Econ 101B Notes

Tomas Villena⇤
May 15, 2015

Contents

I Overview of Macroeconomics 3

II IS-MP Model 11

III Aggregate Demand 27

IV Neoclassical Production Functions 33

V Phillips Curve 36

VI General Equilibrium, Shocks and Stabilization 40

VII Expectations 57

VIII International Macroeconomics 63

This is a compilation of my class notes from Mike Arnold’s lecture and Sergii
⇤

Meleshchuk’s discussion section taught at UC Berkeley.

1
IX The Solow Growth Model 76

X The Financial System 81

XI Financial Crisis and the Great Recession 85

XII Problems 88

2
Part I
Overview of Macroeconomics
GDP
Total value of final goods and services produced within a country in a given
year.
Three approaches:

Production Approach
• To calculate GDP

– Estimate value of all output at market prices.

– Subtract the value of intermediate goods.

• Problems:

– Imputations
– It is not always clear whether a good is final or not.

Income Approach
• Sum income of

– Labor
– Corporate
– Interest Investment
– Farmer’s
– Non-Farmer’s

• Adjust:

– Add indirect taxes minus subsidies

– Add depreciation

3
Expenditure Approach
• C + G + I + NX
• C: Consumption for durable, non-durable goods and services.
• G: Government expenditure
• I: Investment (residential, non-residential fixes, inventory).
• N X = EX Im

Remarks on GDP
• GDP vs GNP

– GDP is income in a country

– GNP is income of the citizens of a country.
– GN P = GDP + N F I
– N F I is net factor income (earnings of citizens living abroad).

• Nominal vs Real GDP

– Nominal GDP is measures in real prices

– Real GDP is measured in prices of a reference (base) year.
– Seasonal Adjustment: Leave fluctuations caused by different sea-
sons out of the measurements of output to compare to different
years.

Price Levels
Weighted average of all the prices.
• Different ways to calculate the weights, this leads to different price
indices:

– Consumer Price Index (CP I)

– Implicit GDP deflator
– California Consumer Price Index

4
Inflation
• Inflation is defined as a change in the price level.
• Measured in terms of the CP I
• Terminology:

– Disinflation: Decrease in Inflation.

– Deflation: Negative Inflation (prices go down).
– Hyperinflation: Very large Inflation.

• Some measure of CP I excludes food and energy prices, because their

prices are volatile.

Inflation Measurement

Pt Pt 1 Pt
⇡t = =
Pt 1 Pt 1

where ⇡t is inflation rate at time t, and Pt is a price index in period t.

• In order for the measurement to work: Calculate correct price levels,
use appropriate weights, account for new and exiting good, make ad-
justments for quality, among others.

Unemployment
• Unemployed people: Without a job but willing and able to work (in
the labor force, actively looking for a job).
• Unemployment Rate
–
#of unemployed
UN =
labor f orce

labor f orce = employed + unemployed = E + U N

In recent years U N has decreased because people have left the labor
force.

5
Unemployment Measurement
BLS asks 60,000 respondents to complete the Current Population Survey. Ac-
cording to responses, people are categorized as either employed, unemployed
or out of the labor force.
There are various measures of unemployment, U 1 through U 6.

Interest Rates
Why do interest rates matter?

• Interest rate (i): The rate paid by borrowers for the money lent by
lenders.

• Different kinds of interest rates.

• Interest rates influences the economy generally as follows:

High i Low i
Stimulate Saving (" S) Discourage Saving (# S)
Discourage Consumption (# C) Stimulate Consumption (" C)
Discourage Investment (# I) Stimulate Investment (" I)

Monetary Policy
Central Bank tries to achieve objective such as price stability, full employ-
ment and stable economic growth.
Monetary policy tools:

• Open Market Operations (FOMO): Buying and Selling government

debt.

• Reserve Requirements.

• Discount window (discount rate).

• Quantitative Easing (Long-term bonds).

• Interest rate on reserves.

6
How does it work?
• Banks need to keep a certain percent of consumer deposits in form of
reserves. Reserves can be held in:

– Cash in the vault.

– Deposits within the Fed.

• The more reserves a bank has ! More deposits it can attract ! More
lending potential.

• Excess Reserves: Reserves above the required level. Banks can lend
this to other banks overnight.

• If the bank does not have enough reserves, it can borrow them overnight
from other banks with excess reserves.

Federal Funds Rate (FFR)

• Interest institutions charge one another for overnight loans of reserves.

• The FFR heavily influences the economy

– Short term rate (FFR)! Long term rate! Consumer and busi-
ness spending! Economic activity (GDP and employment).

Open Market Operations

• Mechanism through which the Fed tries to achieve a target FFR by
buying or selling US government securities (Treasury Bills).

• How does it work?

Buying Securities: Interest rate is higher than the target (it >
itarget ) ! Fed buys Treasury Bills! More supply of excess reserves!
Reduction of price of reserves! FFR Decreases (# F F R )# it ).

Selling Securities: Interest rate is lower than the target (it <
itarget ) ! Fed sells Treasury Bills! Less supply of excess reserves!
Increase of price of reserves! FFR Increases (" F F R )" it ).

7
Quantitative Easing

• Fed buys long-term assets from banks to decrease interest rates in the
long-run.

• Quantitative easing increases reserves of banks.

• Unlike FOMO, QE can not influence FFR, since QE is used when

FFR=0, the zero lower bound.

Interest Rate on Reserves

• New policy tool to control the FFR. Pay interest on required and excess
reserves.

• Sets a floor on the FFR.

• So far, the interest rate has been stable set on 0.25%.

US Government Debt Securities

• Different Treasury Bill maturities (2-10 years, 20-30 years).

• Treasury inflation protected securities (TIPS) - Inflation indexed bonds.

• Interest rate of a zero-coupon bond:

f ace value purchase price 360

⇥ ⇥ 100%
f ace value days until maturity

Yield Curve

• Curve showing interest rates on bonds of different maturities.

8
Discount Rate

• Interest rate charged to banks that borrow from regional Fed banks.

• Important during Great Depression.

Business Cycles
• Irregular short-term fluctuations of GDP

Cyclicality of Variables

• Cyclicality is defined as a co-movement with GDP during the business

cycle

• Pro-Cyclical variables:

– Consumption (C)
– Investment (I)
– Inflation

• Counter-cyclical variables:
– Unemployment rate (U N ).

• Acyclical variables:
– Net exports (N X)

9
Leading and Lagging Indicators

• Some variables precede fluctuations in GDP (leading indicators):

– Housing Prices.
– Bond yields.
– Consumer Expectations.

• Some variables fluctuate with a lag real$be to GDP (lagging indicators):

– Average duration of unemployment spell.

– Labor costs.

Possible Explanations of Business Cycles

• Fluctuations in Aggregate Demand (Keynesian Theory).

• Credit-debt cycle (Keynesian Theory).

• Fluctuations in the Level of Technology (Real business cycles theory).

10
Part II
IS-MP Model
IS Curve
Why do we need the IS curve?
• IS curve reflects the equilibrium on the goods market:

– Planned expenditures are equal to actual expenditures:

Y P = Yt

• Equilibrium Conditions

– Planned spending is equal to actual spending.

– Planned savings is equal to planned investment.
– Planned expenditure:

Y P = C + IP + G + N X

– Individual components of Y P are functions of interest rate.

Deriving the IS Curve:

Consumption Expenditures
• Simple approach: Constant Marginal Propensity to Consume (M P C).

C = C0 + M P C ⇥ (Y T) C1 r

• Where:

– C0 is autonomous consumption.

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 ∗ This is consumption at zero income. Strictly positive. De-
pends on preferences, wealth, etc.
∗ C0 > 0
– 0 < M P C < 1, tells us how much people consume out of each
additional dollar.
– C1 is the sensitivity of consumption with respect to real interest
rate r. C2 > 0.
– Y is income.
– T stands for taxes.

Government Spending Multiplier

• Assume G, T , I autonomous. Also, assume C2 = 0.

• In equilibrium, Y P = Yt

• Then:

– YP =C +I +G
– C = C0 + M P C ⇥ (Y T)
– Plug C into Y P , we get:

I + G + C0 M P C ⇥ T
YP =Y =
1 MP C

• The government spending multiplier is the term:

1
1 MP C
– It lies between 1 and 1.
– Tells us how much aggregate demand increases with an increase
of 1 unit of government purchases.

• The extent to which government can influence aggregate demand is

determined by the multiplier.

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Planned Investment Expenditures
• Simple approach: investment is a linear function of interest rate.

