2009 10 Lecture Notes Macro

Macroeconomics 1
It studies not only a single good, a single price, or a

market, but the economy as a whole:
single market
for instance, the Italian economy;
or the European
p economy;y;
or the American economy;
or the world economy;
more in general, any economy;
and so on.
There are, in fact, important questions that occur at aggregate

level, that is, relate to the performance (the success, the health,
the difficulties) of the economy as a whole. Such questions are
treated by Economics with specific methods and models
(pr i l those
(precisely th pertaining
p rt inin tto Macroeconomics).
M r n i )
Macroeconomics – Definitions and statistical regularities
The most important
p q
questions 2
1. Economic Growth: there is a general tendency of the
economic systems to grow in the long run; but the velocity
of growth is not uniform over time, and is not equal among
different economies.
2. Economic Fluctuations : in the short run, the dynamics of
the economyy shows an irregular
g alternation of phases
p of
accelerated growth (booms) and phases of slowdown, or
phases of contraction (recessions).
3. Unemployment : the economic system is unable to create
jobs for all who wish to work (also the unemployment rate
fluctuates significantly).
4. Inflation : on average, the prices of goods and services tend
to increase (deflation is a far more rare phenomenon).
The Domestic Product 3
The level of economic activity of a country is measured by the
GDP.
Definition: it is the value of goods and services produced
within a country in a given year, net of goods and services
consumed to produce them.
The pper capita
p GDP ((GDP divided byy the overall population)
p p ) is
an indicator of the wealth (welfare) of a country.
In the long
g run, the GDP tends to increase ((see FIGURES 2-3).
)
This phenomenon is the basis of “economic development”.
The GDP g growth is not regular.
g In the short run, it shows
ups and downs, according to the features of economic
fluctuations. Such fluctuations are also called “business cycles”
(see FIGURE 4).
Unemployment
p y 4
Unemplo ed (U ): are allll persons who

Unemployed h wantt to
t work
k
and do not work.
Labor Forces (NF ): are all Employed

p y (N):
persons who want to work. are all persons who work.
Unemployed: U = NF − N

The unemployment
p y rate ((u)) 5
Is the share (percentage) U  NF − N
u
of the unemployed to the NF NF
total labor forces:  1− N
NF
N  1−u
Let us simplify the NF
formula, making use of ln N  ln1 − u 
logarithms NF
ln N − ln N F  ln1 − u  ≈ − u
Setting lnNF = nF
u  nF − n
and lnN = n, it follows
The numbers of unemployment
p y 6
The behavior of the unemployment rate in Italy is
illustrated in FIGURES 5-6:
5 6:
It is much changed over the years (forty years ago it was
much lower);
It displays large fluctuations up and down (it has been
decreasing of about six percentage points over the 1998-
1998
2007; but in 2008-2009 it increased by two points);
g slowlyy ((“persistence”).
It changes p )
A comparison between the dynamics of the unemployment rate in
Europe the U.S.,
Europe, U S Japan,
Japan and Italy is also illustrated in FIGURE 6.
6
There are similarities and differences.

Statistical regularities
g (1)
() 7
1. The dynamics of unemployment in Italy and Europe are
very similar (though, on average, the Italian
unemployment rate is slightly higher).
2 E
2. Europe andd the
h U.S.S di
display,
l iinstead,
d very diff
different
dynamics: in particular, the U.S. fluctuations are more
frequent and sudden
sudden.
3. Another difference between Europe and the U.S.
concerns the long
g run: until the 1980s,, unemployment
p y in
Europe is lower; later, the opposite occurs.
J p has a different historyy: unemployment
4. Japan p y is much
lower, but there has been a sharp deterioration in
recent years.

Inflation 8
Definition: It is a situation characterized by a continuous
increase in the prices of goods, that is,
is by a continuous
decrease in the purchasing power of money.
Measuring inflation: one constructs a price index and
computes its percentage variation.
Price index: it is a weighted average of the prices of all goods
considered:
n
pti
P t  100  ∑ gi
p0i
i1
where gi is the weight of price i in computing the average;
therefore, one has ∑i gi = 1.
Byy p 0i we indicate the values of prices
p at a conventional initial
date (called the index “base year”). Thus one has P 0  100 ).
Level and variations 9
General price level (P). The value of the index Pt depends on
the prices considered in the computations, that is, on the vector
p  p 1 , , p n  , and on their weights, that is, on the vector
g  g 1 , , g n  . An ideal index should consider all the prices of
goods and services,
services and the weights attached to the goods
quantities actually purchased.
This ideal index is called g general price
p level.
In practice, one computes the weights using a bundle of goods,
which is representative of the expenditures of a household type
(or in un another way that we will see later).
Rate of inflation (P̃ ). It is the percentage variation of P t :
̃P t  P t−P tt−1
P t−1
Taking logs and setting lnP t  p t , one can easily obtain:
P̃ t  p t − p t−1  Δp t
Statistical regularities
g (2)
( ) 10
FIGURE 12 displays the inflation dynamics in Europe, Italy, and
the U.S.
U S They suggest the following observations:
1. The general price level always (“almost” always, see FIGURES
11 12) increases: that is,
11-12) is inflation may be more or less high,
high but is
positive; currently it is close to zero, but in the past has been
much higher
g (in
( other periods
p and/or
/ in other countries,, huge).
g )
2. The three dynamics are quite similar, though not identical;
this suggests that there are common causes for inflation, but
also specific causes.
3. There is a clear ranking: on average, inflation in Italy was
higher than inflation in Europe, which in turn was higher than
inflation in the U.S.; this suggests that common causes
generate different effects on individual economies
economies.
The Phillips
p curve 11
If one displays in a scatter plot graph the numbers for the
nemplo ment rate (u) and the inflation rate (P̃ )), one obtains a
unemployment
clear inverse correlation: the higher the inflation rate, the lower
the unemployment
p y rate.
FIGURE 19 illustrates the case of Italy. But one can find a similar
relation
l i also
l ffor other
h countries.
i
W thus
We h h ̃  fu
have P i h f ′ u  0
f  with
This inverse correlation is called:

Phillips Curve

A little of caution 12
payy attention to statistical regularities.

We must p g
The relationship between

bet een inflation and
unemployment may prove to be more
complicated
co pl cated than that suggested
by the Phillips curve.
In FIGURE 20 we plot the data of a larger period;

and the inverse relationship becomes confused.
Thi fact
This f t suggestst that
th t the
th issue
i is
i more
complex.

“Comovements” 13
The correlation between inflation and unemployment is not the
onlyy type
yp of correlation between aggregate
gg g variables.
In FIGURE 7 we plot the variations in GDP and
p y
unemployment in the U.S. economy.
y
They are clearly mirror curves.
This is an example of comovement.
The unemployment dynamics is negatively correlated with
the dynamics of economic activity: if the GDP grows a lot,
lot
unemployment decreases; if it grows a little (or decreases)
unemployment increases.
This stylized fact is called:
“Ok n Law”
“Okun L ”
The Okun Law 14
The “Okun Law” for the U.S. economy is presented within a
scatter plot (between the Δ% of GDP and the Δ% of
unemployment) in FIGURE 8.
It emerges a clear inverse correlation.
Thee intercept
te cept w
with
t the
t e vertical
ve t ca axis
a s indicates
d cates the
t e GDP
G growth
g owt
above which unemployment decreases (about 3.6%).
The slope of the straight line measures the reduction in
unemployment associated, on average , to a one-point increase
in GDP (about 0.6%).
This is an elasticity :
Δ lnU/Δ
l U/Δ lnGDP
l GDP
Output
p and unemployment
p y in Italyy 15
FIGURE 9 shows that for Italy the relationship between changes
in output and in unemployment is remarkably week
(almost not existent).
This is due to an institutional difference (in Italy it is much

more difficult to lay off/in people because of the presence of
fi i costs
firing t ).
)
There is still a relation between output and labor employed; but

it applies in an alternative way:
The relation is between GDP fluctuations and hours worked.
See the scatter plot in FIGURE 10, commented in the next slide.

GDP Fluctuations and hours worked 16
In Italy we have a sui generis “Okun’s law”,
which precisely
which, precisely, does not concern
employment, but hours worked.
Hours worked increase

(with an elasticity of about 0.5,
as shown
h n in th
the slope
l p off th
the straight
tr i ht lin
line))
when the GDP grows by more than 1%
(as shown in the intercept on the vertical axis).
CONCLUSION:
The short-run relationship
between output and labor-utilization dynamics
holds also in Italy (it holds in all countries)
countries).
Shocks and propagation
p p g 17
The fluctuations concern the main macroeconomic variables:
GDP (see FIGURE 4), 4) unemployment (see FIGURE 6), 6) and
inflation (see FIGURES 12 and 13). But they concern also other
variables, like exchange rates (see FIGURE 17) and
stockk market
k iindexes
d ((see FIGURE 14).
14)
The origin of fluctuations are generally related to shocks,
that hit the economy, hence altering the equilibrium.
But fluctuations also depend
p on the wayy
in which economies respond to shocks, that is, on
the so-called propagation mechanisms.
The propagation mechanisms, the laws underlying the
behavior of the economy, are different across countries, but
h
have some iimportant common features
f .
The oil p
price 18
Its dynamics (FIGURE 16) does provide several examples of shocks:
The first (1973-74)
(1973 74) is an example of permanent shock.
The second (1978-79) is an example of persistent shock.
The third (1986) is an example of negative (persistent) shock
(it is known as “counter-shock”).
There are also temporary
p y shocks ((for instance in 1991).
)
In recent years there is a rising tendency.
Compare these
C h shocks
h k to GDP ( FIGURE 4), 4) unemployment
l
(FIGURE 6) and inflation (FIGURE 12) dynamics.
FIGURE 16 plots the different dynamics for the oil price in dollars,
in euros (lire), and in “real” terms. The “real” oil price measures
the quantity of goods (GDP) that one needs to purchase it.
Whyy macroeconomics? 19
The problems illustrated in the preceding slides
( n mpl m nt infl
(unemployment, inflation,
ti n fl
fluctuations
t ti n off GDP) show
h
evident links (Phillips curve, Okun’s law).
Therefore, these problems should not be studied

in isolation but taking into account these links.
Macroeconomics investigates this.

I studies
It di the
h bbehavior
h i off an economic i system as a whole,
h l
highlighting the links between different economic phenomena.
To achieve
T hi this
thi task,
t k it drastically
d ti ll reduces
d the number
th b off
agents and goods (and hence also of prices and markets).
It does this by aggregating .
Macroeconomics – A simplified model
A ((very)
y) simplified
p model 20
The simplest macroeconomic model considers
an economyy with onlyy two markets :
The goods (Y) market, whose price is P ;
The labor (N) market, whose price is W ;
There are only two aggregate agents :
Firms : they produce the good with the technology Y = F(N),
buy labor (Nd), sell the good (Ys), and distribute profits (π) to
households;
Households
H h ld : buy
b the h goodd (Yd),
) sell
ll llabor firms (Ns),
b to fi ) and d
obtain profits (π).
Two budget constraints :
PYd = WNs + π (households )
WNd + π = PYs (firms )
The link between the two markets 21
Adding both sides of the two constraints, simplifying and
rearranging yield: P(Yd − Ys) + W(Nd − Ns) = 0
This identity is called
W l ’L
Walras’ Law
Meaning : The sum of the values of excess demand (the

expressions within the bracket) is equal to zero; if in the goods
market supply Ys exceeds demand Yd (negative excess demand),
in the labor market the opposite occurs (and viceversa); if in the
market there is equilibrium (demand equals supply), there must
b equilibrium
be ilib i also
l iin the
h other
h market.k
So one can concentrate on what happens in one of the two

markets (the other will adjust accordingly).
The g
goods market 22
Assumption : in the labor market, the wage does not react to
demand since it is fixed in contracts (a plausible
excess demand,
assumption in the short run). We shall thus write
̄  1
W  W
and concentrate on the goods market.
market we need four ingredients:
To describe a market,
1. Description of buyers’ behavior (demand curve):
  with D ′  0 ;
Y d  DP
2. Description of sellers’ behavior (supply curve):
  with S ′  0 ;
Y s  SP
3. Compatibility between the two behaviors (equilibrium
condition): Yd = Ys;
4. Description of what happens off the equilibrium (reactions).
The law of demand and supply
pp y 23
Equilibrium : if P = PL, the quantity demanded is equal to the
quantityy supplied
q pp ((Yd = YS = YL), and the market is in equilibrium
q .
Off the equilibrium : if P ≠ PL, for instance P = PH, the quantity
demanded is less than that supplied (Yd < YS), and in the market
a competition between sellers starts,
causing the price to lower.
Viceversa occurs if initially we have
P
P < PL. In this case a competition
SH S between sellers starts, causing g the
DH
PH price to rise.
L
PL These reactions are called
“Law
L off d demand d andd supplyl ”.
”
It is described by the equation
D dP
  P DP − SP
0 Yd YL Ys Y dt
The labor market 24
According to the Walras Law, what occurs in the goods markets
affects the labor market: if the first is in equilibrium,
equilibrium then also
the second is in equilibrium; if in the first there is an excess
demand,, then in the second there is an excess supply.pp y
The law of demand and supply, which is operative in the goods
market,, leads to equilibrium
q also the labor market,, even if the
wage is rigid ( W  W ̄  1 ) since is fixed in contracts.
Labor demand and supply
pp y depend
p on the real wage
g ((W/P).
/ )
In the presence of excess demand in the goods market, changes
in P bring
g about opposite-sign
pp g changes
g in the real wage
g which
reduce excess supply in the labor market.
At the end,, the two markets simultanouslyy arrive at equilibrium.
q

The effective demand principle
p p 25
Empirical observation: even prices of goods react a little (and
slowly) to excess demand.
demand
What happens to the goods market if prices are rigid (P  P̄ )?
Firms react in a different way to excess demand:
they rise production (ΔY > 0) when Yd > Ys;
they
h reduce
d d i (ΔY < 0) in
production i the
h oppositei case (Yd < Ys).
)
Let E = Yd be the quantity demanded at a given price P  P̄ .
The firms’ behavior is described by the following equation:
dY
dt
  Y E − Y  con  Y  0
In macroeconomics, this equation is called the
“effective
ff i d demand d principle
i i l ”
Macroeconomic equilibrium
q 26
Assume that in the goods market prices are rigid (P  P̄ ), and
hence the effective demand principle holds
holds.
When the system arrives at Y = E, the market is in equilibrium
(the formula says that output does not change). But this is a
different equilibrium with respect to the equilibrium that results
when the law of demand and supply is operative.
W indicate
We i di by YM . It
iit b I is
i the
h P
macroeconomic equilibrium.
S
The “arrows”
arrows tell us what E
P̄
happens in the market when we L
have Y ≠ YM (that is, when the
market is not in equilibrium).
Indeed, firms react by changing D
the output produced. 0 YM YL Y
Aggregate
gg g variables 27
Let construct a “richer” model. Instead of two goods (output
andd llabor),
b ) we shall
h ll consider
id ffour:
1. Output
p ((Y ), which represents
p all g
goods and services
produced (it corresponds to the GDP). It can be consumed
(C ), or used as a mean of production (I ). The means of
production accumulated in the past are capital goods (K ).
2. Labor (N ), which is another means of production (with K ).
3 Money (M ),
3. ) which is the only means of payment.
payment
4. A fixed-income Bond (B ), purchased by those who save.
This if we abstract from foreign trade (“closed” economy). To model “open”

economies,, one needs to add at least foreign
g output
p ((YF), foreign
g money,
y, or
currency ($), and foreign bonds (BF).
Macroeconomics – Aggregation and “Walars’ Law”
Aggregate
gg g agents
g 28
Also the number of agents is augmented by one:
1. HOUSEHOLDS. Theyy aggregategg g all consumers of
microeconomics. They own firms (obtaining profits) and
supply labor. They spend their (capital and labor) incomes,
b i “pieces”
buying i f consumption
off Y for i (C ), b d B for
) or bonds f
saving (S ).
2 FIRMS. They produce Y , employing N and K , and sell it to
2.
households (C ), to the firms themselves − investments (I ) −
or to the State (G ); to finance their activities, they can issue
bonds.
3. The STATE. It purchases goods and services − public
expenditure
p dit (G ) − and k transfers
d makes t f tot households
h h ld (T
(Tr ).
) It
finances itself by taxes (T ), or issuing money and bonds.
This in more simplified models
models. Later on
on, we shall consider other agents (like
BANKS and the CENTRAL BANK).
Prices and markets 29
We have four goods, so also four prices and four markets : the
goods labor,
goods, labor bonds,
bonds and money markets.
markets
1. The price of output is the general price level P.

