Econ Course 202 Academy Say

LearningObjectives
Studythedeterminantsofthedemandforgoods
Showhowequilibriumoutputisdeterminedinthegoodsmarket
Consideranalternativewayofthinkingabouttheequilibrium,based
ontheequalityofsavingandinvestment
Takeafirstlookathowfiscalpolicyaffectsequilibriumoutput
InteractionamongDemand,Production,andIncome
InteractionamongDemand,Production,andIncome
Changesinthedemand forgoodsleadtochangesinproduction
Changesinproductionleadtochangesinincome
Changesinincome resultinchangesinthedemand forgoods

Intheshortrun,yeartoyearmovementsinoutput areprimarily
drivenbydemand.
Changesindemandcanleadtoadecrease inoutput (a recession)or
anincrease inoutput (anexpansion).
TheCompositionofGDP
Tounderstandwhatdeterminesthedemandforgoods,itmakes
sensetodecomposeaggregateoutput(GDP)fromthepointofview
ofdifferentgoodsbeingproduced,andfromthepointofviewof
differentbuyersforthesegoods.
Consumption,denotedbytheletter ,representsthegoodsand
servicespurchasedbyconsumers.Consumptionisbythelargest
componentofGDP.
Inthefirstquarterof2016,itaccountsfor68.7% ofGDP.
TheCompositionofGDP
Investment,denotedbytheletter ,issometimescalledfixed
investment todistinguishitfrominventory investment.
Investmentisthesumofnonresidential investment (thepurchaseby
firmsofnewplantsornewmachines)andresidential investment
(thepurchasebypeopleofnew housesorapartments).
Thedecisionsbehindthemhavemoreincommonthanmightfirst
appear.Firmsbuymachinesorplantstoproduceoutputinthefuture.
Peoplebuyhousesorapartmentstogethousingservicesinthefuture.
Inbothcases,thedecisiontobuydependsontheservicesthesegoods
willyieldinthefuture,soitmakessensetotreatthemtogether.
TheCompositionofGDP:Investment
*Thepurchaseofland isnot countedaspartofGDP(landisnot
produced!!)
*Stock purchasesarenot countedaspartofGDP(stocktransactions
donot representproduction theyaresaving!)
Thereisadifferencebetweenfinancial andeconomic investment!!!!!
Thepurchaseofnewcapitalgoods,suchas(new)machines,(new)
buildings,or(new)housesisreferredtoasinvestmentby
economists.Thepurchaseofgold,orsharesofGoogle,orother
financialassetsisconsideredtobefinancial investmentby
economists.
TheCompositionofGDP
Governmentspending
representsthepurchaseofgoodsand
servicesbythefederal,state,andlocal government.Thegoodsrange
fromairplanetoofficeequipment.Theservicesincludeprovidedby
governmentemployees:Ineffect,thenationalincomeaccountstreat
governmentasbuyingtheservicesprovidedbygovernmentemployees
andthenprovidingtheseservicestothepublic,freeofcharge.
,like
Note that doesnotincludegovernment transfers
MedicareorSocialSecuritypayments,norinterest paymentsonthe
governmentdebt.Althoughtheseareclearlygovernment
expenditures,theyarenot purchasesofgoodsandservices.
Table3.1:TheCompositionofU.S.GDP,2016I
1
2
3
4
GDP
Consumption
Investment
Nonresidential
Residential
Government spending
Net exports
Exports
Imports
Billions of Dollars
18,221.1
12,511.0
2,935.5
2,275.9
659.6
3,213.8
-508.2
2170.9
2,679.1
Percent of GDP
100
68.7
16.1
12.5
3.6
17.6
-2.8
11.9
14.7
Inventory investment
69
0.4
TheCompositionofGDP
1+2+3:ThepurchasesofgoodsandservicesbyU.S.consumers,
U.S.firms,andtheU.S.government.
Netexports ortradebalance
betweenexportsandimports.
Exports imports

Exports imports
isthedifference
TheCompositionofGDP
Inanygivenyear,productionandsalesneednot beequal.
Someofthegoodsproducedinagivenyeararenot soldinthatyear,
butinlateryears.Andsomeofthegoodssoldinagivenyearmayhave
beenproducedinanearlieryear.
Inventoryinvestment isthedifferencebetweengoodsproducedand
goodssoldinagivenyear;thatis,
Inventoryinvestment=production sales.
Production =sales +inventory investment
Sales =production inventory investment
TheCompositionofGDP
Production sales
inventory investment firms accumulate inventories

Production sales
inventory investment firms inventories

Inventoryinvestmentistypicallysmall positiveinsomeyearsand
negativeinothers.
TheDemandforGoods

,
whereZ (totaldemandforgoods)=aggregatedemand(AD)forgoods
=aggregateexpenditure(AE)forgoods.
Inventory investment isnot partofdemand.
Investment,sometimescalledfixed investment(I),ispartofdemand:
Thesumofnonresidential investment thepurchaseofnewplants
ornewmachinesbyfirms andresidential investment the
purchaseofnewhousesorapartmentsbypeople.
SomeAssumptionsabouttheDemandforGoodsModel:
(i)Allfirmsproducethesame goodandarewillingtosellany amount
ofoutputatthegiven level ofprice.
(ii)Thepriceofagoodisfixed orsticky fixedP.Thatis,production
adjustsautomaticallytooutput withoutchanges inprice.This
assumptionisvalidonlyintheshort run.
(iii)Investmentdoesnotrespondtotheinterest rate.Thisisolatesthe
goodsmarketfromthefinancial market.
(iv)Investmentisexogenous:Itdoesnot dependonoutput,noris
thereinventory investment,eitherplannedorunplanned.
Theeconomyisclosed:NX =0.

TwoTypesofVariables
Economicmodelhavetwotypesofvariables:
(i) Endogenous variable:Variablethatdependsonother variables in
theeconomicmodelandisexplained bytheeconomicmodel
(ii)Exogenous variable:Variablethatistakenasgiven andsoisnot
explained bytheeconomicmodel
a)Consumption(C)
KeynessConjecturesabouttheConsumptionFunction:
First,Keynesconjecturedthatthemarginal propensity toconsume
(MPC)isbetweenzero andone.
Menaredisposed,asaruleandontheaverage,toincrease their
consumptionastheirincomeincreases,butnotbyasmuchasthe
increaseintheirincome.
Second,Keynespositedthattheratioofconsumptiontoincome,
calledtheaverage propensity toconsume (APC)falls asincomerises.
Third,Keynesthoughtthatincome istheprimarydeterminantof
consumptionandthattheinterest rate doesnot haveanimportant
role.
a)Consumption(C)
Consumptionfunction:
3.1 :
EconomistscallEq(3.1)abehavior equation toindicatethatthe

equationcapturessomeaspectofbehavior thebehaviorof
consumers.
(Disposable incomeoraftertax income)
=incomeincludingtransfer payments taxes
3.2 :
(Keynesianconsumptionfunction)
a)Consumption(C)
Therelationbetween and ischaracterizedbytwoparameters
and :
(slope)iscalledthepropensity toconsumer orthemarginal
propensity toconsume

Theeffectofanadditional dollarofdisposable incomeon
consumption
Fractionofadditional currentincomeconsumed incurrentperiod
Foragivenlevelof
tosave:
, howmuchtoconsume willdecidehowmuch
a)Consumption(C)
1
rises,C rises,butnot byasmuchasY,
Whencurrentincome
soS rises:0
1.
a)Consumption(C)
Theparameter (intercept),calledautonomousconsumptionor
consumer confidence,iswhatpeoplewouldconsumeiftheir
disposable income inthecurrentyearwereequaltozero.
Itistoreflectfactorsaffectingconsumptionotherthanincome.
Changesin reflectschangesinconsumptionforagivenlevelof
disposableincome:Increases in reflectsanincreasein
consumption foragivenlevelofincome,decreases in reflectsa
decreaseinconsumption foragivenlevelofincome.
Q:Whymaypeopledecidetoconsumemoreorless,giventheirlevel
ofincome?
Figure 3.1:ConsumptionandDisposableIncome
a)Consumption(C)
3.3 :
ConsumptionC isafunctionofincome
andtaxes T.
Higherincomeincreases consumption,butlessthanoneforone.
Highertaxesdecrease consumptionbutlessthanoneforone.
As
rises,
falls,andsotheaverage propensity toconsume falls.
a)Consumption(C)
Keynesexpectedthe rich tosaveahigher proportionoftheirincome
thanthe poor.
Keynesianconsumptionfunctiondoesnot seemtomatchshortrun
(household)data,althoughitdoesmatchlongrun (crosscountryand
loneruntimeseries)data.
OtherFactorsThatMayAffectCurrentConsumption
Effectofchangesinexpected future income:Higher expectedfuture
incomeleadstomore consumptiontoday,sosavingfalls.
Effectofchangesinwealth:Increases inwealthraises current
consumption,solowers currentsaving.
Effectofchangesinreal interest rate
:Increased realinterestrate
hastwoopposing effects
(i)Substitution effect:Positive effectonsaving,sincerateofreturnis
higher;greater rewardforsavingelicitsmore saving
(ii)Income effect:Forasaver,negative effect,sinceittakesless
savingtoobtainagivenamountinthefuture(targetsaving).
Foraborrower,positive effectonsaving,sincethehigherrealinterest
ratemeansaloss ofwealth.
*Empiricalstudieshavemixedresults;probablyaslightincreasein
aggregatesaving.
b)Investment(I)
Q:Whyisinvestmentimportant?
A:(i)Investmentsharplyfluctuates overthebusiness cycle
(morethananyotherspendingcomponent!Only1/6oftotalGDP,
butinthetypicalrecessioninvestmentaccountsformorethanof
totaldeclineinspending),
soweneedtounderstandinvestmenttounderstandthebusiness
cycle.
(ii)Investmentplaysacrucialroleineconomic growth thelongrun
productivecapacityoftheeconomy(capital,K,affects .
3.4 :

Investmentwillbetreatedasgiven tokeepthemodelsimple.
c)Governmentpurchases(G)
TogetherwithtaxesT,G describesfiscal policy thechoice
oftaxes andspending bythegovernment.G,TR andT will
betakenasexogenous.
TheDeterminationofEquilibriumOutput
3.5 :
Output isdeterminedbyequilibriuminthegoods market.

Theequilibriumconditionisproduction (supply)equalsdemand.
Thus,intheshortrun,outputisfullydeterminedbydemand without
anychangeinprice.
Assumingthatfirmsdontholdinventories,equilibriumcondition:
3.6
3.7 :
Inequilibrium,production (oroutput),Y,isequaltodemand.
Demand inturndependsonincome,Y,whichisitselftoproduction.
Production andincome areidenticallyequal.
Macroeconomistsalwaysusethreetoolstodetermineequilibrium:
Algebratomakesurethatthelogiciscorrect
Graphstobuildtheintuition
Wordstoexplaintheresult
From
3.7 , 1
3.8 :
3.8 characterizesequilibriumoutput(endogenous variable),

thelevelofoutputsuchthatproduction (orsupply)equalsdemand
thequantityofoutputproduced=thequantitydemanded.
iscalledautonomous (or
Theterm
independent)spending partofthedemandforgoodsthatdoesnot
dependonoutput (orincome).
When

, unplanned inventoryordisinvestment
.
Q:Isautonomousspendingpositive?
A:Notalways,butitisverylikelytobe!
, and arepositive.
Balancedbudget:
If
(balancedbudget),then
1
0 andso
autonomousspendingispositive.
Onlyifthegovernmentwererunningaverylargebudget surplus if
taxes weremuchlargerthangovernment spending could
autonomousspendingbenegative.
iscalledthemultiplier (anumbergreaterthanone).
Thecloser isto1,thelarger themultiplier;thehigher MPC,the

larger themultiplier.
Forexample,if
0.6, themultiplier
2.5,
sooutputincreasesonaverageby2.5x$1billion=$2.5billionif
increasesby$1billion.
MultiplierEffect
Q:Wheredoesthemultipliereffect comefrom?
A:Anincreasein increasesdemand.Theincreaseindemand then
leadstoanincreaseinproduction.Theincreaseinproduction leads
toanequivalentincreaseinincome.Theincreaseinincome further
increaseconsumption,whichfurtherincreasesdemand,andsoon.
Multipliereffect
Aseriesofinduced increases(ordecreases)inconsumption
spendingthatresultsfromanincrease(oradecrease)inautonomous
spending;thiseffectamplifiestheeffectofeconomicshockson
production (Y orrealGDP)
Multipliers
3.8 :
Spending(orexpenditure)multiplier:
Governmentpurchasesmultiplier:
Taxmultiplier:
Figure 3.1:ConsumptionandDisposableIncome
a)Consumption(C)
3.3 :
ConsumptionC isafunctionofincome
andtaxes T.
Higherincomeincreases consumption,butlessthanoneforone.
Highertaxesdecrease consumptionbutlessthanoneforone.
As
rises,
falls,andsotheaverage propensity toconsume falls.
a)Consumption(C)
Keynesexpectedthe rich tosaveahigher proportionoftheirincome
thanthe poor.
Keynesianconsumptionfunctiondoesnot seemtomatchshortrun
(household)data,althoughitdoesmatchlongrun (crosscountryand
loneruntimeseries)data.
Effectofchangesinexpected future income:Higher expectedfuture
incomeleadstomore consumptiontoday,sosavingfalls.
Effectofchangesinwealth:Increases inwealthraises current
consumption,solowers currentsaving.
Effectofchangesinreal interest rate
:Increased realinterestrate
hastwoopposing effects
(i)Substitution effect:Positive effectonsaving,sincerateofreturnis
higher;greater rewardforsavingelicitsmore saving
(ii)Income effect:Forasaver,negative effect,sinceittakesless
savingtoobtainagivenamountinthefuture(targetsaving).
Foraborrower,positive effectonsaving,sincethehigherrealinterest
ratemeansaloss ofwealth.
*Empiricalstudieshavemixedresults;probablyaslightincreasein
aggregatesaving.
b)Investment(I)
Q:Whyisinvestmentimportant?
A:(i)Investmentsharplyfluctuates overthebusiness cycle
(morethananyotherspendingcomponent!Only1/6oftotalGDP,
butinthetypicalrecessioninvestmentaccountsformorethanof
totaldeclineinspending),
soweneedtounderstandinvestmenttounderstandthebusiness
cycle.
(ii)Investmentplaysacrucialroleineconomic growth thelongrun
productivecapacityoftheeconomy(capital,K,affects .
3.4 :

Investmentwillbetreatedasgiven tokeepthemodelsimple.
c)Governmentpurchases(G)
TogetherwithtaxesT,G describesfiscal policy thechoice
oftaxes andspending bythegovernment.G,TR andT will
betakenasexogenous.
3.5 :
Output isdeterminedbyequilibriuminthegoods market.