I P = I0 I1 r

• Where:

– I0 is autonomous investment, at r = 0.
– Investment is decreasing in interest rate.

• Investment is shifted to the right (increased) by:

– Higher future marginal product of capital.

– Lower price of capital.
– Lower depreciation rate.
– Improved business confidence.

Net Exports
• Assume net exports to be negatively related to interest rate.

N X = N X0 N X1 r

• Where:

– N X0 is autonomous net exports, at r = 0.

– Negative relationship between r and N X.

• Autonomous Net Exports (N X0 )

– Increase if foreigners start preferring domestic goods.

– Decrease if citizens shift preferences towards foreign goods.
– Decrease if foreign countries increase tariffs on domestic goods.

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Government Spending and Taxes
• Assume G and T to be autonomous.
• In real life they both may depend on real output and other variables
such as:

– Unemployment rate
– Inflation rate
– Size of the budget deficit

EQUILIBRIUM
Accepting the assumptions made previously, we can derive from the equilib-
rium conditions the following expression for the IS curve:

Y =YP

) Y P = C + IP + G + N X = Y

C0 MP C ⇤ T C1 r + I 0 I 1 r + G + N X 0 N X1 r
)Y =
1 MP C
From this, we can find a more useful expression for graphically under-
standing changes in the IS curve:
(C0 M P C ⇤ T + I0 + G + N X0 ) (I1 + C1 + N X1 )r
Y =
1 MP C 1 MP C
According to our assumptions:

I 1 + C1 + N X 1 > 0
From this, we can infer that the IS curve is downward sloping, since the
slope is
(I1 + C1 + N X1 )
1 MP C
and
0 < M P C < 1 ) 0 < (1 M P C) < 1
In order to understand the mechanics of the IS curve, we should note
that:

14
 • The intercept of the curve is given by:

(C0 M P C ⇤ T + I0 + G + N X0 )
1 MP C
Thus, any shift in autonomous components shifts the IS curve.

• The slope of the curve is given by:

(I1 + C1 + N X1 )
1 MP C
Thus, any change in response parameters of investment, consumption or
net exports rotate the curve, given a change in slope.
If M P C is assumed to have the ability to change, then a change in M P C
will both shift and rotate the IS curve.

Another Approach to Deriving the IS Curve:

• We used the fact that Y = Y P .

• Another (equivalent in closed economy) approach is to use the condition

that planned savings are equal to planned investments.

– Y P = CP + I + G
– IP = Y P C G
– S=Y C G ) S = I P in equilibrium.
– In open economy: S = I P + N X

SP = I P

• Saving will be increasing in r, as S = Y C G, and C is decreasing

in r.

15
IS Curve Mechanics:
Recall our main IS curve equation:
(C0 M P C ⇤ T + I0 + G + N X0 ) (I1 + C1 + N X1 )r
Y =
1 MP C 1 MP C
We usually plot the IS curve with r on the vertical axis, so it is sometimes
useful to define r in terms of Y and the other components:
(C0 M P C ⇤ T + I0 + G + N X0 ) (1 M P C)
r= Y
(I1 + C1 + N X1 ) (I1 + M P C + N X1 )
We might use the same approach for determining shifts and rotations of
the curve using the r expression. It is useful to remember that changes in
endogenous variables such as rand Y are movements along the curve, while
changing other components are shifts. Whether these are parallel or slope-
changing can be determined knowing that:
• Intercept:

(C0 M P C ⇤ T + I0 + G + N X0 )
(I1 + C1 + N X1 )
• Slope:

(1 M P C)
(I1 + M P C + N X1 )
The direction of the shifts can be determined by figuring out how the
change in a given parameter affects the sign of the intercept and/or slope
expressions.

Particular Cases: Lets use an arbitrary IS curve with the following

parameters:

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• Increase in Autonomous Consumption (" C0 )

– Increase in intercept! Shift to the right of the IS curve.

• Increase in Sensitivity to Interest Rate (in absolute terms) ("k I1 k)

– Increases the slope! Rotation clockwise of the IS curve.

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• Decrease of M P C (# M P C)

– Decreases intercept, decreases slope! Shift to the left and rota-

tion anti-clockwise of the IS curve.

4-Quadrant Diagram for the IS Curve:

• Savings-Income Schedules:

– Plot Y on vertical axis and S on the horizontal axis.

– Use S P + T = Y C to construct this curve.

• Investment-Interest Rate Schedule:

– I = I0 I1 r.

• The four quadrant diagram allow us to better identified the propagation

mechanism of different shocks.

• Graphically, if we show a shock in G:

18
 • Intuition:

– I +G+N X schedule shifts to the right because of a direct increase

in G.
– S P + T schedule shifts to the right because increase in G leads to
increase in income and thus savings.

Savings and Wealth

• Let N Wt be the national wealth at period t.

N Wt+1 = N Wt (1 + r) + St+1

Where St is savings at period t, ris some net rate of return on Walt.

• Flow:

S=Y C G = (Y C T )+(T G) = S P rivate +S Government = I+N X

S I = NX

N Wt = N ational Assetst N ational Liabilitiest

Money
• Money is the asset in an economy used to buy goods and services within
a market.

• The function of money:

– Medium of exchange (for transactions).

– Unit of account.
– Store of value.

• Because money is the economy’s medium of exchange, it is the most

liquid asset available.

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Types of Money
• Commodity Money: Money that takes the form of a commodity good
that has intrinsic value. The gold standard existed to sustain this idea
of money.

• Fiat Money: Money without intrinsic value, it is an order or decree

established by the government.

Components of the Money Supply

• M0 : Cash

• Monetary Base (M B): M0 + Bank Reserves

• M1 = M0 + Demand Deposits

• M2 = M0 + Savings Deposits
Who affects the Money Supply?
• Central Bank

• Depositary Institutions (banks)

• Non-banking agents (the public)

The Central Bank

• The Federal Reserve, the central bank of the United States, is respon-
sible for regulating the U.S. monetary system.

• It consists of the Board of Governors, 12 regional Reserve banks and

Federal Open Market Committee.

• The Fed is run by its board of governors, which has seven members
appointed by the president and confirmed by the Senate.

• The Fed chairman is appointed by the President and confirmed by

Congress every four years.

• The chairman is the lead member of the FOMC) which meets about
every six weeks to consider changes in monetary policy.

20
 • Through the decisions of the FOMC, the Fed has the power to increase
or decrease the number of dollars in the economy.

• FOMC can decide to buy or sell government securities and conduct

monetary policy, (primarily) influencing the FFR.

• FFR holds a strong relation to the actual interest rate, given its relation
to the availability of reserves.

Fed Balance Sheet

• Money supply process is based on the Fed’s balance sheet.

• The balance sheet consists of:

– Assets: Government securities, discount loans to depositary insti-

tutions, asset-backed securities.
– Liabilities: Currency in circulation, reserves.

• The total assets must be equal to the total liabilities.

Banking Institutions

• Depositary institutions accept deposits and make loans.

• They impact the system heavily: If bankers decide to make fewer loans
and hold greater reserves, the money supply falls.

Non-banking Public

• Hold money as currency, borrow and make bank deposits.

• They impact the system heavily: If people withdraw deposits and

hold more currency, the banking system loses reserves and creates less
money; thus, the money supply falls.

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Types of Bank Reserves
• Required Reserves

– Legal minimum banks must hold against their deposits.

– Fraction of total deposits that a bank holds as required is called
required ratio (rr).
– rr is determined by a combination of government regulation and
bank policy.

• Excess Reserves (Er)

– Additional reserves that banks choose to hold above their required

reserves.

Fractional Reserve System

• Assume rr = 10% = 0.1
• The bank has $10 of reserves and can choose to have $90 of loans
(assume Er = 0).
• There are $100 of deposits and $90 of debt that, let’s assume, borrowers
hold in currency.
• Total money supply is $190.
• The bank created money because it only holds a fraction of deposits as
reserves.

Formulas
• In this scenario, the money multiplier is 10.

– M B = 100, M = 1, 000.

• Extensions:

– if consumers do not deposit everything they borrow, they hold on

to some cash:
Cash = c ⇤ Deposits

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 – If banks want to keep excess reserves:

Er = e ⇤ Deposits

Money Multiplier

• Total Money Supply:

M = C + D = (c + 1) ⇤ D

• Monetary Base:

M B = C + R + Er = (c + rr + e) ⇤ D

• Money Multiplier:
M 1+c
m= =
MB c + rr + e

Costs of Inflation
• Shoe-leather Cost

– To avoid inflation, hold less cash by going to the bank more often.
Making more trips to the bank cause you shoes to wear out more
quickly.
– The point is: time and convenience is sacrificed to avoid inflation.