2. The price of labor is the nominal wage W.
3. The pprice of the bond (P b )); we will see that it is an inverse
relation of the interest rate r : P b  br with b ′ r  0 .
price of money is 1 (money is the numeraire).
4. The p
The relative prices are obtained dividing prices by P : we thus

have the real wage W/P and the real value of money 1/P. 1/P
The distinction between nominal variables , i.e. expressed in euros, and real
variables , i.e. expressed
p in units of output,
p , is veryy important.
p The real variables
are obtained dividing the corresponding nominal variables by P.
product and domestic income 30
Domestic p
FIRMS produce goods Q , sell them at price P, and obtain profits π
((that distribute to HOUSEHOLDS)).
  Rt − Ct 
 P Q − W N  r   P K  P Mr 
The domestic product Y is the value of goods and services produced,
net of goods and services consumed to produce them. That is:
Y  PQ − Mr − K
Let us set P = 1 (for simplicity). It follows: Y  WN  rK  
That is, domestic product equals the sum of all incomes.
t both
Y represents b th domestic
d ti product
d t and dd ti income
domestic i .
Households’ domestic income (Y ) and disposable income (Yd ):
Yd = Y − SF − T + Tr (retained profits, taxes, transfers)
Budget
g constraints 31
A simplified world: FIRMS and HOUSEHOLDS (without the STATE)
A further simplification: all profits are distributed (SF = 0)
Therefore: Yd = Y
Firms’ budget constraint: Ass: P = 1,
A 1 Pb = 1
REVENUES: Q + ΔBS PAYMENTS: Mr + WN + rK + δK + π + I
Q + ΔBS = Mr + WN + rK + π + I + δK
ΔBS = I
Households’ budget constraint:

REVENUES: Yd = Y PAYMENTS: C + S = C + ΔBd
Y =C+S
Y = C + ΔBD
The “Walras law” 32
Adding both sides of the two budget constraints yields:
Y + ΔBS = C + ΔBD + I
Let us bring all terms to the left-hand-side and rearrange:
((C + I − Y ) + ((ΔBD − ΔBS ) = 0
First bracket: excess demand in the goods market;
Second bracket: excess demand in the bonds market.
Walras’ law :
• the sum (of values) of the two excess demand is zero ;
• If in one market there is equilibrium, there must be
equilibrium also in the other one;
• The excess demand have opposite sign.
It highlights the link between the two markets.
Question. Why in the Walras law the labor market does not appear?
Fixed p
prices? 33
In the formula of “Walras’ law”, prices do not appear
((we imposed,
p y, P = 1,, Pb = 1))
, for simplicity,
p
Is it justified to neglect prices? Yes and No.
Yes if we suppose that P does not react to an excess demand in
Yes,
the goods market (fixed-price hypothesis).
hypothesis prices vary only in the long run.
According to this hypothesis,
In several goods markets this hypothesis is justified.
Assuming
A i fifixed
d prices,
i the
h “W
“Walras
l llaw”” enables
bl us to concentrate
only on the goods market (overlooking the bonds market).
Also in the labor market this hypothesis is justified.
This means indeed that if there is a negative excess demand in the labor
market ((unemployment)
p y g does not varyy (rigid-wage
) the wage g g hypothesis).
yp )
Wages vary only in the long run.
Macroeconomics – Aggregate expenditure
Aggregate
gg g expenditure
p and effective demand 34
In the goods market there is equilibrium when output is sufficient
to meet all ((households and firms’)) requests:
q
Y =C+I
right hand side is called aggregate expenditure:
Expression in the right-hand-side
C+I=E
Wh there
When h iis no equilibrium
ilib i (Y ≠ E ),
) prices
i d not vary (by
do (b ass.).
)
Quantities produced do vary, instead: if output exceeds aggregate
expenditure (Y > E ), firms produce less (ΔY < 0); if output is lower
than requests (Y < E ), firms increase output (ΔY > 0). Production
adjusts to demand.
demand
dY
That is, the differential equation dt
 βE − Y  with β > 0 holds.
This equation describes the “effective demand principle ”.
The model hypotheses
yp 35
Let us recall again the model hypotheses:
1. “Fixed” prices;
p ;
2. Output adjusts to demand.
For 2 to hold, we need a third hypothesis:
3. Availability of spare production capacity.
Therefore, it is a short-run model.
We have an equilibrium condition (Y = E ) and an equation
describing the behavior of Y outside the equilibrium, that is the
effective demand principle, ΔY
Δ = β(
β(E − Y ).
)
To determine the equilibrium value of Y, and study the
“convergence” to equilibrium, we have to establish what
determines aggregate expenditure E, that is, what determines its
t consumption
components, ti C and d investment
i t t I.
I
What do C and I depend
p on? 36
Some stylized facts about C and I are illustrated in FIGURES 18-
23 To take into account them,
23. them assume,
assume for now,now what follows:
About consumption :
C = C(Yd ) 0 < C′ < 1
Consumption
p g function of disposable
is an increasing p income
(with a derivative lower than one).
About investment :
I  Ī
Investment is autonomous (and, for now, exogenous).
The term “autonomous” means that it does not depend on Y.
Macroeconomics – The consumption function

The consumption
p function 37
Let us assume a linear specification of the relationship between
consumption
p and disposable
p income
_ :
_ C = C + cYd
• C > 0 is autonomous consumption .
• 0 < c < 1 is the marginal propensity to consume .
There is no the State, so
Yd = Y . It follows that: C _
_ C = C + cY
C = C + cY
The graph of the
consumption function is
presented in the figure.
p g It is _
an increasing straight line C c
with positive intercept and
slope lower than 45°. 0 Y
“Microfoundation” 38
QUESTION: is it justified the linear specification in the relationship
between consumption
p and disposable
p income shown in slide 37?
ANSWER: we will see that, at least, it is consistent with the
(microeconomic) theory of consumer’s rational choice.
The procedure according to which the choice of the
macroeconomic agent is derived aggregating the rational
choice of the individual agent is called microfoundation.
Let us assume identical consumers (“representative-consumer”
hypothesis) and model the choice between consumption and
hypothesis),
saving for the single consumer. Once aggregated, it describes the
choice of all consumers,, that is of the agent
g HOUSEHOLDS.
Microeconomics tells us that the single consumer maximizes her
utility function given her budget constraint.
We adapt this to the choice between consumption and saving.
The intertemporal
p budget
g constraint 39
(Simplifying) HYPOTHESIS: the consumer lives for two periods.
g constraint for the first p
Budget period :
(1) Y=C+S
g constraint for the second ((and last)) p
Budget period :
(2) S(1 + r) + YF = CF
(saving yields an interest and the consumer doesn
doesn’tt leave bequests)
Let us get S from (2), substitute into (1), and rearrange.We obtain
the intertemporal budget constraint:
1 1
(3) C 1r
CF  Y  1r
YF
left hand side there are the choice variables C e CF (the
In the left-hand-side
discount factor 1/(1+r) can be interpreted as the price of future
consumption);
p ) in the right-hand-side
g there are the available
resources.
The g
graph
p of the budget
g constraint 40
The graph of the budget constraint (3) is a decreasing straight line.
The explicit
p form of the equation
q g for CF) is
((obtained solving
C F  Y1  r  YF  − 1  r C
• The slope is −(1(1 + r).
• The line always passes through point E, with coordinates (Y, YF);
it is the point of initial endowments.
• If the chosen point is S, we haveCF
C < Y, and the consumer saves the
tit S = Y – C (in
quantity (i ththe second
d S
period she will consume CF > YF).
• But the consumer has the YF E
possibility (getting into debt) of D
choosing also a point of the line −(1 + r)
(like D) in which C > Y. 0 Y C
Consumer’s preferences
p 41
The consumer chooses the preferred combination of current
consumption
p ((C)) and future consumption
p ((CF) amongg all those
respecting her intertemporal budget constraint.
Preferences are described by a utility function. For instance :
1
UC, CF   lnC  1 lnC F
γ > 0 is the subjective discount rate for future utility (it is also
called time preference).
This function has positive marginal utilities:
∂U 1
∂U
∂C
 C1  0 ∂C F
 1C F
0
Its marginal
g rate of substitution is decreasing:g
∂U/∂C
MRS  ∂U/∂C F
 1   CCF dMRS
dC
0
H
Hence i indifference
its i diff curves are convex.
Consumer’s choice 42
The chosen combination of C and CF is graphically identified by
the highest indifference curve, that is by the point of tangency
between the budget line and the indifference curve.
In the example given in the graph, it is point A, with
coordinates C ∗ , C ∗F .
Given her p preferences,, the
consumer has chosen to save in CF
the current period the quantity
S = Y – C*. ∗ A
CF
This choice enables her to YF E
consume in the following
period the quantity
C ∗F = YF + S(1 + r).
r) 0 C* Y C
Computing
p g the choice 43
The chosen combination C ∗ , C ∗F  can be computed by two
procedures :
p
(1) Solving the system composed of the budged constraint and
the optimality condition MRS = 1 + r
which imposes that the slope of the indifference curve is equal to
the slope of the budget line (tangency condition).
(2) C
Computing
i theh constrained
i d maximumi off the
h utility
ili ffunction
i
using the Lagrangian method.
Both procedures lead to the following function:
1 YF 1
C 2 1r
 2
̄  cY
Y C
 C̄ and 1
1 YF
where we set 2 1r 2
 c.
The “microfoundation” confirms the functional form of
consumption adopted in the income-expenditure model.
The income-expenditure
p model 44
Static version:
YE Equilibrium condition
E  CI Definition of aggregate expenditure
CC ̄  cY
Y C
Consumption
i function
f i
IĪ Investment (autonomous)
The model solution: Y ∗  1 ̄  Ī

C
1−c
Let us set:
1
m 1−c M ltiplier
Multiplier
̄  Ī Autonomous expenditure
ĀC Y∗  m Ā
Macroeconomics – Income-expenditure model

The model g
graph
p 45
We now construct a graph with domestic product (Y ) on the
horizontal axis and aggregate
gg g expenditure
p (E
( ) on the vertical axis.
The equilibrium is on the 45° line (exactly where Y = E ).
Aggregate expenditure is represented by the line E  Ā  cY .
Th equilibrium
The ilib i i id
is identified
ifi d b
by the
h iintersection
i
E Y=E point between the two lines.
E To the right of Y* one has Y > E ;
so one has ΔY < 0.
To the left of Y* one has Y < E ;
Ā so one has ΔY > 0.
s stem converges
The system con erges
Y<E Y>E toward the equilibrium Y*
45° ((the equilibrium
q is stable)).
Y∗ Y
The dynamic
y version 46
It is used to describe what occurs to the model outside the
equilibrium.
q It is based on the “effective demand p principle”.
p
It is obtained replacing the equilibrium condition Y = E with the
differential equation dY dt
 E − Y with β > 0.
This equation describes the behavior of Y over time starting by an
initial value Y0  Y 0 . In particular, it tells us if Yt converges or
not toward the equilibrium value Y ∗.
It is a first-order (linear and with constant coefficients)
q
differential equation, , that can be written in the form
Ẏ  1 − cY  Ā
where
h we sett Ẏ  dY
dt
Th solution
. The l ti off th
the equation
ti is:
i
Yt  Y ∗  Y0 − Y ∗ e −1−ct
And it effectively shows that output converges to equilibrium.
The multiplier
p 47
If convergence is guaranteed, one can perform comparative statics,
that studies how equilibrium
q changes
g when an exogenous
g variable
changes. EXAMPLE: change in autonomous expenditure
dY
dA
m ΔY  mΔA
Since m > 1, it follows that ΔY > ΔA.
QUESTION: since output responds to aggregate expenditure (ΔY =
ΔE), when does expenditure in excess to ΔA come from?
ANSWER: the variation in autonomous expenditure sets out a
hi h causes consumption
process which ti tot increase
i .
GENERAL IDEA: each time that firms increase output (ΔY > 0),
they distribute incomes to households (ΔYd > 0),
0) which are
partially spent (ΔC > 0), hence stimulating aggregate expenditure
and so once again output. A positive-feedback mechanism starts.

Expenditure
p p
push and p
propagation
p g 48
Let us investigate step by step the expenditure multiplication
g about byy an autonomous variation ΔI > 0:
brought
ΔA ΔE ΔY ΔC
ΔI ΔI ΔI cΔI
+ cΔI + cΔI c 2 ΔI
+ c2 ΔI + c2 ΔI c3 ΔI
+ c3 ΔI +… …
c<1
+… +… …
1
 1−c
ΔI
Δ

  c  c 2    c n    ΔI ∑ c i  limn→
ΔY  ΔI1 1−cn1
1
1−c
ΔI 
i0
Production lag
g 49
HYPOTHESIS: production requires time: it is equal to demand of
the p
previous p
period:
Yt  E t−1
Y t  Ā  cY tt−11 Y t − cY tt−11  Ā
Et  Ct  It
̄  cY t
Ct  C “Finite-difference” (first-order, linear)
equation; it describes the dynamics,
dynamics resulting
It  Ī
from the model, of Y over (“discrete”) time.
EQUILIBRIUM: when one has Y t  Y t−1  Y ∗. It follows Y ∗  1
1−c
Ā
DYNAMICS: it is described by the general solution of the finite-
diff r n equation,
difference q ti n given
i nb by
Y t  Y ∗  Y 0 − Y ∗ c t
Since c < 1,
1 the second term tends to 0 (there is convergence).
convergence)
Saving
g (S
( ) 50
DEFINITION: in general, S = Yd − C . In this model
((without the State)) we have Yd = Y . It thus follows S = Y − C.
SAVING FUNCTION. It _ is derived from
_ the consumption
_ function:
S = Yd − C = Yd − C − cYd = − C + ((1 − c)Yd = − C + sYd
s = 1 − c is the marginal propensity to save (0 < s < 1).
In this model (without the State):
S _
S = − C + sY
S
The graph of the function
i an iincreasing
is i liline with
ith
0
Y negative intercept and
̄
−C
C 1 c
1−c less than one derivative.
Saving
g and investment 51
In equilibrium : Y = C + I Y−C=I S=I
It is an equivalent way to write the equilibrium condition Y = E
Recall that S = ΔBD and that I = ΔBS .
Thus S = I ΔBD = ΔBS (equilibrium in the bonds market).
market)
Consistently with the “Walras law”, the goods market leads to
equilibrium also the bonds market (see the GRAPH).
To the right of Y* one has S > I, so
S, I ΔBD > ΔBS , and so Y > E . It then
S follows Δ Y < 0, and so Δ BD < 0.
Viceversa occurs to the left of Y*.

Ī I The two markets converge
Y<E Y>E
simultaneously to the
0
Y∗ Y equilibrium.
The “saving
g paradox”
p 52
Note that S > I ΔS < 0 (because Y > E and thus ΔY < 0);
and that S < I ΔS > 0 ((because Y < E and thus ΔY > 0).
)
It is saving that adjusts to investment, because it is output that
adjusts to aggregate expenditure.
For the same reason, in this model, it is bonds’ demand that
adjusts to bonds’ supply. _
CONSEQUENCE. If households
h h iis ΔC < 0 and/or
h ld want to save ((that d/
Δs > 0 ), they will not succeed
_ as long as investment does not
change (as long as I = I ).)
The only result of the higher parsimony is a reduction in _Y,
because the autonomous expenditure decreases (when ΔC < 0)
and/or the multiplier decreases (when Δs > 0).
EXERCISE. Try to illustrate this “saving paradox” performing comparative
statics starting from the graph in the previous slide.
How the budget
g constraints change
g 53
Let us introduce the State (together with Households and Firms).
We abstract ((temporarily)
p y) from the p
possibilityy to create money.
y
The State budget constraint:
T  ΔB SG  G  Tr
REVENUES: taxes (T ) and issuance of bonds (ΔB S );
G
PAYMENTS: public expenditure (G ) and transfers (Tr ).