Theequilibriumconditionisproduction (supply)equalsdemand.
Thus,intheshortrun,outputisfullydeterminedbydemand without
anychangeinprice.
Assumingthatfirmsdontholdinventories,equilibriumcondition:
3.6
3.7 :
Inequilibrium,production (oroutput),Y,isequaltodemand.
Demand inturndependsonincome,Y,whichisitselftoproduction.
Production andincome areidenticallyequal.
Macroeconomistsalwaysusethreetoolstodetermineequilibrium:
Algebratomakesurethatthelogiciscorrect
Graphstobuildtheintuition
Wordstoexplaintheresult
From
3.7 , 1
3.8 :
3.8 characterizesequilibriumoutput(endogenous variable),

thelevelofoutputsuchthatproduction (orsupply)equalsdemand
thequantityofoutputproduced=thequantitydemanded.
Theterm
iscalledautonomous
(orindependent)spending partofthedemandforgoodsthatdoes
not dependonoutput (orincome).
When

, unplanned inventory
or
disinvestment:
.
Q:Isautonomousspending
positive?
A:Notalways,butitisverylikelytobe!
, and arepositive.
Balancedbudget:
If
(balancedbudget),then
1
0 andso
autonomousspendingispositive.
Onlyifthegovernmentwererunningaverylargebudget surplus if
taxes weremuchlargerthangovernment spending could
autonomousspendingbenegative.
iscalledthemultiplier (anumbergreaterthanone).
Thecloser isto1,thelarger themultiplier;thehigher MPC,the

larger themultiplier.
Forexample,
if
0.6, themultiplier
2.5,
sooutputincreasesonaverageby2.5x$1billion=$2.5billionif
increasesby$1billion.
If
0.9, themultiplier
10.
MultiplierEffect
Q:Wheredoesthemultipliereffect comefrom?
A:Anincreasein increasesdemand.Theincreaseindemand then
leadstoanincreaseinproduction.Theincreaseinproduction leads
toanequivalentincreaseinincome.Theincreaseinincome further
increaseconsumption,whichfurtherincreasesdemand,andsoon.
Multipliereffect
Aseriesofinduced increases(ordecreases)inconsumption
spendingthatresultsfromanincrease(oradecrease)inautonomous
spending;thiseffectamplifiestheeffectofeconomicshockson
production (Y orrealGDP)
Multipliers
3.8 :
Spending(orexpenditure)multiplier:
or
or
Taxmultiplier:
or
TheKeynesiancrossprovidesbasicintuitionaboutthebuilding and
solving ofmodels,thedeterminationofoutput,andtheroleoffiscal
policy.
First,plotproductionasafunctionofincome:sinceproduction and
income areidenticallyequal,therelationbetweenthemisthe45
degreeline,thelinewithaslopeequalto1.
Second,plotdemandasafunctionofincome.Therelationbetween
demandandincomeisgivenby
3.5 :
.
AggregateDemand:
Demanddependsonautonomous spending andonincome

viaitseffectonconsumption.
Thelineisupward sloping buthasaslopeofless than 1.
Figure 3.2:EquilibriumintheGoodsMarketUsing
theKeynesianCross
Inequilibrium,production equalsdemand.Equilibriumincomeisthe
productoftwofactors:autonomous spending andamultiplier.
Considertheeffectsonoutputofanincreaseinautonomous
spendingby$1billionbecauseofanincreaseinconsumer
confidence.
Theaggregatedemand(Z orAD)scheduleshiftsupward,meaning
thatateachlevelofincome,aggregatedemandishigher byan
amount$1billion.
Figure 3.3:TheEffectsonOutputofanIncreaseinAutonomous
SpendingBecauseofanIncreaseinConsumerConfidence
$1 billion becauseofthemultiplier effect

Thefirstroundincreaseindemand (thedistanceAB)equals$1
billion.
Thisfirstroundincreaseindemandleadstoanequalincreasein
production,or$1billion,bythedistanceAB.
Thisincreaseinproductionof$1billionimpliesthatincomes
increasesby$1billionshownbythedistanceBC
(Recall:income =production).
ThesecondroundincreaseindemandshownbythedistanceCD
$
.
equals$
Thissecondroundincreaseindemandleadstoanequalincreasein
productionshownbythedistanceCD,andthusanequalincreasein
income shownbythedistanceDE.
Thethirdroundincreaseindemandequals$1
(theincreasein
incomeinthesecondround)
$ ,andsoon.
Totalincreaseinoutput

$1
$1

$1
Productiondependsondemand,whichdependsonincome,whichis
itselfequaltoproduction.
Demand Production Income More demand
More production More income ,andsoon.
Theendresultisanincreaseinoutput thatislarger thantheinitial
shiftindemand,byafactorequaltothemultiplier.
Thesize ofmultiplierisdirectlyrelatedtothevalueofMPC:
thehigher theMPC,thelarger themultiplier.
Example (3.1):EquilibriumOutput
Usethefollowinginformationtocalculateequilibriumoutput(all
valuesareintrilliondollarsof2005dollars):
Consumption:
Investment:
Governmentpurchases:
Netexports
Taxes:
Governmenttransfer
payments
$1.0 0.75
$1.9
$2.0
$0
$2.5
$2.0
$1.0
$1.0 0.75
$4.525 0.75
Equilibriumcondition:
$4.525 0.75
0.75
$4.525
0.25Y $4.525
$ .
.
$18.1 trillion
0.75
$2.0 $2.5
$1.9
$2.0
b)Nowsupposethatfullemploymentoutput(potentialGDP)equals
$19.0trillion.Ifequilibriumoutputequalstheamountyoucalculatedin
part(a),usethevalueforthegovernmentpurchasesmultiplierto
calculatehowmuchgovernmentpurchaseswouldhavetochangefor
equilibriumoutputtoequalpotentialGDP(assumingthattaxesremain
unchanged).
(Ans.)
$0.225 trillion
$225 billion
c)Nowsupposethatfullemploymentoutput(potentialGDP)equals$19.0
trillion.Ifequilibriumoutputequalstheamountyoucalculatedinpart(a),
usethevalueforthetaxmultipliertocalculatehowmuchgovernmenthasto
changeforequilibriumoutputtoequalpotentialGDP(assumingthatG
remainunchanged).
(Ans.)
Taxmultiplier:
$0.3 trillion $300 billion

Noticethatbecausethetaxmultiplierissmaller (inabsolutevalue)than
thegovernmentpurchasesmultiplier,thecutintaxesneedstobelarger
thantheincreaseingovernmentpurchasestoresultinthesame increase
inequilibriumoutput.
d)Useagraphtoillustrateyouranswer.
(Ans.)
Multiplier
Q:Byhowmuchdoesa$1increaseinautonomousspendingraisethe
equilibriumlevelofoutput?
A:
autonomous spending
, called the multiplier
Theamountbywhichequilibriumoutputchangeswhen
autonomousaggregatedemandincreasesby1unit
Thelarger themarginalpropensitytoconsume(MPC),thelarger the
multiplierbecauseahighMPCimpliesthatalarger proportionofan
additionalincomewillbeconsumed,andthusaddedtoaggregate
demand,therebycausingalarger inducedincreaseindemand.
Multiplier
Q:Whyfocusonthemultiplier?
A:Becausethemultiplierispotentiallypartoftheexplanationofwhy
outputfluctuates.Themultipliersuggeststhatoutputchangeswhen
autonomousspending(includinginvestment)changesand thatthe
changeinoutputcanbelarger thanthechangeinautonomousspending.
Themagnitudeoftheincomechangerequiredtorestoreequilibrium
dependsontwofactors:
(i)Thelarger theincreaseinautonomousspending,thelarger theincome.
(ii)Thelarger theMPC thatis,thesteeper theaggregatedemand
schedule thelarger theincomechange.
TheGovernmentSector
Wheneverthereisarecession,peopleexpectanddemandthatthe
governmentshoulddosomethingaboutit.
Q:Whatcanthegovernmentdowithrespecttoaggregatedemand?
A:(i)Governmentpurchasesofgoodsandservices(G)
(ii)Taxes(T)andtransfers(TR)affecttherelationbetweenoutputand
income,Y.
Fiscalpolicy
Thepolicyofgovernmentwithregardtothelevelofgovernment
purchases,theleveloftransfers,andthetaxstructure.
TheGovernmentSector
Q:Whathappenstothevalueofthegovernmentspendingmultiplier
ifwetakeintoaccountthetaxrate thathouseholdspayontheir
income?
A:Supposethatthegovernmentimposesaproportionalincometax,
collectingafraction,t,ofincomeintheformoftaxrates:
.
TheslopeoftheZZ lineisflatter becausehouseholdsnowhaveto

paypartofeverydollarofincomeintaxes andareleftwithonly
1
dollars
TheGovernmentSector
3.9 :
Forexample,
Themultiplieris
0.2 20% and

.
0.75.
.
2.5.
Proportionalincometaxesreduce themultiplierbecausetheyreduce
theinducedincreaseofconsumptionoutofchangesinincome.
Theinclusionoftaxesflattens theaggregatedemandcurve(ZZline)
andhencereduces themultiplier.
TheDeterminationofEquilibriumOutputinaGraph
TheKeynesiancrossprovidesbasicintuitionaboutthebuilding and
solving ofmodels,thedeterminationofoutput,andtheroleoffiscal
policy.
First,plotproductionasafunctionofincome:sinceproduction and
income areidenticallyequal,therelationbetweenthemisthe45
degreeline,thelinewithaslopeequalto1.
Second,plotdemandasafunctionofincome.Therelationbetween
demandandincomeisgivenby
3.5 :
.
TheDeterminationofEquilibriumOutputinaGraph
AggregateDemand:
Demanddependsonautonomous spending andonincome

viaitseffectonconsumption.
Thelineisupward sloping buthasaslopeofless than 1.
Figure 3.2:EquilibriumintheGoodsMarketUsing
theKeynesianCross
Inequilibrium,production equalsdemand.Equilibriumincomeisthe
productoftwofactors:autonomous spending andamultiplier.
Considertheeffectsonoutputofanincreaseinautonomous
spendingby$1billionbecauseofanincreaseinconsumer
confidence.
Theaggregatedemand(Z orAD)scheduleshiftsupward,meaning
thatateachlevelofincome,aggregatedemandishigher byan
amount$1billion.
Figure 3.3:TheEffectsonOutputofanIncreaseinAutonomous
SpendingBecauseofanIncreaseinConsumerConfidence
$1 billion becauseofthemultiplier effect

Thefirstroundincreaseindemand (thedistanceAB)equals$1
billion.
Thisfirstroundincreaseindemandleadstoanequal increasein
production,or$1billion,bythedistanceAB.
Thisincreaseinproductionof$1billionimpliesthatincome
increasesby$1billionshownbythedistanceBC
(Recall:income =production).
ThesecondroundincreaseindemandshownbythedistanceCD
$
.
equals$
Thissecondroundincreaseindemandleadstoanequal increasein
productionshownbythedistanceCD,andthusanequal increasein
income shownbythedistanceDE.
Thethirdroundincreaseindemandequals$1
(theincreasein
incomeinthesecondround)
$ ,andsoon.
Totalincreaseinoutput

$1
$1

$1
TheDeterminationofEquilibriumOutputinWords
Productiondependsondemand,whichdependsonincome,whichis
itselfequaltoproduction.
Demand Production Income More demand
More production More income ,andsoon.
Theendresultisanincreaseinoutput thatislarger thantheinitial
shiftindemand,byafactorequaltothemultiplier.
Thesize ofmultiplierisdirectlyrelatedtothevalueofMPC:
thehigher theMPC,thelarger themultiplier.
Usethefollowinginformationtocalculateequilibriumoutput(all
valuesareintrilliondollarsof2005dollars):
Consumption:
Investment:
Governmentpurchases:
Netexports
Taxes:
Governmenttransfer
payments
$1.0 0.75
$1.9
$2.0
$0
$2.5
$2.0
$1.0 0.75
$2.0

$1.0 0.75

$4.525 0.75
$4.525 0.75
0.75
$4.525
0.25Y $4.525
$ .
.
$18.1 trillion
$2.5
$1.9
$2.0
b)Nowsupposethatfullemploymentoutput(potentialGDP)equals
$19.0trillion.Ifequilibriumoutputequalstheamountyoucalculatedin
part(a),usethevalueforthegovernmentpurchasesmultiplierto
calculatehowmuchgovernmentpurchaseswouldhavetochangefor
equilibriumoutputtoequalpotentialGDP(assumingthattaxesremain
unchanged).
(Ans.)
$0.225
$225
c)Nowsupposethatfullemploymentoutput(potentialGDP)equals$19.0
trillion.Ifequilibriumoutputequalstheamountyoucalculatedinpart(a),
usethevalueforthetaxmultipliertocalculatehowmuchgovernmenthasto
changeforequilibriumoutputtoequalpotentialGDP(assumingthatG
remainunchanged).
(Ans.)
Taxmultiplier:
$0.3
$300
Noticethatbecausethetaxmultiplierissmaller (inabsolutevalue)than
thegovernmentpurchasesmultiplier,thecutintaxesneedstobelarger
thantheincreaseingovernmentpurchasestoresultinthesame increase
inequilibriumoutput.
d)Useagraphtoillustrateyouranswer.
(Ans.)
Multiplier
Q:Byhowmuchdoesa$1increaseinautonomousspendingraisethe
equilibriumlevelofoutput?
A:
autonomous spending
, called the multiplier
Theamountbywhichequilibriumoutputchangeswhen
autonomousaggregatedemandincreasesby1unit
Thelarger themarginalpropensitytoconsume(MPC),thelarger the
multiplierbecauseahighMPCimpliesthatalarger proportionofan
additionalincomewillbeconsumed,andthusaddedtoaggregate
demand,therebycausingalarger inducedincreaseindemand.
Multiplier
Q:Whyfocusonthemultiplier?
A:Becausethemultiplierispotentiallypartoftheexplanationofwhy
outputfluctuates.Themultipliersuggeststhatoutputchangeswhen
autonomousspending(includinginvestment)changesand thatthe
changeinoutputcanbelarger thanthechangeinautonomousspending.
Themagnitudeoftheincomechangerequiredtorestoreequilibrium
dependsontwofactors:
(i)Thelarger theincreaseinautonomousspending,thelarger theincome.
(ii)Thelarger theMPC thatis,thesteeper theaggregatedemand
schedule thelarger theincomechange.
TheGovernmentSector
Wheneverthereisarecession,peopleexpectanddemandthatthe
governmentshoulddosomethingaboutit.
Q:Whatcanthegovernmentdowithrespecttoaggregatedemand?
A:(i)Governmentpurchasesofgoodsandservices(G)
(ii)Taxes(T)andtransfers(TR)affecttherelationbetweenoutputand
income,Y.
Fiscalpolicy
Thepolicyofgovernmentwithregardtothelevelofgovernment
purchases,theleveloftransfers,andthetaxstructure.
TheGovernmentSector
Q:Whathappenstothevalueofthegovernmentspendingmultiplier
ifwetakeintoaccountthetaxrate thathouseholdspayontheir
income?
A:Supposethatthegovernmentimposesaproportionalincometax,
collectingafraction,t,ofincomeintheformoftaxrates:
.
TheslopeoftheZZ lineisflatter becausehouseholdsnowhaveto

paypartofeverydollarofincomeintaxes andareleftwithonly
1
dollars
TheGovernmentSector