• Menu Costs

– Costs in which firms incur for changing prices.

• Tax Distortions

– Law makers often fail to take into account inflation.

– Inflation tends to raise the tax burden on income earned from
savings. This is a tax distortion.

23
Quantity Theory of Money

M ⇥V =P ⇥Y

Where:

• M is money supply

• V is money velocity

• P is price level

• Y is real output.

The relation between money and nominal income is through the velocity of
money:
PY
V =
M
• Velocity is the turn-over of money supply.

• Institutions and payment technologies are assumed to change very grad-

ually.

• Consequently, velocity was assumed to be constant.

• Thus, the level of nominal income (or output) P ⇥ Y is determined

solely by the quantity of money M .

Quantity Theory of Money: A Keynesian Approach

• If V is constant and M is exogenous:

– M determines the level of output P ⇥ Y (nominal output).

– If prices are fixed (assumption reasonable for the short-run), this
is true.
– If prices change and are flexible, this is not true.

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Quantity Theory of Money: A Classical Approach
• In the long-run, economic output Y is determined by:

– Quantity of the factors of production.

– The level of total factor productivity.

• These real variables are unaffected by the quantity of money of the

price level, which are nominal values.
• This is the Classical Dichotomy.
• Therefore, changes in the money supply will not have an effect on real
variables.
• “Long-run Neutrality of Money”.

MP Curve
• Relationship between real interest rate and expected inflation.
• This relationship is based on the Central Bank’s monetary policy rule.

• The MP is upward sloping:

– Real interest rate will be higher the higher the expected inflation.

r = r0 + ⇡ e

25
 • Autonomous component r0

• Positive Slope >0

• By changing autonomous component, Fed can tighten or ease monetary

policy. Increase r0 is tightening, decreasing is an easing of monetary
policy.

Taylor Principle and Taylor Rule

• Upward sloping MP curve is also called Taylor’s principle.

• The taylor rule describes the reaction of the Fed’s target nominal in-
terest rate to expected inflation.

i = ↵(⇡ e ⇡)

The taylor principle says ↵ > 1.

Why are prices sticky if at all?

• Menu costs.

• Information frictions.

• Rigid contracts.

• In a lot of macroeconomic models we just assume some fraction of

firms doesn’t change prices in each period (without specifying why this
happens).

26
Part III
Aggregate Demand
• IS curve:

(C0 M P C ⇤ T + I0 + G + N X0 ) (I1 + C1 + N X1 )r
Y =
1 MP C 1 MP C
• MP curve:

r = r0 + ⇡ e

• Plug the MP curve into the IS curve to get the AD curve:

C0 M P C ⇤ T + I0 + G + N X0 I 1 + C1 + N X 1
Y = (r0 + ⇡ e )
1 MP C 1 MP C

C0 M P C ⇤ T + I0 + G + N X0 r0 1 MP C
⇡e = Y
(1 + C1 + N X1 ) (1 + C1 + N X1 )

• AD curve Intercept:

C0 M P C ⇤ T + I0 + G + N X0 r0
(1 + C1 + N X1 )
Assumed to be positive.
• The AD slope increases in:

– Autonomous consumption, investment, net exports and govern-

ment purchases.+

• The AD slope decreases in:

– Autonomous taxes
– MP C

27
 –
– r0
– C1 , I 1 , N X 1

• AD curve Slope:

1 MP C
Y
(1 + C1 + N X1 )

Slope is negative. Slope becomes flatter if:

• M P C increases.

• MP curve increases.

• Sensitivity of C, I and N X to interest rate increase.

Policy Mix
• Combination of fiscal and monetary policy to manage the economy.

• Examples: Government increases G but central bank raises autonomous

interest rates to prevent inflation.

• Easy fiscal policy would lead to increase in output and interest rate (IS
curve), which would also be associated with higher inflation.

• Central bank raises interest rates even more and this undoes the effect
of fiscal policy on output and inflation.

• In this case, the resulting effect is the same level of output and inflation.
Larger government expenditures, with lower level of consumption and
investments.

• This is known as government crowding out of private spending.

28
Fiscal Policy
• Fiscal policy refers to taxation and expenditure policies of government.

• Expansionary fiscal policy uses higher government spending and/or

lower rates of taxation to increase aggregate economic activity.

• Contractionary fiscal policy uses lower government spending and/or

higher taxation to reduce aggregate economic activity.

Government Budget and Debt

• Major components of government outlays:

– Government Purchases G
∗ Government consumption Gc
∗ Government investment GI
– Grants in-aid to state and local governments.
– Net interest payments (N IP ).
– Transfer Payments (T r)

• Budget deficit

Def icit = Outlays Receipts = (G + T r + N IP ) T axes(T )

• Financing of budget deficit

Def icitt = Debt + 4M Bt

Is government debt a burden?

• Yes if:

– It crowds out private productive investment

29
 – It lead to increase in interest rate and/or debt repudiation
– It leads to tax distortions

• No if:

– Invested in project that lead to higher rate of return than interest

rate on debt:

∗ Creation of productive capital assets.

∗ Creation of productive human capital.

Fiscal Multipliers Remember the AD curve equation:

C0 M P C ⇤ T + I0 + G + N X 0 I 1 + C1 + N X 1
Y = (r0 + ⇡ e )
1 MP C 1 MP C
The multiplier will then be:

• Spending:
dY 1
= >0
dG 1 MP C
• Taxes:
dY MP C
= <0
dT 1 MP C
• Balanced Budget:

dY dY
+ =1>0
dG dT

30
Size of the Multipliers
• In Keynesian theory multipliers are large if M P C is large and there is
no counterbalancing response of monetary policy.
• Multipliers are low if:

– Expansionary fiscal policy is balanced by contractionary monetary

policy:
∗ Government spending crowds out private spending.
– Ricardian equivalence holds:
∗ People expect future increases in taxes and thus save more
today, decreasing the M P C.

Automatic vs Discretionary
• Automatic changes do not require government action.
• Tax collection for example, falls automatically during a recession be-
cause unemployed workers do not pay taxes.
• Moreover, government expenditures automatically increase, because
transfer payments rise.
• Discretionary fiscal policy involves active policy changes in response to
economic fluctuations.
• For example, the economic stimulus act of 2008.

Debt to GDP ratio and Steady State

Assume parameters (...)t between period tand t + 1.

Debtt = Debtt 1 (1 + it ) + P rimary Def icitt

P rimary Def icitt

Debtt = Debtt 1 (1 + it ) + GDPt
GDPt

Debtt = Debtt 1 (1 + it ) + ↵GDPt

31
Let
Debtt
dt =
GDPt
Divide both sides by GDPt

Debtt Debtt 1 (1 + it ) P rimary Def icitt

= + GDPt
GDPt GDPt GDPt

GDPt 1 P rimary Def icitt

dt = dt 1 (1 + it ) +
GDPt GDPt

• Assumptions about steady state:

– Primary deficit is constant share of GDP

P rimary Def icitt

=↵
GDPt

– Nominal GDP grows at a constant rate

GDPt
=1+g
GDPt 1

– Nominal interest rate is constant

it = i

• We then have that Debt GDP ratio converges to:

1+g
d=↵
g i

32
Part IV
Neoclassical Production Functions
Simplification to establish a relationship between total output in the economy
and the factors of production. Generally, we have the form:
Yt = At F (Kt , Lt )
Examples:
1. Leontieff Production Function (labor and capital are perfect comple-
ments):
Yt = At min(↵Kt , Lt )
2. Linear Production Function (labor and capital are perfect substitutes):
Yt = At (↵Kt + Lt )
3. Constant Elasticity of Substitution
1/ 1/
Yt = At (↵Kt + Lt )

Properties of Neoclassical Production Functions

Cobb-Douglas Production Function

Y = AK ↵ L
Where:
• A is total factor productivity. Usually related to efficiency of technology
or technological knowledge.
• Kis capital. ↵ is the share of capital.
• L is labor. is the share of labor.
• Usually, the following condition is assumed:

↵+ =1
We then have:
Y = AK ↵ L↵ 1

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Growth Accounting
The following identity is useful for assessing contributions to output growth
from the growth of K, L and A.