T  C  ΔB D
Y − T  Tr
REVENUES: disposable income (Yd = Y − T + Tr );
PAYMENTS: cons mption (C ) and sa
consumption ing (S = ΔBD ).
saving )
The Firms’ budget constraint does not change:
ΔB SF  I
Macroeconomics – Income-expenditure with the State
How the “Walras law” changes
g 54
To derive it, aggregate the three budget constraints and lead all
terms to the left-hand-side. Rearranging,
g g, we obtain:
C  I  G − Y  ΔB D − ΔB S   0
that
h iis again
i the
h Walras
l llaw.
Notice that in the aggregation process, T and Tr cancel out
(because they appear into both the revenues and payments).
payments)
DIFFERENCES WITH RESPECT TO THE FOREGOING VERSION:
1 Wh
1. When there
h iis the
h SState, aggregate demand
d d is
i not llonger
C + I but becomes E = C + I + G;
2. When there is the State, the bonds supply is the sum of bond
issued by firms and the State ( ΔB S  ΔB SF  ΔB SG ).
But the link between the two markets remains the same as before.
before
The consumption
p function 55
̄  cYd
CC Consumption and disposable income
Yd  Y − T  TTr Definition of disposable income
T  T̄  tY Tax function
Tr  Tr Exogenous transfers
Substituting
g yields
y the function C(Y)
( ): Taxes are ppartiallyy
autonomous ( T̄ ) and
C  C̄ − cT̄  cTr  c1 − tY
partially depend on Y
where c1 − t  is the marginal propensity according
di to theh
to consume out of domestic product. marginal rate t .
The functional form is similar to that of the model without the
State, but autonomous consumption and the marginal propensity
to consume now depend
d h budgetary
d on the b d i bl T̄ , Tr
variables T and d t.
The model 56
Let us limit our analysis to the static version:
Y  CIG Equilibrium condition
̄ − cT̄  cTr  c1 − tY Consumption function
C  C
IĪ (Autonomous) investment
̄
GG (Autonomous) public spending
The model solution:
Y∗  1
1−c1−t
 ̄ − cT̄  cTr  Ī  G
C ̄ Y∗  m Ā
where now we set:
1
m 1 Multiplier m ∂S/∂Y∂T/∂Y
1−c1−t
̄ − cT̄  cTr   Ī  G
C ̄ Autonomous expenditure
Budgetary
g y policies
p 57
When there is the State, the equilibrium value Y* depends upon
the values of the “budgetary
g y variables” : G, Tr, T̄ and t.
∂Y ∗
∂G
m0
∂Y ∗
∂Tr
 cm  0
One easily obtains: ∂Y ∗
∂T̄
 −cm  0
∂Y ∗
∂t
 −cm 2 Ā  −cmY ∗  0
ΔG has an expansionary
p y effect on Y ((measured byy the multiplier
p m));
ΔTr and ΔT̄ have an opposite effect (but of equal size);
In general, the increase in the expenditure components of the
government
rnm nt budget
b d t isi expansionary
p n i n r , while
hil th
the in
increase
r in th
the
revenue components is contractionary.
The State is enabled to use the budget to influence the level of Y
in the desired direction (example of “economic policy”).
Two uses of macroeconomic models 58
A macroeconomic model can be read in two ways:
11. As a description 2 As an instrument to
2.
of what happens: decide “what to do”:
Given the effective values of Given the desired values of

“exogenous” variables, what “endogenous” variables, what are
are the
h results
l obtained
b i d ffor the
h values
l that
h the
h ““exogenous”
the “endogenous” variables? policy-controlled variables must
assume to obtain them?
EXAMPLE 1: given G, and EXAMPLE 2: given the desired level

thus A, the model tells us YT, what must be the level of A,
what is the equilibrium and thus of G, which allows to
level h iis Y* = mA
l l off Y: that A. b i iit?? A* = YT/m.
obtain
Deficit 59
In the model without the State, the equilibrium condition might
be written in two equivalent ways: Y = E and S = I (see slide 51).
When there is the State, Y = E does always hold (it is obvious) but
S = I does not.
Definition of saving: S = Yd − C = (Y − T + Tr) − C;
In equilibrium : S = (C + I + G) − T + Tr − C = I + (G − T + Tr).
Let us set: D = G − T + Tr. It is the State budget balance.
Therefore, in equilibrium we have: S = I + D .
When we have D > 0, 0 there is a budget deficit.
The State finances the deficit by issuing bonds: D = ΔB SG .
H h ld save ( S  ΔB D ) and,
Households d d
doing
i so, llendd resources tto
firms ( I  ΔB SI ) and to the State ( D  ΔB SG ).
Y=E S=I+D ΔB D  ΔB SF  ΔB SG
Effects of budgetary
g y policies
p 60
On Y : we have already studied them (see slide 57). Summing up:
For a given size of the intervention, ΔG > 0 is more expansionary
than ΔTr > 0, which has the same effect of ΔT̄  0 (reduction in
autonomous taxes). Why is public spending more expansionary?
ANSWER : the variation in public spending
translates all in new demand (ΔG = ΔA ); variations in transfers
andd ttaxes only
l partially T = ΔYd = cΔA , and
ti ll (ΔTr d so on.).
)
On D : the expansionary policies increase the part of taxes
dT
depending on Y: dY  t  0 (see slide 65).
65)
But, overall, they make the deficit worsen : ΔD > 0.
1−c1−t dD
EXAMPLE:
dD dY
 1 − t dG  1−c1−t . Notice that: 0  dG
 1.
dG
The balance worsens because of the increase in spending (ΔG >
0), but catches ppartially up
p because of the increase in the tax base
(ΔG > ΔT > 0).
The “balanced budget
g theorem” 61
What is the effect on Y of a simultaneous increase in public
spending
p g and taxes which leaves the budget
g balance unchanged?g
SIMPLIFIED EXAMPLE . Assume t = 0, so that T  T ̄.
Compute
p the effect of ΔG = ΔT > 0 ((which implies
p ΔD = 0)) on Y :
The two separate effects are ΔYG = mΔG and ΔYT = −cmΔT ;
Adding both terms we have ΔY = m(1 − c)ΔG = ΔG > 0; recall that,
in our case, we have ΔG = ΔT and m  1−1 c (since t = 0).
GENERAL CASE . Hypothesis:
yp ((i)) ΔG > 0; ((ii)) ΔD = 0 ((and ((iii)) ΔI = 0).
)
From S = I + D we get ΔS = ΔI + ΔD = 0; and also ΔYd = ΔS/s = 0.
Then we have ΔY = ΔC + ΔI + ΔG= ΔG (since ΔC = cΔYd = 0).
CONCLUSION . An expansionary public spending management
financed to prevent effects on the budget balance causes output
to increase by ΔY = ΔG (the multiplier is 1).
Deficit and the “business cycle”
y 62
Beyond the effects of “fiscal variables” (G, Tr, T̄ and t ), the level
of deficit depends
p also on the equilibrium
q value of Y*.
Taxes depend on the level of income: T = T(Y) with T ′ > 0 .
When domestic product varies for reasons that are independent
of economic policy (for instance because of ΔI), taxes vary and
hence also the deficit.
A recession (ΔY < 0) worsens the budget balance (ΔD > 0). 0)
If there is D > 0 because of a recession, one speaks about

Cyclical deficit
If there is D > 0 under full-employment
p y conditions
(when output is at its potential level), one speaks about
Structural deficit

Public debt 63
It is the value of all bonds issued in the past by the State, held by
g
several agents (in
( our simplified
p world,, byy households).
)
We will indicate the level of public debt by B.
What is the link between the deficit and the public debt?
SIMPLIFYING HYPOTESIS: transfers are composed only of
interests on public debt: Tr = rB . In this case one has
Dt = Gt −Tt + rBt−1
If there is D > 0, the State finances itself by issuing new bonds:
Dt > 0 ΔBt = Bt − Bt−1 = Dt
Thus one has: Dt = Gt −Tt + rBt−1 = Bt − Bt−1 and, solving for Bt ,
Bt = (Gt −Tt) + (1 +r )Bt−1
This equation describes the public debt dynamics.
Macroeconomics – Public debt
Public debt dynamics
y 64
PRIMARY BALANCE (F): it is the difference between public
g net of interests and tax revenues. In our case we have
spending
p
F=G−T
We can have a primary deficit (F > 0), a primary surplus (F < 0),
or a primary balance equal to zero (F = 0).
Using the definition of primary balance, the equation describing
the dynamics of public debt becomes
Bt − Btt−11 = Ft + r Btt−11
This equation shows that public debt tends to explode even when
the p
primaryy balance is equal
q to zero (Ft = 0).
)
To prevent an increase in public debt, there must be a primary
surplus: Ft = −r Bt−1.
Therefore, implementing a counter-cyclical deficit is risky.
Macroeconomics – Public debt
Investment choice 65
Let us relax the hypothesis of exogenous investment (I  Ī ).
What does investment depend
p on ?
Rationale at microeconomic level: the decision to buy additional
means of p production byy the single
g firm is motivated byy the p
profit
objective.
Let K0 be the cost of a ggiven investment. The firm compares
p it
with the expected present discounted flow of future net revenues
that it plans to obtain (with the present value of the project PV0).
That project will be undertaken (by spending K0) if K0 ≤ PV0
R1 R2 RT
pv 0  1r
 . . .  r is the interest rate
1r 2 1r T
Ri (i = 1,
1 22, …, T ) are the expected future net revenues
Macroeconomics – Investment
The net p
present value criterion 66
Net present value (NPV): it is the difference PV0 − K0.
g R0 = − K0, one has
Setting
T
npv 0  ∑ Ri
1r i
i0
NPV criterion: the project will be undertaken if NPV ≥ 0.

0
∂NPV 0 ∂NPV 0 ∂NPV
Notice that ∂r
 0 , that  −1  0 , and that ∂R i 0  0 .
∂R 0
The NPV is a decreasing function of the interest rate r and of the
project cost K0 = − R0, while is an increasing function of the
expectedd ffuture net revenues.
Thus, when r increases, a project previously convenient can
become no longer convenient (viceversa when r decreases).
decreases)
The internal rate of return 67
Internal rate of return (IRR): it is the discount rate which equalizes
the flow of expected
p future net revenues to the cost of the p
project.
j
Let us indicate it by ρ : it is the solution of the equation:
T
K0  ∑ Ri
1 i
i1
The IRR is
Th i a generalization h concept off profit
li i off the fi rate. Setting
S i T
= 1 we soon obtain, in fact,
R1 −K
K0
 K0
IRR criterion:
it i th
the project
j t will
ill be
b undertaken
d t k if ρ ≥ r.
ρ represents the return of one euro invested in the project.
r represents the return of one euro employed in the market.
From the micro level to the macro level 68
Assume that there are N projects available for the aggregate
operator “firms” .
Each investment project Kn ( n = 1,1 22, …, N) has its own ρn .
We can rank the Kn projects in a decreasing order with respect to
the p y, measured byy its own ρn (K1 is the most p
profitability, profitable,,
it follows K2, and so on.)
K1 K2  Ks  KN
1 ≥  2 ≥  ≥  s ≥  ≥ N
The number of the projects undertaken depends on the level of r :
if r > ρ1, then no project is convenient; if r ≤ ρN, all projects will
be undertaken; if r ≤ ρs, the first s p
projects will be undertaken,
and the aggregate level of investment will be
s
I  ∑ Kn
n1
The investment function 69
s
If r rises, the summation I  ∑ n1 Kn looses terms, and I
decreases;; if r falls,, the summation ggains terms,, and I increases.
We thus have:
I = I(r) with I′ < 0.
Assume a linear specification:
r
I(r)
I  Ī − br
The parameter Ī represents the
state of expectations.
The expectations explain the
observed fluctuations of I. 0 Ī I
One could obtain the same result using the NPV criterion instead
of the IRR criterion.
The IS schedule 70
In the income-expenditure model, we had I = Ī . Let us replace it
with the function I = I(r)
( ) . We obtain the solution
Y 1 ̄ − cT̄  cTr  Ir  G
C ̄
1−c1−t
That is:
Y  mĀ − br 
where we used the linear specification Ir   Ī − br,
and now Ā represents the exogenous component (independent
of r) of the autonomous expenditure
p :
ĀC ̄ − cT̄  cTr  Ī  G ̄
The multiplier m, instead, did not change.
We no longer have a single equilibrium Y*. We have a “locus” of
equilibrium points, one for each level of r.
Thi “locus”
This “l ” off equilibrium
ilib i points
i iis called
ll d IS schedule.
h d l
Macroeconomics – The IS schedule
The characteristics of the IS schedule 71
The IS identifies all the combinations of Y and r such that Y = E
((such that there is equilibrium
q in the g
goods market).
)
The IS is a decreasing curve (straight line): dY
dr
 −bm  0
Economic reason: the increase in r decreases I (since dI  −b ),
dr
and the fall in I decreases Y by an amount measured by m.
The intercept on the Y axis is
obviously mĀ . r
bm
So ΔA > 0 moves the IS to the right;
the shift is measured byy the
multiplier (why?);
Δb > 0 makes it rotate downwards
(what is the economic reason?);
Δm > 0 makes it rotate upwards
(what is the economic reason?).
reason?) 0
mĀ Y
“Outside” the IS schedule 72
The points on the IS identify equilibrium combinations (of Y
goods market. On the IS we have Y = E.
and r ) in the g
What happens outside the IS? Obviously there is no equilibrium.
To the right of the IS we have Y > E.
In fact, we have Y  mĀ − br   E .
According to the effective demand principle,
r
Ẏ   Y E − Y 
If the system is to the right of the IS,
Y>E o tp t tends to decrease.
output decrease
To the left of the IS we have Y < E.
According to the effective
Y<E demand principle, if the system
p
is to the left of the IS, output
0
Y tends to increase.
The IS with g
generic functions 73
To obtain the IS, we have assumed that the consumption and
investment functions were linear.
Its main properties hold also with generic functions.
Assume C = C(Y) with 0 < C ′ < 1, and I = I(r) with I ′ < 0.
The IS equation then will be Y = C(Y) + I(r) + G ,
and thus also, taking variations, dY = dC +dI + dG .
To find dY, compute the total differential:
dY  C ′ dY  I ′dr  dG
S i dG = 0,
Setting 0 one easily
il obtains
b i the h slope
l off the
h IS
IS:
dY I′
(1)
dr
 1−C ′
0
Setting dr = 0, one easily obtains the effect of dG:
dY 1
(2) dG
 1−C ′
1
Note the correspondence of (1) and (2) with the results in slide 71.
The bonds p
price and the interest rate 74
What is the relationship between Pb and r?
EXAMPLE 1 ((“zero-coupon”
p bond):) the bond ggives the right
g to a
certain payment Rb after one year; how much is one willing to pay
it today? Not more nor less than its present value:
P b  1Rbr
It is imposed by the arbitrage mechanism:

If Pb > PV, nobody wants to buy the bond and everybody
wants to sell it;; hence BS > BD and,, because of the “law of
demand and supply”, it follows ΔPb < 0 (up to that Pb = VA).
The opposite occurs when Pb < VA.
In this example, there is an inverse relationship between the bond
price and the interest rate: dP b Rb
d
dr
 − 2
0
 
1r
Macroeconomics – The bonds price and the interest rate

The inverse relation between Pb and r 75
This holds also for bonds other than zero-coupon bonds.
EXAMPLE 2 ((“level-coupon
p bond”): ) the bond g
gives the right
g to a
constant coupon c over T years. Because of the arbitrage
mechanism, condition Pb = VA always holds, that is
c c cRb
Pb  1r
 
1r2 1r T
also it emerges a clear inverse relation between Pb and r.
Here also,
Here,
EXAMPLE 3 (“perpetuity” bond): it gives the right to a constant
p c forever ((and it will never be repaid
coupon p )). The arbitrage
g
principle leads to the result:

Pb  ∑ c
1r t
 c
r
t1
where the inverse relation between the bond price and the interest
rate emerges in a particularly simple and transparent way.
Macroeconomics – The bonds price and the interest rate
The “Sayy law” 76
Let us assume a perpetuity bond with a coupon equal to unity.
Therefore P  1 b r
In the bonds market, the “law of demand and supply” holds .

