Economics 214: MACRO INTRODUCTION

Whats macroeconomics about

o Study of society as a whole
o Why we have unemployment, causes of recessions, effects of a budget deficit, etc
o Need a method to understand the macro-economy
o With a strong base we can start analysing other issues

We need a model
o Williamson builds model from micro foundations
o Consumer and firm behaviour matters
o Models built to explain macroeconomic phenomena
o Important phenomena are long-run growth & business cycles
o Growth theory is about the LR growth rate of an economy
o SR and MR fluctuations analyses the trend (business cycle theory)
Growth theory vs business cycle theory
growth theory
 business cycle theory

- SA business cycle
How we got to where we are now

SOUTH AFRICA’S GDP PER CAPITA (1960-2015)

Getting economic data
o World Bank
o OECD
o International Financial Statistics, published by International Monetary Fund
o SA Reserve Bank
o Stats SA
Translation of amounts
Chapter 1: Introduction and Measurement issues
What is macroeconomics
o Models built to explain macroeconomic phenomena
o Important phenomena are long-run growth & business cycles
o Approach used here: build up macroeconomic analysis from microeconomic principles

Gross domestic product, economic growth & business cycles

o GDP: the quantity of goods & services produced within a country’s borders over a particular period
of time
o Time series of GDP separated into 2:
o Trend
o Business cycle components
à per capita real GDP: measure of average level of
income for a US resident (in this case)
!"
Gt =!"#$ – 1

lnYt – lnyt-1 = Gt

à slope is approximately equal to the growth rate per

capita of real GDP
o Fundamental macro questions:
o What causes sustained economic growth
o Could economic growth continue indefinitely, or is there some limit to growth
o Is there anything that governments can or should do to alter the rate of economic growth
o What causes business cycles
o Could the dramatic decreases & increases in economic growth that occurred during Great
Depression and WW2 be repeated?
o Should governments act to smooth business cycles

SA real GDp per capita

Figure 1.3: Natural logarithm of per capita real GDP & trend
deviations from smooth trend represent business
cycles
trend = blue
actual = black
Figure 1.4 percentage deviations from trend in per capita real GDP

Macroeconomic models
o Macroeconomic model captures essential features of world needed to analyse a particular
macroeconomic problem
o Should be simple, but they need not be realistic
o Assume consumers & firms optimise: do the best they can given the constraints they face
o Competitive equilibrium: assume that all goods are bought and sold on markets in which consumers
and firms are price takers, they behave as if their actions have no effect on market prices
o Equilibrium is reached when: market prices are such that quantity of each good offered for
sale (quantity supplied) is equal to quantity that economic agents want to buy (quantity
demanded) in each market
Basic structures of macroeconomic model
o Consumers & firms
o Set of goods that consumers consume
o Consumers’ preferences
o Production technology
o Resources available

Microeconomic principles
o Build macroeconomic principles on sound microeconomic principles
o Macro is sum of micro decisions

Disagreement in macroeconomics
o Old vs new Keynesian model:
o Old: wages & prices are sticky in short run, and don’t change sufficiently quickly to yield
efficient outcomes. Government intervention through monetary & fiscal policy can correct the
inefficiencies that exist in markets
o Real business cycle theory: government policy aimed at smoothing business cycles is at best
ineffective & at worst detrimental to economy’s performance
 o Coordination failures: economy can be stuck in bad equilibrium because economic agents are
self-fulfillingly pessimistic
o New Keynesian models: include sticky wages & prices, but use microeconomic tools that all
modern economists use

What do we learn from macroeconomic analysis?

o What is produced & consumed in the economy is determined jointly by the economy’s productive
capacity & the preferences of consumers
o In free market economies, strong forces tend to produce socially efficient economic outcomes
o Unemployment is painful for individuals, but is a necessary evil in modern economics
o Improvements in a country’s standard of living are brought about in the long run by technological
progress
o A tax cut is not a free lunch
o Credit markets, banks play key roles in the macroeconomy
o What consumers & firms anticipate for the future has an important bearing on current
macroeconomic events
o Money takes many forms & society is much better off with it than without it, once we have it
however, changing its quantity ultimately doesn’t matter
o Business cycles are similar, but they can have many causes
o Countries gain from trading goods & assets with each other, but trade is also a source of shocks
to the domestic economy
o In the long run, inflation is caused by growth in the money supply
o If there is a short-run tradeoff between output & inflation, that has very different implications
relative to the relationship between nominal interest rates & inflation

Understanding recent and current macroeconomic events

Aggregate productivity
!
o A measure of productivity in aggregate economy: average labour productivity: %
o Y = aggregate output
o N = employment
o Can measure aggregate productivity as total quantity of output produced per worker
o Growth in aggregate productivity is what determines growth in living standards in the long run
slope denotes the growth rate in average labour
productivity
average labour productivity: quantity of aggregate
output produced per worker
high growth rate: 1950s & 1960s
low growth rate: 1970-1980 & 2010-2015
unemployment and vacancies
o Interest in what explains the unemployment & what reasons for fluctuations in unemployment over
time
unemployment rate is determined by productivity, the
generosity of government-provided unemployment
insurance & matching efficiency

search model of unemployment suggests shifting of

Beveridge curve could be due to mismatch in labour
market
mismatch could result from difference between skills firms
want & what would-be workers possess, or because job
vacancies are not in same geographical regions where
unemployed reside

taxes, government spending & the government deficit

taxes = tax revenue
government spending by all levels of government (federal,
state & local) as % of total GDP
increased government activity in general causes a crowding
out of private economic activity

when gov surplus is negative = government deficit

Inflation
o The rate of change in average levels of prices (price level)
inflation rate shown as the percentage rate of increase
in the consumer price index (CPI)
high inflation is economically costly