gY = gA + ↵gK + (1 ↵)gL

where
it+1
gi = ln( )
it
Growth rate of output per capita:

gY /N = gA + ↵gK/L + gL/N

Growth Accounting: Derivation

Assume we know Kt, Lt, and we calibrated a. Now we can calculate:
Yt
At = ↵ 1 ↵
Kt L t
We have all we need to calculate contribution of technology, capital and
labor to the growth rate of output per capita.
Use the log linearization approximation: ln(1 + x)⇡x. This work when x
is small, it generally works with macroeconomic fluctuations.
Define gx = xxt+1
t
1. Then:

Yt+1
1 + gY =
Yt

↵
At+1 Kt+1 L1t‘+1↵
) 1 + gY =
At Kt↵ L1t‘ ↵

At+1 Kt+1 Lt+1

ln(1 + gY ) = ln( ) + ↵ ln( ) + (1 ↵) ln( )
At Kt Lt

gY ⇡gA + ↵gK + (1 ↵)gL

34
 It is possible to decompose growth rate in output per capita into growth
rate of TFP, capital per worker, and labor force participation rate.
Denote total population as Nt .
Output per capita can be computed:
Yt
yt =
Nt

At Kt↵ L1t ↵
=
Nt

Kt ↵ L t
= At ( ) ( )
Lt Nt
Use this expression to compute the ratio yt+1 /yt

yt+1 At+1 ( Kt+1 ↵ Lt+1

Lt+1
) ( Nt+1 )
=
yt At ( K t ↵ Lt
Lt
) ( Nt )

Use the log linearization approximation: ln(1 + x)⇡x.

We get:

gY /N ⇡gA + ↵gK/N + gL/N

35
Part V
Phillips Curve
Empirical Approximation (1958)

⇡=c !U

• Description of the short-run trade-off between inflation and unemploy-

ment.

– Implication: Room for inflationary policies to reduce unemploy-

ment in the short-run.

• In the long-run, Ut = Un . Phillips curve in the long-run is vertical at

the natural rate of unemployment.

– Implication: No room for reduction of the long-run unemployment

by means of inflationary policy.

• Why is Un 6= 0?

– Want people being at their best fitting job. You can search for jobs
that fit you better. This is efficient for the economy. Temporary
unemployment.

• Why does it work?

– Assume a very low level of unemployment.

– Wages would increase very quickly.
– Wages are major cost of production.
– Increase in cost of production increases prices.

36
Expectations Adjusted Phillips Curve

⇡ = ⇡e !(U Un )

• Intercept: Expected Inflation.

• Short-run tradeoff inflation-unemployment.

• Still no long-run trade-off

• Changes in expected inflation SHIFT the phillips curve.

Phillips Curve and Price Shocks

⇡ = ⇡e !(U Un ) + ⇢

• ⇢ is a price shock:

– Oil price changes (Any cost of production price shock).

– Changes in labor market regulations.
– Shocks to expectations.

• Assume Adaptive Expectations

⇡te = ⇡t 1

• Measuring ⇡ e

– Use Fischer equation:

i = r + ⇡e
∗ Ordinary i, r using TIPS rate (Treasury Bills).
– Survey Method:
∗ Consumer Survey made by the FED
∗ University of Michigan

37
Short-run Phillips Curve, Assuming Adaptive Expecta-
tions
Plugging in the adaptive expectations assumption into the short-run phillips
curve considering the parameter ⇢:

⇡t = ⇡t 1 !(U Un ) + ⇢t

Phillips Curve & Aggregate Supply

• The phillips curve is the basis for deriving the aggregate supply curve.

• LRAS and SRAS curves correspond to the short and long-run phillips
curves.

LRAS
LRAS is a function of L, K, A (TPF).
Example: Cobb-Douglas Production Function

Y = AK ↵ L

• Any change in the economy that alters the natural rate of output shifts
the long-run aggregate supply curve.

• Shifts in LRAS:

– 4L
– 4K
– 4A
∗ A is a component related to technology, efficiency, knowledge
of technology. It is a residual.

38
SRAS from the Phillips Curve
The SRAS is the Phillips curve, but instead of unemployment gap, using
Okun’s Law, we plug in output gap.
Recall Okun’s Law

ut uN = C(Yt Y P)

Yt Y P is measured in percentage points (not real money quantity).

⇡t = ⇡te + (Yt Y P ) + ⇢t

39
Part VI
General Equilibrium, Shocks and
Stabilization
AS/AD Mechanics
Shifts in Aggregate Demand Curve
• Any factor that shifts either the IS or MP curve shifts AD.

• Examples:

– " Autonomous monetary policy (r0 ) ) shift in AD ( )

– " Government Purchases (G) ) shift in AD (!)
– " Taxes (T ) ) shift in AD ( )
– "Autonomous Net Exports (N X0 )=)shift in AD (!)
– " Consumer Optimism (C1 ) ) shift in AD (!)
– " Business Optimism (I1 ) ) shift in AD (!)

Shifts in Short-run Aggregate Supply Curve (SRAS)

• Changes in the following produce a shift in the SRAS curve:

– A change in expected inflation.

– A price shock, even when caused by a significant change in the
exchange rate.
– A persistent output gap U Nt >> U Nn , where U Nn = N AIRU
∗ If the output gap is persistent over a long period of time, it
might affect the LRAS. This is called “Hysteresis”.
– A persistent period when U N << U Nn

40
Shifts in Long-run Aggregate Supply Curve (LRAS)
• Changes in the following produce a shift in the LRAS curve:

– A change in the quantity of labor.

– A change in the quantity of capital.
– A change in total factor productivity.

General Equilibrium
General Equilibrium Conditions
• General equilibrium exists when all markets are simultaneously in equi-
librium, that is:

AS = SRAS = LRAS

• The economy is simultaneously both in short-run and long-run equilib-

rium.

• Graphically:

41
Short-run Equilibrium
• The condition for short-run equilibrium is:

AD = SRAS

• Graphically:

Disequilibrium Dynamics
• Assume short-run but not long-run equilibrium.

– How would the economy adjust?

∗ Short-run equilibrium will move over time to its long-run equi-
librium, when U N >> U Nn . This is the “self-correcting”
mechanism.
· This mechanism might be slow.
∗ Because current inflation is different from inflationary expec-
tations, i.e., ⇡t 6= ⇡ e , inflationary expectations will change
and there will be a shift in the SRAS curve.

42
Disequilibrium: Y > Y p
• If Y > Y P , then:

– There is an increase in the demand for labor.

– This leads to a faster increase in wages.
– This causes higher inflation.
– This produces higher inflationary expectations.
– The SRAS shifts to the left, until general equilibrium is reached.

43
Disequilibrium: Y P > Y
• If Y P > Y , then:

– There is an decrease in demand for labor.

– This leads to a slower increase in wages.
– This causes lower inflation inflation.
– This produces lower inflationary expectations.
– The SRAS shifts to the right, until general equilibrium is reached.

The Self-Correcting Mechanism

• Regardless of where short-run equilibrium is, the economy will adjust
over time to its general equilibrium level at potential output.

– The magic behind the self-correcting mechanism lies in the fact

that inflationary expectations eventually match actual inflation.
– There are important differences among economists on the velocity
of the self-correcting mechanism.
– This debate inspired Keynes’ famous quote, “in the long run, we’re
all dead!”

44
Shocks
• A shock is an event that produces a significant change in the economy.
Shocks can be:

– Positive or Negative
– Permanent or Temporary
– Supply sided or Demand sided

• Examples of shocks:

– Permanent negative aggregate demand shock

– Positive SRAS and LRAS shocks
– Permanent negative aggregate demand + liquidity trap

Permanent Negative AD Shock

• There is a shock to consumers borrowing capacity.

• People start consuming less (there is a decrease in autonomous con-

sumption). This increases savings.

• Investment curve does not change.

• Savings curve shifts down.

• IS curve shifts to the left.

• AD curve shifts to the left.

45
• In the short-run:

– Inflation falls
– Output falls
– Prices fall and MP curve is fixed) Interest rate falls

• In the long-run:

– Inflation falls even more (LRAS is fixed).

– Output recovers (since LRAS is fixed).
– Since prices fall and MP curve is fixed, interest rate falls even
more.

46
Negative AS Shock
• No effect on IS.

• No effect on MP.

• No effect on AD.

• There is an effect in either SRAS or LRAS.

Positive SRAS Shock

• Short-run:

– Output increases.
– Inflation decreases.
– Since inflation decreases, interest rate decreases.

• Long-run:

– Original equilibrium.
– All short-run changes are undone.