Then the Walras law must be rewritten as follows:
Then,
E − Y  P b ΔB D − ΔB S   0
Let us assume E < Y. We then will have ΔBD > ΔBS ; according to
the law of demand and supply, it will follow ΔPb > 0; so Δr < 0; so
ΔI > 0; so ΔE > 0; and
nd so on,
n upp tto the
th equilibrium,
q ilibri without
ith t any
n
need about a reduction in Y. The behavior of the bonds market
(which is faster than the adjustment of the goods market) caused
the effective demand principle to vanish.
The mechanism in which the bonds market prevails over the
goods market, and leads to equilibrium, is called “Say’s law”.
Macroeconomics – The “Say law”
The “neoclassical” model 77
The Say law leads to the goods market equilibrium
for anyy g
given level of Y.
In fact, it is the demand E that adjusts to the supply Y.
The traditional formulation of the Say law is exactly:
“S
“Supply l (Y ) creates its
i own d demandd (E )”.
)”
But what does determine the level of Y?
In this model, called “neoclassical model” (in contrast with the
“Keynesian” approach of the income-expenditure model), the
labor market determines it:
Since their production surely finds an outlet, firms have an
i
incentive l all
i to employ ll the
h available
il bl llabor.
b
The “neoclassical” model displays full employment, unless this
is prevented by the fact that the labor market doesn
doesn’tt work well.
well
The g
graph
p of the “neoclassical” model 78
FIRST GRAPH: supply of goods; determined at full employment level Ȳ by the
production function Y(N) and by the (exogenous) labor supply NS = N ̄.
SECOND GRAPH: demand d d of goods,
d
Y E
NS E  mĀ − br  Er .
YN
THIRD GRAPH: bonds market.
Ȳ FOURTH GRAPH: inverse
E0 relation between Pb and r.
Initiallyy one has E0 < Ȳ and
Er (in the bonds market)
D S.
̄ r ΔB 0  ΔB 0
Pb N N
Pb The bonds price rises,
The interest rate falls,
P ∗b The aggregate expenditure rises,
until one obtains,
P b0 simultaneously ,
ΔB S ΔB D P b r q
equilibrium
ΔB S0 ΔB D0 B r∗ r0 r in both markets.
The neoclassical and Keynesian approaches 79
The behavior of the macroeconomic system in the neoclassical
model is symmetric with respect to that of the Keynesian model:
KEYNESIAN MECHANISMS: NEOCLASSICAL MECHANISMS:
1. Output Y adjusts to 1. Aggregate expenditure E
aggregate expenditure
d E. adjusts
d to output Y .
2. Saving S adjusts to 2. Investment I adjusts to
investment I; saving S;
3. The goods market prevails 3. The bonds market prevails
over the bonds market. over the g
goods market.
Shortcomings of “this” neoclassical model. The representation of
the bonds market is too simple : ((i)) there are also “old” bonds
(not only the new issuances); (ii) there are not only the
savers who demand bonds ((also the speculators
p )); (iii)
it is not considered the role of money (as an alternative to bonds).
Moneyy 80
DEFINITION. In macroeconomics the word “money” identifies the
set of means of payments commonly accepted.
Notes and coins are obviously part of money. They
constitute the means of payments
that must be accepted (legal money).
The majority of payments does not involve the hand-exchange of
l l money. C
legal Credit
di cards,
d checks,
h k b bank
k transfers,
f and
d so on, are
commonly accepted to make payments. These payments involve
the transfer of bank deposits
p .
Also the bank deposits

p , therefore,, are moneyy
(“bank” money).
Anyy means of payment
p y that became commonlyy accepted
p ((“tickets”?)) would
automatically be part of money.
Macroeconomics - Money
Functions of moneyy 81
Three are the main functions:
1. The first is that of mean of p
payment
y . Moneyy solves the
“double coincidence of needs” problem, which renders
barter extremely cumbersome.
2. The second is that of unit of account. Its importance
emerges when one has to make payments denominated in
terms off another
h (f
(foreign)
i ) currency, or when
h the h money
itself is changed (the transition from the lira to the euro).
3. The third is that of reserve of value. Money shares with
bonds the property of being a financial asset (that is, it
enables one to store wealth over time). Advantage of the
bond: it is a fruitful financial asset (it yields an interest).
Advantage of money: it is liquid (it enables one to make
payments without
ih costs or llags).
)
The moneyy “market” 82
The expression money “market” appears strange: one does not
buy or sell money, and its price is 1 (we have seen that money is
unit of account, that is the numeraire).
Recall that, in macroeconomics, a market (model) is defined by
f
four elements:
l
(i) a description of demand ;
((ii)) a description
p of supply
pp y ;
(iii) a condition of equilibrium ;
(iv) a description of what happens outside the equilibrium.
Regarding money, it is possible to define all these four elements:
one can speak about money demand (L), money supply (M ),
equilibrium condition (L = M ),
) and also what happens when
there is no equilibrium.
Thus, one can speak about the money market. It should be added
to the goods
d andd bonds
d (and
d labor) markets.
k
“Demanding”
g moneyy 83
DEFINITION. Money demand (L) is the quantity of money
withheld on average by households and firms (the banks are
excluded).
One withholds (demands) money for three main motives:
1. The transactions motive. One holds money (cash and
deposits) waiting for spending it; this is because the dates at
which one receives incomes and the dates at which incomes
are spent are not synchronized.
Th precautionary
2 The
2. ti motive.
ti OneO holds
h ld money because
b th
there
might be situations in which one wants or needs to make
p y
payments.
3. The speculative motive. One holds money as a financial asset,
in alternative to bonds (if one wants to speculate on the
difference between the current and expected bonds price).
price)
Moneyy supply
pp y 84
Money supply. It is the quantity of means of payments (notes,
coins and deposits) in circulation. Money supply (M) is the
sum of currency (Cu) and banks’ deposits (De):
M = Cu + De
Monetary base. It is also called “high-powered money”. It can

be regarded
b d d as a synonym off llegall money (l
(later on, we will
ill give
i
a more precise definition). Let us indicate it by H. It consists of
currencyy p
plus banks’ reserves (Re)):
H = Cu + Re
Two questions :
1. What is the link between monetary base and money supply?
2 Who does make the monetary base circulate? And how?
2.
Macroeconomics – Money supply
Monetaryy base and moneyy supply
pp y 85
Let us indicate by γ the currency-deposit ratio:
Cu
  De
Let us indicate by δ the reserve-deposit ratio :
Re
 De
We thus have:
H  C u  Re  De  D
 e  
  D
 e
And also:
M  Cu  De  De  De  1  De
Deriving De from H and substituting into M, one obtains:
1
M 
H  H
W h
We have α > 1.
1 Hence
H i a multiple
M is l i l off H.
The deposit
p multiplier
p 86
1
The coefficient    is called deposit multiplier.
The reason for this denomination becomes clear if one examines
how a variation ΔH generates a multiple variation ΔM.
Suppose that private agents come into possession of a given
amount off cashh ΔH. They
Th will ill di
distribute
ib iit b
between currency andd
deposits according to the parameter γ: ΔH = γΔDe + ΔDe = (γ +
1))ΔDe. We thus have a first creation of banks’ deposits
p equal
q to
1 
ΔDe  1 ΔH . Banks will create a reserve ΔRi  1 ΔH
and lend to the rest of private agents, who in turn, as before, will
hold a share γ in terms of currency,
currency depositing the remaining
amount. It can easily be shown that the deposit propagation
process is described by the geometric series
 j
ΔDe  ΔH
1
∑ j0
1−
1
 ΔH

Adding ΔCi = γΔDe , one exactly obtains ΔM = αΔH.

Creation of monetaryy base 87
How can the monetary base enter the economic circuit?
There are three “creation” (or “destruction”) channels of H.
1. TREASURY. When the Central Bank makes a loan to the
Treasury (buying bonds issued by it), it pays by ΔH > 0. When
the Treasury repays the loan, the monetary base is destroyed
(ΔH < 0).
2. FOREIGN SECTOR. When the Central Bank buys foreign

currency paying by euros, it introduces monetary base into the
i it (ΔH > 0).
circuit ) When,
Wh n in
instead,
t d sells
ll currency
n in exchange
h n off
euros, it takes monetary base away from the circuit (ΔH < 0).
3. CREDIT COMPANIES. When the Central Bank makes a loan to

banks, it creates monetary base (ΔH > 0). When these repay it,
the monetary base is destroyed (ΔH < 0).
)
Control of moneyy supply
pp y 88
In the operation of the three channels described in the foregoing
slide, the role of the central bank is passive. The decisions on ΔH
are taken, in practice, by the Treasury, which buys foreign
currencies in exchange of euros, and the banks.
But
u thee central
ce bank
b iss also
so able
b e to
o control
co o money supp y M,
o ey supply
using the following instruments:
1. Becoming emancipated from the Treasury “seignorage”. This
occurs if the central bank is not obliged to buy its bonds,
bonds but it can
decide how much and whether purchasing them.
2. Managing the coefficient δ, that incorporates reserve
f a given H, one has ∂M
requirements: for ∂
 0.
3. Managing the official discount rate , that measures the cost of
loans made to banks.
banks Its increase reduces the use of these loans
by banks, and therefore causes ΔH < 0.
4. Buying and selling bonds in the secondary market : the purchase
of bonds creates monetary base (ΔH > 0), the sale destroys it.
Budget
g constraints and moneyy 89
Let us consider a simplified case, without banks and without the
central bank. In this case we have De = 0 and Re = 0, so that
money supply coincides with the monetary base: M = H.
In the budget constraints, money does appear. It is one of the
seignorage ), which supplies it (ΔM), and
resources of the State ((“seignorage”),
one of the uses of the private sector (households plus firms),
which demands it (ΔL).
The State budget constraint:
T  ΔB SG  ΔM  G  Tr
Y − T  Tr  C  ΔBD  ΔLH
Firms’ budget constraint:
ΔB SF  I  ΔL F
Macroeconomics – The Walras law and money
The Walras law and moneyy 90
Applying the usual procedure of aggregation of the budget
constraints, one obtains:
(E − Y) + (ΔBD − ΔBS) + (ΔL − ΔM) = 0
law which in this case involves three markets.
that is the Walras law,
To write the formula for the Walras law, we have set:
E  CIG
ΔBS  ΔBSG  ΔBSF
ΔL  ΔLH  ΔLF
The presence of money calls into crisis the neoclassical model of

the Say law. In fact, the potential equilibrium in the bonds market
does not guarantee anymore equilibrium in the goods market.
market
Stocks and flows 91
The Walras law can be written in a slightly different way:
To do this,
this let us set ΔB D  B Dt − B Dt−1 and ΔB S  B St − B St−1 ;
Assume that in the previous period there was equilibrium, i.e. that
B Dt−1  B St−1  B t−1 ; it follows that
ΔB D − ΔB S  B D − B S
Using a similar procedure (assuming that also in the money
market there was equilibrium at t −1), we can write
ΔL − ΔM  L − M
Because of these changes, the Walras law becomes
E − Y   B D − B S   L − M   0
In the bonds and money markets, one is considering stocks
instead of flows. This enables one to highlight the importance of
“old” bonds (they are equivalent to new bonds).
Moneyy demand for transactions 92
At the beginning of the month a representative household holds for
monthlyy expenditures
p the liquid
q amount L0, which it spends
p regul-
g
arly each day (according to a linear path L(t)). Its money demand
for transactions (quantity of money held on average) will be L0/2.
Th time
The i pathh ffor li
liquid
id stocks
k off a representative
i fifirm iincreases
with the sales and decreases with the payments (here, also,
one can compute the average).
average)
L0 L(t) At aggregate level, money demand
for p
private agents’
g transactions is
an increasing function of Y (which
L0
2
is an indicator of the level of
transactions).
We will write: L T  kY
0 1 t with k > 0.
Macroeconomics – Money demand
Precautionaryy moneyy demand 93
For its definition see slide 83. It can be identified, in a graph with
the time in the horizontal axis and liquid
q funds in the vertical
axis, as the minimum level touched by such funds, i.e. by the
function L(t), during the month (the average of funds that exceed
the minimum is money demand for transactions purposes).
In the graph, the liquid funds decrease
during the month but do not vanish; its
L0 L(t) behavior identifies, beyond the demand
for transactions LT , a p
precautionaryy
demand LP .
The determinants of this demand are
LT Y and r. We shall write:
LP L P  L PY, r 
0 1 t with ∂LP  0 and ∂LP  0
∂Y ∂r
.
Moneyy as an alternative to bonds 94
One has a speculative demand when private agents hold money
instead of bonds in their portfolios (it is measured,
measured as usual,
usual by
the average stock).
The cost of holding money instead of bonds is measured by
the interest rate. It represents the “price for the liquidity
preference” (Keynes),
p y or also, symmetrically,
y y the “premium
p for
not holding liquidity” .
At micro level, a single agent (a speculator) exchanges bonds
in her portfolio with money when she foresees that their price
will fall; viceversa when she foresees that Pb will rise.
The speculator compares the market price Pb with what she believ-
es is the normal level PN : if she observes Pb > PN , then she sells the
b d ((viceversa,
bonds i she
h bbuys ththe b
bonds
d if she
h observes
b Pb < PN ).
)
The speculative
p moneyy demand 95
At macro level, if Pb is high, for the majority of speculators there
will be Pb > PN . Thus,, the agents’
g speculative
p moneyy demand will
be high. If instead Pb is low, for the majority of speculators there
will be Pb < PN , and the agents’ speculative money demand will
be low
low.
Let us summarize this in the function:
LS = L( Pb) with L′ > 0
Given the relationship between the bonds price and the interest
rate, (see slides 74
74-75),
75), we can write:
LS = L( r) con L′ < 0
Li idi trap. There
Liquidity Th is
i an inferior
i f i li limiti r . It
I is
i that
h li
limit
i which
hi h
one has when for all speculators condition Pb > PN holds: nobody is
g to hold bonds, and everybody
willing y y is willing g to hold in the
portfolio any quantity of money.
Moneyy demand and supply
pp y 96
Aggregating the three components LT + LP + LS , one obtains the
money demand function:
L = L( Y, r)
with
i h LY  ∂L ∂L
∂Y
 0 and i h Lr 
d with ∂r
 0.
Usually, we will assume a linear (but “imprecise”) specification:
L( Y, r) = kY − hr
Money supply will be assumed as an exogenous variable
MM ̄
since the central bank is able to control it (see slide 88).
88)
In the model, money supply M̄ is considered as an
economic policy (monetary policy) variable.
variable
Macroeconomics – The LM schedule
The LM schedule 97
Let us set M = L, and substitute into the equality between the two
functions: ̄  kY − hr
M
This equation is the equilibrium condition in the money market.
I identifies
It id ifi all h combinations
ll the bi i off Y and
d r which
hi h ensure such
h an
equilibrium. It is called the LM schedule.
Solving for r, one obtains:
r
k 1
r  hY− hM L=M
dr
The LM is increasing : dY  hk  0
The position of the curve is
p ΔM
controlled byy M: for example,
> 0 moves the curve downwards. r
The liquidity trap imposes that
r≥r. 0
Y
Again
g on the LM schedule 98
QUESTION. Why, in the equilibrium between L and M (beyond
algebra) for a higher level of output Y is associated a
the algebra),
higher level of the interest rate r?
ANSWER. A higher
g level of Y implies
p a higher
g moneyy demand
̄,
for transactions kY; since money supply is fixed at the level M
the remaining part of money demand (the speculative one
−hr
h ) must be lower, and hence r must be higher.
QUESTION. Why does ΔM > 0 move the LM downwards?

ANSWER. When one has ΔM > 0, it follows that, given Y, at the
old level of r one has M > L. To restore equilibrium, it is
necessary a higher level of L. This requires, given Y, a lower
level of r.
Outside the LM 99
The points on the LM depict equilibrium positions (combinations
of Y and r) in the moneyy market,, in which,, that is,, one has L = M.
In the points under the LM, for a given Y, r is lower, money
demand is higher (since Lr < 0) and one thus has L > M.
Agents try to obtain the missing money by selling bonds.
Therefore it follows ΔPb < 0 and Δr > 0.
r Th opposite
The i occurs in i the
h points
i above
b
L=M the LM: the reaction causes Δr < 0.
L<M
graph the movements in r
In the graph,
outside the equilibrium are
represented
p byy the “arrows”.
The market dynamics is given
L>M by the differential equation:
0 ṙ   r L − M 
Y
The IS-LM model 100
The macroeconomic equilibrium is the combination of Y and r
which simultaneouslyy ensures equilibrium
q in the g
goods market
(E = Y) and in the money market (L = M). When this occurs,
equilibrium in the bonds market is ensured by the Walras law.
I is
It i id
identified
ifi d b h intersection
by the i i point
i b between the
h IS schedule
h d l
(where E = Y) and the LM schedule (where L = M).
r The equilibrium can be computed
IS LM by solving the following system for
the unknowns Y and r :
r* Y  mĀ − br 
̄  kY − hr
M
The first equation is the IS; the
0 Y* Y second equation is the LM.
Macroeconomics – The IS-LM model
Solution of the IS-LM model 101
Deriving r from the LM, substituting into the IS and solving for Y
yyield,, after some algebra,
g , the following
g result:
Y∗  m 1Ā  m 2 M̄
where we set:
1
m1  1−c1−tbk/h
m
b
m2  m 1 h
̄ − cT̄  cTr  Ī  G
Ā  C ̄
m1 > 0 is the multiplier of (the exogenous component of)