Interest rates
o Interest rates affect many private economic decisions, like how much consumers decide to borrow
and lend & decisions of firms concerning how much to invest in new PPE
nominal interest rate & inflation rate are positively related
inflation rate tracts the nominal interest rate
economic decisions based on real rather than nominal
interest rates = nominal interest rate – expected rate of
inflation

Fisherian theory: a central bank conducts monetary policy

by targeting nominal interest rate – best way to increase
inflation is to increase nominal interest rate
Business cycles
business cycles: deviations from trend in aggregate
economic acitivity

Credit markets and the financial crisis

o Financial crisis and subsequent recession in 2008-2009 – unexpected, and caused
macroeconomists to revise their thinking concerning importance of credit markets, banking and
financial relationships for aggregate economic activity
o Credit markets frictions or imperfections acct to amplify shocks in economy:
o Asymmetric information: a situation where the economic actors on one side of a market have
more info than economic actors on other side
o Limited commitment: a borrowers lack of incentive to repay in the credit market – institutions
attempt to solve this by requiring a borrower to post collateral

Current account surplus

current account surplus = net esports – net factor
payments
Econ 214: chapter 2 – measurement
Learning objectives
1. Construct measures of GDP using the product approach, expenditure approach, and the income
approach
2. State importance of each expenditure component of GDP, & issues associated with measuring
each
3. Construct real & nominal GDP, and price indices, from data on quantities and prices in different
years
4. State the key difficulties in measuring GDP and the price level
5. State the accounting relationships among savings & income in the private and public sectors &
explain the importance of these relationships for wealth accumulation
6. Construct key labour market measures from the household survey data

Measuring GDP: the national Income and product accounts (NIPA)

o GDP measured using: product approach, expenditure approach & income approach
National income accounting example
o Fictional island economy
o Coconut producer, restaurant, consumer, government
Table 2.1 coconut producer

In this market: coconut is intermediate good, and a final consumption good

Calculate after tax profits = total revenue – interest – cost of intermediate inputs – taxes
Table 2.2 restaurant

From the 2.1 & 2.2: the after tax profits can be calculated
Table 2.3 after tax profits
after tax profits from the producers in this
economy
then take government into account, provide for national defence in this economy:
table 2.4: government
The product approach to measuring GDP
o Also called the value-added approach
o Main principle: sum of value added to goods & services across all productive units in the economy
o Add value of all goods & services produced in the economy and subtract value of all intermediate
goods used in production to obtain total value added
Table 2.5 consumers Table 2.6 GDP using product approach

Coconuts: value added = total revenue (no intermediate goods used in production)
Restaurant: value added = total revenue – cost of coconuts (intermediate good)
Government: value added = only input to production was labour

Expenditure approach
o Calculate GDP as total spending on all final goods & services production in the economy
o GDP = C + I + G + NX
o C = consumption expenditure
o I = investment expenditure
o G = government expenditure
o NX = net exports (exports – imports)
Table 2.7 GDP using the expenditure approach

Income approach
o Add up all the income received by economic agents contributing to production
o Income includes profit made by firms
o In the NIPA: income includes compensation of employees, proprietor’s income, rental income,
corporate profits, net interest, indirect business taxes, depreciation
o Aggregate income = aggregate expenditure (C + I + G + NX)
Table 2.8 GDP using the income approach
An example with inventory investment
o Any goods that are produced during current period but are not consumed – finished goods, goods
in process and raw materials
o Continue with example: produce 13 million coconuts but 3 million are not sold but stored as
inventory:
o Value added: add the extra 6 million to total value of coconuts produced – use market price
of coconuts sold in current year ($2)
o Expenditure: I = 6 million (just gets added)
o Income: add 6 million to coconut producer’s profits – an addition to firm’s assets

An example with international trade

o Alter example: suppose 2 million coconuts imported at 2$ each, in addition to domestic coconut
producer, restaurant still sells $30 million
o Value-added: restaurant: food produced ($30 million) minus value of intermediate goods ($16
million, includes cost of imported coconuts), total GDP = $39,5 million
o Expenditure: C = $8 million (consumption by consumers) + $30 million (restaurant service
consumption). Imports = $4 million SO NX = -4 million. New GDP of $39,5 million
o Income: change in after tax profits of restaurant – reduced by $4 million. New GDP = $39,5
million

Gross national product (GNP)

o GNP = GDP + NFP (net factor payments)
o NFP is larger in countries where a large fraction of national productive capacity is foreign
owned

What does GDP leave out?

o Issues with GDP as a measure of economic welfare
o Aggregate GDP doesn’t take into account how income is distributed among individuals – if one
individual has all income and rest have none, average level of economic welfare will be low
o GDP leaves out non-market activity – such as work in the home (eg: if people eat a restaurant
and not at home GDP rises, because now more services provided than before)
o Issues with GDP as a measure of aggregate output
o Economic activities in the underground economy (trade in illegal drugs, or exchange of money
for babysitting services for cash) – goes underground to avoid legal penalties and tax
o How government expenditures are counted – most of what gov produces not sold at market
prices – solution is to value gov expenditure at cost