47
Positive LRAS Shock
• Short-run:
– No real effect.

• Long-run:
– Output increases.
– Inflation decreases.
– Because inflation decreases, interest rate falls.

48
Positive Demand Shock
• Some shocks influence the IS curve

– Autonomous components that have similar consequences:

∗ Increase C
∗ Increase I
∗ Increase G
∗ Increase N X
∗ Decrease T

• Some shocks influence the MP curve

– Decrease autonomous component ro

• Note: Changes to MPC, interest rate sensitivities and slope parameter

of the MP curve also rotate the curves

Negative Demand Shock & Liquidity Trap

• Very large negative shock to aggregate demand.

• This generate very low interest rates.

• Interest rate reaches the zero lower bound and can not continue to
decrease.

• MP curve and AD curve become kinked.

49
• Short run:

– AD is kinked.
– Part of it slopes upward.
– Can be a huge decrease of output even if demand shock is small.
– Intuition:
∗ Initial negative demand shock.
∗ Inflation should fall.
∗ If nominal interest rate reaches zero, interest rate rises.
∗ This further reduces demand.
∗ Inflation should fall.
∗ Vicious circle.

50
Stabilization Policy: Reaction to Shocks
Stabilization policy is a result of the combination between monetary policy
and fiscal policy.
Some of the indicators that policy uses in order to make decisions are
highly controversial because they are sensitive to modeling assumptions and
researcher bias. These indicators are basically:

• NAIRU1 , which denotes the natural rate of unemployment U Nn .

– U Nn is not zero because certain sorts of unemployment are desir-

able or economically feasible:
∗ Frictional Unemployment: People that are in-between jobs.
Sometimes people quit their jobs because it is not the best
fit for them. As a result, they are looking for a job that
better fits their skills. This is the least controversial kind of
unemployment.
∗ Structural Unemployment: This kind of unemployment is
linked to skills of workers becoming obsolete. Economically,
it is desirable for people to actualize their skills. This kind of
unemployment is controversial, because some people suggest
only fictional unemployment should be allowed.

• Potential GDP Y P . This indicator is the quantity of output the econ-

omy should produce at full employment.

Goals of Monetary Policy

• Depending on policy-makers and legal framework, central banks can
pursue two types of goals. They can choose to privilege one over the
other or give them equal importance:

– Stabilization of price levels.

– Stabilization of output.

1
Non-accelerating inflation rate of unemployment

51
 • There are two main central banking systems for policy making:

– Hierarchical: One goal is given more importance than everything

else.
– Dual Mandate: Both price levels and output/employment are
given equal importance.

Dual Mandate: Loss Functions

• A loss function is a mathematical way of representing the policy trade-
offs between addressing inflation and unemployment. Different views
on which issue is more important generate different loss functions.

• The isoquants of a loss function can vary from view to view.

• An inflation “dove” would associate a larger loss to high unemployment

levels, while an inflation “hawk” would associate a larger loss to high
inflation.

52
The Federal Reserve
• The Fed operates under a dual mandate, its goals are:

– Stable employment (employment equal to the natural level or

NAIRU).
– Stable price levels (particularly, stable inflation).

Policy Response to Negative AD Shock

• Suppose an initial general macroeconomic equilibrium.

• Suppose there is a decrease in autonomous spending.

• Policy response:

– Expansionary fiscal policy.

– Expansionary monetary policy.

• How does the initial shock look like?

53
• Expansionary Fiscal Policy:

– Changes savings curve, IS curve and AD curve.

– Output, inflation and interest rates will go back to equilibrium
levels. Only government debt would change.

• Expansionary Monetary Policy:

– Can change AD by acting through the MP curve.

– Output and inflation will go back to equilibrium levels. Interest
rates (both nominal and real) would decrease.

54
 • AD Shocks, Takeaway:

– Negative effect on output and inflation can be offset by economic

policy.
– Monetary policy can stabilize both inflation and ouput. “Divine
Coincidence”: No tradeoff between policy goals.

Policy Response to Negative SRAS Shock

• Two contradicting options for monetary policy:

– Maintain stable level of inflation.

– Maintain stable output.

• How does the initial shock look like?

• To stabilize output, shift AD curve:

– Shift MP downward.
– Expansionary policies in response to negative shocks, shift AD
upward.

55
• Policy response to negative SRAS shocks

– Fiscal policy response:

∗ Output go backs to equilibrium.
∗ Inflation decreases.
∗ Real interest rate decreases.
– Monetary policy response:
∗ Output goes back to equilibrium.
∗ Inflation increases.
∗ Real interest rate decreases.
– Policy response amplifies short run effects on inflation in the long-
run.

56
Part VII
Expectations
Why do we care about expectations?
• Fisher Equation

r=i ⇡e

• SRAS

⇡ = ⇡e b ⇤ (Y Yp ) + ⇢

• In the real world:

– Expectations shape people’s behavior and are thus important for

predicting policy results, looking at financial markets and making
other important econmic decisions. In macroeconomics, expecta-
tions play a cruial

How to model expectations?

• Adaptive Expectations

– Weighted average of past values of variables will indicate value of

future variables.

⇡te = ⇡t 1

• Rational Expectations

– All possible information about the future is incorporated into mak-

ing a preditcion.
– Error is random, since all the information is within expected val-
ues.

57
How to measure expectations?
• Ask people about their expectations:

– Michigan Survey of consumers

– Survey of Consumer Finance
– Survey of professional forecasters

• Look at Financial Markets:

– TIPS versus ordinary T-Bills

– Futures Contracts

Rational Expectations
• In rational expectations, predictions are centered around true values.

• The less information is available, the more likely forecast error will
occur.

• Only new information information can change expectations.

Lucas Critique
• People’s behavior might change if they observe changes in the behavior
of variables that determine their behavior.

• Implications of this argument might be:

– If we use simple Keynesian postulates to estimate parameters of

the model you might get wrong estimates.
– Whether a policy if effective or not heavily depends on people’s
expectations and policy-maker’s credibility and expectations man-
agement.

• So, if policy makers change fiscal policy people might change their
MPC.

58
Ricardian Equivalence
• In this example, if for a constant level of MPC is assumed and a higher
G effectively occurs, recall the fiscal multiplier:

1
1 MP C
• However if G increases, people might expect higher tax levels in the
future. This would make people more likely to save and less likely to
spend, thus decreasing the MPC.

• This particular application of the Lucas Critique is called the Ricardian

Equivalence.

Expectations and Policy

• Types of policy:

– Discretionary Policy
∗ Based on ad-hoc judgements of policy makers.
– Rules-based Policy
∗ Based on policy rules.

Discretionary Policy
• Pros

– Assuming rational expectations: Policy will only be effective if it

is in fact a nuance in people’s mind, this occurs if dicretionary
policy is carried out and not predictable rules-based policy.
– Discretionary policy is flexible: useful for dealing with recessions
and structural changes.

• Cons

59
 – Time inconsistency problem: What the policy-maker thinks is the
best thing for the present might not be good for the future. For
example, generous governement expenditure leave high debt for
successors.
– Discretionary policy decisions are affected by election-cycle polit-
ical incentives and general political ties which make policy slower,
short-sighted and in many ocassions, inneffective for solving prob-
lems.
– In real time, a substantial amount of relevant information might
be missing for taking appropropriate actions in terms of policy-
making.

Rules-based Policy
• Pros

– Expectation management is easier: the public knows exactly what

to think, there are no credibility issues.
– Rules are time consistent, which is not the case with judgement.
– Rules have no election-cycle political incentives, which make dis-
cretionary policy

60
 • Cons

– Lack of flexibility in the short term. If activist intervention is

required in a recession or upon a structural change, rules-based
policy-making is likely not to be effective and will not deal with
issues as soon as discretionary regimes would.
– Acheiving and imposing the perfect rule for policy is impossible.
It is also hard to come up with rules based on data.

• Examples of Rules-based Monetary Policy

– Targeting money supply.

– Pegging exchange rate.
– Targeting level of reserves.
– Taylor Rule (the inflation-unemployment tradeoff).

Policy Credibility
• Principle: Publically credible commitment to nominal target or anchor
helps the policy-making agency or body to achieve the nominal target.

• Method: Influencing people’s expectations.

• Result: Policy credibility helps achieve more desireably outcomes after

different shocks.

• How to establish policy credibility?

– Step 1: Set a nominal anchor

∗ Examples:
· Inflation targeting.
· Nominal GDP targeting.
– Step 2: Credibility assurances
∗ Central bank independence for example: If politicians have
influence on the central bank, it may lose credibility and start
conducting time-inconsistent policies.
∗ Accountability and public statements.