autonomous expenditure, Ā ; it is lower than the multiplier m,
due to the presence of the term bk/h > 0 in the denominator.
m2 > 0 is the multiplier of money supply.
The dynamic
y version of the model 102
Outside the equilibrium, we have the system of differential
equations:
q
Ẏ   Y E − Y
ṙ   r L − M 
(see slide 72, and slide 99).
The dynamics of the system is
r
Ẏ  0 ṙ  0 described by the phase diagram
(see the GRAPH):
Each point has two “arrows”;
arrows ;
The trajectory changes direction
everyy time that it meets a curve;;
and it does converge to the
LM IS equilibrium, where one has
0 Y = Y* and
d r = r* .
Y
The effective dynamics
y 103
In practice, the adjustment in the two markets occurs with very
different velocities: in the moneyy market it is almost instantaneous
while in the goods market it is relatively slow (  r   Y ).
Thus, first the system switches to the LM, and then it “runs” along
the
h LM until il reaching
hi alsol the
h equilibrium
ilib i iin the
h goodsd market.
k
See the GRAPH:
r in Y0 one has L < M; thus,
thus
IS LM the interest rate falls (Δr < 0)
Y0 g to the LM;
until arriving
Y* at this point,
investments grow and, along
with them, aggregate
expenditure grows, until arriving
0 to the equilibrium Y*.
Y
Monetaryy retroaction 104
In the IS-LM model, a variation in autonomous expenditure
((for instance ΔG > 0) affects the equilibrium
q p Y.
output
∗
The effect is positive: ∂Y  m1  0
∂G
but it is lower than in the income-expenditure model: m1 < m.
ΔG > 0 shifts the IS by an amount equal to mΔG; but also
the equilibrium interest rate rises, thereby lowering the level of I.
So one has ΔY* = m1ΔG < mΔG. ISN
r
Monetary retroaction: ΔY  0 ISO LM
→ kΔY  0 → hΔr  −kΔY →
→ Δr  0 → ΔI  0 rN
It depends
p parameters: rO
on three p
∂L ∂r 1 ∂I mΔ G
∂Y
 k ∂L  − h ∂ r  − b
h iis bk/h.
that 0 YO YN Y
The “Keynes
y effect” 105
In the IS-LM model, the equilibrium output Y is also influenced
byy a change
g in moneyy supply ( instance,, ΔM > 0)).
pp y (for
The effect is positive : ∂Y ∗  m2  0
∂M
The increase in M shifts the LM downwards, the interest rate
decreases, and the equilibrium output increases.
The transmission mechanism is:
ΔM  0 → L  M → ΔP b  0 → r LMO
→ Δr  0 → ΔI  0 → ΔE  0 IS
which is known as “Keynes’
Keynes effect
effect”. LMN
Its size depends on: rO
∂r 1 and on ∂I  −b
∂L
 − h ∂r rN
That is, on how much the policy
makes r fall and how much I
reacts to the fall in r. 0 YO YN Y
Economic policy
p y 106
In the IS-LM model, the equilibrium output Y is influenced by
economic p policyy.
BUDGETARY POLICY (or fiscal policy): change in G, Tr, T̄ and t; it
IS It is less effective than in the income-
acts shifting the IS.
expenditure model, because of the monetary-retroaction effect.
MONETARY POLICY : change in M (through the instruments for
controlling money supply); it acts shifting the LM.
In this model, money has real effect (is not neutral).
The effectiveness of the two policies depends on the slopes of the
two curves: (1) the steeper the IS (the lower ∂∂rI ), the less effective
monetary policy; (2) the steeper the LM (the lower ∂L ), the less
∂r
effective fiscal policy; (3) the flatter the LM (the higher ∂L ),
∂r
the less effective monetary policy and more effective fiscal policy.
“Open”
p economies 107
So far we have supposed that there were no transactions with the
“rest of the world”. Now we shall relax such a restriction.
RESIDENTS: those who carry out their main economic activity
(consumption, production, labor, and so on) within the country.
REST OF THE WORLD: those who carry out their main
economic activity abroad.
An economic system is “open” when its residents make economic

transactions with the rest of the world.
ECONOMIC TRANSACTIONS:
• transactions
i off goods
d and d services;
i
• transactions of financial assets (bonds);
• transfers
transfers.
Macroeconomics – “Open” economies
The balance of payments
p y 108
It records all economic transactions between
“residents” and the “rest of the world”.
world”
Residents’ revenues are recorded with the sign plus; payments are
recorded with the sign minus.
We will indicate by Bp the balance of payments.
The current account balance (Bc) is the difference between
revenues and payments associated to the transactions of goods
and services.
The capital account
acco nt balance (Bk) is the difference between
bet een
revenues and payments associated to the transactions of bonds.
The following g identityy holds:
Bp = Bc + Bk
For simplicity, we neglect transactions of real capitals and transfers.

The exchange
g rate 109
FOREIGN CURRENCY : it is the mean of payment used for
transactions between residents and the rest of the world (i.e.,
( ,
it is the international money). Alternatively, one can assume it
is the money used in the rest of the world. Let indicate it by $.
NOMINAL EXCHANGE RATE (e): it is the number of unities of
domestic money needed to buy one unity of foreign currency;
h price
i iit iis the
i.e., i off fforeign
i currency (for
(f iinstance, iit
measures the number of euros needed to buy one dollar).
REAL EXCHANGE RATE (v): it measures the number of unities

of domestic product needed to buy one unity of foreign
product:
d
v  eP F
P
where
h PF is
i the
h price
i llevell iin the
h rest off the
h world.
ld
Some simplifications
p 110
To write the agents’ budget constraints and derive the “Walras”
law in an open economy, we use the following hypotheses (they
are not essential, but simplify formulas):
• Domestic and foreign goods (and bonds) prices are fixed and
equal to 11. It follows that the nominal exchange rate (e)
coincides with the real exchange rate (v);
• There are no banks ((there is onlyy the Central Bank). ) It follows
that one has M = H;
• Only households demand money. It follows that one has
ΔLF = 0 (and ΔLF = ΔL);
• Transactions between residents and the rest of the world
concern only goods and services (no bonds)
bonds). This is the
“absence of capital mobility” hypothesis (it will be relaxed);
• The sizes of the economy are small with respect to those of
the rest of the world. This is the “small country” hypothesis.
The “old” budget
g constraints 111
Budget constraints for households, firms and the State change
p to those of slide 89:
veryy little with respect
HOUSEHOLDS:
Y − T  Tr  C  ΔBDH  ΔL
FIRMS:
ΔB SF  I
STATE:
T  ΔB SG  G  Tr
TWO OBSERVATIONS:
• The State does not issue moneyy (the
( central bank does it);
);
• The purchases of goods by agents (C, I, G) can concern both
domestic products (Y ) and foreign products, i.e., imports (Z ).

The “new” budget
g constraints 112
They are that of the central bank and that of the rest of the world:
CENTRAL BANK:
ΔM  ΔB DCB  eΔ$ CB
The central bank creates moneyy to buyy bonds and currency. y
The opposite holds, too: by selling bonds ( ΔBD CB  0 ) or
currency ( Δ$ CB  0 ), the central bank destroys money.
REST OF THE WORLD:

eZ  eΔ$ S  X  eΔ$ D
The rest of the world buys “pieces” of of the country domestic
product (exports – X ), paying by supplying currency (eΔ$S),
andd sells
ll ((to h
households,
h ld fifirms, and
d the
h SState)) ““pieces”
i ” off
foreign product (imports – Z ), getting currency (eΔ$D). It soon
follows that X − eZ
Z = Bp
B = e(Δ$S − Δ$D)
Walras’ law and open
p markets 113
Add the five agents’ budget constraints; aggregate according to
the relative market;; as usual,, translate the analysis
y from flows to
stocks; we obtain a new version of the Walras law, this time also
involving the currency market:
E − Y  BD − BS   L − M  e$D − $S  Δ$CB   0
I the
In h fi
first b
bracket
k we set:
E = C + I + G + (X − eZ)
That is, the demand of domestic products (E) equals the demand
of p
products comingg from domestic operators
p (C + I + G), to
which we must subtract the part of the demand for foreign
products (imports Z), but we must add the demand of domestic
products coming from the rest of the world (exports X).
Currencyy reserves 114
The forth element of the Walras law is the currency market (or
exchange
g market):
)
e[($D − $S) + Δ$CB]
The last term,, Δ$CB , ppertains to the central bank interventions,,
that is, to its net purchases of currency.
The central bank ensures the daily operation of the currency
market, selling currency to operators when it is demanded, and
buying currency from operators when it is supplied.
If the
th market k t is i equilibrium
i in ilib i , that i if $D = $S, the
th t is, th central
t l
bank’s purchases and sales balance each other, and so Δ$BC = 0.
But the central bank may decide autonomously (not in response to
operators’ requests) to do an intervention in the market: deciding
Δ$CB > 0, it accumulates currency in its own currency reserves ;
deciding instead Δ$CB < 0, it draw currency out of reserves.
Exchange
g rate “regimes”
g 115
In the exchange market, in the absence of interventions by the
central bank, the law of demand and supply holds:
de
dt
  e $D − $ S   Δ$CB 
(with  e  0)). The currency price e (the exchange rate) varies as a
direct function of its excess demand. Nevertheless, the central
bank, intervening in the market, is able to control its variation
and, in the limit case, completely eliminate it.
• If the central bank never intervenes (Δ$CB = 0), we have a
market-based
k b d exchange h i ” ((or floating
rate ““regime” fl i exchange
h rates).
)
• If the central bank systematically intervenes to compensate the
excess demand for currency (Δ$CB = −($D − $S) ), we have a fixed
exchange rate “regime”.
• If the central bank will intervene whenever it believes that
doing so is appropriate, we have a managed floating “regime”.
Floating
g exchange
g rates 116
It is the exchange rate regime that one has when the central bank
never makes interventions (Δ$CB = 0) and lets market forces
determine the exchange rate. That is, we have:
de ((with  e  0)
d
dt
 e$D − $S 
In the very short run (the market day), the currency demand is a
decreasingg function of the exchange
g rate,, while the currencyy
supply is an increasing function of the exchange rate:
D ∂$D
$  De with ∂
∂e
0
∂$S
$S  Se with ∂e
0
The reason is similar to that of the speculative money demand:

for given needs of currency, one anticipates the purchase when
the price is low and delays it when the price is high.
Equilibrium
q in the exchange
g market 117
In the very short run, there is equilibrium when one has:
D(e) = S(e)
This equation determines the equilibrium exchange rate e*.
Graphically, it is identified by the intersection point between the
demand curve and the supply curve.
If the
h exchange
h rate iis hi
higher
h e
that the equilibrium one (e > e*), $D $S
the demand for currency is lower
than the supply ($D < $S), so that
the exchangeg rate tends to fall e*
( de
dt
 0 ). The opposite occurs
when e < e* .
Th this
Thus, hi equilibrium
ilib i is bl . 0
i stable $* $
Fixed exchange
g rates 118
We have a fixed exchange rate when the central bank intervenes
in the currency market with the rule Δ$BC = $S − $D (see slide 115).
Three main cases:
• EXCHANGE RATE AGREEMENT. The central bank of a countryy
draws up a treaty with the central banks of other countries in
which it commits itself to keep the exchange rates fixed;
• UNILATERAL “PEGGING”. The Th centrall bank
b k off a country
commits explicitly itself to keep its own exchange rate linked to
the currency of another country;
• EXCHANGE RATE MANAGEMENT. The central bank of a
countryy systematically
y y intervenes to keepp stable the exchange
g
rate also in the absence of an explicit commitment.
Fixed exchange rates require availability of currency reserves to
finance interventions implying currency sales.
Open
p economyy and macro-equilibrium
q 119
In relation to the exchange market, one must distinguish between
the very short run (the single day), the short run (the year), and
the long run.
With respect to the very short run, see slide 116.
In h short
I the di i $D = $S, determining
h run, condition d i i theh equilibrium
ilib i
exchange rate, coincides (see slide 112) with condition
Bp = 0
According to the Walras law (see slide 113), a balance of payment
equal to zero is linked to what occurs in the goods, bonds, and
money markets, i.e., to the macroeconomic equilibrium.
This issue should thus be studied in the context of the IS-LM
model. Such a framework must, however, be modified to take into
account that the economy is “open”. This extension is called
“Mundell-Fleming” model
Macroeconomics – Open economy and macroeconomic equilibrium
The three fundamental equations
q 120
There are several versions of the Mundell-Fleming model. We will
see four. In all these versions, we will work under the assumption
of “small country” (see slide 110). So what happens within our
economy does not affect the economy in the rest of the world.
All versions are based on three equations :
E=Y equilibrium in the goods market (the IS);
L=M equilibrium in the money market (the LM);
Bp = 0 balance of payment equal to zero (the BB).
The distinctions between the four versions relate to two elements:

Fixed or floatingg exchange
g rates;;
the type of transactions with the rest of the world:
• Only goods and services ( “absence of capital mobility”);
• Also
Al b bondsd (“
(“capital
i l mobility”).
bili )
Imports
p and exports
p 121
In an open market, the definition of E (see slide 113) is as follows:
E = C + I + G + (X − vvZ) = C + I + G + Bcc
where, to value imports, we used the real exchange rate v.
Let us specify functions X and Z. We have:
∂X
X = X(v,YF), with ∂X  0 and ∂Y 0
∂v F
(i e exported quantities are an increasing function of
(i.e.,
both the real exchange rate and the world demand);
Z = Z(v,Y), with ∂Z  0 and 0  ∂Z ∂Y
1
∂
∂v
(i.e., imported quantities are a decreasing function of the real
exchange rate and an increasing function of domestic product);
Therefore, the current account balance Bc depends (positively) on
YF and (negatively) on Y. It also depends on the real exchange
rate. How? Positively or negatively?
Current account and exchange
g rate 122
An increase in the exchange rate has two effects of opposite sign
on the current account balance Bc:
It increases exports and decreases imports; and this improves
the current account (quantity effect);
It
I makes
k iimports more expensive;
i and d this
hi worsens the
h current
account (price effect);
To see what of the two effects prevails,
prevails let us compute the
derivative of the current account with respect to the exchange
rate: dBc
 dX − v dZ  Z 
dv dv dv
One can show, after some algebra, that this derivative is positive
(i e the increase in the exchange rate improves the current
(i.e.,
account) if the “Marshall-Lerner condition” holds, that is, if:
 X  Z  1
The Marshall-Lerner condition 123
We have just seen that its formula is
ηX + ηZ > 1
where ηX and ηZ are, respectively, the elasticities of exports and
imports with respect to the (real) exchange rate:
dX
X  X
/ dvv  dX v
d X
dv
 Z  − dZ
d
dv
v
Z
The condition states that an increase in the (real) exchange rate

i
improves th
the currentt accountt balance
b l th sum off th
if the the
elasticities of exports and imports is greater than one, that is, the
exported and imported quantities are sufficiently sensitive with
respect to changes in the exchange rate in order to offset the
higher cost of imports brought about by the increase in the
exchange rate.
Fixed exchange
g rates: the IS schedule 124
We assume a “small country” and fixed exchange rates. Exports
become exogenous: we set X  X̄
We also assume a linear relationship between imports and
domestic income: we set Z  Z̄  zY
From condition
d Y = E, definition
d f E = C + I + G + Bc
B , and
d
Bc  X̄ − vZ̄  zY , we derive the usual IS formula:
Y  mĀ − br
b 
where now we have (one can easily show it):
1
m 1−c1−tvz (
(open-market
k multiplier)
l i li )
̄ − cT̄  cTr   Ī  G
Ā  C ̄  X̄ − vZ̄ (autonomous expenditure)
Note that the multiplier is smaller than that in the closed market.
Note also that now in the autonomous expenditure there are
exports and (with the sign minus) imports.
Macroeconomics – IS-LM and fixed exchange rates
The current account and the level of Y 125
What is the effect of an increase in Y on the current account?
At first sight, the answer is: the increase in Y rises imports (ΔZ =
zΔY) and so worsens Bc. But the answer is only partial.
One must take into account what has generated the increase in Y.
T do
To d this,
hi llet use the
h IS ((taking i li i r).
ki constant, ffor simplicity, )
Consider the effect of an exogenous variation ΔX > 0:
O output : we have
On h ΔY* = mΔX > 0;
0
On the current account: we have ΔBc = (1 − mz)ΔX ; making m
in the bracket explicit,
explicit we obtain:
1−c1−t
1 − zm  1−c1−tz
which is a positive number (even if it is less than one). Therefore,
the increase in output caused by ΔX > 0 improves Bc.
Instead, Bc worsens when the increase in output is triggered by a
change in the domestic autonomous expenditure (e.g. ΔG > 0).
Fixed exch. rates: the LM schedule 126
Regarding money demand, nothing changes: we have (as in the
closed economy)
L = kY − hr
Regarding money supply, things change.
F
From the
h centrall bbank’s
k’ bbudget
d constraint f slide
i ((cfr. lid 122),
122) setting
i
D
ΔBBC = 0 (for the sake of simplicity and/or realism), it follows
ΔM = Δ$CB
(where we set e = 1). That is, money supply does not vary only if
there are no interventions in the currency market.
One has Δ$CB = 0 and thus ΔM = 0 only when one has Bp = 0.
US ON.
CONCLUSION
CONC W e thee eexchange
When c ge ratee iss fixed
ed, money
o ey supp
supplyy
becomes endogenous (it is an unknown). The LM formula
becomes: M = kY − hr
(with no “bar” on M).
Fixed exch. rates: the BB schedule 127
In a fixed exchange rate regime, if we do not have Bp = 0, we do
not even have ΔM = 0, that is, there is no macroeconomic
equilibrium. This is why the Mundell-Fleming model has the
third equation (the BB), beside the IS and the LM.
Let us keep (for now) the hypothesis of absence of capital mobility.
Thus one has
Bk = 0
It then follows
Bp = Bc
and the third equation of the model becomes
Bc = 0
Recalling the definition of Bc, we get the BB equation
X̄ − vZ̄  zY  0
Mundell-Fleming
g – Version 1 128
It is the version with FIXED EXCHANGE RATES and ABSENCE OF
CAPITAL MOBILITY. The three equations
q are:
Y  mĀ − br (IS)
M  kY − hr h (LM)
X̄ − vZ̄  zY  0 (BB)
The three unknowns are Y, r and M ; the real exchange rate v
((which is fixed)) is exogenous
g .
The third equation soon determines Y* :
̄ ̄
Y ∗  X −vzvZ  YXZ
In this model, the equilibrium output is determined by the