The components of aggregate expenditure

Table 2.9 GDP for 2015
Consumption
o Largest expenditure component
o Expenditure on consumer goods and services during the current period, and components are
durable goods, nondurable goods and services
Investment
o Expenditure on goods that are produced during current period, but not consumed in current
period
o Fixed investment: production of capital such as PPE and housing
o Non-residential: plant, equipment, software that make up. Capital stock for for producing goods
& services
o Residential: housing
o Inventory investment: goods essentially put into storage
Net exports
o Exports – imports
o When imports are larger than exports: trade deficit
Government expenditures
o Expenditure by federal, state and local governments on final goods & services
o Federal defence spending, federal non-defence spending & state and local spending
o Does not include transfers

Nominal and real GDP and price indices

o Price index: weighted average of a set of observed prices that gives a measure of the price level
o Price indices: allow us to measure the inflation rate – the rate of change in the price level
o A measure of the inflation rate allows us to determine how much of an increase in GDP is nominal
and how much is real
Real GDP

o GDP1 = (1 x 50) + (0,8 x 100) = $130

o GDP2 = (1,25 x 80) + (1,6 x 120) = $292
!"#$
o % increase in GDP = (!"#% − 1) x 100% = 125%
o Need to find out how much is accredited to inflation:
o RGDP OF 2: take year 2 quantity x year 1 price = $176 (with year 1 as base year)
o Ratio of real GDP in year 2 to year 1 = g1 = 176/130 = 1.354 (so a 35,4% increase in real GDP)
o Base year choice matters in the answer
CHAIN WEIGHTING scheme:
o Fisher index is used
o Gc = $𝑔1 𝑋 𝑔2
o So multiply rate using the different base
years

Measure of the price level

o 2 measures: Implicit GDP price deflator & Consumer Price index
&'()&*+ !"#
o Implicit GDP price deflator = 𝑋 100
-.*+ !"#
/'01 '2 3*0. 4.*- 56*&1)1).0 *1 /6--.&1 7-)/.0
o Current year CPI = 𝑋 100
/'01 '2 3*0. 4.*- 56*&1)1).0 *1 3*0. 4.*- 7-)/.0

Table 2.11 implicit GDP price deflators

Measures are broadly similar but at

times can be substantial differences

CPI increases by a factor of 10,97 while

GDP deflator increase by a factor of
8,77
Problems in measuring real GDP and price level
o Relative prices of goods change over time – a problem for CPI measurement
o Quality of goods and services changes over time
o New goods and services are introduced and some goods and services become obsolete

Savings, wealth and capital

o Flow vs stocks:
o Flow: rate per unit time
o Stock: quantity in existence of some object at a point in time
o Private disposable income = Yd = Y + NFP + TR + INT – T
o Y = GDP
o NFP = Net Factor Payments
o TR = transfers from government to private sector
o INT = interest on government debt
o T = taxes
o Private sector saving = Sp = Yd – C = Y + NFP + TR + INT – T – C
o Government saving = -government deficit = Sg = T – TR – INT – G
o National saving = private saving + government saving = S = Sp + Sg = Y + NFP – C – G
o National saving is reflected in investment + CA surplus: S = I + NX + NFP = I + CA
o Current account surplus: a measure of the balance of trade in goods with the rest of the
world

Labour market measurement

o The Bereau of Labour Statistics monthly household survey divides the working-age population into
3 groups
o Employed
o Unemployed
o Not in labour force
o Labour force = employed + unemployed
3 key labour market measurements
89:;<= 98<:>?@A<B
o Unemployment Rate =
?C;@9= D@=E<
?C;@9= D@=E<
o Participation Rate =
F@=GH8I CI< >@>9?CJH@8
<:>?@A:<8J
o Employment/Population Ratio =
F@=GH8I CI< >@>9?CJH@8
Econ 214: chapter 3 – business cycle measurement
Regularities in GDP fluctuations
o Business cycles are fluctuations about trend in real GDP
o Turning points in deviations of real GDP from trend are peaks & troughs
o Persistent positive deviation from trend are booms, and persistent negative deviations from trend
are recessions
black curve: idealised path for real GDP over time
coloured line: growth trend in real GDP
max negative deviation from trend = trough
max positive deviation from trend = peak
amplitude: size of max deviation from trend
frequency: number of peaks that occur within a
years time
peaks & troughs = turning points

deviations from trend in real GDP are irregular

o Fluctuations in GDP about trend are quite choppy
o No regularity in amplitude of fluctuations in real GDP about trend
o No regularity in frequency of fluctuations in real GDP about trend
Though deviations from in trend in real GDP are persistent, which makes short term forecasting
relatively easy, above 3 features imply that longer term forecasting is difficult
o Choppiness of fluctuations make fluctuations hard to predict
o Lack of regularity in amplitude & frequency makes it difficult to predict severity and length of
recessions and booms
5 most recent recessions: 1974-1975, 1981-1982, 1990-
1991, 2001, 2008-2009
Comovement
o Definition: how aggregate economies variables move together over the business cycle
o Macroeconomic variables measured as time series
o Eg: 2 macroeconomic time series, transform by removing trends & let x & y denote percentage
deviations from trend in 2 time series (fig 3.3)
o Can look for positive or negative correlation
(a): positively correlated, when x is high, y tends
to be high as well (same for low)
(b): negatively correlated: when x is high y tends
to be low (and vice versa)

o Another method is a scatter plot: each point is an observation of x or y for a particular time period
o Correlation determined by the slope of a straight line that best fits points in scatter plot