3.9 :
Forexample,
Multiplier=
0.2 20% and

.
0.75.
.
2.5
4.
Proportionalincometaxesreduce themultiplierbecausetheyreduce
theinducedincreaseofconsumptionoutofchangesinincome.
Theinclusionoftaxesflattens theaggregatedemandcurve(ZZline)
andhencereduces themultiplier.
TheGovernmentSector
3.9 :
IncomeTaxesandAutomaticStabilizers
Theproportionalincometaxisoneexampleoftheimportantconcept
ofautomaticstabilizers.
Automaticstabilizer
Somepoliciesdesignedtoreducethelagsassociatedwith
stabilizationpolicy policiesthatstimulateordepresstheeconomy
whennecessarywithoutanydeliberatepolicychange
Anymechanismintheeconomythatautomatically thatis,
withoutcasebycasegovernmentintervention reducestheamount
bywhichoutputchangesinresponsetoachangeinautonomous
demand
AutomaticStabilizers
Examples:(i)Thesystemofincometaxesautomaticallyreducestaxes
whentheeconomygoesintorecession:withoutanychangeinthetax
law,individualsandfirmspaylesstaxwhentheirincomefalls.
Inthepresenceofautomaticstabilizersweshouldexpectoutputto
fluctuateless thanitwouldwithoutthem.
(ii)Unemploymentinsuranceandwelfaresystemautomaticallyraise
transfer paymentswhentheeconomymovesintoarecession.
Thismeansthatdemandfallsless whensomeonebecomes
unemployedandreceivesbenefitsthanitwouldiftherewereno
benefits.Thismakesthemultipliersmaller andoutputmorestable.
EffectsofaChangeinFiscalPolicy
3.9 :
Q:Whyisthemultiplierfortransferpaymentsmallerthanthatfor
governmentpurchasesbyafactor ?
A:BecausepartofanyincreaseinTR issaved.
Q:Ifthegovernmentraisesmarginaltaxrates,whatwillhappen?
A:Twothingshappen.
(i)Directeffect:aggregatedemandwilldecrease sincethehigher
taxesreducedisposable income andthereforeconsumption.
(ii)Indirecteffect:themultiplierwillbesmaller,soshockswillhavea
smaller effectonaggregatedemand.
TheBudget
Overthelongsweepofhistory,thefederalgovernmenttypicallyran
surplusesinpeacetimeanddeficitsduringwars.
Question:Isthereareasonforconcernoverabudgetdeficit?
Wedealwiththegovernmentbudget,itseffectonoutput,andthe
effectsofoutputonthebudget.
Budgetsurplus(BS):
3.10 :
3.10 ,
TheBudget
3.10 ,
3.10 :
Thebudgetsurplusistheexcess ofgovernmentrevenues(taxes)over
itstotalexpenditureconsistingofpurchasesofgoods
and
services
andtransferpayments.
Thebudgetsurplusisapositive functionofthelevelofincome for
givenG,TR,andincometaxrate,t.
Figure 3.4:TheBudgetSurplus
TheBudget
Atlowlevelsofincome,thebudgetisindeficit (thesurplusis
negative)becausegovernmentspendingexceedsitstaxrevenues.
Athighlevelsofincome,thebudgetisinsurplus.
Q:Doesanincreaseingovernmentpurchases(G)reducethebudget
surplus?
A:Increasedgovernmentpurchasesreduce surplusorincrease
deficit.However,theincreasedgovernmentpurchaseswillcausean
increaseinincome andthereforeincreasetax revenues.
TheBudget
3.9 :
TheBudget
Therefore,anincreaseingovernmentpurchaseswillreduce the
budgetsurplus(orincrease thebudgetdeficit).
Q:Doesanincreaseinthetaxrateincreasethebudgetsurplus?
A:Infact,anincreaseinthetaxrate,keepingG andTR constant,
increases thebudgetsurplus,despitethereductioninincome thatit
causes.
AlternativeWayofThinkingaboutGoodsMarketEquilibrium
Anequivalentwayofthinkingaboutgoodsmarketequilibrium
focusesoninvestmentandsaving.
Savingisthesumofprivate savingandpublic saving.
Privatesavingsrate
Saving Investment
If
, publicsavingispositive
Thegovernmentrunsabudgetsurplus.
If
, publicsavingisnegative
Thegovernmentrunsabudgetdeficit.
3.11 :
Saving Investment
Equilibriumconditioninthegoodsmarket:
Subtract
frombothsidesandmoveC totheleftside:
3.12
Saving Investment
3.12 :

Eq(3.12)saysthatequilibriuminthegoodsmarketrequiresthat
investment equalssaving.Whatfirmswanttoinvest mustbeequal
towhatpeopleandgovernmentwanttosave.
Twoequivalentwaysofstatingtheconditionforequilibriuminthe
goodsmarket:
Production(Y)=Demand(Z) Investment(I)=Saving(S)
Saving Investment
Giventheirdisposableincome,onceconsumershavechosen
consumption,theirsavingisdetermined,andviceversa.
1

3.13
Marginalpropensitytosave (MPS):Howmuchofanadditionalunitof
incomepeoplesave
TheGovernmentSector
3.9 :
IncomeTaxesandAutomaticStabilizers
Theproportionalincometaxisoneexampleoftheimportantconcept
ofautomaticstabilizers.
Automaticstabilizer
Somepoliciesdesignedtoreducethelagsassociatedwith
stabilizationpolicy policiesthatstimulateordepresstheeconomy
whennecessarywithoutanydeliberatepolicychange
Anymechanismintheeconomythatautomatically thatis,
withoutcasebycasegovernmentintervention reducestheamount
bywhichoutputchangesinresponsetoachangeinautonomous
demand
AutomaticStabilizers
Examples:(i)Thesystemofincometaxesautomaticallyreducestaxes
whentheeconomygoesintorecession:withoutanychangeinthetax
law,individualsandfirmspaylesstaxwhentheirincomefalls.
Inthepresenceofautomaticstabilizersweshouldexpectoutputto
fluctuateless thanitwouldwithoutthem.
(ii)Unemploymentinsuranceandwelfaresystemautomaticallyraise
transfer paymentswhentheeconomymovesintoarecession.
Thismeansthatdemandfallsless whensomeonebecomes
unemployedandreceivesbenefitsthanitwouldiftherewereno
benefits.Thismakesthemultipliersmaller andoutputmorestable.
3.9 :
Q:Whyisthemultiplierfortransferpaymentsmallerthanthatfor
governmentpurchasesbyafactor ?
A:BecausepartofanyincreaseinTR issaved.
Q:Ifthegovernmentraisesmarginaltaxrates,whatwillhappen?
A:Twothingshappen.
(i)Directeffect:Aggregatedemandwilldecrease sincethehigher
taxesreducedisposable income andthereforeconsumption.
(ii)Indirecteffect:Themultiplierwillbesmaller,soshockswillhavea
smaller effectonaggregatedemand.
TheBudget
Overthelongsweepofhistory,thefederalgovernmenttypicallyran
surplusesinpeacetimeanddeficitsduringwars.
Question:Isthereareasonforconcernoverabudgetdeficit?
Wedealwiththegovernmentbudget,itseffectonoutput,andthe
effectsofoutputonthebudget.
Budgetsurplus(BS):
3.10 :
3.10 ,
TheBudget
3.10 ,
3.10 :
Thebudgetsurplusistheexcess ofgovernmentrevenues(taxes)over
itstotalexpenditureconsistingofpurchasesofgoods
and
services
andtransferpayments.
Thebudgetsurplusisapositive functionofthelevelofincome for
givenG,TR,andincometaxrate,t.
Figure 3.4:TheBudgetSurplus
TheBudget
Atlowlevelsofincome,thebudgetisindeficit (thesurplusis
negative)becausegovernmentspendingexceedsitstaxrevenues.
Athighlevelsofincome,thebudgetisinsurplus.
Q:Doesanincreaseingovernmentpurchases(G)reducethebudget
surplus?
A:Increasedgovernmentpurchasesreduce surplusorincrease
deficit.However,theincreasedgovernmentpurchaseswillcausean
increaseinincome andthereforeincreasetax revenues.
TheBudget
3.9 :
TheBudget
Therefore,anincreaseingovernmentpurchaseswillreduce the
budgetsurplus(orincrease thebudgetdeficit).
Q:Doesanincreaseinthetaxrateincreasethebudgetsurplus?
A:Infact,anincreaseinthetaxrate,keepingG andTR constant,
increases thebudgetsurplus,despitethereductioninincome thatit
causes.
AlternativeWayofThinkingaboutGoodsMarketEquilibrium
Anequivalentwayofthinkingaboutgoodsmarketequilibrium
focusesoninvestmentandsaving.
Savingisthesumofprivate savingandpublic saving.
Privatesavingsrate
Saving Investment
If
, publicsavingispositive
Thegovernmentrunsabudgetsurplus.
If
, publicsavingisnegative
Thegovernmentrunsabudgetdeficit.
3.11 :
Saving Investment
Equilibriumconditioninthegoodsmarket:
Subtract
frombothsidesandmoveC totheleftside:
3.12
Saving Investment
3.12 :

Eq(3.12)saysthatequilibriuminthegoodsmarketrequiresthat
investment equalssaving.Whatfirmswanttoinvest mustbeequal
towhatpeopleandgovernmentwanttosave.
Twoequivalentwaysofstatingtheconditionforequilibriuminthe
goodsmarket:
Production(Y)=Demand(Z) Investment(I)=Saving(S)
Saving Investment
Giventheirdisposableincome,onceconsumershavechosen
consumption,theirsavingisdetermined,andviceversa.

3.13
Marginalpropensitytosave (MPS):Howmuchofanadditionalunitof
incomepeoplesave
Saving Investment
Inequilibrium,
1
1
3.14
TheParadoxofSavingorTheParadoxofThrift
Virtuesofthrift Thosewhospendalltheirincomearecondemned
toenduppoor.Thosewhosavearepromisedahappylife.
Supposethat,atagivenlevelofdisposableincome,consumers
decidetosavemore;consumersdecrease ,thereforedecreasing
consumptionandincreasingsavingatagivenlevelofdisposable
income.
Q:Whathappenstooutputandtosaving?
A:Equilibriumoutputfalls:Aspeoplesave moreattheirinitiallevel
ofincome,theyreducetheirconsumption.
Butthisdecreasedconsumptiondecreasesdemand whichdecreases
production.
1
from . 3.13
ishigher(lessnegative):consumersaresavingmore atanylevel
ofincome;thistendstoincreasesaving.But,ontheotherhand,their
incomeY islower:Thisdecreasessaving.
Neteffect?
Accordingto
3.12 ,
.
Byassumption,investmentdoesnot change:
.
NordoT orG orTR.
Inequilibrium,privatesavingcannot change,either.
Althoughpeoplewanttosavemoreatagivenlevelofincome,their
incomefalls byanamountsuchthattheirsavingisunchanged.
Thismeansthataspeopleattempttosavemore,theresultisbotha
declineinoutput andunchanged saving.
Thissurprisingpairofresultsisknownastheparadoxofsaving.
Awarning:Policiesthatencouragesavingmightbegoodinthe
medium runandinthelong run,buttheycanleadtoafallindemand
andsoinoutput,andperhapsevenarecession,intheshort run.
IstheGovernmentOmnipotent?
Q:Canthegovernmentreallychoosethelevelofoutputitwant?
A:Obviouslynot!
Changinggovernmentspendingortaxesisnoteasy.GettingtheU.S.
Congresstopassbillsalwaystakesthetime.
Investmentandexportsaremorelikelytorespondinavarietyof
ways.Someoftheincreaseddemandbyconsumersandfirmswillnot
befordomesticgoodsbutforforeign goods.
Theexchangeratemaychange.
Alltheseresponsesmakeitharderforthegovernmenttoassessthe
effectsofitspolicieswithmuchcertainty.
Expectations arelikelytomatter.Forexample,thereactionof
consumerstoataxcutislikelytodependonwhethertheythinkof
thetaxcutastemporary orpermanent.Themore theyperceivethe
taxcutaspermanent,thelarger willbetheirconsumptionresponse.
Achievingagivenlevelofoutputcancomewithunpleasantside
effects.Tryingtoachievetoohighalevelofoutputcanleadto
increasinginflation.
Cuttingtaxesorincreasinggovernmentspending,asattractiveasit
mayseemintheshortrun,canleadtolargerdeficits andan
accumulationofpublic debt.Alargedebthasadverse effectsinthe
long run.
Inshort,thepropositionthat,byusingfiscalpolicy,thegovernment
canaffectdemandandoutputintheshortrunisanimportantand
correctproposition.
Butaswerefineouranalysis,wewillseethattheroleofthe
governmentingeneral,andthesuccessfuluseoffiscalpolicyin
particular,becomesincreasingly difficult.
MarketforGoodsintheClassicalModel
Q:Whatensuresthattheamountofconsumption ,investment
,andgovernmentpurchase
equalstheamountofoutput
produced
intheclassicalmodel?
A:Intheclassicalmodel,theinterest rate playsacrucialroleof
equilibratingaggregatesupplyandaggregatedemand.
Theclassicaleconomistsbelievethatahigher (lower)interestrate
encourages (discourages)savinganddiscourages (encourages)
consumption.
EquilibriumintheMarketforGoods
, where istherealinterestrate.
Investmentisanegative functionoftheinterest rate.

Realinterestrate:truecost ofthefundsusedtofinanceinvestment
Figure 3A.1:InvestmentFunction
Theinvestmentfunctionslopes downward:whentheinterestrate
rises,fewerinvestmentprojectsareprofitable,andsothequantityof
investmentdemandedfalls.
EquilibriuminGoodsMarket
& : exogenousvariablessetbypolicymakers
Forsimplicity,
,
,thelevelofoutputisfixed byinputs
(orfactorsofproduction).
Equilibriumingoodsmarket:

Therealinterestrate istheonlyvariablenot alreadydetermined
sincetheinterestratemustadjusttoensurethattheaggregate
demandforgoodsequalstheaggregatesupply.
.
Attheequilibriuminterestrate,Z(
TheSupplyandDemandforLoanableFunds
Q:Howdoestheinterestrategettothelevelthatbalancesthesupply
anddemandforgoods?
Toseehowtheinterestratebringsthemarketforloanablefundsinto
equilibrium,rewritenationalincomeidentityas:
where

Forfixedvaluesof , , , and , (national)saving isalsofixed.
Figure 3A.2:Saving,Investment,andtheInterestRate
Thesavingfunctionisavertical linebecauseinthismodelsaving
doesnot dependontheinterest rate.
Theinterestrateadjuststobringsavingandinvestmentintobalance.
Saving:thesupply ofloanablefunds
Investment:thedemand forloanablefunds
Attheequilibriuminterestrate priceofloanablefunds,
thequantityofloanablefundssupplied=thequantityofloanable
fundsdemanded.
ChangesinSaving:TheEffectofFiscalPolicy
Letsseehowfiscalpolicyaffectstheeconomy.
Whenthegovernmentchangesitsspendingortheleveloftaxes,
itaffectstheaggregatedemandforgoodsandalterssaving,
investment,andtheequilibriuminterestrate.
Anincreaseingovernmentpurchases

becauseoutputisfixed bythefactorsofproduction,disposable
income
isunchanged,soconsumptionisunchanged as
well.
Figure 3A.3:ReductioninSaving
Increaseingovernmentpurchases
0 isnot accompaniedby
anincreaseintaxes
Thegovernmentfinancesadditionalspendingbyborrowing
thatis,byreducingpublic saving
Withprivatesavingunchanged,thisgovernmentborrowing
reduces (national)saving
Thesupplyofloanablefundsshiftsleftward
Theequilibriuminterestraterises
Investmentfalls
Thus,anincreaseingovernmentpurchasescausestheinterestrateto
rise from to andtheinvestmenttofall.
Adecreaseintaxes
Areductionintaxesof
0
Disposableincomerises by andconsumptionrisesby
Savingfalls bythesameamountasconsumptionrises,sinceY is
fixedandGremainsunchanged
Thesupplyofloanablefundsshiftstotheleft
Investmentfalls
Thus,areductionintaxesraises theinterestrateandcrowds out
investment.
Crowdingout
Thereduction ininvestmentthatresultswhenexpansionaryfiscal
policyraises theinterestrate
ChangesinInvestmentDemand
Wecanalsousethemodeltoinvestigatetheothersideofthemarket
thedemandforinvestment.
CausesofChangesinInvestment:
(i)Technologicalinnovation
(ii)Thegovernmentencouragesordiscouragesinvestmentthrough
thetaxlawssuchasinvestment tax credits.
Atanygiveninterestrate,thedemandforinvestmentgoods(andalso
forloanablefunds)ishigher
Theinvestmentfunctionshiftstotheright
Theequilibriuminterestraterises,buttheamountofinvestment
remainsunchanged becauseweassumedthatthesupplyofloanable
fundsorsavingisfixed
Figure 3A.4:AnIncreaseinDemandforInvestment
Becausetheamountofsavingisfixed,theincreaseininvestment
demandraises theinterestratewhileleavingtheequilibriumamount
ofinvestmentunchanged.
Modification:
Consumptiondependsontheinterest rate;
consumptionisanegative functionoftheinterestrate,whichmeans
savingisapositive functionoftheinterestrate,sothesaving
schedulewouldbeupward slopingratherthanvertical.
Figure 3A.5:AnIncreaseinInvestmentDemandWhenSaving
DependsontheInterestRate
AnIncreaseinInvestmentDemandWhenSaving
Anincreaseininvestmentdemand
Boththeequilibriuminterestrateandtheequilibriumquantityof
investmentrise
Thus,theincrease intheinterestratecauseshouseholdstoconsume
less andsavemore.Thedecreaseinconsumptionfreesfundsfor
investment.
Example (3A.1):GoodsMarketinClassicalModel
Considerthefollowingmodeloftheeconomy(inbillionsof$):
3600 2000
0.10
1200 4000
1200 and
100
a)Byhowmuchdoes changeforeachpercentagepointincreasein
therealinterestrare ?
(Ans.)
4000
Investmentfallsby4000.
b)Writeoutthesavingsfunctionforthiseconomy.Byhowmuchdoes
increasewhen increasesbyoneunit?
(Ans.)
3600 2000
0.10
1200
4800 2000
0.9
0.9
c)When
6000
,findtherealinterestratethatclearsthe
marketforgoods.
(Ans.)
4800 2000
0.9
1200 4000
0.9
6000 6000 .
6000,0.9 6000 6000 6000
When
6000
600
0.1
10%
d)Governmentpurchasesriseto1440,holdingothervariablesconstant.
Howdoesthischangethesavingequation?Showthechangegraphically.
Whathappenstothemarketclearingrealinterestrate?
(Ans.)
WhenG =1440,
3600 2000
0.10
1440
5040 2000
0.9 .
5040 2000
0.9
1200 4000
0.9
6240 6000
At
6000,0.9 6000 6240 6000
6000
840
0.14.
MarketforGoodsintheClassicalModel
Q:Whatensuresthattheamountofconsumption ,investment
,andgovernmentpurchase
equalstheamountofoutput
produced
intheclassicalmodel?
A:Intheclassicalmodel,theinterest rate playsacrucialroleof
equilibratingaggregatesupplyandaggregatedemand.
Theclassicaleconomistsbelievethatahigher (lower)interestrate
encourages (discourages)savinganddiscourages (encourages)
consumption.
EquilibriumintheMarketforGoods
, where istherealinterestrate.
Investmentisanegative functionoftheinterest rate.