condition imposing the current account balance equal to zero.
Solution and g
graphical
p analysis
y 129
Once found Y* = YXZ, the IS determines the equilibrium value r*.
Once found Y
Y* and rr*, the LM yields the equilibrium value M
M*.
To construct the graph, one must start from the BB, which is a
vertical straight line at YXZ. One then draws the IS identifying r*.
To the right of the BB we have Bc < 0; to the left we have Bc > 0.
Th r f r to
Therefore, t the
th right
ri ht off the
th r BB LM0
BB we have Bp < 0 and ΔM < 0 IS
(viceversa to the left). LM*
It follows that the final r0
((equilibrium)
q )p position of the r*
LM is given by the intersection
point between the BB and the
IS,
S whatever
h iits iinitial
i i l position.
ii 0 Y0 YXZ Y
Implications
p for economic p
policyy 130
In this model, the position of the LM is endogenous. Monetary
policyy is unable to influence the macroeconomic equilibrium
p q .
Changes in M are determined by interventions in the currency
market, needed to maintain the exchange rate fixed.
The monetary authority can temporarily obtain Y* * > YXZ , but only
by continuing to loose currency reserves (as long as it has them).
Budgetary policy is ineffective, too. For instance, ΔG > 0 moves
the IS to the right, but the resulting increase in Y is only
temporary , since the LM soon begins to shift upwards.
upwards
In equilibrium, only the interest rate changes.
In this model,
model are there any ways for economic policy to influence
the equilibrium level of Y ? There would be one way to do this:
one must alter the level of the real exchange rate. To see the
effects, we have to study the model with flexible exchange rates.
Mundell-Fleming
g – Version 2 131
It is the version with FLEXIBLE EXCHANGE RATES (again WITH
NO CAPITAL MOBILITY)). Let see how the three equations
q change.
g
Let us begin with the BB, with the equation Bc = 0.
Now the real exchange g rate is an endogenous
g variable. Thus,, Bc
is a function of v. We assume that the Marshall-Lerner condition
is satisfied (see slide 123). This implies ∂Bc  0 .
∂v
We assume (for simplicity) that the relationship between BcB and v
is linear : Bc  Bc − zY  nv  0
where the parameter n > 0 measures the influence of the exchange
rate on the current account. This is the new version of the BB.
When the exchange rate is market-determined, the central bank
does not intervene, hence regaining control on M. In the LM
money supply is exogenous: M̄  kY − hr
h
Macroeconomics – IS-LM and flexible exchange rates
Flexible exch. rates: the IS schedule 132
How does the IS change in a flexible exchange rate regime? To see
this,, let us start with the definition of aggregate
gg g expenditure
p E:
E = C + I + G + Bc
Recalling that, consistently with the BB, we have Bc = 0, it follows
that equilibrium in the goods market requires
Y=C+I+G
That is, we get the same IS as in the “closed” economy:
Y  mĀ − br 
where both Ā and m equals the closed economy case.
Note that the LM is that of the closed economy as well.
The model determines Y and r, but the third unknown changes
compared to fixed exchange rates case: M is no longer an unknown
(is again exogenous); the real exchange rate v is endogenous.
The model 133
In a fixed exchange rate regime, the level of Y is determined by
the BB. In a flexible exchange
g rate regime
g , Y* comes back to be
determined, together with the interest rate, by the intersection
between the IS and the LM. Given Y*, the BB residually
determines the equilibrium exchange rate v* *.
In this model, economic policy is again effective .
If one wants to reach YN > Y* r BB BBN LM
one can, for instance, increase M, IS
moving g the LM byy the desired LMN
amount. The implied negative
r*
current account will be
eliminated by the increase in v
(depreciation) resulting in the
currency market.
k t 0 Y* Y Y N
Capital
p mobilityy and fixed exch. rates 134
We now consider a third version of the Mundell-Fleming model.
g hypotheses:
It is based on the following yp
fixed exchange rates;
residents and the rest of the world can hold in their portfolios
p
both the domestic bond B (whose return is r) and a foreign bond
BF, whose return is rF; the bonds transactions between residents
and non-residents constitute the capital account balance , Bk;
perfect capital mobility : the domestic bond and the foreign
bond are perfect substitutes ; the markets for the two bonds are
perfectly competitive, with negligible transaction costs.
CONSEQUENCE
Q . If there is capital
p mobility,
y, one must have
r = rF
The equality
q between returns of the two bonds is imposed
p by the
arbitrage mechanism.
Macroeconomics – Capital mobility and fixed exchange rates
Mundell-Fleming
g – Version 3 135
We have the usual three equations : the IS, the LM, and the BB.
Since exchange rates are fixed , the IS is that illustrated in slide
124 (is that of version 1 of the model).
The LM is that of version 1 as well ((see slide 126);
); in the p
presence
of fixed exchange rates, M is an endogenous variable (unknown).
The noveltyy concerns the BB. First of all we have
Bp = Bc + Bk = 0
So it follows that
Bc = −Bk
It is not necessary that both the account balances are equal to
zero; it is sufficient that the balances compensate each other.
We shall soon see that this result applies when one has
r = rF
Capitals
p and the balance of p
payments
y 136
Let see why the BB equation in this model is
r = rF
Capitals can be moved much faster than goods.

If r > rF, they
h continue
i to fl h country (ΔBk > 0).
flow iin the 0)
Even if we had Bc < 0, such an uninterrupted and rapid capital
inflow makes Bk grow until we have Bk > |Bc| and hence Bp > 0.
0
If r < rF, the same mechanism generates an uninterrupted
p
capital outflow,, which determines Bp p < 0.
Hence, one can have Bp = 0 only when one has r = rF.
QUESTION. When r = rF, does it follow that Bk = 0?
ANSEWER. No! It only follows ΔBk = 0 (there are no capital flows
generated by the interest-rate differential).
Since Bp = 0, we instead have Bk = −Bc (we shall now see why).
Saving
g and the current account 137
Let us recall the definition of saving:
S = Y − T + Tr − C
In open economies, the equilibrium output is equal to
Y = C + I + G + Bc
Substituting and rearranging, we have that in equilibrium
S = I + D + Bc
In open economies, households finance firms (I), the State (D),
and the rest of the world (Bc) (when Bc < 0, the rest of the world
contributes to financing I and D).
Saving takes the form of bonds purchase. When Bc > 0,
Households lend to the rest of the world buying foreign bonds.
bonds
We precisely have
Bk = −Bc
Viceversa occurs when Bc < 0.
Equilibrium
q and p
policyy with fixed ex. rates 138
According to the “small country” hypothesis, rF is exogenous. In
the ggraph, g r* = rF.
p , the BB is an horizontal line,, soon determining
Given r*, the IS determines the equilibrium level of Y*.
Given r* and Y*, the LM (whose position is endogenous)
determines the level of money supply M*.
In this model, monetary policy (the shift of the LM)
i impossible
is i ibl (and
( d wouldld anyway r LM LM
ISN
be ineffective). IS N
Fiscal policy (the shift of the IS)

is instead possible, and it is rF BB
effective.
There is no monetary retroaction,
either, because r does not increase
(since r = rF), and the LM moves. 0 Y* YN Y
Capital
p mobilityy and flexible ex. rates 139
This is the fourth version of the Mundell-Fleming model.
Let soon see how the IS and the LM change:g
IS: The current account depends on the exchange rate (which
is now an endogenous variable) according to the relationship
(see slide 131) Bc  Bc − zY  nv
Thus,, from condition Y = E, one derives,, after some algebra,
g ,
Y 1
1−c1−tz
̄  Bc  nv − br 
C̄ − cT̄  cTr   Ī  G
which
hi h iis the
h model
d l version h usuall Y  mĀ − br
i off the b  with
ih
m  1−c11−tz and Ā  C̄ − cT̄  cTr   Ī  G ̄  Bc  nv .
LM: The central bank must no longer intervene in the

currencyy market;; so it is able to control moneyy supply:
pp y
M̄  kY − hr
Macroeconomics – Capital mobility and flexible exchange rates
“Uncovered” interest rate parity
p y 140
How does the condition imposing Bp = 0 (the BB) change?
Let us continue to assume p perfect capital
p mobilityy. The BB
schedule is still described by an arbitrage condition, but is no
longer r = rF, which held in the case of fixed exchange rates.
Now, it becomes ̃
r  r F  Ee
where Eẽ is the expected
p percentage
p g variation of the exchange g
rate. This formula is called “uncovered interest rate parity”.
EXPLANATION. Suppose we have Eẽ > 0 (we expect a
d
depreciation
i i ).) Who
Wh spends d one euro iin a fforeign
i b bondd fforesees a
return greater than rF because she expects that with the currency
in which the bond is denominated she will buy more euros than
before. Viceversa if she expects a revaluation.
This is why in the countries with “weak” currencies (where
depreciations are frequent), the interest rates are relatively high.
Equilibrium
q and p
policyy with flex. ex. rates 141
For simplicity, assume Eẽ = 0 (so that the BB is again r = rF ).
The BB is still an horizontal line which determines r* = rF.
This time, given r*, it is the LM which determines output Y*.
Given r* and Y*, the IS (whose position is endogenous, (since it
depends on v) determines the equilibrium exchange rate v*.
In this model, fiscal policy (the shift in the IS)
is impossible (and would anyway r ISN LM LM
ineffective). IS N
Instead monetary
Instead, monetar policy
polic
(the shift in the LM) rF BB
is p
possible andd effective.
TRANSMISSION MECHANISM: the
increase in v stimulates the
current account and moves the IS. 0 Y* YN Y
Another development
p of the IS-LM model 142
In the foregoing slides we have studied both “closed” and “open”
versions of the IS-LM model.
Role for economic policy :
“CLOSED” VERSION. Policy y is “omnipotent”:
p it can always
y
bring Y* (and also r* ) to the desired level, managing
appropriately budget variables and money supply.
“OPEN” VERSIONS. Things, for economic policy, become less
simple, but (with certain exceptions) still possible.
In the next slides we will study another development of the
model: what happens when the price level P becomes and
endogenous
d variable
i bl ?
FIRST STEP: what is the effect on macroeconomic equilibrium
(described by the IS LM model) of a variation (exogenous) in P ?
IS-LM
Macroeconomics – Aggregate demand
Nominal variables and real variables 143
Let relax the hypothesis that P  P̄  1 . The distinction
between nominal variables and real variables becomes relevant.
NOMINAL VARIABLES: are those expressed in units of account.
REAL VARIABLES: are those expressed in units of domestic
product. They are derived dividing the corresponding
nominal variables by P.
W are more concerned
We i h reall output (which
d with ( hi h affects
ff
employment) than nominal output.
ABSENCE OF MONEY ILLUSION: consistently with the hypothesis
of rationality , economic choices depend on real variables
and relative p
prices ((that are p
prices in units of account
divided by P).
The symbols
y of the foregoing
g g models indicate, unless explicitly
p y
noticed, real variables: Y is real output, C real consumption,…
The IS-LM model with P variable 144
If the hypothesis of absence of money illusion holds, in the IS
nothingg changes,
g , exceptp that now all variables are real:
Y  mĀ − br 
Also money demand is expressed in real terms:
L  kY − hr
̄ ).
But the central bank controls the nominal money supply (M
Thus, the LM must be written as follows:
̄
M
P
 kY − hr
that is, the real money supply equals the real money demand.
Solving the model with the usual procedure yields
̄
M
Y  m1Ā  m2 P
T
This result shows that P has real effects
ff : ΔP > 0 → ΔY < 0.
The aggregate
gg g demand curve 145
The graph of the function Y  m 1 Ā  m 2 MP̄ (with Y in abscissa
and P in ordinate)) is a decreasing g curve, asymptotic
y p with respect
p
to the abscissa axis. It is called aggregate demand curve (AD).
The AD curve gives, for each value of P, the quantity of output
that firms can sell (recall that the AD has been derived by the IS-
LM model, so that one has, indeed, Y = E).
Th position
The i i off the
h AD d dependsd P
on A and M: we have ∂Y ∂A
 m1  0
(A controls the vertical
asymptote) and ∂M ∂Y
 mP2  0 . So
ΔA > 0 and/or ΔM > 0 move the
AD curve to the right.
Therefore, economic policy AD
controlsl the
h AD position.
ii 0 Y
Variations in P and “Keynes’
y effect” 146
̄
From the AD it follows that  − m 22M  0. What is the
dY
dP P
transmission mechanism from P to Y ? Recall that P appears in
the LM. A decrease in P implies an increase in real money supply;
thus, it shifts the LM downwards and, as consequence, generates
an expansionary effect on output Y.
In the graph, the LMO position depends on M ̄ /P O . We have Y = YO .
If we move ffrom PN < PO , we r LMO
have an increase in real money IS
̄ /P O  M/P
supply ( M/P
M ̄ /P N ), and
M LMN
the LM shifts downwards.
Output increases (YN > YO ).
The mechanism is the same of
the Keynes effect (see slide 105),
but is triggered by ΔP. 0 YO YN Y
Wealth effect 147
The Keynes effect meets a limit in the interest rate decline (the
liquidity
q y trap). g about dY
p) But there is another effect that brings dP
0
along the AD: the wealth effect (or Pigou effect).
Households’ WEALTH is ggiven byy the overall goods,
g , bonds and
money that they have: PK + M + B.
REAL WEALTH: is derived dividing wealth by P:
MB
K P
ΔP < 0 increases the real wealth.

The real wealth positively affects consumption.
It follows that the decrease in P causes consumption
p to increase:
ΔP  0 → ΔC  0 → ΔE  0 → ΔY  0
Thi transmission
This i i mechanism
h i is i k
known as the
h “Pi
“Pigou effect”.
ff ”
Aggregate
gg g supply
pp y 148
The AD schedule is a “locus” of equilibrium points, one for each
level of P. To determine Y*, we need another curve.
This further relation between P and Y exists, it is called aggregate
supply curve (AS), and (under certain conditions) is increasing.
It indicates, for each level of P, what is the quantity Y that firms
want to produce and sell.
Th intersection
The i i b between AD P AS
and AS schedules determines
the macroeconomic equilibrium,
that is, the levels Y* and P*.
The AD schedule derives from P*
the IS-LM model. Where does
the AS schedule derive from? It AD
derives from firms’ choices. 0 Y* Y
Macroeconomics – Aggregate supply
Profit maximization 149
The objective function of a firm is the maximum profit:
max π = TR − TC
where TR = PY is total revenue and TC is total cost.
Let assume perfect competition. Thus, the single firms are price
taker : the price of output P is outside their control.
T firms’ choice variable is the quantity produced Y. Hence
The
max π → d
dY
0
dTR dTC
Then it follows dY
− dY
 0 ↔ MR  MC , where we set
dTR dTC
MR  dY
and MC  dY
Under perfect competition, one has MR = P. So the condition
becomes max π → P  MC
Marginal
g cost and aggregate
gg g supply
pp y 150
We will see (see slide 152) that, under perfect competition,
the marginal
g cost is increasingg : MC = C(Y) with C ′ > 0.
In the graph on the left, it is identified the firm’s choice for a
given price level P.
When P changes, the choice changes. Thus, the marginal cost
curve can be interpreted (assuming P as an independent variable)
as the supply curve (see the graph on the right):
MC MC P S(P )
P2
P MR P1
0 Y 0 Y1 Y2 Y
Y*
pp y curves to the AS schedule 151
From supply
It is easy to move from the supply curves of the single firms, in
which the single quantity produced depends on the single price,
price
to the aggregate supply curve (the AS schedule),
in which domestic product Y depends on the price level P.
It is sufficient to aggregate the single productions (like one does,
precisely,
p y for domestic product)
p ) and observe that each of these
productions increases (hence making Y increase)
when the corresponding price rises. But when the single price
i
increases, also
l their i h d) average,
h i ((weighted)
that is, the general price level P increases.
As a result, there is an aggregate relation between Y and P. Such a
relation (i.e., the AS schedule) is increasing if the individual supply
curves are increasing,
increasing that is,
is if marginal costs are increasing.
increasing
The marginal
g cost function 152
To derive the supply curve, it is enough to derive
thee marginal
g cost function:
cos u c o : MC  dTC
dY
Let consider total cost: TC = WN + (r + δ)PK.
Let assume that the wage is fixed in the short run : W  W ̄.
Let set (r + δ)PK = Cf (it is the fixed cost). Thus TC = W
̄ N + Cf .
It follows that marginal cost is MC  dTC  ̄ dN .
W
dY dY
It is convenient to rewrite it as:
̄
W
MC  dY/dN
Marginal cost is equal to the ratio of wage to the marginal
productivity of labor. This
T has a clear economic meaning.
Marginal cost is increasing if dY/dN is decreasing.
In perfect
f competition,
ii dY/dN must be
b d decreasing.
i
Marginal
g productivity
p y 153
Let us suppose that the technology to produce Y, with the
employment
p y of N and K, is described byy a Cobb-Douglas
g
production function with constant return to scale: Y  N  K1− .
In the short run, K is given. For simplicity, we set K = 1.
Th aggregate production
The d i ffunction i bbecomes ((see theh GRAPH):
)
Y = Nα
dY
We have dN  N −1  0
(positive marginal productivity) Y Nα
2
and d Y2   − 1N −2  0
dN
(decreasing marginal productivity).
Hence, marginal cost is