Correlation with real GDP

o If deviations from trend in macroeconomic variable are positively
correlated, with the deviations from trend in real GDP, then that
variable is procyclical
o If deviations from trend in macroeconomic variable are negatively
correlated with deviations from trend in real GDP, then that
variable is countercyclical
o If a macroeconomic variable is neither of these – it is acyclical
Correlation coefficient
o Values between -1 & 1
o 1 = perfectly positively correlated
o -1 = perfectly negatively correlated
o 0 = uncorrelated
Leading and lagging variables
o Leading variable: if a macroeconomic variable tends to
aid in predicting the future path of real GDP
o Lagging variable: if real GDP helps to predict the future
path of the macroeconomic variable
o Coincident variable: one that neither lags nor leads real
GDP

Measure of cyclical variability: standard deviation

o Some macroeconomic variables are volatile, while others behave in a smooth way relative to trend

Behaviour of key macroeconomic variables

Components of GDP: consumption & investment
Consumption
o highly positively correlated – consumption
tends to be above trend when GDP is
above trend (& same for below)
o these 2 time series move closely
together
o correlation coefficient = 0,77 – procyclical
o no discernible lead or lag relationship –
coincident variable
o consumption less variable than GDP –
standard deviations from trend tend to be
smaller than those in GDP – consumption
is smoother than GDP
investment
o correlation coefficient = 0,8 – procyclical
o no tendency to lead or lag – coincident variable
(residential investment & inventory investment
do however tend to lead business cycle)
o investment more variable than real GDP – std
dev = 301% - investment is volatile
the price level and inflation
o A.W Phillips observed that there was a negative relationship between the rate of change in money
wages & unemployment rate – Phillips Curve
o Take unemployment rate to be measure of aggregate economic activity (countercyclical) –
Phillips curve captures a positive relationship between rate of change in money prices or
wages
correlation coefficient = -0.17 – negative, weak
correlation (represents a reverse Phillips curve) –
price level tends to be high when price level is
low

correlation coefficient = 0,3 - conforms to

conventional view of Phillips curve

Labour market variables – employment, real wage, average labour productivity

employment
deviations from trend in employment closely track
those in real GDP – procyclical, turning points in
employment closely lag real GDP
correlation coefficient = 0,78 – positively correlated
employment is less variable than GDP – std dev =
65%

real wage
o The purchasing power of wage earned per hour worked – measured as average money wage
for all workers, divided by price level
o Difficult to measure relationship between real wage & real GDP – no strong evidence whether real
wage is a leading or lagging variable
 Average labour productivity
o Y/N
o Y = aggregate output (GDP)
o N = total labour input (total employment)
average labour productivity = procyclical
correlation coefficient = 0,77
APL less volatile than GDP
Std dev = 63%
No apparent tendency for APL to lead or lag
APL coincident variable

Seasonal adjustment
o Essentially all the data that macroeconomists look at is
seasonally adjusted. Statisticians take account of the
regular seasonal fluctuations in the data and try to take
them out in a consistent way. The figure shows the
difference between the unadjusted and adjusted data
for the unemployment rate, to show the amount of
seasonal variation that is taken out. Sometimes there
are issues with seasonal adjustment – a problem is
that seasonal adjustment is purely statistical and takes
no account of economic factors.

Comovement summary
Econ 214 – chapter 4: consumer & firm behaviour: the work-leisure decision &
profit maximisation
Few important things to remember
o Construct model – analysis follows
o Simplified one period model
o Implies consumers & firms make static decisions
o Dynamic: make choices over more than one period
o First consumer behaviour, thereafter firms. Micro approach
o In a barter economy (for now)

The representative consumer

o Acts as stand in for all consumers of economy
o Consumer’s preferences over consumption & leisure are represented by indifference curves
o Consumer’s budget constraint
o Consumer’s optimisation problem: making themselves as well off as possible given their budget
constraint
o How does consumer respond to:
o An increase in non-wage income
o An increase in the market real wage rate

The representative consumer’s preferences (indifference curves)

o Indifference curve slopes downward (more is preferred to less)
o IC is convex (consumer has a preference for diversity in their consumption bundle)
o Utility function: U(C,I)
o More is better than less
o Diversity is preferred
o Consumption & leisure are normal goods (quantity of good increases when income increases)
o Inferior good: consumer purchases less of good as income increases
o Indifference curve: connects a set of points, with these points representing consumption bundles
among which the consumer is indifferent
o Indifference map: a family of indifference curves
U(C1,l1) = U(C2,l2)
Higher IC represent higher welfare for consumer
 Marginal rate of substitution: of leisure for consumption
(MRSl,C) – it is –(slope of indifference curve)

The consumer’s time constraint

The representative consumer’s budget constraint

o Assume consumer behaves competitively – price taker
o Consumption = total wage income + dividend income – taxes

o
o WNs + π = Y
o T = taxes
o Ns = h – l (time constraint = l + Ns = h)
o Ns = time spent working (labour supply)
o l = leisure time
o h = hours of time available
budget constraint accounting for time constraint
𝐶 = 𝑤 (ℎ − 𝑙 ) + 𝜋 − 𝑇
The consumer’s real disposable income
o wage income + dividend income – taxes
o w = real wage
o T = lump sum tax (does not depend in any way on quantity of taxable goods we buy, income
taxes depend on how much we work)
Rewriting the budget constraint
o 𝐶 + 𝑤𝑙 = 𝑤ℎ + 𝜋 − 𝑇
o Right hand side: implicit quantity of real disposable income the consumer has
o Left hand side: implicit expenditure on 2 goods – consumption & leisure
o 𝐶 = −𝑤𝑙 + 𝑤ℎ + 𝜋 − 𝑇
o Slope-intercept form
o Slope of budget constraint is -w
o Vertical intercept is wh + 𝜋 – T
!"#
o Horizontal intercept = h + $
 taxes are greater than dividend income

taxes less than dividend income

kink: as consumer can work zero hours, but still earn
positive income = dividend income

consumer optimisation
o Consumer choose consumption bundle this on their highest indifference curve, while satisfying
their budget constraint
o Consumer is rational
o Optimisation implies: the MRS of leisure for consumption = real wage
Point H = optimal consumption bundle – budget line tangent to
indifference curve