Realinterestrate:truecost ofthefundsusedtofinanceinvestment
Figure 3A.1:InvestmentFunction
Theinvestmentfunctionslopes downward:whentheinterestrate
rises,fewerinvestmentprojectsareprofitable,andsothequantityof
investmentdemandedfalls.
EquilibriuminGoodsMarket
& : exogenousvariablessetbypolicymakers
Forsimplicity,
,
,thelevelofoutputisfixed byinputs
(orfactorsofproduction).
Equilibriumingoodsmarket:

Therealinterestrate istheonlyvariablenot alreadydetermined
sincetheinterestratemustadjusttoensurethattheaggregate
demandforgoodsequalstheaggregatesupply.
Attheequilibriuminterestrate,
.
Q:Howdoestheinterestrategettothelevelthatbalancesthesupply
anddemandforgoods?
Toseehowtheinterestratebringsthemarketforloanablefundsinto
equilibrium,rewritenationalincomeidentityas:
where

Forfixedvaluesof , , , and , (national)saving isalsofixed.
Figure 3A.2:Saving,Investment,andtheInterestRate
Thesavingfunctionisavertical linebecauseinthismodelsaving
doesnot dependontheinterest rate.
Theinterestrateadjuststobringsavingandinvestmentintobalance.
Saving:thesupply ofloanablefunds
Investment:thedemand forloanablefunds
Attheequilibriuminterestrate priceofloanablefunds,
thequantityofloanablefundssupplied=thequantityofloanable
fundsdemanded.
Letsseehowfiscalpolicyaffectstheeconomy.
Whenthegovernmentchangesitsspendingortheleveloftaxes,
itaffectstheaggregatedemandforgoodsandalterssaving,
investment,andtheequilibriuminterestrate.
Anincreaseingovernmentpurchases

becauseoutputisfixed bythefactorsofproduction,disposable
income
isunchanged,soconsumptionisunchanged as
well.
Figure 3A.3:ReductioninSaving
Increaseingovernmentpurchases
0 isnot accompaniedby
anincreaseintaxes
Thegovernmentfinancesadditionalspendingbyborrowing
thatis,byreducingpublic saving
Withprivatesavingunchanged,thisgovernmentborrowing
reduces (national)saving
Thesupplyofloanablefundsshiftsleftward
Investmentfalls
Thus,anincreaseingovernmentpurchasescausestheinterestrateto
rise from to andtheinvestmenttofall.
Adecreaseintaxes
Areductionintaxesof
0
Disposableincomerises by andconsumptionrisesby
Savingfalls bythesameamountasconsumptionrises,sinceY is
fixedandGremainsunchanged
Thesupplyofloanablefundsshiftstotheleft
Investmentfalls
Thus,areductionintaxesraises theinterestrateandcrowds out
investment.
Crowdingout
Thereduction ininvestmentthatresultswhenexpansionaryfiscal
policyraises theinterestrate
Wecanalsousethemodeltoinvestigatetheothersideofthemarket
thedemandforinvestment.
CausesofChangesinInvestment:
(i)Technologicalinnovation
(ii)Thegovernmentencouragesordiscouragesinvestmentthrough
thetaxlawssuchasinvestment tax credits.
Atanygiveninterestrate,thedemandforinvestmentgoods(andalso
forloanablefunds)ishigher
Theinvestmentfunctionshiftstotheright
Theequilibriuminterestraterises,buttheamountofinvestment
remainsunchanged becauseweassumedthatthesupplyofloanable
fundsorsavingisfixed
Figure 3A.4:AnIncreaseinDemandforInvestment
Becausetheamountofsavingisfixed,theincreaseininvestment
demandraises theinterestratewhileleavingtheequilibriumamount
ofinvestmentunchanged.
Modification:
Consumptiondependsontheinterest rate;
consumptionisanegative functionoftheinterestrate,whichmeans
savingisapositive functionoftheinterestrate,sothesaving
schedulewouldbeupward slopingratherthanvertical.
Figure 3A.5:AnIncreaseinInvestmentDemandWhenSaving
AnIncreaseinInvestmentDemandWhenSaving
Anincreaseininvestmentdemand
Boththeequilibriuminterestrateandtheequilibriumquantityof
investmentrise
Thus,theincrease intheinterestratecauseshouseholdstoconsume
less andsavemore.Thedecreaseinconsumptionfreesfundsfor
investment.
Considerthefollowingmodeloftheeconomy(inbillionsof$):
3600 2000
0.10
1200 4000
1200 and
100
a)Byhowmuchdoes changeforeachpercentagepointincreasein
therealinterestrare ?
(Ans.)
4000
Investmentfallsby4000.
b)Writeoutthesavingsfunctionforthiseconomy.Byhowmuchdoes
increasewhen increasesbyoneunit?
(Ans.)
3600 2000
0.10
1200
4800 2000
0.9
0.9
c)When
6000
,findtherealinterestratethatclearsthe
marketforgoods.
(Ans.)
4800 2000
0.9
1200 4000
0.9
6000 6000 .
6000,0.9 6000 6000 6000
When
6000
600
0.1
10%
d)Governmentpurchasesriseto1440,holdingothervariablesconstant.
Howdoesthischangethesavingequation?Showthechangegraphically.
Whathappenstothemarketclearingrealinterestrate?
(Ans.)
WhenG =1440,
3600 2000
0.10
1440
5040 2000
0.9 .
5040 2000
0.9
1200 4000
0.9
6240 6000
At
6000,0.9 6000 6240 6000
6000
840
0.14.
Consumption
InLecturenote#3,weassumedthatconsumptiondependedonlyon
currentdisposable income,butitistoosimpletoprovideacomplete
explanationofconsumerbehavior.Inthisnoteweexaminethe
consumptionfunctioningreaterdetailanddevelopamorethorough
explanationofwhatdeterminesaggregateconsumptionbyshowing
diverseapproachestoexplainingconsumption.
IrvingFisherandIntertemporalChoice
Keynessconsumptionfunctionrelatescurrentconsumptionto
currentincome.However,whenpeopledecidehowmuchtoconsume
andhowmuchtosave,theyconsiderboththepresent andthe
future.Themoreconsumptiontheyenjoytoday,thelesstheywillbe
abletoenjoytomorrow.Makingthistradeoff enableshouseholdsto
lookaheadtotheincometheyexpecttoreceiveinthefutureandto
theconsumptionofgoodsandservicestheyhopetobeableto
afford.
TheIntertemporalBudgetConstraint
TheeconomistIrvingFisherdevelopedthemodelwithwhich
economistsanalyzehowrational,forwardlookingconsumersmake
intertemporalchoices thatis,choicesinvolvingdifferent periodsof
time.
Q:Whydopeopleconsumeless thantheydesire?
A:Becausetheirconsumptionisconstrainedbytheirincome.
Toputanotherway,consumersfacealimitonhowmuchtheycan
spend,calledabudget constraint.
Def.(3B.1):Intertemporalbudgetconstraint
Thelinethatmeasuresthetotalresourcesavailablefor
consumptiontodayandinthefuture
Theconstraintconsumersfacewhendecidinghowmuchto
consumetodayversushowmuchtosaveforthefuture
DevelopmentofFishersModel:
Assumptions:(i)Aconsumerlivesfortwoperiods;periodone
representstheconsumersyouth,andperiodtworepresentsthe
consumersoldage.
(ii)Allvariablesarereal thatis,adjustedforinflation.
(iii)Theinterestrateforborrowingisthesame astheinterestratefor
saving.
:Aconsumersincomeinperiod1
:Aconsumersconsumptioninperiod1
Q:Howdoestheconsumersincomeinthetwoperiodsconstrain
consumptioninthetwoperiods?
Inthefirstperiod, 3 . 1 :
,where canrepresent
eithersavingorborrowing.
Aconsumerissaving,and ispositive.
Aconsumerisborrowing,and isless thanzero.

Inthesecondperiod,
3 .2 :
1
,where isthe
realinterestrate.
Meaning:Consumptioninthesecondperiodequalstheaccumulated
saving,includingtheinterestearnedonthatsaving,plussecond
periodincome.
Consumption
InLecturenote#3,weassumedthatconsumptiondependedonlyon
currentdisposable income,butitistoosimpletoprovideacomplete
explanationofconsumerbehavior.Inthisnoteweexaminethe
consumptionfunctioningreaterdetailanddevelopamorethorough
explanationofwhatdeterminesaggregateconsumptionbyshowing
diverseapproachestoexplainingconsumption.
IrvingFisherandIntertemporalChoice
Keynessconsumptionfunctionrelatescurrentconsumptionto
currentincome.However,whenpeopledecidehowmuchtoconsume
andhowmuchtosave,theyconsiderboththepresent andthe
future.Themoreconsumptiontheyenjoytoday,thelesstheywillbe
abletoenjoytomorrow.Makingthistradeoff enableshouseholdsto
lookaheadtotheincometheyexpecttoreceiveinthefutureandto
theconsumptionofgoodsandservicestheyhopetobeableto
afford.
TheeconomistIrvingFisherdevelopedthemodelwithwhich
economistsanalyzehowrational,forwardlookingconsumersmake
intertemporalchoices thatis,choicesinvolvingdifferent periodsof
time.
Q:Whydopeopleconsumeless thantheydesire?
A:Becausetheirconsumptionisconstrainedbytheirincome.
Toputanotherway,consumersfacealimitonhowmuchtheycan
spend,calledabudget constraint.
Def.(3B.1):Intertemporalbudgetconstraint
Thelinethatmeasuresthetotalresourcesavailablefor
consumptiontodayandinthefuture
Theconstraintconsumersfacewhendecidinghowmuchto
consumetodayversushowmuchtosaveforthefuture
DevelopmentofFishersModel:
Assumptions:(i)Aconsumerlivesfortwoperiods;periodone
representstheconsumersyouth,andperiodtworepresentsthe
consumersoldage.
(ii)Allvariablesarereal thatis,adjustedforinflation.
(iii)Theinterestrateforborrowingisthesame astheinterestratefor
saving.
Q:Howdoestheconsumersincomeinthetwoperiodsconstrain
consumptioninthetwoperiods?
Inthefirstperiod,
3 .1 :
,where canrepresent
eithersavingorborrowing.
Aconsumerissaving,and ispositive.
Aconsumerisborrowing,and isless thanzero.

Inthesecondperiod,
3 .2 :
1
,where isthe
realinterestrate.
Meaning:Consumptioninthesecondperiodequalstheaccumulated
saving,includingtheinterestearnedonthatsaving,plussecond
periodincome.
TheIntertemporal BudgetConstraint
From
3 .2 ,
1
1
1
Bydividingbothsidesby 1
since
;
3 .3 :
Meaning:Thepresent value ofconsumption mustequalthepresent

value ofincome.Itistheconsumersintertemporal budgetconstraint.
Notethat futureconsumptionandfutureincomearediscounted by
afactor 1
.Thisdiscounting arisesfromtheinterest earnedon
savings.
Present(Discounted)Value
Recall theconceptofpresentvalue:Ifyouput$100todayinabank
accountearning5percentinterestayear,in10yearsyouwouldhave
$ 1 0.05
$100 $162.89.
$162.89;
Thus,thepresentvalue of$162.89received10yearsfromnowis
$100.Formally,
where $ is the dollar amount received in year and is