61
Policy Credibility
• Demand Shocks

• Supply Shocks

62
Part VIII
International Macroeconomics
What is an Open Economy?
• Open economy: Open to international trade. There are two key as-
sumptions:

– No trade costs (Free movement of goods).

– Perfect capital mobility (No capital controls, no transaction costs).

• Implications. If trade is frictionless of and capital is perfectly mobile

in the world, then:

– By definition, all countries are open.

– Prices of trdable goods are the same in all countries (the law of
one price).
– Return on capital is the same in all countries.

• If trade and/or capital mobility is prohibited, then this economy is

economy is said to be a closed economy or autarky

Current Account
The current accoun reflect:

• Payments of goods and services.

• Balance of trade plus the nef factor income.

• Difference between country’s savings and investment.

Current Account and GDP

• Net factor payments:

– Difference between GNP and GDP.

63
 ∗ GNP: What the country’s citizens and companies earn abroad
and within the country.
∗ GDP: What the country’s productive force (citizens and for-
eigners) earn domestically.
– GNP-GDP= Difference between what country’s citizens and com-
panies earn abroad and what foreign companies and citizens earn
in the domestice

GDP = C + I + G + N X

GN P = GDP + N F P

GN P = C + I + G‘ + N X + N F P

Where

CA = N X + N F P

and
CA = GN P Domestic Absorption

Savings and Investment, with Current Account

• Add and subtract taxes in the GNP expression:

GN P = C + I + T + G T + CA

CA = (GN P C T ) + (T G) I

CA = S P rivate + S Governement I

X
CA = Si I

64
• Current Account is this a difference between domestic savings and do-
mestic investment.

• Note that in a closed economy, CA = 0 and S = I.

• If we know savings and investment react to changes in some parameters:

– We can predict changes in current accounts.

• For example: Interest Rates increases

– Consumption decreases and savings increase:

X
# C )" S

– Investment Decreases
X
# C )" S )# I

– So, current account goes up:

X
"( S) & # I )" CA

65
Current Account in a Small Open Economy
• Small open economy:

– Domestic interest rate is equal to rest of the world (ROW) interest

rate, due to perfect capital mobility.
– ROW interest rate is determined by intersection of savings and
investment schedules.

• Current Account in SOE graphically:

• rA is an autarky. Intersection of savings and investments at the domes-

tic (no trade) level.

• When economy of a country is open (there is effective trade), then

r⇤ > rA

• Country starts running current account deficits.

• Negative Shock to Autonomous Investment:

66
– Shocks affect savings and investments, through examining invest-
ment and savings, we can determine effect of shocks on current
account balance.
– We know world interest rate is fixed in this case.
– Decrease in autonomous investment shifts investment schedule to
the left (with no effect on savings schedule).
– The net effect is an increase in current account.
– Graphically:

67
Current Account in a Small Open Economy: Interest Rates
• If rA < r⇤ ) CA > 0. Country saves more and invests less than in an
autarky.
• If rA > r⇤ ) CA > 0. Country saves less and invests more than in an
autarky.
• If " r⇤ )" CA (If interest rates in the world increase, current accounts
increase as well).

Current Account in a two large economies:

• Assume that interest rates are the same in equilibrium in two countries.
• Equilibrium is defined through global current account being zero.
So, in equilibrium:
X
CAi = 0
In this case:
CA1 + CA2 = 0

68
• In the example:

– Home country is running a current account surplus (CA > 0).

– Foreign country is running a current account deficit (CA < 0).
– Current account surplus at home is equal (in absolute value) to
current account deficit abroad.

• Decrease in savings and increse in investments at home:

X
# S& "I

• Assume both countries have the same autarky interest rate, and thus
when they open current accounts in each is zero.

– As a result: Homw autarky interest rate increases.

• World interest rates increases by a smaller amount:

– Home country is running a deficit in CA.

– Foreign country is running a surplus in CA.

69
Financial Account (or Capital Account)
• Reflects changes in national ownership of assets.
• Financial account identity:

F A = P urchasesof homeassetsF OREIGN ERS P urchasesof f oreignassetsDOM EST IC RESIDEN T S

• Financial account is positive if foreigners purchase more domestic as-
sets:

– Lend money to home residents (purchase debt).

– Invest more in home enterprises (purchase equity).

Financial Account vs Current Account

• Under balance of payments identity, with no statistical discrepancies:

Balance of payments = CA + F A = 0
• It is assumed that reserve account (central bak transactions) will be
part of the financial account.
• If you sell a lot of goods abroad (more than what is imported), then
you can buy more foreign assets (more than foreigners can buy in your
domestic country).

Balance of Payments Identity

• Every economic transaction is associeated with changes in current and
financial account.
• Changes in absolute value are identical (they have different signs).
• Why does this make sense?

– If you sell goods abroad and then sell foreign currency to get
dollars:
∗ Increase in CA through NX.
∗ Decrese in FA through selling of foreign assets (currency).

70
Exchange Rates
• Quotes

– Direct Quotes
∗ Units of domestic currency per unit of foreign
– Indirect Quotes
∗ Units of foreign currency per unit of domestic
– Indirect Quote= 1/Direct Quote

• Arbitrage
Ability to make strictly positive profits without investing any money
and without risk.

– Arbitrage opportunities are usually assumed not to exist, since

they if they did they would be exploited very quickly by investors
with deep pockets.

• No Arbitrage and Exchange Rates

– Three Currencies X, Y and Z

– Let the two exchange rates be:
∗ A, for X/Y
∗ B, for Z/Y
– What is X/Z exchange rate?
∗ Without arbitrage, it would be A
B
.

Nominal and Real Exchange Rates

• Nominal Exchange Rates: quoted in exchange rate kiosks, banks, new-
papers (mainstream media).

– Real Exchange Rate: Theoretical construct useful to compare

changes in purchasing power parity of two countries’ currencies.
– Let EF/D be the indirect exchange rate, with P the domestic price
level, and P ⇤ the price level in the foreign country.

71
 – Also, call the real exchange rate ".
– Then:

P
" = EF/D ⇤
P⇤

• If real exchange rate is low, then domestic goods are relatively cheaper
compared to foreign goods.

Purchasing Power Parity

• Assume no trade costs. This means:

– Goods are transported at no costs.

– There are no tariffs and restrictions to trade.

• Implications: Purchasing Powe Parity.

– One dollar shall be able to buy you the same amount of goods and
services in the US and any other country.
– In the one dollar scenario:
∗ Can buy P1 goods in the US.
∗ Can buy EF/U SD units of foreign currency.
∗ Can buy EF/U SD /P ⇤ units of foreign good.
∗
1 1 P
= EF/U SD ⇤ ) 1 = EF/U SD ⇤ ="
p P⇤ P⇤
∗ If we believe that the purchasing power parity applies, then
in the long run the exchange rate should equal 1.

Spot vs Forward Rate

• Spot rate:
Rate at which currencies are exchanged at a current period of time.

72
 • Forward rate:
Rate at which currencies are exchanged at some future date (for exam-
ple, in a year).
– For example, you can get a contract that will enable you to buy
1 EUR for 1.2 USD in a year from now: forward ER is 1.2
USD/EUR.
• Hedging with Exchange Rates:

– Assume:
∗ Forward rate: 1.2 U SD/EU R
∗ In the future, the US firm will get 1M EU R in revenues.
– The firm can HEDGE its foreign exchange rate risk:
∗ Get a forward contract to sell 1M EU R in future at rate
1.2 U SD/EU R
∗ No matter what the actual rate will be in the future, a firm
will always get the forward rate.
∗ Thus, there is no exchange risk.
∗ If the firm did not hedge its revenues in dollars, it could have
gotten a higher or lower rate thant the 1.2 U SD/EU R.

Covered Interest Rate Parity

• Investor can borrow/lend riskless rate at home and aborad.
• Borrows 1U SD at riskless rate iU S .
• Buy EF/U S units of foreign currency today, invest into foreign risk-
less securities at rate iF , get contract to sell foreign currency at rate
SD in fututre period.
F
1/EF/U
• In future, investor has to return what he/she borrowed in dollars, needs
to pay (1 + iU S ).
• In future, investor gets from foreign investment: EF/U S ⇤(1+iF )/EF/U
F
S.

• If there are no arbitrage opportunities, what she earns has to be equal

to what she pays:

73
 (1 + iF )
(1 + iU S ) = EF/U S ⇤ F
EF/U S

This is called covered interes parity...