Situation cannot happen – no workers, nothing happens at

firm and there is no production – consumer would have
nothing to consume
The assumption that the consumer always wishes to
consume some of both goods prevents consumer choosing
either point A or B
Real dividends or taxes change for the consumer
o Assume that consumption & leisure are both normal goods
o An increase in dividends or a decrease in taxes will then cause consumer to increase
consumption & reduce quantity of labour supplied (increase leisure)
pure income effect on consumer’s choices: prices
remain same (w remains constant) while disposable
income increases
vertical intercept = wh + 𝜋 – T
shift budget constraint outwards
assumption that consumption & leisure are normal
goods implies that high nonwage disposable income
increases consumption & reduces labour supply
increase in income: AF, but increase in consumption = C2 – C1 – less than AF
as nonwage income increases wage income decreases because consumer is working less
reduction in income does not completely offset the increase in nonwage income, as consumption
has to increase because it’s a normal good

the representative consumer & changes in the real wage: income and
substitution effects
an increase in the market real wage rate
o Substitution effect: price of leisure rises, so consumer substitutes from leisure to consumption
o Income effect: consumer is effectively more wealthy and, since both goods are normal,
consumption increase & leisure increases
o Conclusion: consumption must rise, but leisure may rise or fall
O to H – pure income effect (real wage stays same as
budget constraint shifts out, and nonwage income
increases)
F to O – pure substitution effect (movement along IC in
response to increase in real wage)
 tells us how much labour the representative consumer
wishes to supply given any real wage
Ns(w) = h – l(w) à Labour supply curve
L(w) = a function that tells us how much leisure
consumer wishes to consume, given the real wage

Shifts left when dividend income rises or taxes fall, as a

result of positive income effect on leisure for consumer

Consumption and leisure as perfect

compliments:
o Always wishes to consume these goods in fixed
proportions
o C/l = constant OR C = al

**perfect substitutes: MRS is constant & indifference

curves are downward-sloping straight lines
The representative firm
o The production function
o Profit maximisation & labour demand
The firm’s production function

o Z = total factor productivity – captures degree of sophistication of production – increase in

z, makes both K & Nd more productive, higher z implies more output can be produce
o Y = output of consumption goods
o K = quantity of capital input in production process
o Nd = variable factor of production
o Marginal product: of a factor of production is the additional output that can be produced with one
additional unit of that factor input, holding constant the quantities of other factor inputs
Properties of firm’s production function
o Constant returns to scale
o Output increases with increases in either the labour input or capital input
o Marginal product of labour decreases as labour input increases
o Marginal product of capital decreases as capital input increases
o Marginal product of labour increase as quantity of capital input increases
MPN, given quantity of labour N*, is slope of
production function at point A – slope is the
additional unit of labour input when quantity of
labour is N* & quantity of capital is K*

MPK given, capital K* is slope of production

function at point A
o Increasing returns to scale: implies that large firms are more efficient than small firms
o Decreasing returns to scale: implies that small firms are more efficient than large firms
o Constant returns to scale: small firm just as efficient as large firm
Marginal product of labour declines as quantity of
labour used in production process increases

for an increase in quantity of capital, MP of labour

increases as well (shifts up)

The effect of a change in total factor productivity on the production function

2 important effects:
1. because more output can be produced given
capital & labour inputs when z increases, this shifts
production up

2. MP of labour increases when z increases –

reflected in fact that slope of production function
where z = z2 is higher than slope given in z=z1
Profit maximisation problem of representative firm
Profit maximisation
o When firm maximises profits, marginal product of labour = real wage
MPN = w
solow residual: a measure of total factor productivity & is
calculated here using a Cobb-Douglas production
function
measured total factor productivity has increased over
time & it also fluctuates about trend
%
Solow residual: 𝑧 = &! ()" )#$!

a = average share of capital in national income

Y = zF(K,Nd) – firm’s revenue

wNd firm’s variable cost
profits are different between revenue & variable cost
profit maximising point: MPN = w (distance AB)

firm hires labour up to point where MPN = w

Econ 214: chapter 5 – a closed-economy one period macro-economic model
Closed economy one-period macro model
o Representative consumer
o Representative firm
o Competitive equilibrium
o Experiments: what does model tell us are effects of changes in government spending & in total
factor productivity

