not change, and so does government expenditure.
○ So we have Y = C +G, implying consumption goods market clears.
○ By Walras’s law, credit market clears
○ Therefore, we show change in the timing of taxation does not change interest rate and individuals’ consumption

The budget constraint gets sh

 oods market modfiend for subsituion of Y for productoin
re / MU,consumption
TAX
maximizes U(C,l) subject to resource constraint

iscussed above in a proptional tax Y = zNd

G
Nd = h - l
-G
−l)

esoucrse constraint
n things are in eqlibrium with protional tax
optimal
areto optimal but where the goods market and labour market are in eqlibirum

tive equilibrium to fail to be Pareto optimal? In practice, many factors can result in inefficiency in a market
orting taxes, monopoly power

hift down / pivots

government spending,
es
dget constraint shifts down

straint shifts down

s
e decreases, as N = h−l

mployment
the observed procyclical behavior of consumption and employment, fluctuations in government spending do not
e of business cycles according to this analysis.

ge falls, as w = zF2(K,N)

variables

ps Killers

uTube

mers and firms are price-takers Equilibrium: the actions of all consumers and firms are consistent, that is,
ply in all markets (markets clear)

PPF is the marginal rate of transformation

ich one good can be converted technologically into another
s the rate at which leisure can be converted in the economy into consumption goods through work
ONVERTED?

hift down or pivots?

 • CHANGE IS OFFSET BY CANCELING OUT AND 1+r dividing away
○ This is true for every consumer, so aggregate consumption is the same Aggregate income does not change, and so does government expenditure.
○ So we have Y = C +G, implying consumption goods market clears.
○ By Walras’s law, credit market clears
○ Therefore, we show change in the timing of taxation does not change interest rate and individuals’ consumption

The budget constraint gets sh

- Savings increase by the tax change, as the assumption of consumption smoothing behavior
- Borrowing needs increase by the tax change
- In equilibrium, in credit market, both supply and demand for loanable funds increase
- The interest rate remains the same because the increased demand for money causes interest rate to rise, but because there is more money to be loaned out
the interest rate falls

○ NOTE - The consumer is not better off because they have to pay the tax just in the future
- Ricardian equvilance failure
○ Tax burden not shared equally
• The person who enjoyed the higher tax cut in the current period is not paying in the future period
○ Intergenerational redistrubution
• This generation enjoys tax cuts, but the next generation has higher tax
○ Ricardiance equvliance studies lump sum tax when in the real world it is proptional income tax
○ When there is credit market imperfection

• A two-period macroeconomic model was constructed to understand the intertemporal consumption–savings decisions of consumers and the effects of fiscal policy
choices concerning the timing of taxes and the quantity of government debt. • In the model, there are many consumers, and each makes decisions over a two-period
horizon where a consumer’s incomes in the two periods are given, and the consumer pays lump-sum taxes in each period to the government. • The lifetime budget
constraint of the consumer states that the present value of consumption over the consumer’s two-period time horizon is equal to the present value of disposable
income. • A consumer’s lifetime wealth is his or her present value of disposable income. • A consumer’s preferences have the property that more is preferred to less
with regard to current and future consumption, there is a preference for diversity in current and future consumption, and current and future consumption are
normal goods. A preference for diversity implies that consumers wish to smooth consumption relative to income over the present and the future. • Consumption
smoothing yields the result that, if income increases in the current period for a consumer, then current consumption increases, future consumption increases, and
current saving increases. If future income increases, then consumption increases in both periods and current saving decreases. A permanent increase in income
(when current and future income increase) has a larger impact on current consumption than does a temporary increase in income (only current income increases). •
If there is an increase in the real interest rate that a consumer faces, then there are income and substitution effects on consumption. Because an increase in the real
interest rate causes a reduction in the price of future consumption in terms of current consumption, the substitution effect is for current consumption to fall, future
consumption to rise, and current saving to rise when the real interest rate rises. For a lender (borrower), the income effect of an increase in the real interest rate is
positive (negative) for both current and future consumption. • The Ricardian equivalence theorem states that changes in current taxes by the government that leave
the present value of taxes constant have no effect on consumers’ consumption choices or on the equilibrium real interest rate. This is because consumers change
savings by an amount equal and opposite to the change in current taxes to compensate for the change in future taxes. • Ricardian equivalence depends critically on
the notion that the burden of the government debt is shared equally among the people alive when the debt is issued. The burden of the debt is not shared equally
when: (1) there are current distributional effects of changes in taxes; (2) there are intergenerational distribution effects; (3) taxes cause distortions; or (4) there are
credit market imperfections.

Confusion

Income effect both decrease

hift down or pivots?