increasing.
0 N
The AS schedule formula 154
Consider the “firms” operator at aggregate level. An implicit
representation
p of the AS schedule is
P = MC
It gives us all the combinations of P and Y such that firms
maximize profits. We can derive a more explicit expression using
the marginal
g cost,, the marginal
g productivity
p y and the production
p
function formulas (see slides 152-153).
̄
W W̄ ̄
W 1−
P  MC  dY/dN
   Y 
N−1
The last passage obtains deriving N  Y 1 from the production
f
function
ti and d substituting
b tit ti into
i t the
th marginal
i l productivity.
d ti it
The AS schedule is increasing ( dP  0 ) since 0 < α < 1.
dY
One may wish to derive the explicit function Y = S(P) inverting the function.
The AD-AS model 155
The macroeconomic model hinged on the combination of the
aggregate
gg g demand curve and the aggregate
gg g supply
pp y curve is
known as the AD-AS model. It is synthesized by the system
̄
M
Y  m 1Ā  m2 P
̄
W 1−
P  Y 
While P is an endogenous variable, this version of the AD-AS

model is based on the (essential) hypothesis of short-run rigidity
in the nominal wage (that remains an exogenous variable):
WW ̄
The AD-AS model provides many other informations. It enables
us to compute: (i) the level of employment ; (ii) the level of real
wage; (iii) the
h level
l l and h nature off unemployment
d the l .
Macroeconomics – The AD-AS model
The g
graph
p of the AD-AS model 156
The model can be represented in four graphs with aligned axes:
FIRST GRAPH: the AD and AS schedules determine Y* and P*.
P AS SECOND GRAPH: for now
py
we leave it empty.
THIRD GRAPH: it is needed
P*
onlyy to transfer Y from the
AD abscissa to the ordinate.
Y* Y FORTH GRAPH: Given
Y Y
45° Nα the value of Y*, the
aggregate production
Y*
f
function
i d determines
i
the level of
employment N*.
Y N* N
Labor demand 157
In maximizing profits, the firm takes two decisions:
(i) it decides of p
producing g a certain q
quantityy Y*;
(ii) it decides of buying a certain quantity of labor N*.
Condition max π , that is, P = MC expresses both choices:
f
from b i Y = S(P);
P = MC one obtains
but one also obtains P
W
 dY
, W ND
dN P
which is the labor demand
function (in implicit form). W
Given the value of the real wage P
(horizontal line), to the left of N*
dY
it is convenient to expand the dN
employment of N (one more unit 0
dY W
yields dN  P ). To the right it is N * N
convenient to reduce it.
Thus, function dN dY
is the labor demand curve: N  N WP  .
Real wage;
g ; unemployment
p y 158
Now let us “fill” the SECOND GRAFH with a labor demand curve
ND as a function W/P.
P AS W/P ND NF
Given employment N*,
it determines the real
̄ /P ∗
W
wage W̄ /P∗.
P*
AD
Unemployment is
U
given by the
Y* Y N* N
Y Y difference between
45° Nα labor forces NF (that
Y*
are exogenous) and
employment
l t N*:
Y N* N U = NF − N*
Labor and leisure 159
Not all unemployed are equal. To clarify this point, we need to
introduce labor supply
pp y in the ggraph.
p
Let us start with the budget constraint of a consumer:
PC = WN + R
Disposable income (all consumed, for simplicity) is given by the
sum of labor income WN and other incomes R.
There is a second constraint : T = TL + N.
Disposable time (T, which is exogenous)
must be distributed between leisure (TL) and labor N.
Substituting
g the second constraint in the first and rearranging,
g g,
one obtains:
WTL + PC = WT + R
which
hi h h
has the
h characteristics
h i i off a standard
d db budget
d constraint.
i
The budget
g constraint and the choice 160
The consumer must decide how to distribute her given resources
of time (WT) and income (R) between leisure (TL) and
consumption (C), given the two prices W and P. The wage is the
price of time, since it is an opportunity cost: one unit of TL
implies that the individual forgoes income obtainable with one
unit of labor, that is exactly W.
GRAPH: the budgetg constraint C
starts from point E; the
consumer can choose of not
rkin (TL = T) and
working nd
consuming C  RP . Or she can R E
P
choose, working, along all NS
points of the colored segment, 0 T ∗L T TL
whose slope is given by the real wage W/P.
The choice is identified by the highest indifference curve.
Labor supply
pp y 161
As long as the real wage increases, the budget line becomes
steeper
p ((alwaysy hinging
g g on point
p E)). The choice shifts to a higher
g
indifference curve. Does labor supply increase?
It depends. It increases if the W NS
substitution effect (leisure P
becomes relatively more costly)
pr il on
prevails the income
n th in m effect
ff t (the
(th
higher wage makes the consumer
richer and induces her to work
less). We will suppose that this is
the case. 0 NF N
Then, let assume, at aggregate level, that the labor supply function
dN S
increases along with real wage ( dW/P  0 ). We shall suppose that
the
h growth h will
ill slow
l d down when
h approaching b fforces NF.
hi llabor
Involuntaryy unemployment
p y 162
Let incorporate labor supply in the SECOND GRAPH. The real wage
̄ /P ∗ determines
W
P AS W/P ND NS NF labor supply.
Two types of
̄ /P ∗
W unemployment emerge:
P* involuntary
AD U unemployment
l iis given
i
by N S − N* (are those
Y* Y N* S
N NF N
Y Y who want work at wage
45° Nα
W̄ /P ∗);
Y* voluntary unemployment
is given by NF − NS (are
those who want more).
Y N* N
Nominal wage
g and the “long
g run” 163
The distinction between short and long run has several meanings.
In relation to the labor market, it means what follows:
SHORT RUN. The nominal wage is fixed:

WW ̄
LONG RUN. The nominal wage varies (albeit slowly) as a
function of the difference between labor demand and supply:
̇   W N − N S 
W
Hence, if the short-run macroeconomic equilibrium, determined

by the intersection between the AD and AS schedules
(see slide 156),
156) features involuntary unemployment, in the long
run the nominal wage starts to decline.
This changes the macro-equilibrium,
macro equilibrium which depends on W.
Macroeconomics – AD-AS and the long run
The AD-AS model in the “long
g run” 164
The decline in W shifts the AS schedule ( P  W̄ Y  ) downwards.
1−
The downward shifting g in the aggregate

gg g supply
pp y makes:
•Y increase and P decrease (GRAFH ON THE LEFT);
•N increase and W/P decrease (GRAPH ON THE RIGHT);
and it moves forward until it arrives at point L (in both graphs).
P ASB W/P ND NS
ASL
B
PB (W/P)B B
L
PL
(W/P)L L
AD
0 YB YL Y 0 NB NL NF N
NL is full employment; YL is potential output.
Economic p
policyy and “full employment”
p y 165
One can arrive at NL and YL without waiting the decrease in W.
Economic p policyy is able to move the AD to the right,
g ,
with ΔA > 0 and/or ΔM > 0 (demand management).
GRAPH ON THE LEFT: in this case W is fixed, but P increases.
GRAPH ON THE RIGHT: theh arrival
i l point
i ddoes not change
h (h
(however
the time of adjustment is shorter).
P AS W/P ND NS
L
P1
B B
P0 (W/P)B
AD1 L
(W/P)L
AD0
0 YB YL Y 0 NB NL NF N
(W/P)L is the same of the previous slide.
Imperfect
p competition
p 166
The version of the AD-AS model so far shown is Keynesian.
Usually,
y, however,, in the Keynesian
y versions one assumes
imperfect competition in the goods markets.
W respect
With p to the AD,, nothing g changes
g ((it remains as before).
)
With respect to the AS, something changes:
(i) firms are price maker;
(ii) firms face a decreasing demand curve.
dY
So one has dP
 0 . Then, it follows:
d dP
dY
 0 → P  Y dY
 MC
where the left-hand-side expression is marginal revenue (MR);
note that (as expected) one has MR < P. One also has
1
MR  P  Y dPdY
 P 1  Y dP
P dY
 P1 −  
where η (eta) is firm’s demand elasticity.
Macroeconomics – AD-AS and imperfect competition
Mark-up
p and constant p
productivityy 167
From the maximum profit condition MR = MC, that is
̄
P1 − 1   dY W
d /dN
d
we derive the relationship between P and Y (i.e., the AS schedule):
̄
W 
P dY/dN −1
 MC1  z
Since η > 1 (why?) we have P > MC. We indicate by z  1−1 the
mark-up over marginal cost.
We will assume that the mark-up z is an exogenous parameter.
With h production
Wi h respect to the d i ffunction i , we make
k the
h hhypothesis
h i
that Y = XN
where X is an exogenous parameter representing the average
productivity (Y/N = X ) and the marginal productivity (dY/dN = X ).
h assume a constant marginal
We thus i l productivity
d i i .
The AD-AS with imperfect
p competition
p 168
With the hypotheses of the former slide, the AS schedule becomes:
W
P X
1  z
P W/P NS
W X
X
1  z
1z and is horizontal: (on the
right-hand-side
i h h d id thereh are
P0 ND
AS only constant terms).
AD Th production
The d ti
Y* Y N* NS N function Y = XN is
Y
45°
Y an increasing line.
XN Also labor demand is
Y* horizontal.
We obtain it from the AS:
W X
P
 1z
Y N
Mark-up
p variations 169
Effect of an increase in z on the macroeconomic equilibrium.
It can soon be verified that P increases and Y decreases:
dP
 W
 0 and hence dY  dY dP
 −m 2
M W
0
dz X dz dP dz P2 X
Let draw the graph: Δz > 0 moves the AS schedules upwards,...
upwards
What does the level of z depend on?
1 COMPETITION DEFICIT. It is measured by the degree of
1.
monopoly Cm1z −Cm
g m  P−Cm
P
 Cm1z 
 z
1z
dg m 1
which is a direct function of z: dz
 0
1z 2
In p
perfect competition,
p , we have P = MC and hence z = 0.
2. COSTS DIFFERENT FROM LABOR. For instance, the costs of raw
materials and energy (the effect of an increase in the oil price
can be seen as Δz > 0).
Distributive shares 170
The mark-up, quantifying the firms’ market power by firms, also
affects distributive shares:
s W  WN
PY
wage share of workers
s   PY−WN
PY
 1 − sW profit share of firms
PERFECT COMPETITION. From the AS schedule one obtains:
P  W−1  Y/N
W
→ WN
PY

N
Thus we have s W   and s   1 − 
IMPERFECT COMPETITION ((we use the
h same production
d i ffunction i to
facilitate the comparison):
W  
P  Y/N 1  z → s W  1z and
d also
l s   1 − 1z
We soon see that:  0 and dsdz  0
ds W
dz
The mark-up enlarges the profit share and reduces the wage share.
Pareto-efficiencyy 171
DEFINITION. An allocation is Pareto efficient when it is not
possible improving the position of an agent without worsening
the position of another agent. Pareto-efficiency is equivalent
absence of wastes (all resources are employed at best).
If there is no full employment, there is
inefficiency
(not all resources are utilized).
If full employment occurs, is there efficiency? Not always.
There is efficiency if the market is perfectly competitive
(the first theorem of welfare economics).
If there is imperfect competition,
even in the long-run equilibrium (with full employment) the
allocation is Pareto-inefficient
Pareto inefficient.
Imperfect
p competition
p and inefficiencyy 172
Under imperfect competition (monopoly), the market chooses
point M. It is inefficient since there are buyers willing to pay an
additional unit of the good by more than the cost needed to
produce it: in the monopolist’s chosen point we have SMB > SMC.
Social marginal benefit (SMB): is what society is willing to spend
to have one more unit of y. Social marginal cost (SMC): is how
much it costs society to produce one more unit of y.
p The optimal point is C (what we would have in perfect
competition); but is a point that the monopolist will never
choose spontaneously, since she would not get profits.
pm M Are point C and point M
comparable? No, it would seem
pc C (i C the
(in h monopolistli iis worse);
)
MC = SMC
but the comparison is possible
MR D = SMB ((buyersy could indemnifyy the firm). )
0 ym yc y
The AD-AS model and Pareto-efficiencyy 173
Condition such that there is Pareto-efficiency: P = Cm.
Equivalent condition: WP  dN dY
.
In imperfect competition, we have: P = MC(1+ z) > MC. Thus, the
equilibrium (also the long
long-run
run one) is Pareto-inefficient.
Pareto inefficient
We also have W  X  X  dY (confirming the inefficiency).
P 1z dN
The equilibrium employment is NL;
W/P NS The efficient one is NP, that would
X
P occur if the real wage
g was equal
q to
the marginal productivity of labor
X L
1z
ND (X).
Spontaneously, the market will
never reach NP. Can economic
0 policy do it?
N L N P N
The AD-AS model with logarithms
g 174
Before answering the question in slide 173, it is convenient to
rewrite the model using logarithms.
logarithms Two advantages:
(1) simpler equations; (2) possibility of studying inflation.
The model:
(AD) y = μ1a + μ2(m − p)
(AS) p = w − x + z
The AD is not the same equation we have written in levels, but it
has a very similar meaning: output (y) depends positively on
autonomous expenditure (a) and real money supply (m − p). The
two coefficients μ1 and μ2 are not multipliers
p but elasticities.
The AS is derived from the corresponding equation in levels; we

have simplified it using ln(1 + z) ≈ z.
Macroeconomics – AD-AS and logarithms
The other equations
q 175
The production function Y = XN becomes
y=x+n
Labor demand W X becomes
P
 1z
w−p=x−z
Also here we used the simplification ln (1 + z) ≈ z.