Government
o Wishes to purchase a given quantity of consumption goods, G & finances these purchases by
taxing the representative consumer
o Government has special role in producing public goods – eg national defence
o In this model, assume government spending simply involves taking goods from private sector
o Output is produced in private sector & government purchases exogenous amount of G of this
output, while remainder is consumed by representative consumer
o Exogenous variable determined outside model, while endogenous variable is determined by model
itself
o Government must abide by government budget constraint: G = T
o Introducing government in this way allows us to study basic effects of fiscal policy, which is the
governments choices over its expenditures, taxes, transfers & borrowing
Competitive equilibrium
G = government spending
Z = total factor productivity
K = economy’s capital stock
C = consumption
Ns = labour supply
Nd = labour demand
T = taxes
Y = aggregate output
W = market real wage
o Representative consumer optimises given market prices
o Representative firm optimises given market prices
o Labour market clears
o Government budget constraint is satisfied or G = T
Competitive equilibrium
o A set of endogenous quantities & an endogenous real such that given the exogenous variable the
following is satisfied:
o Representative consumer: chooses C and Ns to make self well off as possible given w, T &
π (optimises given budget constraint)
o Representative firm: chooses Nd to maximise profits with maximised output Y = zF(K, Nd) &
maximised profit π = Y - wNd
o Market for labour clears at Ns = Nd
o Budget constraint satisfied G = T
Income expenditure identity
o In competitive equilibrium, income-expenditure identity is satisfied so: Y = C + G
*In a closed economy (no NX) and 1 period static (I=0)
Consumer’s budget constraint
o C = wNs + π – T
o Which becomes: C = wNs + Y – wNd – G
The production function
o Y = zF(K, N)
o Y= zF(K, h-l)
Figure 5.2 the production function and production possibilities frontier

Production function & output as a function of leisure – just inverted

o A useful concept is production possibilities frontier (PPF) for this economy
o There are 2 goods in this economy, consumption & leisure, and PPF describes possibilities for
producing consumption & leisure in economy, after government takes out G units of
consumption goods: C = Y – G
maximum production = Y*
slope of PPF = Marginal rate of transformation =
MPN & in equilibrium = -w

HF à PPF
Representative firm choose labour input to maxmise
profits in equilibrium where MPN = w
Line AD = slope = -w
Labour demand = h – l*
Produces: Y* = zF(K,h-l*) (from production function)
Maximised profit π* = zF(K,h-l*) – w(h-l*) (total revenue
– cost of hiring labour)
I1 (indifference curve) – must be tangent to AD (budget
constraint) – at point J: MRS = MRT = MPN
Key properties of a competitive equilibrium
o
o At point J on fig 5.3
o Also pareto efficient here

optimality
Key properties of a pareto optimum
o A competitive equilibrium is pareto optimal if there is no way to rearrange production or
reallocate goods so that someone is made better off without making someone else worse off
o In this model, competitive equilibrium & pareto optimum are identical

o
pareto optimum is the point that a social planner would
choose where representative consumer is as well off as
possible given the technology for producing consumption
goods using labour as an input. Here the pareto optimum is
B, where IC is tangent to PPF

First and second welfare theorems

o Apply to an macroeconomic model
o First welfare theorem: under certain conditions, a competitive equilibrium is pareto optimal
o Second welfare theorem: under certain conditions, a pareto optimum is a competitive equilbrium
Sources of social inefficiencies
o Competitive equilibrium may not be pareto optimal because of externalities (any activity for which
an individual firm or consumer does not take account of all associated costs & benefits), eg:
pollution (negative externality)
o Competitive equilibrium may not be pareto optimal because of distorting taxes (depends on
actions of person being taxed)
o Effective wage for consumer = w(1-t), when consumer optimises sets MRS = w(1-t)
o Firm optimises by setting MP = w
o Therefore, MRS < MP < MRT
o Firms may not be price takers: if it has monopoly power – can restrict output, raise prices &
increase profits

Working with the model: the effects of a change in government expenditure

o G increases
o Essentially a pure income effect
o C decreases, l (leisure) decreases: they are normal goods, given normal goods assumption, a
negative income effect from downward shift of PPF curve must reduce consumption and leisure
o Y increases, w falls: employment rises, and because of this quantity of output must rise (Y)
o With same quantity of capital, and increase in labour, total factor productivity held constant
output must rise
B is the new point of equilibrium
Negative income effects on C & l, employment
rises, while output (C+G) rises

World war II increase in G

o Very large increase in G
o Y increases, C decreases by a small amount
Working with the model: a change in total factor productivity (z)
o Increase in z: PPF shifts out & becomes stepper – income & sub effects are involved
o C increases, I may increase or decrease, Y increases, w increases
increases quantity of labour input & Marginal
product of labour for each quantity of labour input

Slope of PPF = -MPN

C increases from F to H
Leisure can increase or decrease – example
shows it stay the same
Increase in aggregate output (Y = C + G), G stays
same, C increases

A to D = substitution effect
- PPF3 = C = z2F(K,h-l) – G – C0 (artificial PPF)
- for consumption to increase & leisure to
decrease, so hours worked increases
- involves increase in MRS (IC gets steeper) –
movement along IC
D – B = income effect
- PPF2 = C = z2F(K,h-l) – G
- for both consumption & leisure to increase
The real wage, = MRS must be higher in equilibrium when z is higher
Total factor productivity and real GDP
deviations from trend in Solow residual closely track
deviations from trend in real GDP, as it is consistent with
real business cycle theory

government spending has fallen on trend from 1947-2015

as % of GDP

total government outlays have grown on trend from

1947-2015, relative to fig 5,12 this reflects growth in role of
transfers

A distorting tax on wage income, tax rate changes & Laffer curve
A simplified model with a proportional income tax
o Use model to study the incentive effects of income tax, and to derive the “Laffer curve”
Production function without capital
o Labour is only input, but there is still constant returns to scale (linear production function)
o Y = zN
Production possibilities frontier
o C = z(h-l) – G
o Maximum quantity of C is (zh – G) – when
leisure is 0