theinterestrate.
isthepriceof2ndperiodconsumptionmeasuredintermsof
1stperiodconsumption:itistheamountof1stperiodconsumption
thattheconsumermustgiveuptoobtain1unitof2ndperiod
consumption.
From
3 . 3 ,
Figure 3B.1:ConsumersBudgetConstraint
Point :Theconsumerconsumesexactlyhis/herincomeineach
and
,sothereisneither saving nor
period
borrowing betweenthetwoperiods.
Point :Theconsumerconsumesnothinginthe1st period
0
andsaves allincome,sothe2nd periodconsumption is
1
.
Point :Theconsumerplanstoconsumenothinginthe2nd period
0 andborrows asmuchaspossibleagainst2ndperiodincome,
so1stperiodconsumption
is
ConsumerPreference
Theindifference curve representstheconsumerspreference
regardingconsumptioninthetwoperiods;i.e.,itshowsthe
combinationsof1stperiodand2ndperiodconsumptionthatmake
theconsumerequally happy.
Def.(3B.2):Indifferencecurve
Thecurvethatshowsdifferentcombinationsof and
tothesame levelofoverallhappiness(utility orwelfare)
thatlead
Figure3B.2:ConsumersPreferences
ThreeCharacteristicsofIndifferenceCurves
(i)Thefarther anindifferencecurveisfromtheorigin,thehigher its
utility.
Theconsumerisindifferent amongcombinations , , and
Becausetheyareallonthesame curve .
Becauseweareassumingthatmore consumptionisalwaysbetter,it
mustbetruethateverypointon
musthaveahigher utilitythan
everypointon .
(ii)Indifferencecurvesslopedown.
Tokeepaconsumerjustashappy,alossofhappinessfromlower
2ndperiodconsumptionmustbeoffsetbyhigherconsumptionin
period1,andviceversa.Indifferencecurvesarethereforedownward
sloping,illustratingthetradeoff betweenconsumingtodayversus
consumingtomorrow.
(iii)Indifferencecurvesarebowedin towardtotheorigin.
Thebowedinshapeoftheindifferencecurves,referredtoas
convexity,resultsfromthetypicalconsumersdislikeoflarge
fluctuationsinconsumptionfromoneperiodtothenext.Ingeneral,
peopleprefersmooth consumptionovertime.
The3rd characteristiccanbedescribedthroughtheconceptofthe
marginalrateofsubstitution (MRS)alsocalledtheintertemporal
marginalrateofsubstitution.
Def.(3B.2):Marginalrateofsubstitution
Therateatwhichaconsumeriswillingtogiveup(substitute)
consumptioninperiod2foradditionalconsumptioninperiod1
Theslopeoftheindifferencecurve
Sinceconsumersprefertosmooth consumptionovertime(andthus
becomesincreasinglyaversetogivingupconsumptioninperiod2),
themarginalrateofsubstitutionbecomessmaller as2ndperiod
consumptionfalls,givingtheindifferencecurveaconvex shape:
InFigure 3B.2,
issmaller than
,sothattheslopeofthe
indifferencecurvebecomesless negative.
Optimization
Usingbothanintertemporal budgetlineandasetofindifference
curves,wecanidentifytheoptimallevelofconsumptionforboth
periods.
Figure 3B.3:ConsumerOptimization
Optimization
Theoptimumindifferencecurvegiventheconsumersbudget
constraintis ,whichistangent totheintertemporal budgetlineat
pointO.AtpointO,consumptioninperiod1is andconsumption
inperiod2is .
1
1
From
3 . 3 ,
Theslopeoftheintertemporal budgetline:
AtpointO,theoptimumforaconsumeris:
TheslopeoftheIC =TheslopeoftheIBL
3 .4 :
Example (3B.1):Optimization
SupposeatypicalconsumernamedJenniferlivesfortwoconsumption
periods.Herrealincomeineachofperiods1and2, and ,equals
12.Designateconsumptionduringperiods1and2as and ,
respectively.Assumethatanysavingfromperiod1earnsinterestata
realinterestrateof50%,or0.50.SinceJenniferknowsshewilldieat
theendofperiod2,shedoesnotsaveinthesecondperiod.
a)WritedownJennifersintertemporal budgetconstraint,i.e.,the
budgetconstraintthatrelatesherlifetimeincomewithherlifetime
consumption.
(Ans.)
.
.
Slope:
. ,indicatingthateachunitofconsumptionin
period1canbetransformedinto1.5unitsofconsumptioninperiod2
becauseanysavingearnsinterestattherateof50percent.
b)DrawJennifersintertemporal budgetconstraintandlocatethe
point onthegraphatwhichsheconsumesallofhercurrentincome
ineachofthetwoperiods,thepoint atwhichshesavesallofher
incomeinperiod1inordertomaximize ,andthepoint atwhich
shemaximizes byborrowingagainstallofherincomeinperiod2.
(Ans.)
c)Furthermore,assumethattheamountofJenniferstotalsatisfaction
isgivenbythisutilityfunction:
.Findtheoptimal
consumptionof and ,locatethispointonthegraphinpart(b),
andlabelitpoint .Findherutilityattheoptimum.
(Ans.)
(i)Findthemarginalrateofsubstitution(MRS):
and
(ii)SetMRS equaltotheslopeofthebudgetline:
1.5
.
.
By(1)and(2),
10
15 and
10
15 150.
HowChangesinIncomeorWealthAffectConsumption
Letsexaminehowconsumptionrespondstoanincreaseinincomeor
.Anincreaseineither or orwealthshifts
wealth
thebudgetconstraintoutward.
Figure 3B.4:ResponsetoaRiseinCurrentIncome,Future
Income,orWealth
TheindifferencecurvesinFigure 3B.4aredrawnunderthe
assumptionthatconsumptioninperiod1andconsumptioninperiod
2arebothnormal goods.Becausetheconsumercanborrowandlend
betweenperiods,thetimingoftheincomeorwealthisirrelevant to
howmuchisconsumedtoday(exceptthatfutureincomeorwealthis
3 . 3 ,consumption
discounted bytheinterestrate).From
dependsonthepresentvalueofcurrentandfuture
incomeorwealth,lifetimeresources,
initialwealth.
where
is
NoticethatthisisquitedifferentfromKeynes.Keynespositedthat
apersonscurrentconsumptiondependslargelyonthecurrent
income.Fishersmodelsaysthatconsumptionisbasedontheincome
theconsumerexpectsovertheentire lifetime.
Consumptionriseswhenthepresentvalueoflifetimeresources
increases,regardlessofitssource(currentincome,futureincome,or
wealth).
Consumerswillspreadoutanyincreaseinconsumptionovertoday
andtomorrow,eveniftheincreasestemssolelyfromanincreasein
current income.Thisbehaviorisknownasconsumption smoothing.
Consumptionsmoothingisalogicalconsequenceoftwoelementsof
theintertemporal choicemodel:theconvexity ofindifferencecurves
andtheabilityofconsumerstoborrow orsave.
Indeed,consumptionsmoothingisastrongfeatureofthedata
becauseconsumptionfluctuatesmuchless thanGDP.
HowChangesintheRealInterestRateAffectConsumption
LetsnowuseFishersmodeltoconsiderhowachangeinthereal
interestratealterstheconsumerschoices.
Therearetwocasestoconsider:
Case1:Theconsumerisinitiallysaving
Case2:Theconsumerisinitiallyborrowing
Case1:Seewhathappenswhentheinterestraterisefrom
to .
Figure3B.5:ResponsetoaRiseintheInterestRate
Atpoint ,thecurrentconsumptionisequaltoinitialwealthplus
.Inthisspecialcase,the
1stperiodincome;thatis,
consumerisneitherborrowing norsaving (lending),soconsumption
inthesecondperiodisequaltosecondperiodincome,
.
Whentheinterestraterisesto ,point isstillonthenew
because,withnoborrowing or
intertemporal budgetline
saving,thelevelofinterestratedoesnot matter,leaving
and
.
Whentheinterestraterisesto ,theslopeofthebudgetline
, sothe
becomessteeper.
becomesmorenegative 1
Becauseitstillgoesthroughpoint ,thismeansthatthenew
pivotsclockwise aroundpoint .
intertemporal budgetline
Sinceconsumersonaveragesavesomeoftheirincome,the
consumersinitialoptimalconsumptionoccursatpoint ,inwhich
.Whentheinterestraterisesto andthe
,thenewoptimallevelof
intertemporal budgetlinepivotsto
consumptionatpoint isonahigher indifferencecurve, .
Consumptioninperiod1hasfallen to
period2hasrisen to
,whileconsumptionin
Wecandecomposetheimpactofanincreaseintherealinterestrates
onconsumptionintotwoeffects:
Incomeeffect
Thechangeinconsumptionduetochangesinincome
Thechangeinconsumptionthatresultsfromthemovementto
ahigherindifferencecurve
Theconsumerhassavings,sohe/shelends money(probablyby
depositingthefundsinhis/herbankaccount)fromperiod1toperiod
2.Atahigher interestrate,theconsumerearnsmore interest,which
giveshim/hermore resourceswithwhichtoconsume.Thus,the
consumercanspendmore inbothperiods.Forsavers,theincome
effectincreases consumptioninboth periodswheninterestrates
rise.
Substitutioneffect
Thechangeinconsumptionthatoccursfromthechangeinthe
relative price ofconsumptioninthetwoperiods
Withahigher interestrate,thepresent(discounted)valueof
consumption
inthesecondperiodfalls,soconsumptioninthe
secondperiodbecomesless expensiverelativetoconsumptioninthe
firstperiod.Asaresult,theconsumerwilldecidetosubstituteaway
andreducefirstperiodconsumptiontoconsumemore inthesecond
period.Thesubstitutioneffectfromhigher interestratesleadsto
less consumptioninperiod1butmore consumptioninperiod2.
Wecanalsothinkofthesubstitutioneffectintermsofsaving.When
interestraterises,thereturntosavingishigher andsoaconsumer
willsavemore inthefirstperiodbyreducingconsumption,enabling
him/hertospendmore inthesecondperiod(consumptionrises).
Conclusion:Wheninterestratesincrease,bothincomeand
substitutioneffectsshiftsecondperiodconsumptionhigher.Butin
thefirstperiod,thesubstitutioneffecttampsdownconsumption
whiletheincomeeffectliftsconsumption.Hence,theultimate
directionofthechangeintodaysconsumptiondependsonthe
relative sizeofincomeandsubstitutioneffects.
Assumption:Inpractice,weusuallyassumethatthesubstitution
effectoutweighstheincomeeffect.
InFigure 3B.5,sincethesubstitution effectdominatestheincome
effect,arise ininterestrateslowers todaysconsumption(increases
saving),butboost futureconsumption.
Wemakethisassumptionbecauserealworlddatasupporttheview
thathigher interestratesareassociatedwithhigher savingandlower
consumptiontoday.However,theempiricalevidenceonthe
relationshipofinterestratestoconsumptionandsavingisnot
overwhelminglystrong.
BorrowingConstraints
Sofarwehaveassumedthatconsumerscanborrowandlendatthe
same interestrate.However,notallconsumersaregodcreditrisks.
Consumerswithlittleornowealthmayfindthattheycannot get
loans.
Iftheconsumerhasno wealthandcannot borrow,he/shecannot
spendmorethanhe/sheearns.Aconstraintonborrowingcan
,indicatingconsumptiontodaymust
thereforebewrittenas:
beless thanorequal toincometoday.Thisadditionalconstrainton
theconsumeriscalledaborrowing constraint (oraliquidity
constraint).
Toseetheimplicationforconsumptionchoices,letsfirstlookatthe
effectofaborrowingconstraintontheconsumersintertemporal
budgetline.
Intertemporalbudgetlinewithaborrowingconstraint
Supposethatwithoutaborrowingconstraint,theintertemporal
budgetlineisastraightlinewithaslopeof 1
.Witha
borrowingconstraint,theconsumercannot spendmore thanhis/her
currentincome.Thatis, cannot riseabove .Atpoint ,where
,theintertemporalbudgetlinebecomesvertical.
Figure 3B.6:ABorrowingConstraint
Q:Howwillaborrowingconstraintchangetheconsumers
consumptionchoices?
A:Weconsidertwocases.
Case1:Borrowingconstraintisnotbinding
Sincetheconsumersoptimallevelofconsumptionisless than ,
he/shehasno needtoborrow.Asaresult,he/shewillnot be
constrainedbyhis/herinabilitytoborrow,andwecansaythatthe
constraintisnot binding.
Figure 3B.7:OptimizationwithaBorrowingConstraint
Case2:Borrowingconstraintisbinding
Theconsumerwouldliketoborrowandchoosepoint .Butbecause
borrowingisnot allowed,thebestavailablechoiceispoint .When
theborrowingisbinding,firstperiodconsumptionequalsfirstperiod
and
.Theslopeoftheindifference
income,so
,sothat
.
curveatpoint issteeper than 1
Example (3B.2):ContinuationofExample (3B.1)

Thecurvelabeled
representsJennifersinitialintertemporal
budgetconstraintorline.SupposethatJennifersincomeinperiod1
risesto12.78,while remainsequalto12.
a)WritedownJennifersnewintertemporal budgetlineorconstraint.
Graphthisnewintertemporal budgetconstraintandlabelit
(Ans.)
.
.
.
.
.

b)Findthenewoptimalconsumptionof and ,locatethispointonthe
graphinpart(a),andlabelitpoint .Findherutilityatthenewoptimum.
(Ans.)
SetMRS equaltotheslopeofthebudgetline:
.
.
By(1)and(2),
15.59 and
10.39 and
10.39 15.59 162.

Consumptionduringeachperiodhasincreased.Thechangesin
consumptionbetweenpoint andpoint aretheresultofthe income
effect.

c)Finally,supposethatJennifersincomeineachperiodreturnstoits
formerlevelof12andthattherealinterestraterisesto100percent,or
1.0.WritedownJennifersnewintertemporal budgetlineorconstraint.
.
(Ans.)
d)Findtheoptimalconsumptionof and ,locatethispointonthe

graphinpart(a),andlabelitpoint .Findherutilityattheoptimum.
(Ans.)
18 and
9 and
9 18 162.
By(1)and(2),
Thechangeinconsumptionfrompoint topoint reflectsthe
substitutioneffect.Jenniferrespondstothischangeintherelative
priceofconsumptioninthetwoperiodsbydecreasing and
increasing .Sincethesubstitutioneffectoutweighstheincome
effect inthiscase, obviouslyfallswhile increases.
Sofarwehaveassumedthatconsumerscanborrowandlendatthe
same interestrate.However,notallconsumersaregodcreditrisks.
Consumerswithlittleornowealthmayfindthattheycannot get
loans.
Iftheconsumerhasno wealthandcannot borrow,he/shecannot
spendmorethanhe/sheearns.Aconstraintonborrowingcan
,indicatingconsumptiontodaymust
thereforebewrittenas:
beless thanorequal toincometoday.Thisadditionalconstrainton
theconsumeriscalledaborrowing constraint (oraliquidity
constraint).
Toseetheimplicationforconsumptionchoices,letsfirstlookatthe
effectofaborrowingconstraintontheconsumersintertemporal
budgetline.
Intertemporalbudgetlinewithaborrowingconstraint
Supposethatwithoutaborrowingconstraint,theintertemporal
budgetlineisastraightlinewithaslopeof 1
.Witha
borrowingconstraint,theconsumercannot spendmore thanhis/her
currentincome.Thatis, cannot riseabove .Atpoint ,where
,theintertemporalbudgetlinebecomesvertical.
Figure 3B.6:ABorrowingConstraint
Q:Howwillaborrowingconstraintchangetheconsumers
consumptionchoices?
A:Weconsidertwocases.
Case1:Borrowingconstraintisnotbinding
Sincetheconsumersoptimallevelofconsumptionisless than ,
he/shehasno needtoborrow.Asaresult,he/shewillnot be
constrainedbyhis/herinabilitytoborrow,andwecansaythatthe
constraintisnot binding.
Case2:Borrowingconstraintisbinding
Theconsumerwouldliketoborrowandchoosepoint .Butbecause
borrowingisnot allowed,thebestavailablechoiceispoint .When
theborrowingisbinding,firstperiodconsumptionequalsfirstperiod
and
.Theslopeoftheindifference
income,so
,sothat
.
curveatpoint issteeper than 1

Thecurvelabeled
representsJennifersinitialintertemporal
budgetconstraintorline.SupposethatJennifersincomeinperiod1
risesto12.78,while remainsequalto12.
a)WritedownJennifersnewintertemporal budgetlineorconstraint.
(Ans.)
.
.
.
.
.

b)Findthenewoptimalconsumptionof and ,locatethispointonthe
graphinpart(a),andlabelitpoint .Findherutilityatthenewoptimum.
(Ans.)
.
.
By(1)and(2),
15.59 and
10.39 and
10.39 15.59 162.

Consumptionduringeachperiodhasincreased.Thechangesin
consumptionbetweenpoint andpoint aretheresultofthe income
effect.

c)Finally,supposethatJennifersincomeineachperiodreturnstoits
formerlevelof12andthattherealinterestraterisesto100percent,or
1.0.WritedownJennifersnewintertemporal budgetlineorconstraint.
.
(Ans.)
d)Findtheoptimalconsumptionof and ,locatethispointonthe