Labor supply N S   W
P
 becomes
ns = γ(w − p)
Let us consider also the simplified version of the AD
p=m+v−y
obtained from the AD of the foregoing slide setting μ1a = v and
i μ2 = 1.
assuming
Three identities 176
(1) The simplified version of the AD, p = m + v − y , written in
levels and solved for V becomes the definition of money
velocity :
V  PY
M
It measures the average number of purchases (of “pieces” of
domestic product) made by one unit of M.
(2) Also y = x + n is a definition, precisely of
per worker product (or labor productivity):
X  NY
(3) The third implicit definition is w − p = x − z (the AS or the ND).
It defines the distributive wage share :
s W  WN
PY
 1
1z
Th are three
They h id i i ; so they
identities h must b be respected dbby any theory.
h
The four graphs
g p 177
Also the model in logarithms can be represented by the usual four
graphs.
graphs
p m + v w−p It is very easy to
w−x+z x−z NS perform
p
ND comparative-static
AS
exercises.
AD Δm > 0 moves the h AD
y* y n* ns n to the right (also for
y y Δv > 0 is the same);
45° x+n
Δw > 0 moves the AS
upwards;
p Δz > 0 moves
the AS upwards and
x the NS downwards,
y n andd so on.
The unemployment
p y rate 178
Recall the definition (see slide 5):
u  NNF −N
F
 1 − N
NF
That is, using the properties of logarithms,
u = nF − n
In the short-run equilibrium, it is u* = nF − n* (segment BF).
The involuntary unemployment rate is ns − n* (segment BL).
In the long run we have w−p n F
uL = nF − nL
NS
(all voluntary unemployment). B L F
x−z ND
For “neoclassicals”, uL is the
natural rate of unemployment.
Keynesians uL is the NAIRU.
For “Keynesians” 0 n* nL nF n
The inflation rate 179
Recall the definition (see slide 9):
P̃ t  PtP−Pt−1t−11  Pt
Pt−1
−1
That is, using the properties of logarithms,
P̃ t  p t − p t−1  Δp t
From the identities in slide 176,, we can derive two expressions
p for
the inflation rate:
Form identityy (1),
( ), derived from the AD schedule:
Δ p = Δ m − Δy + Δ v
From identity (3)
(3), derived from the AS schedule:
Δ p = Δ w − Δx + Δ z
A theory
Any h fl i must respect these
off iinflation h relationships.
l i hi
Macroeconomics - Inflation
The cost-inflation mechanism 180
Inflation triggered by a variation in the right-hand side of the AS
((Δw, or Δx, or Δz) is called cost inflation.
MECHANISM: (1) Δz > 0 (shock: e.g., the oil price increases); (2) the
AS shifts upwards
p ((from ASo to ASn);
(3) output decreases (from yo to yn).
It could stop here: in the AS Δp = Δz and in the AD Δp = −Δy.
p
But it could continue:
ADo ADn (4) the policy maker avoids the recession
2 (Δy < 0) moving the AD. AD
ASn (with Δm > 0 or Δv > 0).
1 Itt cou
could so stop aalso
d aalso so he
heree:
ASo
in the AS Δp = Δz and in the AD Δp = Δm.
There would be an una tantum Δp,
yn yo y not inflation (continuous variation).
The p
price – wage
g spiral
p 181
It is likely that the story in slide 180 continues.
In the new equilibrium
q ((after the shift in the AS and the AD we
are in the intersection between the AS1 and the AD1) the real wage
Δ(w − p) = −Δp = −Δz is decreased:
(5) To recover, workers ask (and obtain!) Δw = Δp,
position AS2; ((6)) the p
the AS shifts to the p policyy maker
p AD2 avoids the recession (Δy < 0) moving
AD0 AD1 again the AD (to the position AD2);
AS2
Δw (7) a process of growth in p starts,
AS1 and continues.
Δz
AS0 Now we have not an una tantum Δp, but
exactly inflation (continuous variation).
The economic system
y moves along g
yv y the black arrow of the graph.
Inflation and the distributive conflict 182
When does the price – wage spiral start?
(i) Δz > 0 − example l ((already
l d seen): ) oil
il price,
i andd so on;
(ii) Δx < 0 − “negative” productivity shock;
(iii) Δw > 0 − distributive conflict (for example about a growth
in productivity occurred in the past and not distributed).
When does the price – wage spiral finish?
(i) With a recession ((if the p
policyy maker forgoes
g to offset it).
)
It reduces labor demand and weakens workers;
(ii) With an agreement between social parties,
parties stating new
distributive shares sW and sπ.
The “spiral” can be made persistent by indexations.
Demand and p
price increase 183
Inflation triggered by a variation in the right-hand-side of the AD
((Δm, or Δv) is called demand inflation.
MECHANISM: (1) By assumption we are in full employment (y = yL);
((2)) demand shock ((Δv > 0); the AD moves to the right g
(from ADo to ADn); (3) demand of goods increases (from yL to
(4) In the labor market there is excess demand: y*);
nd = n* > ns = n ; (5) it thus follows Δw > 0;
p L
ADo ADn (6) the AS moves upwards (from ASo
1 t ASn);
to ) (7) output
t t comes back t yL.
b k to
ASn Often things stop here: in the AD
2
ASo Δp = Δv and in the AS Δp = Δw.
There would be an una
tantum Δp, not inflation
yL y* y (continuous variation).
Demand inflation 184
For the process described in slide 183 to continue, and to translate
into ((demand)) inflation, one needs that there is a continuous
adjustment Δm > 0 (or Δv > 0) to maintain demand for goods in
y*, counterbalancing the recessive effect of Δw > 0.
I this
In hi case, the
h economy moves along l the
h trajectory
j off the
h bl
black
k
arrow, with y = y* and Δp > 0 in each period (inflation).
This result requires that the policy
p maker has the objective y = y* > yL ,
AS2 g to tolerate the cost
and that is willing
Δw AD3 of the corresponding inflation Δp > 0
AS1
Δw AD2 to obtain it.
AS0
AD1
Why does one want to go beyond full
AD0
employment yL? When there is
y * y
competition, yL is inefficient.
imperfect competition
L y
The costs of inflation 185
Inflation has an advantage: it enable the economy to go beyond
yL, i.e.,, to be more efficient.
Does it has costs? It does, but we cannot see them in the model.
(1) Inflation (especially if unexpected) has redistributive effects:
(i) it advantages debtors and penalizes creditors;
(ii) it penalizes who receives fixed incomes in nominal terms.
(2) Inflation
I fl i reduces
d h reall values
the l off wealth.
lh M Moreover, iit makes
k
more costly holding money (“inflation tax”).
Inflation when is high, tends to be seflfulfilling: agents
(3) Inflation,
tend to sell off money as soon as possible. Then, money
velocity increases, thereby increasing g again
g inflation:
Δp → Δv → Δp → Δv → 
Inflation erodes the value of money. When it is high, it tends to
destroy it, compromising the working of the economy.
Inflation and economic policy
p y 186
We have seen that a some inflation (as a sort of “additive”) allows
a more efficient employment
p y of resources.
If inflation did not produce also the costs we have seen in slide
185, it would make sense to generate inflation until bringing the
economy from yL to yP (to the Pareto-optimal level).
CONCLUSION:
Some inflation is convenient but not too much.
Economic policy can think to use inflation (to push the economy
beyond yL), but without exaggerating. The objective will be
yL  y∗  yP
How can one determine y*? GENERAL PRINCIPLE: until the point in
which the marginal benefit of inflation counterbalances the
marginal cost of inflation. We shall see it in the next slides.
The Phillips
p curve 187
All the Keynesian versions of the AD-AS model had the following
hypotheses
yp on the nominal wage: g
SHORT RUN: the nominal wage is fixed ( W  W ̄ );
LONG RUN: W goes down until we have N* = NS = NL.
We can synthesize all in the (difference) equation:
W̃  wt − wt−1  n t − n L 
where ε > 0 measures the velocity of adjustment. The equation
says precisely that, as long as employment is lower than the full-
employment level, the nominal wage decreases.
Since u = nF − n and therefore n = nF − u, the equation becomes
Δwt  u L − u t 
From the AS, we have Δp = Δw; substituting results in the Phillips
c r e:
curve Δp t  u L − u t 
Macroeconomics – The Phillips Curve
The characteristics of the Phillips
p curve 188
The Phillips curve, i.e., the equation
P̃  Δp  u L − u
is an inverse relation between the inflation rate ( P̃ ) and the
unemployment rate (u). Its GRAPH is a decreasing line,
dP̃
with slope du  − and intercept with the abscissa u = uL.
It states that p
prices g
go up,
p, that is,,
Δp > 0, when u < uL, that is, when
P̃ n > nL , while go down (since wages go
d
down) h n < nL .
) when
An exogenous variation in the mark-up,
Δz > 0
Δz > 0, shifts the curve upwards:
Δp  Δw  Δz  u L − u  Δz
uL u This is consistent with the stylized
y
facts (see slide 18).
The trade-off between inflation and unemployment 189
The Phillips curve shows that
u  u L  Δp  0 i.e.,, that n  n L  Δp  0
We already knew this: if the objective for economic policy is
n* > nL ((i.e.,, u* < uL), one must p
payy it with some inflation.
But the Phillips curve tells us how much inflation one must
accept given level of u* < uL . It is p
p for each g preciselyy the ordinate
of the curve.
The Phillips curve measures the trade-off
between inflation and unemployment
p y
For this reason we said that the Phillips curve represents the
set of possibilities of choice for economic policy, in the
sense that the policy maker can choose any of the
combinations of u and Δp that are on the curve.
What combination will it choose?
Preferences of the p
policyy maker 190
Preferences are described by a “loss function”:
P̃   P̃ 2  1 −  u 2
Lu, P
The weight of inflation in the policy-maker preferences is given by
the parameter 0 < λ < 1 (with λ = 1 only inflation matters,...).
As long as inflation and/or unemployment increases,
the value of the loss rises, more than proportionally:
Marginal loss of inflation:
∂L
 2P̃  0
∂P̃
∂L
M i l lloss off unemployment:
Marginal l ∂u
 21 −  u
 0
The policy maker must solve the “constrained-minimum”
problem: ̃
min Lu, P
st
s.t. P̃  u L − u
The choice: “optimal”
p inflation 191
The solution can be found graphically: the point of the Phillips
curve corresponding
p g to the lowest indifference curve ((the tangent
g
one). We find u* and P̃ *. P̃
Or u* and P̃ * can be computed
solving the system
P̃ *
MRS  
P̃  u L − u
u* uL u
The marginal rate of substitution is:
∂L/∂u 1− u
MRS  
∂L/∂P̃  P̃
The MRS is increasing (so the indifference curves are concave).

ECONOMIC REASON: when unemployment is high, one is willing to
pay much
h iinflation
fl i to reduce
d iit ((and
d viceversa).
i )
Other implications
p of the Phillips
p curve 192
1. WAGES ARE STICKY. They go down slowly in the presence of
involuntaryy unemployment:
p y
wt  wt−1  u L − u t 
2. “COMOVEMENT” BETWEEN PRICES AND OUTPUT. Prices ggo upp
when output increases (and viceversa). We know that
p t  p t−1  u L − u t 
(also prices are “sticky”). From this relation it follows:
p t  p t−1  n t − n L 
and, since nt = yt − x and nL = yL − x, it also follows
p t  p t−1  y t − y L 
An increasing relation between yt and pt emerges ( ∂∂py t    0),
t
that can be interpreted
p as an aggregate
gg g supplypp y curve when wages g
are sticky (“bridge” between short and long run).
Macroeconomics – AD-AS with sticky wages
The AD-AS model with stickyy wages
g 193
The equations are: To construct the graph, we use
the p p y that when yt = yL,
property
ad y t  mt − p t  vt then pt = pt−1.
as p t  pt−1  y t − yL  The slope is measured by ε , i.e.,
by the velocity of wage
ADN adjustment.
p
ADO Sh run equilibrium:
Short ilib i B.
p0 N AS1
p1 B AS2 Period by period, the AS moves
p2 AS3 downwards until reaching
downwards,
the position ASL in the long
L ASL
run (p(point L)).
But economic policy can
(moving the AD) bring soon
0 y1 y2 y3 yL y the economy to point N.
Macroeconomics – AD-AS with sticky wages
Keynesians
y vs Neoclassicals 194
KEYNESIANS Markets NEOCLASSICALS
Imperfect competition Perfect competition (efficiency)

(inefficiency) Work well:
Work badly: (i) precise signals from prices;
(i) distorted signals from prices; (ii) timely reactions;
(ii) delayed reactions; (iii) temporary disequilibria;
(iii) persistent disequilibria; (iv) fast adjustment.
(iv) slow adjustment.
Economic policies
Are useful (i) to soon achieve Are useless (because markets
full employment, (ii) to stabilize work alone), and are conter-
the economy, (iii) to gain productive (because destabilize
efficiency.
ffi i th economy).
the )
Macroeconomics – The “pure” neoclassical model
Stylized
y facts 195
METHODOLOGIACL APPROACH: the realism of hypotheses does
not matter (trade-off between realism and simplicity);
p y); the
capability of explaining facts does matter.
Stylized
y d facts to be explained
p d ((and
d that Keynesian
y models
d explain):
p )
1. Unemployment;
2
2. Unemployment fluctuations;
3. Domestic product fluctuations (the business cycle);
4
4. D
Demand: d money h has reall effects
ff (i
(is not neutral);
l)
5. Procyclical prices (the AS schedule is increasing);
6. Sticky prices and wages (the Phillips curve);
These stylized facts do not seem to be in agreement with the
neoclassicals’ hypotheses (rational agents and efficient markets).
The “pure”
p neoclassical model 196
The model (in logarithms): 1 y   0   1 n
(1) production function;
(2) labor demand; 2 n   0 −  1 w − p
(3) labor supply; 3 n s   0   1 w − p
(4) market equilibrium; 4 n  n s
(5) aggregate demand.
5 y  m − p  v
(1) is derived taking logs in the function Y  XN 1 , with
0 < α1 < 1 (decreasing marginal productivity); (2) is derived taking
logs in the usual condition W/P = MP; (3) is the usual increasing
labor supply; ( ) is the equilibrium
pp y (4) q condition in the labor market;
(5) is the usual aggregate demand.
A Keynesian would accept all equations except (4).

The “hierarchy”
y of the model 197
The core of the model is represented by equations (2), (3) and (4)
describing the labor market equilibrium: three equations in three
unknowns, n, ns, and the real wage (w−p).
They determine simultaneously employment n* = nL and the real
wage (w−p)* = (w−p)L.
In the “pure” neoclassical model we are always in full employment.
F
From nL we go up to yL through
h h
w− p
NS the production function.
The only role of aggregate
demand is to determine p.
(w− p)L
Therefore,, moneyy does not have
real effects (is “neutral”). Real
ND variables only depend on relative
nL n prices.
i
The model solution 198
Let us simplify the equations removing some constant term: let
us set α0 = 0 and γ0 = 0. Solving the three equations of the labor
market, we find the real wage and employment:
∗ 0  01
w − p  w − p L   1  1
n∗  nL   1  1
Substituting nL in the production function yields:

 10 1
p AS y∗  yL   1  1
p2 Hence, in this model the AS is

vertical.
p1 It follows that Δm > 0 shifts the AD
AD2 to the right,
But the only effect is Δp > 0.
AD1
yL y Precisely money is neutral.
Precisely,
Little agreement
g with “stylized
y facts” 199
The model is perfectly consistent with neoclassicals’ hypotheses:
1 Markets work well (market clearing hypothesis);
1.
2. Agents are rational (look only at relative prices);
But the model is lacking in the agreement with stylized facts:
In relation to the list in slide 195, it accounts for the
first, unemployment, which, however, is only voluntary.
The model can be “adjusted” to find an agreement with facts 2-3
g a stochastic disturbance (supply
((fluctuations)) introducing pp y
shock) into labor demand, which becomes
n   0 −  1 w − p  
where ε is a random variable (for instance a white noise).
But this does not solve the issue of lack of agreement with the
other stylized facts, those decisive (also for neoclassicals).

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2009 10 Lecture Notes Macro

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Macroeconomics 1

It studies not only a single good, a single price, or a

There are, in fact, important questions that occur at aggregate

Unemplo ed (U ): are allll persons who

Labor Forces (NF ): are all Employed

Macroeconomics – Definitions and statistical regularities

There are similarities and differences.

Macroeconomics – Definitions and statistical regularities

Macroeconomics – Definitions and statistical regularities

This inverse correlation is called:

Macroeconomics – Definitions and statistical regularities

payy attention to statistical regularities.

The relationship between

In FIGURE 20 we plot the data of a larger period;

Macroeconomics – Definitions and statistical regularities

It emerges a clear inverse correlation.

This is due to an institutional difference (in Italy it is much

There is still a relation between output and labor employed; but

Macroeconomics – Definitions and statistical regularities

Hours worked increase

Therefore, these problems should not be studied

Macroeconomics investigates this.

Meaning : The sum of the values of excess demand (the

So one can concentrate on what happens in one of the two

Macroeconomics – A simplified model

This if we abstract from foreign trade (“closed” economy). To model “open”

1. The price of output is the general price level P.

The relative prices are obtained dividing prices by P : we thus

Households’ budget constraint:

Macroeconomics – The consumption function

The model solution: Y ∗  1 ̄  Ī

Macroeconomics – Income-expenditure model

Macroeconomics – Income-expenditure model

Viceversa occurs to the left of Y*.

Households’ budget constraint:

Given the effective values of Given the desired values of

EXAMPLE 1: given G, and EXAMPLE 2: given the desired level

If there is D > 0 because of a recession, one speaks about

Macroeconomics – Income-expenditure with the State

NPV criterion: the project will be undertaken if NPV ≥ 0.

It is imposed by the arbitrage mechanism:

Macroeconomics – The bonds price and the interest rate

In the bonds market, the “law of demand and supply” holds .

Also the bank deposits

Monetary base. It is also called “high-powered money”. It can

Adding ΔCi = γΔDe , one exactly obtains ΔM = αΔH.

2. FOREIGN SECTOR. When the Central Bank buys foreign

3. CREDIT COMPANIES. When the Central Bank makes a loan to

The presence of money calls into crisis the neoclassical model of

QUESTION. Why does ΔM > 0 move the LM downwards?

m1 > 0 is the multiplier of (the exogenous component of)

An economic system is “open” when its residents make economic

For simplicity, we neglect transactions of real capitals and transfers.

REAL EXCHANGE RATE (v): it measures the number of unities

Macroeconomics – “Open” economies

REST OF THE WORLD:

The reason is similar to that of the speculative money demand:

The distinctions between the four versions relate to two elements:

The condition states that an increase in the (real) exchange rate

In this model, the equilibrium output is determined by the

Capitals can be moved much faster than goods.

Fiscal policy (the shift of the IS)

LM: The central bank must no longer intervene in the