Consumer’s budget constraint

o C = 𝑤 (l − 𝑡)(ℎ − 𝑙) + π
Profits for the firm
o
o Z-w: profit firm makes for each unit of
labour input
o Choose Nd to make profits as large as
possible
o If z > w – firm earns positive profits, will hire
labour
o If z < w – firm earns negative profits, will
hire 0 units of labour
o If z = w – firm is indifferent and does not
care how much labour they hire
o Firm is infinitely elastic (as in fig 5.15)
Consumer’s budget constraint in equilibrium
o C = z(1-t)(h-l)
o DF = budget constraint
o AB = PPF
o Comp equilibrium – point H
o Pareto optimal – point E
Revenue for government given the tax rate t
o REV = tz(h-l(t))
o Z(h-l(t)) – tax base – value of quantity traded in the
market of the object being taxed, valued in terms of
consumption goods multiplied by real wage rate z
o Total tax revenue doesn’t only depend on tax rate
but also tax base
o If tax base doesn’t change when t increases, tax
revenue will increase – tax revenue will increase in
when tax rate increases
o Also possible for tax revenue to go down when t
increases – if l(t) increases sufficiently when t
increase – that declining tax base offsets effect of
increase in tax rate
o If G < REV* or if G > REV* - can be 2 possible equilibrium tax rates (as seen in fig 5,17)
point F: lower tax rate t1 from above
point H: higher tax rate t2
budget constraint less steep at t2
consumption is higher, quantity of labour supplied
higher, leisure lower & aggregate output higher
in lower tax rate equilibrium
point F on higher IC – consumer better off with
lower tax rate

a model of public goods: how large should the government be?

o To this point, we have assumed that government spending is to acquire goods that are thrown
away
o Economically, defense spending: defense may make us better off but it diverts resources from
other uses
o What if we allow for public goods – eg: parks, public transportation, health services – that provide
direct benefits to the private sector?
A model of public goods
o Representative consumer’s budget constraint: C + T = Y
o PPF: C = Y -G/q
o q = efficiency of government relative to private sector
o larger q = smaller drain in resources at margin, from converting private goods into public
goods
the optimal choice of government spending
o government chooses G to make representative consumer as well off as possible
o G chosen so that MRS of private for public goods = MRT
 choose quantity of G*, implies T = G*/q
points B & D – sub-optimal choices for government
competitive equilibrium – Point A (where indifference
curve for representative consumer is tangent to PPF –
which is pareto optimal
to arrive at pareto optimal: government needs to be able
to figure out representative consumer’s & to understand
its own technology for converting private to public goods
factors in determining G*: total GDP, Y, q, the relative
efficiency of government and the private sector, & consumer’s preferences over private and public
goods
what happens to optimal choice of G when Y increases
o Works like pure income effect
o Private consumption & government spending both increase
o Wealthier countries choose to have larger governments – but not clear whether G/Y increases
or decreases. Is G a luxury or inferior good?
when GDP increases from Y1 to Y2
PPF shifts outward & slope remains unchanged –
that is determined by q
Assuming public & private goods normal –
equilibrium shifts from A to B – government will
choose to increase spending
Positive income effect on both private & public
goods because of higher level of GDP – gov will
spend more on public goods
o Whether public goods increase as a fraction of GDP depends if they are luxury goods or not – if
luxury:
o If private sector economic agents wish to spend larger fractions of income supporting public
parks as their income increases, then size of government as % of GDP will grow as GDP
increases
o Other factors, as countries develop they acquire better technologies for collecting taxes –
making less costly to support government activity – reflected in q not Y
 effect of increase in q
PPF shifts right & becomes more flat
Income and sub effects here
A to D = substitution effect – reduces C & increases G
D to B = income effect – increases both C & G
G increase but C may increase or decrease

What happens if government becomes more efficient?

o q increases – can produce more G for a given input of private goods
o Income and substitution effects
o G increases but private consumption may increase or decrease
 Econ 214: chapter 9 – a 2 period model: the consumption-savings decision and
credit markets
Important concepts
o 2 time periods: current and future
o Real interest rate introduced: interest rate at which can borrow and lend (determines relative price of
c in future (c’) and c in present (c)
o Consumption smoothing
o G increase has real effects on macroeconomic activity… Ricardian equivalence theorem starting point
for thinking about sharing of tax burden
o Simplified model, but have shown consistent results with complicated models

A 2 period model of the economy

Consumers
Budget constraints: current-period
c+s=y–t
o Model of many consumers – representative consumer
o S > 0 = lender (buy bonds)
o S < 0 = borrower (sell bonds and get money for consumption goods)
o Bonds: assume consumers or government can issue bonds
Budget constraints: future-period
c’ = y’ – t’ + (1+r)s
o In future period, consumer has their future disposable income & interest earnings on savings
o All consumed, as consumer doesn’t live beyond future period
o Consumer treats real market rate r as given – price taker

! ! "# ! $ & !
1. Solve for s: s = '$(
! ! "# ! $ & !
2. Sub in current constraint: c + =y–t
'$(