• On of the implications:

– If (1 + iF ) = (1 + iU S ), then EF/U
F
S = EF/U S .

– In other words, if nominal riskless interest rates are the same in

the foreign and domestic economy, then spot and forward rate will
be eqaul.

Exchange rate deteremination

• Ideally, exchange rates are determined just like prices of goods and
services are determined.

• Actual exchange rate should be the rate at which supply and demand
for one currency are equal.

• Upward pressure on domestic currency price

– Associated with increase in demand for domestic currency or re-

duction in supply of domestic currency. This occurs when:
∗ Exports grow faster than imports.
∗ Foreigners start buying more assets at home than domestic
citizens abroad.
∗ Central bank limits supply of domestic currency.
– *Corollary: Expansionary Monetary Policy
∗ Fed decides to lower target interest rate.
∗ It buys governement securities to increase supply of reserves
(and lower FFR and interest rate).
∗ This increase monetary base and money supply.
∗ Dollar may depreciate as a result.

• Covered Interest Rate Parity

74
 – We know that with no arbitrage opportunities:

F (1 + iF )
EF/U S = EF/U S ⇤
(1 + iU S )

– But when does this fail?

∗ Transaction costs.
∗ Risk.
∗ Investors would only invest in risky assets if they offer higher
return. This is called a risk-premium.

• Shocks to Exchange Rates

– Exogeneous appreciation of currency (considering depreciation is

the same with different direction).

Impossible Trinity
• Can only enjoy two of the following:

– Independent Monetary Policy

– Fixed Exchange Rate
– Perfect Capital mobility

75
Part IX
The Solow Growth Model
Assumptions
• One comodity: Output. Two inputs: Labor (N ) and Capital (K).

• Output is allocated to consumption and investment:

– Y (t) = C(t) + I(t)

• Growth rate of labor force:

– N (t) = egN T N (0)

• Production Function:

Y (K, N ) = AF (K, N )

• Can assume Cobb-Douglas, but results hold for any constant returns
to scale function.

• Economy is closed, no government, so

I=S

• No technology growth (for now).

Capital Accumulation

dK(t)
= I(t) K(t) = sAf (K(t), N (t))
dt

76
Cobb-Douglas per Worker Simplification:

Y
y=
N

K
k=
N

Y = AK ↵ N 1 ↵

y = AK ↵ N ↵

K ↵
) y = A( ) = Af (k)
N

Growth rate of Capital per Worker

dk(t)/dt dln(k(t)) d(K(t)/N (t)) d(ln(K(t)) ln(N (t)))

gk = = = = = gk gN
k(t) dt dt dt

dk(t)
= gk k(t)
dt

dk(t)
= sAf (k(t)) k(t)(gN + )
dt

Steady State
Capital per worker is constant, so:

gk = 0

gK = gN

77
 gY = gA + ↵gK + (1 ↵)gN

gY = gN

Growth level of capital and output are equal to the growth rate of popu-
lation.
Growth rates of capital per worker and output per worker are zero.
In steady state:

gk=0

dk(t)/dt
=0
k(t)

dk(t)
=0
dt

sAf (k(t)) = k(t)(gN + )

Graphically:

78
 • Increase in Savings Rate:

– Higher capital in new equilibrium.

– Higher output in new equilibrium.
– Higher growth of capital and output in TRANSITION period.
– No change in long-term growth.

Technology Growth in the Solow Model

• To analyze the model with technology changes, use variables per EF-
FICIENT unit of labor, namely:

Y
y=
AL

K
k=
AL
• Output per efficient unit of labor:

Y (t)
= K(t)↵ (A(t)N (t)) ↵
= f (k)
A(t)N (t)

79
 • Capital Accumulation:

dK(t)
= I(t) K(t) = S(t) K(t)
dt

dK(t)
= sAF (K(t), N (t)) K(t)
dt
• Capital per efficient unit of labor:

dk(t)
= sf (k(t)) k(t)(gN + gA + )
dt
• Steady State:

Only capital per efficient unit labor will be constant (capital per labor is
growing).

d(k(t))
=0
dt

sf (k(t)) = k(t)(gN + gA + )

The Golden Rule

• Is there a savings rate at which consumption is maximized in the Solow
model in the steady state?

• Is that rate unique?

YES!

• The golden rule is savings rate equal to capital share.

• It is a unique maximand.

80
Part X
The Financial System
• Financial system channels funds from lenders to borrowers

• Direct and Indirect Finance

– Direct: Lenders and borrowers interact with each other materially.

– Indirect: Intermidiary institution.

• Financial System

– Lenders (net savers)

∗ Households
∗ Firms
∗ Government
∗ Non-residents
– Borrowes (net spenders)
∗ Firms
∗ Government
∗ Households
∗ Non-residents

• Direct finance channels funds through:

– Money Market
– Capital Market

• Indirect finance channels funds through:

– Credit Institutions
– Other Monetary Financial Institutions

81
 • How it all works?

Financial Derivatives
• Contract that derives value from the performance of underlying asset
(entity).

• Example: Mortgage Backed Securities (MBS)

– Bank issues mortgage loans to customers

– Loans generate monthly payments
– Bank sells those mortgages to INVESTMENT BANKS (repay-
ments go to that investment bank)
– Investment bank SECURITIZES those mortgages into MBSs
– Investment bank SELLS MOBSs to clients who now earn income
from payments on mortgages underlying the mortgage backed se-
curity

• Why is this convenient?

– Risk of default is minimized (mortgage is split)

∗ 1 MBS worht 1/100 of a mortgage is less risky than the whole
mortgage.

82
Principal-Agent Problem
• Principal hires agent to perform some action

• Incentives may not be aligbed between principal and agent

• Agents can have motivations to act in their own best interest and this
may not be good for the principal.

Moral Hazard
• Agent takes excessive risk because someone else takes the burden.

• Information Assymentry:

– Agent who takes action knows that he is going to be risky

– Party bearing the risk does not know of these intentions

• Example:

– Loan originators issued a lot of subprime loans, because they could

sell them (not incurring in loans).

Adverse Selection
• One party has more information about the product (the transaction)
ex ante.

• Adverse selection occurs when “bad” products (only sellers know their
products are not as good as they seem) are more likely to be sold on
the market.

• Example

– “Market for Lemons” (G. Akerlof). Car dealers are likely to sell
you a lemon if you cannot check quality of the car.
– People who are more likely to get injured buy insurance coverage.

83
 – Borrowers who are not likely to pay debt are more likely to borrow
if there is no screening of borrowers (NINJA).
– Issuers of MBSs may securitize bad loans and sell MBSs as being
safe.

Difference between Moral Hazard and Adverse

Selection
• Moral Hazard occurs after the transaction occurs.

• Adverse Selection occurs before the transaction occurs.

Concept Relevant in the Financial Crisis

Leverage
• DEFINITION: Ratio of assets to equity.

• Remeber: A = E + L (assets equal equity + liabilities)

• If leverage is high: small changes in assents will be large relative to

equity.

• Example

– Leverage=10, assets depreciate by 10%- what are total losses?

A
= 10
E

A
= 10%
A

A A A
= ⇤ = 10 ⇤ 10% = 100%
E A E

84
Part XI
Financial Crisis and the Great
Recession
• Tranquil economic times lead to excessive risk-taking.

• This leads to a collapse of financial intermediaries.

• Borrowers don’t have access to funds and thus cut down spending.

Debt-Deflation Spiral (I. Fisher)

• Accumulation of debt in the economy in normal times.

• At some point this leads to a point in which debt is liquidated (bor-

rowers need to reduce their debt burden).

• They sell assets to pay back debt.

• Preces of assets fall.

• Agents become even more indebted (and thus need to sell even more
assets).

• Why does this matter?

– Debt deflation spiral leads to rellocation of wealth from debtors

to lenders.
– If marginal propensities to consume (MPC) are not different, this
should not matter.
– However, debtors generally have higher marginal propensities to
spend than lenders. Debt-deflation spiral in this case, will ruin
their balance sheets and lower aggregate spending.

85
Beginning. The ’Great Moderation’
• Since 1980’s economic fluctuations much smaller.

• People believed macroeconomics has been thoroughly optimized, pre-

venting financial crises.

• This lead to people taking more risk, higher concentration of risk lead
to a collapse of the banking system.

Some Facts
• In the beginning of XXIst century, regulation and general sentiment
lead to expansion of SHADOW BANKING.

• Loans were made to subprime borrowers. This drove housing prices up,
making people more willing to borrow to buy a new home.