graphinpart(a),andlabelitpoint .Findherutilityattheoptimum.
(Ans.)
18 and
9 and
9 18 162.
By(1)and(2),
Thechangeinconsumptionfrompoint topoint reflectsthe
substitutioneffect.Jenniferrespondstothischangeintherelative
priceofconsumptioninthetwoperiodsbydecreasing and
increasing .Sincethesubstitutioneffectoutweighstheincome
effect inthiscase, obviouslyfallswhile increases.
FrancoModiglianiandtheLifeCycleHypothesis
Inaseriesofpaperswritteninthe1950s,FrancoModigliani(thenat
CarnegieMellon,lateratMIT)andhiscollaboratorsAlbertAndoand
RichardBrumberg extendedFishersintertemporalchoicemodelof
consumerbehaviortomanyperiods,developingthelifecycle
hypothesis.
Goals:Solvetheconsumptionpuzzle thatis,toexplain
theapparentlyconflictingpiecesofevidencethatcametolightwhen
Keynessconsumptionfunctionwasconfrontedwiththedata.
FrancoModiglianiandtheLifeCycleHypothesis
Modiglianiemphasizedthatformostpeople,incomechanges
systematicallyoveralifetime,mostnotablywhenincomedeclinesat
retirement.Asthetheorysuggested,peopletendtosmooth
consumptionovertheirlifecycle bymovingtheirincomefromthose
timesinlifewhenincomeishigh tothosetimeswhenitislow.
Thisinterpretationofconsumerbehaviorformedthebasisfor
thelifecyclehypothesis.
LifeCycleConsumptionFunction
Consideraconsumerwhostartsearninganincomeattime
0,
thestartingageofadulthood(say,age20),andworksuntilhe/she
retires yearslater(say,45=age65 age20).Theconsumerexpects
tolivefor additionalyearsafterhe/shebecomesanadult
(say,60=age80 age20).
Q:Whatlevelofconsumptionwilltheconsumerchooseifhe/she
wantstomaintainasmoothlevelofconsumptionoveralifetime?
Assumption:Forsimplicity,theinterestrateiszero,sothatallfuture
incomeandconsumptionstreamshavethesame present
(discounted)valueascurrent incomeorconsumption.
Untiltimeperiod ,theconsumerearnsayearlysalaryof ,but
whenhe/sheretiresattime ,his/hersalaryfallstozero.
Atanygivenpointintime ,theconsumerslifetimeresourcesare
and(ii)
,
madeupoftwocomponents:(i)wealth
timesthesalary.
thenumberofyearshe/shelefttowork
.
Theconsumerstotallifetimeresourcesattime is:
Sincetheconsumerwantstosmoothhis/herconsumptionandenjoy
thesame consumptionthroughouttherestofhis/herlife,he/shewill
dividehis/herlifetimeresourcesby
,thenumberofyears
he/shelefttolive,todetermineeachyearsconsumption:
3 .5 :
Wecanrewritethisconsumptionfunctionbyseparatingoutthe
wealthandincometermsasfollows:
3 .6 :
where
and
Theparameter isthemarginalpropensitytoconsumeroutof
wealth andtheparameter isthemarginalpropensitytoconsume
outofincome.
Conclusion:Changesinconsumptionaredrivenbychangesinincome
andwealth.
Figure 3B.6:TheLifeCycleConsumptionFunction
Noticethat theinterceptoftheconsumptionfunction
fixed value,butinsteaddependsonthelevelofwealth.
isnot a
Example (3B.3):ConsumptionFunction
SupposeCarmenisprettyyoung,say25yearsold,sothat
5,and
alsosupposethatshewillretireat65andhasalifeexpectancyof80.
a)WritedownCarmensconsumptionfunction.
(Ans.)
and
.
.
WhenCarmenisyoung,shewillhaveaMPCof2centsoutofevery
dollarofwealthand73centsoutofeverydollarofincome.
b)WritedownCarmensconsumptionfunctionwhensheis60years
old.
(Ans.)
,
,
.
.
CarmennowhasaMPCof5centsoutofeverydollarofwealthand
25centsoutofeverydollarofincome.
c)DrawaconclusionfromCarmenslifecycleconsumptionfunction.
(Ans.)
Asconsumersgetolder,theMPCoutofwealthrises,whiletheMPC
outofincomefalls.
Intuitivelyspeaking,asconsumersgetolder,theyhavefeweryearsto
liveandsowillconsumeahigher fractionoftheirwealtheachyear,
whiletheirannualincomewillcontinueforfeweryears,sothe
increaseintheirlifetimeresourceswillbelower relativetotheir
annualincomeandtheywillspendless ofit.
SavingandWealthOvertheLifeCycle
Accordingtothelifecycleconsumptionfunction,theaverage
propensitytoconsume(APC)is:
3 .7 :
Becausewealthdoesnotvaryproportionatelywithincome from
persontopersonorfromyeartoyear,weshouldfindthathigh
incomecorrespondstoalow APCwhenlookingatdataacross
individualsorovershort periodsoftime.Butoverlong periodsof
time,wealthandincomegrowtogether,resultinginaconstant ratio
andthusaconstant APC.
Considerhowconsumptionfunctionchangesovertime.Keynes
positedthattheAPCfalls asincomerises.ButKeynessconjecture
holdsonlyintheshort runwhenwealthisconstant.Inthelong run,
aswealthrises,theconsumptionfunctionshiftsupward.Thisupward
shiftpreventstheAPCfromfalling asincomeincreases.
Inthisway,Modiglianiresolvedtheconsumptionpuzzleposedby
KeynessconjectureandbySimonKuznetssdata.
Figure 3B.7:HowChangesinWealthShifttheConsumption
Function
Thelifecyclehypothesishelpsseehowsavingandwealthevolveover
peopleslifetimes.
Forsimplicity,weassumethattherearenocapitalgainsorlosseson
theconsumerswealth,sothatthechangeinwealthforanyyearis
equaltotheamounthe/shehassaved:
.
Sincetheconsumerwantstosmoothconsumption,he/shewillwant
his/herconsumptiontobethesame everyperiodat :
3 .8
.
Example (3B.5):Continuation ofExample(3B.3)

IfCarmenhasasalaryof$50,000,howmuchwillsheconsumeevery
year?
(Ans.)
everyyear.
Nowletslookatwhathappenstosavingandwealthovertime.
Forthefirst45yearsofherworkinglife,
.
.
.
$
$ ,
.Everyyearhersaving
(wealth)isincreasingby$12,500untilsheretiresatageof65.
Figure3B.8:ConsumptionandSavingovertheLifeCycle
Figure 3B.9:WealthovertheLifeCycle
Wealthincreaseslinearly withaslopeof .
$ ,
.
Atretirement,Carmenstotalwealthhasaccumulatedto
$ ,
$
,
.Afterretirement,shehasnegative saving
equaltoherconsumption of .
or$37,500.Attheendofher
lifeshehasexhausted allofhersavings.
Thelifecyclehypothesisimpliesthataspeoplegrowolderbefore
retirement,theirwealthgrows;afterretirement,theirwealth
declines.Thisresultexplainsanimportantfactfoundinthedata:
older peopletendtohavehigher holdingsofassets(stocks,bonds,
andhousing)thandoyounger people.
Accordingtothelifecycleconsumptionfunction,theaverage
propensitytoconsume(APC)is:
3 .7 :
Becausewealthdoesnotvaryproportionatelywithincome from
persontopersonorfromyeartoyear,weshouldfindthathigh
incomecorrespondstoalow APCwhenlookingatdataacross
individualsorovershort periodsoftime.Butoverlong periodsof
time,wealthandincomegrowtogether,resultinginaconstant ratio
andthusaconstant APC.
Considerhowconsumptionfunctionchangesovertime.Keynes
positedthattheAPCfalls asincomerises.ButKeynessconjecture
holdsonlyintheshort runwhenwealthisconstant.Inthelong run,
aswealthrises,theconsumptionfunctionshiftsupward.Thisupward
shiftpreventstheAPCfromfalling asincomeincreases.
Inthisway,Modiglianiresolvedtheconsumptionpuzzleposedby
KeynessconjectureandbySimonKuznetssdata.
Figure 3B.7:HowChangesinWealthShifttheConsumption
Function
Thelifecyclehypothesishelpsseehowsavingandwealthevolveover
peopleslifetimes.
Forsimplicity,weassumethattherearenocapitalgainsorlosseson
theconsumerswealth,sothatthechangeinwealthforanyyearis
equaltotheamounthe/shehassaved:
.
Sincetheconsumerwantstosmoothconsumption,he/shewillwant
his/herconsumptiontobethesame everyperiodat :
3 .8
.
Example (3B.5):Continuation ofExample(3B.3)

IfCarmenhasasalaryof$50,000,howmuchwillsheconsumeevery
year?
(Ans.)
everyyear.
Nowletslookatwhathappenstosavingandwealthovertime.
Forthefirst45yearsofherworkinglife,
.
.
.
$
$ ,
.
Everyyearhersaving(wealth)isincreasingby$12,500until
sheretiresatageof65.
Figure3B.8:ConsumptionandSavingovertheLifeCycle
Figure 3B.9:WealthovertheLifeCycle
Wealthincreaseslinearly withaslopeof .
$ ,
.
Atretirement,Carmenstotalwealthhasaccumulatedto
$ ,
$
,
.Afterretirement,shehasnegative saving
equaltoherconsumption of .
or$37,500.Attheendofher
lifeshehasexhausted allofhersavings.
Thelifecyclehypothesisimpliesthataspeoplegrowolderbefore
retirement,theirwealthgrows;afterretirement,theirwealth
declines.Thisresultexplainsanimportantfactfoundinthedata:
older peopletendtohavehigher holdingsofassets(stocks,bonds,
andhousing)thandoyounger people.
ThePermanentIncomeHypothesis
Sinceborrowingconstraintsapplytoaminorityofhouseholds,Milton
Friedman(UniversityofChicago),inhismonumentalworkpublished
in1953,ATheoryofConsumptionFunction,arguedthatconsumption
smoothingwasakeyfeatureofconsumptionbehavior.
Friedmanspermanentincomeemphasizedthatconsumerslook
beyondcurrent income.
FriedmanspermanentincomehypothesiscomplementsModiglianis
lifecyclehypothesis:bothuseIrvingFisherstheoryoftheconsumer
toarguethatconsumptionshouldnotdependoncurrentincome
alone.
Butunlikethelifecyclehypothesis(whichincomefollowsaregular
patternoverapersonslifetime),thepermanentincomehypothesis
emphasizesthatpeopleexperiencerandom andtemporary changes
inincomefromyeartoyear.
Friedmandividedincomeintotwocomponents,permanentincome
andtransitoryincome
:
3 .9
.
Transitoryincome isthecomponentofincomethatdoesnot persist

foralongperiodoftimeandsoissubjecttotemporaryfluctuations
whilepermanentincomeisthepartofincomethatpeopleexpectto
persistintothefuture.
Putdifferently,permanentincomeisaverage income,andtransitory
incomeistherandom deviationfromtheaverage.
MiltonFriedmanreasonedthatconsumerswouldnot consumemuch
more becauseofhigher transitory income(likewinningajackpot)but
wouldinsteadsave mostofit,andspendalittlemoreovermany
years.Ontheotherhand,ifpermanent incomerose,saybecauseof
anadvanceddegree,consumptionwouldbemuchhigher.
ThePermanentIncomeConsumptionFunction
Friedmanconcludedthatwecanapproximately treatconsumptionas
afunctionofpermanent income:

3 . 10
In
3 . 10 , isaconstant fractionthatrepresentsthemarginal
propensitytoconsume(MPC)relativetopermanentincome.
Inotherwords,thepermanentincomehypothesisindicatesthat
consumptionis proportional topermanentincome.
RelationshipofthePermanentIncomeHypothesisand
IntertemporalChoice
Usingtheconceptofpermanentincome,wecanseehowinter
temporalchoicetheorycomestothesameconclusion:
thatconsumptionrespondsmoretoariseinpermanent incomethan
itdoestoariseintransitory income.
Inthetheoryofintertemporalchoice,consumptionrespondstothe
presentvalueoffutureincomestreams,
.Apermanent rise
inincomeliftsboth and ,liftinglifetimeresourcesand

increasingconsumptionbothtoday andtomorrow.
RelationshipofthePermanentIncomeHypothesis
andIntertemporalChoice
Ontheotherhand,atransitory hikeinincomewilllift butnot ,
andboostlifetimeresources(andtodaysconsumption)byamuch
smaller amount.Becausethepermanentincomehypothesisis
derivedinamultiperiodframework,itcomestoanevenstronger
conclusionthatconsumptionrespondsmostlytopermanent income
andhardlyatalltotransitory income.
ImplicationsofThePermanentIncomeHypothesis
Thepermanentincomehypothesissolvestheconsumptionpuzzleby
suggestingthatthestandardKeynesianconsumptionfunctionuses
thewrong variable.Accordingtothepermanentincomehypothesis,
consumptiondependsonpermanentincome ;yetmanystudiesof
consumptionfunctiontrytorelateconsumptiontocurrent
consumption .Friedmanarguedthatthiserrorinvariable problem
explainstheseeminglycontradictoryfindings.
LetsseewhatFriedmanshypothesisimpliesforthe
Accordingtothepermanentincomehypothesis,the
dependson
theratioofpermanent incometocurrent income.
Nowconsiderthestudiesofhouseholddata.Friedmanarguedthat
thesedatareflectacombinationofpermanentandtransitoryincome.
Householdswithhigh permanentincomehaveproportionately
higher consumption.Ifallvariationincurrentincomecamefromthe
permanent component,the
wouldbethesame inall
households.
Butsomeofthevariationinincomecomesfromthetransitory
component,andhouseholdswithhigh transitoryincomedonot have
higher consumption.Therefore,researchersfindthathighincome
householdshave,onaverage,lower
.
Similarly,considerthestudiesoftimeseriesdata.Friedmanreasoned
thatyeartoyearfluctuationsinincomearedominatedbytransitory
income.Therefore,yearsofhigh incomeshouldbeyearsoflow
.
Butoverlong periodsoftime say,fromdecadetodecade the
variationinincomefromthepermanent income.Hence,inlong time
series,oneshouldobserveaconstant
,asinfactKuznetsfound.
RobertHallandtheRandomWalkHypothesis
In1978,RobertHall(thenfromMITandnowatStanford)published
apathbreakingpaperbasedonthelifecycleandpermanentincome
hypothesisthatifconsumersareveryforesighted,thenchangesin
consumptionshouldbeunpredictable:Thebestforecastof
consumptionnextyearwouldbeconsumptionthisyear!Putanother
way,changesinconsumptionshouldbeveryhardtopredict.
RobertHallandtheRandomWalkHypothesis
Thisresultcameasasurprisetomostmacroeconomistsatthetime,
butitisinfactbasedonasimpleintuition:Ifconsumersarevery
foresighted,theywillchangetheirconsumptiononlywhentheylearn
somethingnew aboutthefuture.But,bydefinition,suchnews
cannot bepredicted.Whenchangesinavariableareunpredictable,
thevariableissaidtofollowarandom walk,andthatiswhyHalls
theory consumptionfollowsarandomwalk hasbecomeknownas
therandomwalkhypothesis. Thispaperbecamethebenchmarkin
consumptionresearchthereafter.
RandomWalkHypothesis
Thereasoningbehindtherandomwalkhypothesisstartswiththree
steps.
Step 1:Thelifecycleandpermanentincomehypothesis(aswellas
thetheoryofintertemporalchoice)implythatconsumersare
forwardlooking.Thatis,theybasetheirconsumptiondecisionson
theircurrentexpectation onfuture incomethatwilldeterminetheir
lifetimeresources.
Step 2:Onlywhenexpectationsoffutureincomechangewill
expectationsoflifetimeresourceschange.
RandomWalkHypothesis
Step 3:Sincecurrentconsumptionisdeterminedbychangesin
expectationsoflifetimeresources,changesinconsumptionshould
onlychangewhentheseexpectationschange.
Becauseexpectationsarederivedfromallavailableinformation,only
new information,thatis,unanticipated surprises,willcause
expectationstochange.Hence,expectationsoflifetimeresources
andcurrentconsumptionwillchangeonlywhenthereis
unanticipated newinformation,andsochangesinconsumptionare
unpredictable. Thatis,theyfollowarandom walk.
ImplicationsofRandomWalkHypothesis
Ifconsumersobeythepermanentincomehypothesisandhave
rational expectations,thenonlyunexpected policychangesinfluence
consumption.Thesepolicychangestakeeffectwhentheychange
expectations.Forexample,supposeCongresspassesataxcut when
theeconomyisinrecession,butthistaxcutwasalreadyexpected
becauseCongresshasalwayspassedsuchtaxcutsinprevious
recessions.Thetaxcutwillnot changeexpectationsoflifetime
resourcesandhencewillnot causeconsumptiontochange.Onlyif
thetaxcutisasurprise willitworktoraise consumption.
Indeed,ataxcutthatissmaller thanthepublicexpectscouldeven
causeconsumptiontofall,not rise.Becausethepublicexpectedits
disposableincometobehigher asaresultofalarger taxcut,the
smallertaxcutwouldcausethepublictorevisedownward its
expectationsoflifetimeresources.Therandomwalkhypothesisthus
statesthattheeffectsoftaxpolicyonconsumptionarehighly
uncertain becausetheeffectonconsumptiondependsonwhatthe
policyisrelativetowhatitwasexpectedtobe.
Conclusion:Accordingtotherandomwalkhypothesis,taxpolicy
cannot beusedtomanagefluctuationsinconsumptioninorderto
softenswingsineconomicactivity.Toputanother,sinceexpectations
cannot beobserveddirectly,itisthusoftenhardtoknowhowand
whenchangesinfiscalpolicyalteraggregatedemand.
BehavioralEconomicsandConsumption
Keynescalledtheconsumptionfunctionafundamentally
psychologicallaw.Yet,psychologyhasplayedlittleroleinthe
subsequentstudyofconsumptionsincetherationalmaximization
modelofhumanbehaviorwasthebasisforalltheworkon
consumptiontheoryfromIrvingFishertoRobertHall.Recently,
economistssuggestthattheoptimizingbehaviorofconsumersmay
not beacompletelyaccuratecharacterizationofhowconsumers
actuallybehave.
Morerecently,economistshavestartedtoreturntopsychology.
Theyhavesuggestedthatconsumptiondecisionsarenot madeby
theultrarationalHomo economicus butbyrealhumanbeingswhose
behaviorcanbefarfromrational.Thisnewsubfieldinfusing
psychologyintoeconomicsiscalledbehavioral economics.Themost
prominentbehavioraleconomiststudyingconsumptionisHarvard
professorDavidLaibson.
Behavioreconomics
Anewfieldineconomicsthatappliesofconceptsfromothersocial
sciences,suchasanthropology,sociology,and(inparticular)
psychology,tothestudyofeconomicbehavior
Considerthefollowingtwoquestions:
Question 1:Wouldyouprefer(A)acandytodayor(B)twocandies
tomorrow?
Question 2:Wouldyouprefer(A)acandyin100daysor(B)two
candiesin101days?
Inasense,manypeoplearemorepatient inthelong runthanthey
areintheshort run.Thisraisesthepossibilitythatconsumers
preferencesmaybetimeinconsistent;theymanyaltertheirdecisions
simplybecausetimepasses.
Oneimplicationofbehavioreconomicsisthatconsumersmaybe
swayedbyinstant gratification,andsotheirdecisionsmaynot put
enoughweightonthefuture.DavidLaibson haslabeledthis
phenomenonhyperbolicdiscounting,tocapturetheideathat
consumerswillnot consistentlydiscount thefutureovertime,asis
assumedinthetheoryofintertemporalchoice.
Weseethiskindofbehaviorinmanysituationsinlife.When
tomorrowarrives,thepromisesareinthepast,andanewselftakes
controlofthedecisionmaking,withitsowndesireforinstant
gratification.Oneresultofsuccumbingtoinstantgratificationand
therebymakingdecisionswithtoohighadiscountrateisthat
consumersmayoverreact tocurrent incomeandnot smooth
consumptionsufficiently.
Theseobservationsraiseasmanyquestionsastheyanswer.
Money
Moneyistheeconomictermforassets thatarewidelyusedand
acceptedasameansofpayment.
Theformsofmoneyhavebeenverydifferent:fromshellstogoldto
cigarettes!
Mostpricesaremeasuredinunitsofmoney
Understandingtheroleofmoneyisimportanttounderstandinflation.
Manyeconomistsbelievethatmoneyhasalsoimpactonreal variables.
Moneyhasthemostliquid buthasalow return.
Liquidity
Theeaseandquicknesswithwhichanassetcanbeconvertibleintoa
meansofpayment withlittlelossinvalues
FunctionsofMoney
(i) Mediumofexchange orMeansofpayment:Moneypermitsto
tradeatlesscostintimeandeffort!
Barterisinefficient becauseitisdifficultandtimeconsumingtofind
thetradingpartner.Moneymakesdoublecoincidenceofwants
unnecessary.
Otherbenefitsofmoney:allowspecialization andincrease
productivity.
(ii)Unitofaccount:Moneyisabasicunitformeasuringeconomic
value.
Giventhatgoodsandservicesaremostlyexchangedformoney,itis
naturaltoexpresseconomicvalueintermsofmoney.
FunctionsofMoney
Incountrieswithvolatileinflation,moneyisapoorunitofaccount
becausepricesmustbechangedfrequently.Morestableunitsof
accountsshouldbeused(dollarsorgold),eveniftransactionsuse
localcurrency.
Centralbankdiscardslocalcurrencyafteryearsofhyperinflation
whichatonepointreached500,000,000,000%
FunctionsofMoney
(iii)Storeofvalue:moneyisawayofstoringwealth.
Othertypesofassetsmaypayhigher returns,butarenot amedium
ofexchange.
Money
*Moneyisastock variable.
Stock variable:somethingmeasuredatagivenpointintime
Examples:wealth,amountofcapital,governmentdebt,thenumber
ofunemployedpeople,savings
Flow variable:somethingmeasuredperunitoftime
Examples:GDP,income,expenditure,saving,amountofinvestment,
budgetdeficit,thenumberofpeoplelosingtheirjobs
Thevalueofstock variablechangesovertimeasthevalueofflow
variablechanges.Forexample,wealthcanonlychangeovertimeas
yousaveordissave.
MeasuresofMoney
Therearetwomainofficialmeasuresofmoneystockcalledmonetary
aggregates:M1 isthenarrowestdefinitionofmoney.
TwoBroadMeasuresoftheMoneyStock:
Symbol
Assets included
M1
Currency (coins and bills in the hands of the public)