Consumer’s lifetime budget constraint

!) # ! "& !
c+ = y – t + 1 '$(
'$(

o Left: PV of consumption
o Right: PV of disposable income
Consumer’s lifetime wealth
# ! "& !
we = y – t +
'$(

o What consumers have to spend on consumption

Simplified lifetime budget constraint
!)
c+ = we
'$(

slope intercept: y = mx + c
c’ = -(1+r)c + we(1+r)
quantities of current & future consumption consumer
can acquire given current & future incomes and taxes
E = endowment point – no borrowing or lending
BE: s ≥ 0
EA: s ≤ 0

The consumers preferences

o 3 properties:
o More is preferred to less
o Consumer likes diversity in consumption – diminishing MRS
o Current and future consumption are normal goods
slope = -MRS of current consumption for future
consumption

Consumer optimization
o Marginal condition that holds when consumer is optimizing:
MRSc,c’ = 1 + r
o MRS = to relative price of current consumption in terms of future consumption
 saves, and then consumes more than future income
in the future

borrowing from future income, spending more than

what you have now

an increase in current-period income

o Current & future income increases
o Saving increases
o Consumer acts to smooth consumption over time
Initial endowment: E1, chooses to consume at A
(initially a lender)
Y2 – y1 = change in lifetime wealth (we) –
determined by move from E1 to E2
New endowment: E2, chooses to consume at B
Consumption changes from c1 to c2 & c’1 to c’2

Observed consumption-smoothing behaviour

o Aggregate consumption of non-durables & services is smooth relative to aggregate income, but the
consumption of durables is more volatile than income
o This is because durables consumption is economically more like investment than consumption
 Consumption of nondurables and services & real GDP
fairly close to pure flow of consumption services,
much smoother than real GDP, reflecting motive of
consumers to smooth consumption relative to
income

2 possible explanations for excess variability in consumption

o Imperfections in credit market, in reality consumers have less ability to smooth consumption than they
do in theory – this would make model considerably more complicated
o When all consumers are trying to smooth consumption in same way simultaneously, this changes
market prices

An increase in future income for the consumer

o Aggregate consumption of non-durables and services is smooth relative to aggregate income, but
consumption of durables is more volatile than income
o This is because durables consumption is economically more like investment than consumption
we1 to we2, shifting budget constraint right &
leaving slope unchanged
initially point A – chooses B after the shift
future consumption increases by less than
increase in future income, savings decreases &
current consumption increases
temporary and permanent increases in income
o As a permanent increase in income will have a larger effect on lifetime wealth than a temporary
increase, there will be a larger effect in current consumption
o A consumer will tend to save most of a purely temporary income increase
temporary: budget constraint shift from AB to DE
– optimal consumption bundle H to J
permanent: AB to FG – optimal consumption H
to K

an increase in the real interest rate (r)

budget constraint becomes steeper and pivots
around endowment point (E)
pivot is because consumer must always be able
to consume their disposable income in each
period no matter what interest rate is

An increase in the market real interest rate

o An increase in the market real interest rate decreases the relative price of future consumption goods
in terms of current consumption goods – this has income & sub effects for consumer
sub effect: movement from A to D
income effect: D to B
current consumption and saving may rise or fall but
future consumption increases
 sub effect: A to D
income effect: D to B
current consumption decreases while saving increases &
future consumption may rise or fall

o For both lenders & borrowers, there is an intertemporal substitution effect of an increase in real
interest rate
o Higher real interest rate lowers relative price of future consumption in terms of current consumption
– leads to sub effect of future consumption for current consumption & therefore and increase in
savings

Perfect compliments example

o With perfect complements, ratio of future consumption to current consumption is constant:
o c’ = ac
o consumer’s budget constraint must hold
!!
o c+ = we
'$(
o can solve explicitly for current & future consumption

o
optimal point at D
effects of an increase in r on c and c’ depends
only on whether consumer is lender or borrower
– there are no sub effects when preferences
have perfect compliments property
government budget constraints
current-period
G=T+B
o B = number of bonds issued in current period by government
o T = aggregate quantity of taxes collected by government in current period
o G = consumption goods in current period
Future-period
G’ + (1+r)B = T’
Present value

o Government present value of purchases must equal present value of taxes

Competitive equilibrium
o 3 conditions must hold:
o Each consumer chooses first & second period consumption & savings optimally given interest
rate r
o Government present-value budget constraint holds
o Credit market clears
Credit market equilibrium condition
o Total private savings = quantity of government bonds issued in current period
Sp = B
Income expenditure identity
o Credit market equilibrium implies income expenditure identity holds
Y=C+G

The Ricardian equivalence theorem

o Illustrated algebraically, numerically & in 2 graphs
Key equation
o Consumer’s lifetime tax burden is equal to consumer’s share of the present value of government
spending – the timing of taxation doesn’t matter for consumer

o Then sub in consumer’s budget constraint – taxes don’t matter in equilibrium for consumer’s lifetime
wealth, just present value of government spending
 current tax cut leaves consumer’s budget
constraint unchanged – optimal bundle remains at
A
endowment point goes from E1 to E2 – savings
increase by amount of current tax cut

Ricardian equivalence and credit market equilibrium

curve denotes private supply of credit
upward sloping – assumption that sub effects
outweigh income effects
with decrease in current taxes, gov debt goes
from B1 to B2 – credit supply curve shifts to right
by same amount
equilibrium real interest rate unchanged & private
saving increases by amount equal to reduction in
government saving

why might Ricardian equivalence fail in practice

o Redistributional effects of taxes: tax changes affect the wealth of different consumers differently
o Intergenerational redistribution: debt issued by government today is paid off by future generations
o Taxes are not lump sum, they cause distortions
o Credit market frictions