• When housing prices fell, borrowers defaulted on their loans and shadow
banking collapsed.

Shadow Banking System

• Non-banking financial intermidiaries that provide similar services to
banks. For example, credit card loans, home loans, student loans, etc.

– Examples:
∗ Hedge Funds
∗ Investment Banks

• Difference from traditional banks:

– No federal deposit insurance (subject to runs).

– No subject to prudential regulations (can take excessive risks).

• What can Shadow Banks do?

– Issue loans to people who cannot borrow from the banks (sub-
prime loans).

86
 – Securitize those loans and sell them in the form of mortgage backed
securities to pension funds, hedge funds, etc.
– Shadow banks can be very leverd institutions which make them
very vulnerable.

• Why the vulnerability of Shadow Banks?

– Subject to “runs”: Shadow banks have no deposit insurance.

– Very levered: subject to bankruptcy as a result of small fluctuca-
tions of asset value.

• Why does this all matter?

– 60% of total lending was in hands of shadow banking.

– When shadow banking went bankrupt, the economy lost a lot of
lending capacity.
∗ Less consumption and investment.

• Is there empirical eviednce that shadow banking system matters?

– Evidence that regions with higher level of household debt suffered

more through the recession.

87
Part XII
Problems
Multiple Choice
1) The fundamental identity of national income accounting implies
________.

A) Expenditure = Production + Income

B) Expenditure = Production = Income

C) Income =Expenditure - Production

D) Income =Expenditure/ Production

Solution: (B). Y = AD = Output

2) Nominal GDP =________ where the price level is the

________.

A) Price level ÷ Real GDP; GDP deflator

B) Price level × Real GDP; CPI

C) Price level ÷ Real GDP; CPI

D) Price level × Real GDP; GDP deflator

N ominal(GDP )
Solution: (D). GDPdef lator = Real(GDP )
⇤ 100

3) Please indicate which of the following arguments below are

TRUE. (Note there may be more than one. If none are true, write
“None”.)

A) the establishment survey counts a worker who holds two jobs

twice and the household survey does not

88
B) the establishment survey only counts employees of a company
and the household survey also counts the self employed

C) the establishment survey covers more workers than the household

survey

Solution: (A) and (B).

4) (3 pts) Since 1996, the “official” real GDP measure has been
calculated using the

A. Laspeyres Index

B. Paasche Index

C. Chain Index

Solution: (C).

5) The classical view believes that ________.

A) economies move slowly to their long run equilibrium levels

B) a rise in the quantity of money leads to increases in saving and

investment

C) a rise in the quantity of money has no impact on real economic

activity

D) wages and prices are sticky

E) none of the above

Solution: (C). Look at the classical SRAS curve.

89
6) Which of the following statements are FALSE? (Note: There
may be more than one false statement. If all are true, write
“None”).

A) For the IS curve, an increase in the real interest rate constitutes

an upward movement along the curve

B) For the IS curve, an increase in autonomous aggregate consump-

tion constitutes a downward movement along the curve

C) For the IS curve, an increase in taxes constitutes a rightward shift

of the curve

D) The IS curve traces out the points at which the goods market is
in equilibrium

E) The IS curves tells us that as the real interest rate rises planned
expenditures go down leading to increases in savings that satisfy
the goods market equilibrium

Solution: (A) and (E).

7) When the Fed buys government securities in the open market,

the money supply ________ because ________.

A) decreases; banks lose liquidity, they make fewer loans and check-
ing account deposits decrease

B) increases; banks gain liquidity, they make more loans and check-
ing account deposits increase

C) increases; banks lose liquidity, they make more loans and checking
account deposits increase

D) decreases; banks gain liquidity, they make fewer loans and check-
ing account deposits decrease

Solution: (C). Look at the classical SRAS curve.

90
8) The impact of a change in taxes on income is likely to be less
than the effect resulting from a change in government spending
since ________.

A) the federal government typically operates in a deficit situation.

B) exports and imports can only assume positive values, but net
exports can be positive or negative.

C) changes in the supply of money will be necessary if government

spending is increased.

D) changes in taxes exert an indirect impact on total spending through

changes in consumption.

Solution: (D).

91
Look at the Figure:

9) On figure 1 above, suppose the labor market is in equilibrium

at point 2, then the demand curve shifts down to the position
shown on the graph. If the real wage has not changed, then the
horizontal distance between points ________ measures the un-
employment that results.
A) 2&4
B) 2&1
C) 3&4
D) 6&4

Solution: (B).

10) On the modern Phillips curve, the beginning of a recession is

shown by ________.
A) an upward movement along the Phillips curve to a higher inflation
rate
B) an upward shift of the Phillips curve leading to higher inflation
rates for any unemployment rate
C) a downward shift of the Phillips curve leading to lower inflation
rates for any unemployment rate
D) a downward movement along the Phillips curve to higher unem-
ployment rates

92
 Solution: (D).

Short Answer
11) (5 points) Given the accelerationist Phillips curve ⇡ = 0.3(U
6) + ⇢, suppose that inflation in the preceding period was 3 percent,
unemployment is 7 percent, and there is no price shock. The cur-
rent inflation rate is ________.

Solution:

U =7

) ⇡= 0.3(7 6)

) ⇡t 3= 0.3

) ⇡t = 2.7

12) (5 pts) If the GDP Gap is -2% , real potential GDP is growing
at 2%/year, and real GDP grows at 3%/year, how many years will
it will take for real GDP to equal real potential GDP?

Solution:

Yt YP = 0.02

Yt = Y t 1 e g Y t

YtP = YtP 1 egY P t

gY P =0.02

93
 gYt =0.03

Recall that:

ln( YYtp 1 )
t 1
t=
gY P gY

ln(.98)
t=
0.02 0.03

0.02
)t= = 2 years.
0.01

94
 Autonomous Component Interest Rate Sensitivity Parameter
Consumption (C) 2 0.5
Planned Investment (I P ) 3 0.3
Government (G) 1.45 N/A
Net Exports (N X) 1 0.15
Taxes (T x) 1.6 N/A
MP C 0.75 N/A

Table 1:

13) (10 points) Using the values in Table 1 and the equations on the
right, what is the equation for the IS curve?

Solution: Use the IS curve formula:

(C0 M P C ⇤ T + I0 + G + N X0 ) (I1 + C1 + N X1 )r
Y =
1 MP C 1 MP C
The IS Curve is:
2 + 3 + 1.45 0.75 ⇤ 1.6 + 1 (0.5 + 0.3 + 0.15)
Y = r
1 0.75 1 0.75

95
14) (10 points) Adaptive Expectation Mechanics. In figure 2, sup-
pose point G is on the short-run aggregate supply curve p = 2
+ 2∗(Y - 23) and aggregate demand curve Y = 30 - 0.5p. Solve
for equilibrium Y and ⇡. Then using this information + the as-
sumption that inflation expectations are adaptive, then calculate
equilibrium Y and ⇡for the next period. [Show your work.]

Solution:

AS : ⇡ = 2 + 2(Y 23)

AD : Y = 30 0.5⇡

At equilibrium, AS = AD:

() ⇡ = 2 + 2Y ⇤ 46 = 60 2Y ⇤ ) Y ⇤ = 26

() ⇡ ⇤ = 2 ⇤ 26 44 = 8

Assume adaptive expectations, that is, ⇡t+1

e
= ⇡t⇤
Assume the model
⇡t = ⇡te + (Yt −Yp )
So, if ⇡te = 8

⇡t = 8 + 2(Yt −23)

At equilibrium (use the same AD curve):

() ⇡t+1 = 8 + 2(30 0.5⇡t+1 ) 46

) ⇡t+1 = 60 ⇡t+1 38 ) 2⇡t+1 = 22

⇤
) ⇡t+1 = 11

⇤
Yt+1 = 30 0.5 ⇤ 11 = 24.5

96
15) The IS curve is Y = 20 - 1.5r, and the aggregate demand curve
is Y = 15.5 - 0.3p.

a) What is the equation for the MP curve?

Solution:

15.5 0.3⇡ = 20 1.5(r0 ⇡)

) 15.5 0.3⇡ = 20 1.5r0 + 1.5 ⇡

=) 15.5 = 20 1.5r0 ) r0 = 3

=) 0.3⇡ = 1.5 ⇡ =) = 0.2

So, the MP curve is:

r=3 0.2⇡

b) What is p when r is 7 percent?

Solution:

7=3 0.2⇡

)⇡= 20

97