+ Demand deposits (e.g., checking accounts) at banks
(non-interesting-bearing bank deposits on or against which agents can write checks)
+ Other checkable deposits (interest-earning checking accounts)
+ Travelers checks
M2
Everything in M1
+ Small time deposits (Certificate deposits less than $100,000)
+ Saving-type deposits (deposits at banks and other thrift institutions)
+ MMMFs (money market mutual funds)
+ Money market deposit accounts (MMDAs)
PortfolioAllocationandDemandforAssets
Tounderstandhowagentsdeterminetheamountofmoneythey
choosetohold,wefindananswerforthequestion:howdoagents
allocatetheirwealthamongmanydifferentassetsthatareavailable?
Portfolioallocationdecision
Agentsdecisionaboutwhichassetsandhowmuchofeachasset
tohold
Agentsdecisiononhowtodistributewealthamongmanytypesof
assets
Portfolio
Thesetofassetsthatanagent aholderofwealth choosesto
own
CharacteristicsofAssets
Fundamentally,onlyfour maincharacteristicsofassetsmatterforthe
portfolioallocationdecision:expected return,risk,liquidity,andtime
tomaturity.
Expected return:Therateofreturn istherateofincrease initsvalue
perunitoftime.Everythingbeingequal,thehigher anassets
expectedreturn(aftersubtractingtaxesandfeessuchasbrokers
commissions),themore desirabletheassetisandthemore ofitan
agentwillwanttoown.
Risk:Anassethashigh riskifthereisasignificantchancethatthe
actual returnreceivedwillbeverydifferentfromtheexpected return.
Becausemostagentsareriskaverse,theyholerisky assetsonlyifthe
expectedreturnishigher thanthatinrelativelysafe assets,suchas
U.S.governmentbonds.
Riskpremium
Theamountbywhichtheexpectedreturnonariskyassetexceeds
thereturnonacomparablesafeasset
Liquidity:Liquiditymakestransactionseasier andcheaper andalso
providesflexibilitytotheholderofwealth:aliquidassetcaneasilybe
disposed ofifthereisanemergencyneedforfundsorifunexpectedly
goodinvestmentopportunitiesarise.Thus,everythingelsebeing
equal,themore liquid anassetis,themore attractiveitwillbeto
agents.
Time to Maturity:theamountoftimeuntilafinancialsecurity
maturesandtheinvestorisrepaidhisorherprincipal.
Typically,thereisatradeoff amongfourcharacteristicsthatmakean
assetdesirable:ahighexpectedreturn,safety(lowrisk),liquidity,and
timetomaturity.
Forexample,asafe andliquidassetwithashort timetomaturity,
suchasacheckingaccount,islikelytohavealow expectedreturn.
DemandforMoney
Demandformoney
Quantityofmonetaryassets,suchascashandcheckingaccounts,
thatpeoplechoosetoholdintheirportfolio;
.
Inpractice,two characteristicsofmoneyareparticularlyimportant:
First,moneyisthemostliquid asset,whichisaprimarybenefitof
holdingmoney.
Second,moneypaysalow return (currencypaysazero nominal
return).
Thelowreturnearnedbymoney,relativetootherassets,isamajor
cost ofholdingmoney.
Peoplesdemandformoneyisdeterminedbyhowtheytradeofftheir
desireforliquidityagainstthecostofalowerreturn.
DemandforMoney
Assumption:Agentsonlyhavethechoicebetweentwofinancial
assets,money (transaction liquidity role)andnonmonetary assets
bond(investment):
Wealth=M(money)+B(bonds)
Q:Inwhatproportionsshouldpeopleholdbothmoneyandbonds?
A:Theanswerwilldependmainlyontwovariables:
Leveloftransactions:Thehigher theleveloftransactions,thelarger
thedemandformoney.
Interest rate onbonds(i):Thehigher theinterestrate,thelower the
demandformoney;i.e.agentsarewillingtoholdtheirwealthin
bonds.
DerivingDemandforMoney
4.1 :
where =theaggregatedemandformoneyinnominalterms
(demandforM1);
=theoverallricelevel(CPIorGDPdeflator);
=realincomeoroutput(realGDP);
,thenominalinterestrateearnedbynonmonetaryassets;
=afunctionrelatingmoneydemandtorealincomeandthe
nominalinterestrate.
MeaningofEq(4.1):Themoneydemanddependsontheoveralllevel
oftransactions intheeconomyandontheinterest rate.
ThreeMacroeconomicVariablesandMoneyDemand
(i)Pricelevel
Thehigher thegeneralpricelevel,themore moneypeopleneedto
conducttransactionsandthusthemore moneypeoplewanttohold.
Thus,everythingelsebeingequal,thenominaldemandformoneyis
proportional tothepricelevel.
Thedemandformoneyisproportional tothepricelevel(P):
by 10%
by 10%.
(ii)Nominalincome $
orRealincome
Theoverallleveloftransactionsintheeconomyislikelytobe
roughly proportional tonominalincome(incomemeasuredin
dollars).
Thedemandformoneyincreasesinproportion tonominalincome
$ . Ifnominalincomedoubles,thenthedemandformoneyalso
doubles.Thisiscalledtheliquidity demand formoney.
Becausehigher realincomemakesmoreandlargertransactionsanda
greaterneedforliquidity,theamountofmoneydemandedshould
increasewhenrealincomeincreases.Theincreaseinmoneydemand
neednot beproportional toanincreaseinrealincome.
(iii)Nominalinterestrate orRealinterestrate
Thedemandformoneynegatively dependsontheinterest rate.
Anincrease intheinterestrateonnonmonetaryassetsdecreases the
quantitydemandedformoney.Foragiven ,thequantityofmoneyis
adecreasing (ornegative)functionoftheinterest rate.
Thetheoryofliquiditypreference byKeynespositsthattheinterest
rate isonedeterminantofhowmuchmoneypeoplechoosetohold
becausetheinterestrateistheopportunity cost ofholdingmoney.
Figure 4.1:TheDemandforMoney
curveshowstherelationb/wthedemand formoney andthe

interest rate foragivenlevelofnominal income ($Y).
DemandforMoneyCurve
Thecurveisdownward sloping:
Thelower theinterestrate(theloweri),thehigher theamountsof
moneypeoplewanttohold(thehigherM).
Wheninterestratesonbondsarelow (high),theopportunitycostof
holdingmoneyislow (high),sothequantitydemandedofmoneywill
behigh (low).
Foragiveninterestrate,anincrease innominalincome
increases thedemandformoney:Anincrease innominalincome
shiftsthedemandformoneytotheright,from to
.
MoneyDemandFunction
4.2 :
,
4.2 showsthatforanygivenexpectedrateofinflation
,
increases thenominalinterest
anincrease intherealinterestrate
rate andsoreduces thedemandformoney.
Similarly,foranygivenrealinterestrate ,anincrease inthe
expectedrateofinflation
increases thenominalinterestrate
andsoreduces thedemandformoney.
Rememberthat thenominalinterestrate movesoneforone with
changesinexpectedinflation
.
RealMoneyBalances
Sincethedemandfornominalmoneyisproportional tothe
aggregate(oroverall)pricelevel ,wecandividebothsidesof
nominalmoneydemandequationby :
4.3
RealMoneyBalances
4.3 givestheliquidity demand function orthedemandforreal

balancesfunction.Thelefthandsideof
4.3 isthedemand for
real balances (therealpurchasing power ofmoneyortheamountof
moneydemandedintermsofthegoodsitcanbuy).
Therighthandsideof
4.3 istheliquidity demand function.
Thedemandforrealmoneybalancesisdecomposedintoa
transaction demandformoney(capturedby )andaportfolio
demandformoney(capturedby and ).
OtherFactorsAffectingMoneyDemand
Changesinvariablesotherthantheinterest rate causethedemand
curvetoshift.
Wealth:anincrease inwealthcausesmoneydemandtorise
becausepart
ofanincreaseinwealthmaybeheldintheformofmoney.
Risk:anincrease inriskofalternativeassetscausesmoneydemand
torise sincehigher riskofalternativeassetsmakesmoneymore
attractive.Ontheotherhand,anincrease inriskofmoneycauses
moneydemandtofall becausehigher riskofmoneymakesitless
attractive.
Forexample,inaperiodoferraticinflation,peopletrytoswitch
moneytoinflationhedges(assetswhoserealreturnsarelesslikelyto
beaffectedbyerraticinflation)suchasgold,realestate,and
consumerdurablegoods.
Liquidity ofalternativeassets:anincrease inliquidityofalternative
assetscausesmoneydemandtofall sincehigher liquidityof
alternativeassetsmakestheseassetsmore attractive.
Efficiency ofpaymenttechnology:anincrease inpayment
technologycausesdemandmoneytofall sincepeoplecanoperate
withless money.
Expected inflation:anincrease inexpectedinflationcausesmoney
demandtofall sincehigher expectedinflationmeansahigher return
onalternativeassetsandthusswitchawayfrommoney.
MoneyDemandFunction
4.2 :
,
4.2 showsthatforanygivenexpectedrateofinflation
,
increases thenominalinterest
anincrease intherealinterestrate
rate andsoreduces thedemandformoney.
Similarly,foranygivenrealinterestrate ,anincrease inthe
expectedrateofinflation
increases thenominalinterestrate
andsoreduces thedemandformoney.
Rememberthat thenominalinterestrate movesoneforone with
changesinexpectedinflation
.
RealMoneyBalances
Sincethedemandfornominalmoneyisproportional tothe
aggregate(oroverall)pricelevel ,wecandividebothsidesof
nominalmoneydemandequationby :
4.3
RealMoneyBalances
4.3 givestheliquidity demand function orthedemandforreal

balancesfunction.Thelefthandsideof
4.3 isthedemand for
real balances (therealpurchasing power ofmoneyortheamountof
moneydemandedintermsofthegoods itcanbuy).
Therighthandsideof
4.3 istheliquidity demand function.
Thedemandforrealmoneybalancesisdecomposedintoa
transaction demandformoney(capturedby )andaportfolio
demandformoney(capturedby and ).
Changesinvariablesotherthantheinterest rate causethedemand
curvetoshift.
Wealth:anincrease inwealthcausesmoneydemandtorise
becausepartofanincreaseinwealthmaybeheldintheformof
money.
Risk:anincrease inriskofalternativeassetscausesmoneydemand
torise sincehigher riskofalternativeassetsmakesmoneymore
attractive.Ontheotherhand,anincrease inriskofmoneycauses
moneydemandtofall becausehigher riskofmoneymakesitless
attractive.
Forexample,inaperiodoferraticinflation,peopletrytoswitch
moneytoinflationhedges(assetswhoserealreturnsarelesslikelyto
beaffectedbyerraticinflation)suchasgold,realestate,and
consumerdurablegoods.
Liquidity ofalternativeassets:anincrease inliquidityofalternative
assetscausesmoneydemandtofall sincehigher liquidityof
alternativeassetsmakestheseassetsmore attractive.
Efficiency ofpaymenttechnology:anincrease inpayment
technologycausesdemandmoneytofall sincepeoplecanoperate
withless money.
Expected inflation:anincrease inexpectedinflationcausesmoney
demandtofall sincehigher expectedinflationmeansahigher return
onalternativeassetsandthusswitchawayfrommoney.
DeterminingtheInterestRate
:MethodI
Q:Bywhatisthemoneysupplyaffected?
A:
(i)Thecentralbank (theFederalReserveSystem,justcalledthe
Fed,intheUnitedStates)isthegovernmentinstitutionresponsiblefor
monetarypolicies.
(ii)Depositoryinstitutions areprivatelyownedbanksandthrift
institutions(suchassavingsandloanassociation)thataccept
deposits fromandmakeloans directlytothepublic.
(iii)Thepublic includeseverypersonorfirm(exceptbanks)thatholds
moneyincurrency ordeposits.
AssetMarketEquilibrium
Assumption:Allassetscanbegroupedintotwocategories,money
andbonds ornonmonetary assets

.
4.4 :

=aggregatenominalwealth
4.5 :

aggregatenominalwealth
If
4.6 :
0
0,
mustbezero.
AssetMarketEquilibrium
Thatis,iftheamountsofmoneysuppliedanddemandedare
equal,theamountsofnonmonetaryassetssuppliedand
demandedalsomustbeequal.
Theentireassetmarketisinequilibrium ifthequantityof
moneysupplied equalsthequantityofmoneydemanded.
Itmeansthatthatinstudyingassetmarketequilibriumwe
havetolookatonlythesupplyanddemandformoneyand
canignorenonmonetaryassets.
,M,andtheEquilibriumInterestRate
Intherealworld,therearetwotypesofmoneyinM1:checkable
deposits (suppliedbybanks)andcurrency (suppliedbythecentral
bank).
Assumption inMethodI:Onlymoneyintheeconomyiscurrency in
circulation,thatis,thequantityofmoneyisthenumberofdollars
heldbythepublic.
Wefirstlookatinterestrateusingthemoney marketmodel (also
calledtheliquidity preference model).
, ,andtheEquilibriumInterestRate
Themoneymarketmodelfocusesonhowtheinteractionofthe
demandandsupplyformoneydeterminestheshortterm (theloan
orbondwillmature,orbepaidoff,inoneyearorless)interestrate.
Supposethecentralbankdecidestosupplyamountsofmoneyequal
, theamountofmoneyavailableinaneconomy
toM,so
(moneystockormoneysupply).
Moneymarketequilibriumcondition:
,
,
, ,andtheEquilibriumInterestRate
Exogenousvariables:P,M and
Endogenousvariables:Yand r
Eq(4.7)iscalledtheLM relation.
TheletterL standsforliquidity ameasureofhoweasilyanassetcan
beexchangedformoney.
TheletterM standsformoney.
Inequilibrium,thedemandforliquidity mustequalthesupplyof
money.
Figure 4.2:TheDeterminationofInterestRate
TheDeterminationofInterestRate
Thesupplyofmoney(M)isassumedtobefixed themoneysupply
M isanexogenous policyvariablechosenbyacentral bank:
thecentralbankisabletosetthesupplyofmoneyatwhateverlevel
itchooses.
Inotherwords,themoneysupply(M)isindependent oftheinterest
rate;i.e.themoneysupplycurveisavertical line,andchangesinthe
interestratehavenoeffectonthequantityofmoneysupplied.
ThepricelevelP isalsoanexogenous variablebecauseweassume
thatthepricelevelisfixed intheshortrun.
TheDeterminationofInterestRate
Accordingtothetheoryofliquidity balances,thesupplyanddemand
formoneybalancesdeterminewhatinterest rate prevailsinthe
economy.Thatis,theinterest rate adjuststoequilibratethemoney
market.
Figure 4.3:TheEffectsofanIncreaseinNominalIncomeonthe
InterestRate
Anincrease innominalincomeleadstoanincrease intheinterestrate.

How?
EffectofanIncreaseinNominalIncomeontheInterestRate
Nominalincomeincreasesfrom$ to$
Themoneydemandcurveshiftsrightward from
to
:
Atthe initial interest , thedemandformoneyexceeds thesupply
ofmoney
Agents(householdsorfirms)haveless moneythantheywantto
holdatan initial interestrate : shortage (or excess demand for)of
money
EffectofanIncreaseinNominalIncomeontheInterestRate
Q:Whatdoagentsdowiththeshortageofmoney?
Theyaremostlikelytosell shorttermbonds
Sellingshorttermassetssuchasbondsdrivesdown theirprices
anddriveup theirinterestrates.Thatis,anincrease intheinterest
rateisneededtodecrease theamountofmoneypeoplewanttohold
andtoreestablishequilibrium
Themoneymarketachievesanewequilibriumat
ShiftsofMoneySupply&MoneyDemand
Whatshiftsnominalmoneysupply:
Whatshiftsnominalmoneydemand:
, ,
Whatshiftsrealmoneysupply:
,
Whatshiftsrealmoneydemand:
,
MonetaryPolicyandOpenMarketOperations
Openmarketoperations
Purchases orsales ofgovernmentsecuritiesbythecentralbankin
theopenmarketforbondstochangethesupply ofmoney
Expansionaryopenmarketoperation:purchases ofgovernment
securities(governmentbonds)bythecentralbanktoincrease
(expand)themoneysupply
Contractionaryopenmarketoperation:salesofgovernment
securitiesbythecentralbanktodecrease (contract)themoney
supply
MonetaryPolicyandOpenMarketOperations
Openmarketpurchasesinwhichthecentralbankincreases the
moneysupplybybuying bondsleadtoanincrease inthepriceof
bondsandadecrease intheinterestrate.
Thepurchase ofbondsbythecentralbankshiftsthemoneysupply
totheright.
Openmarketsalesinwhichthecentralbankdecreases themoney
supplybyselling bondsleadtoadecrease inthepriceofbondsand
anincrease intheinterestrate.
Theselling ofbondsbythecentralbankshiftsthemoneysupplyto
theleft.
Figure 4.4:TheEffectofanIncreaseintheMoneySupplyonthe
InterestRate
EffectofanIncreaseintheMoneySupplyontheInterestRate
Anincrease inthesupplyofmoneybythecentralbankleadstoa
decrease intheinterestrate.
How?
Thecentralbankincreases themoneysupply:themoneysupply
curveshiftsrightward from
to
.
Agents(householdsorfirms)havemore moneythantheywantto
holdatan initial interestrate :surplus (orexcess supply)ofmoney
EffectofanIncreaseintheMoneySupplyontheInterestRate
Q:Whatdoagentsdowiththeextramoney?
Theyaremostlikelytousethemoneytobuy shorttermbonds
Buyingshorttermassetssuchasbondsdrivesup theirpricesand
drivedown theirinterestrates
Thedecrease intheinterestrateincreases thequantitydemanded
ofmoneysoitequalsthenowlargermoneysupply
Themoneymarketachievesanewequilibriumat
QuantitativeEasing(QE)
http://www.telegraph.co.uk/finance/economics/11361414/Economic
sexplainerwhatisQE.html
https://www.youtube.com/watch?v=J9wRq6C2fgo
Example(4.1):MoneyMarketEquilibrium
Supposethatmoneydemandisgivenby
$ 0.25
is$100.Also,supposethatthesupplyofmoneyis$20.
a)Whatistheequilibriuminterestrate?
(Ans.)
$20 $100 0.25
$20 $25 $100
$100
$5
0.05 5%
where$Y
Example(4.1):MoneyMarketEquilibrium
b)IftheFederalReserveBankwantstoincreasei by10percentpoints
(e.g.,from2%to12%),atwhatlevelshoulditsetthesupplyofmoney?
(Ans.)
$100 0.25 0.15

$100 0.1 $10.
Example (4.2):MoneyMarketEquilibrium
Supposethatthemoneydemandfunctionis
1000 100 ,
where istheinterestrateinpercent.Themoneysupply is1000
andthepricelevel is2.
a)Whatistheequilibriuminterestrate?
(Ans.)
500
1000
100
1000
5%.
100
b)Assumethatthepricelevelisfixed.Whathappenstothe
equilibriuminterestrateifthesupplyofmoneyisraisedfrom1,000to
1,200?
(Ans.)
600
1000
100
1000
100
4%.
Thus,increasingthemoneysupplyfrom1,000to1,200causesthe
equilibriuminterestratetofall.
d)IftheFedwishestoraisetheinterestrateto7%,whatmoneysupply
shoulditset?
(Ans.)
Set
1000
100
Monetary Policy and Open Market Operations

Open market operations
Purchases or sales of government securities by the central bank in
the open market for bonds to change the supply of money
Expansionary open market operation: purchases of government
securities (government bonds) by the central bank to increase
(expand) the money supply
Contractionary open market operation: sales of government
securities by the central bank to decrease (contract) the money
supply
Monetary Policy and Open Market Operations

Open market purchases in which the central bank increases the
money supply by buying bonds lead to an increase in the price of
bonds and a decrease in the interest rate.
The purchase of bonds by the central bank shifts the money supply
to the right.
Open market sales in which the central bank decreases the money
supply by selling bonds lead to a decrease in the price of bonds and
an increase in the interest rate.
The selling of bonds by the central bank shifts the money supply to
the left.
Figure 4.4: The Effect of an Increase in the Money Supply on the

Interest Rate
Effect of an Increase in the Money Supply on the Interest Rate

An increase in the supply of money by the central bank leads to a
decrease in the interest rate.
How?
The central bank increases the money supply: the money supply
curve shifts rightward from to .

Agents (households or firms) have more money than they want to
hold at an initial interest rate : surplus (or excess supply) of money
Effect of an Increase in the Money Supply on the Interest Rate

Q: What do agents do with the extra money?
They are most likely to use the money to buy short-term bonds
Buying short-term assets such as bonds drives up their prices and
drive down their interest rates
The decrease in the interest rate increases the quantity demanded
of money so it equals the now larger money supply
The money market achieves a new equilibrium at <
Example(4.1): Money Market Equilibrium

Suppose that money demand is given by = $(0.25 ) where $Y
is $100. Also, suppose that the supply of money is $20.
a) What is the equilibrium interest rate?
(Ans.)
Equilibrium condition: = (in nominal terms)
$20 = $100 0.25
$20 = $25 $100
$100 = $5
= 0.05 ( 5%)
Example(4.1): Money Market Equilibrium

b) If the Federal Reserve Bank wants to increase i by 10 percent points
(e.g., from 2% to 12%), at what level should it set the supply of money?
(Ans.)
Equilibrium condition: =
= $100 0.25 0.15 = $100 0.1 = $10.
Example (4.2): Money Market Equilibrium

Suppose that the money demand function is

= 1000 100,
where is the interest rate in percent. The money supply is 1000
and the price level is 2.
a) What is the equilibrium interest rate?
(Ans.)
Equilibrium condition:
1000
2
= 1000 100
500 = 1000 100

=
500
100
= 5%.

(in
real terms)
b) Assume that the price level is fixed. What happens to the

equilibrium interest rate if the supply of money is raised from 1,000 to
1,200?
(Ans.)
1200
2
= 1000 100
600 = 1000 100

=
400
100
= 4%.
Thus, increasing the money supply from 1,000 to 1,200 causes the
equilibrium interest rate to fall.

d) If the Fed wishes to raise the interest rate to 7%, what money supply
should it set?
(Ans.)
= 1000 100 7
= .
Bond Prices and Interest Rates

What determined in bond markets is not interest rates, but bond
prices. We want to show that the interest rate on a bond can be
inferred from the price of the bond.
The relationship between bond prices and interest rates depends on
an important concept called the present value.
Present value
The value of funds today that will be received in the future

4.8 : $ =
$
+
or =
$$
$
or =
$
$
where $ is the present value of a bond and $ is future value.

The higher the price of the bond, the lower the interest rate;
the lower the price of the bond, the higher the interest rate.
Bond market went up (rallied) today

The price of bonds went up, and therefore interest rates went
down.
Treasury yields held lower, with the 10-year yield at 2.12% and
the 2-year yield at 0.67%.
Example (4.3): Bond Price vs. Interest Rate

Suppose the bonds in the economy are one-year bonds bonds that
promises a payment of a given number of dollars, say $1000, a year
from now. What is the value of money received in the future equal to
the value of money today (called present value)?
(Ans.)
$ = $ (1 + ) $ =
$
1+
If = 0.01( 1%), then $ =

If = 0.111, then $ =
$1000
1+0.111
$1000
1+0.01
= $990.
= $900.

Q: Why does a lender charge the interest rate on loans?
(i) Compensation for inflation
(ii) Compensation for default risk the chance that the borrower will
not pay back the loan
(iii) Compensation for the opportunity cost of waiting to spend
money
Notice that these three factors vary from lender to lender and from
loan to loan.
Example (4.4): Present Value for Multiple Years

Suppose that you are willing to loan money for two years if you receive
10% interest in each of the two years. What is the present value of the
payment, $1,210 that will be paid back at the end of the second year?
(Ans.)
$1210
= $ 1 + 0.10 1 + 0.10
= $(1 + 0.10)2
$ =
$1210
(1+0.10)2
= $1,000
The $1,210 you would receive two years from now has a present
value of$1,000.
Present Value for Multiple Years

General formula: 4.6 : $ =
$
+
(i) The higher the interest rate, the lower the present value of a
future payment; the lower the interest rate, the higher the present
value of a future payment: $ and $ .
(ii) The longer an investor has to wait to receive a payment, the less
value it will have for him or her: $ .
$ =
$ =
$1,000,000
(1+.)
$1,000,000
(1+.)
=
=
$1,000,000
$385,543 and $ =
= $148,644
(1+.)
$1,000,000
$92,296 and $ =
= $295,303
(1+.)

Economists use the term time value of money to refer to the fact that
the value of a payment changes depending on when the payment is
received.
Time value of money
The way the value of a payment changes depending on when the
payment is received
Anyone who buys a financial asset, such as a share of stock or a bond,
is really buying a promise to receive certain payments in the future.
Thus, the price of a financial asset should equal the present value of
the payments an investor expects to receive from owning that asset.
Example (4.5): Coupon and Interest Rate

Consider the case of a five-year coupon bond that pays an annual
coupon of $60 and has a face value of $1,000. What is the price of
the bond?
(Ans.)
Coupon
The interest on a bond, which is a flat dollar amount that is
regularly paid each time period and that does not change during the
life of the bond
$ =
$60
(1+)
$60
(1+)2
$60
+
(1+)3
$60
(1+)4
For = 5% (0.05), = $1,043.29.
$60
+
(1+)5
$1,000
(1+)5
Coupon and Interest Rate

General Formula for C:
A bond makes coupon payments, , has a face value (), and
matures in years.
4.7 :
=
(1+)
+
(1+)2
(1+)3
+ +
(1+)
$
(1+)
An increase in interest rates reduces the prices of existing financial

assets, and a decrease in interest rates increases the prices of existing
financial assets.
Example (4.6): Discount Bonds and Interest Rate

Suppose that you pay a price of $961.54 for a $1,000 face value oneyear Treasury bill. U.S. Treasury bills are discount bonds, which means
they do not pay a coupon but are sold at a discount to their face value.
a) What is the interest rate on the Treasury bill?
(Ans.)
$$
=
100
$
1000961.54
=
100
961.54
= 4%

b) Suppose that the day after you purchased your Treasury bill,
investors decided they will only buy one-year Treasury bill if they
receive an interest rate of 5% on their investment. What will be the
price at which you could sell your Treasury bill to another investor?
(Ans.)
$ =
$
(1+)
$1,000
(1+0.5)
= $952.38
As a result of an increase in the interest rate for Treasury bill from 4%

to 5%, you have suffered a capital loss of $9.16:
$952.38 - $961.54 = -$9.16.
Determining the Interest Rate (): Method II
In this section, we see that the money supply is determined not

only by the central bank policy but also by the behavior of
households (which hold money) and banks (in which money is held).
Financial intermediaries
Institutions that receive funds from people and firms and use these
funds to buy financial assets or to make loans to other people and firms
Financial intermediation
The process of transferring funds from savers to borrowers
Central Bank Balance Sheet

Federal Reserve Bank
Assets
Securities
$900
(bonds)
Gold
$100
Total assets
$1000
Liabilities
Currency held by
nonbank public
Vault cash held
by banks
Reserve deposits
Total liabilities
$700
$100
$200
$1000
Currency issued by the central bank (the Fed) and held either by
the nonbank public or in vaults of private-sector banks is a debt
obligation of the Fed.

Monetary base (MB) or high-powered money (H)
= reserve deposits + currency (including both currency held by the
nonbank public and vault cash held by banks)
= $200 + ($700 + $100)
= $1000
Private Banks Balance Sheet

Private Bank
Assets
Vault cash
Liabilities
$100
Deposits
$3000
Total liabilities
$3000
Reserve deposits $200

Loans
$2700
Total assets
$3000
Banks keep as reserves some of the funds (or deposits) they receive.

Reserves
The deposits that banks have received but have not lent out
Reserves are held partly in cash and partly in an account the banks
have at the central bank:
reserves by a bank
= cash in its vault + its reserves at the central bank
= $100 + $200 = $300.
Bank Reserves
Banks hold reserves for three reasons:
(i) Meet some depositors demand for withdrawal
(ii) Meet the demand for checks
(iii) Satisfy reserve requirements by law
Reserve requirements: reserve requirement set by the central bank
that banks must hold reserves in some proportion of their checkable
deposits
Bank Reserves
Reserve ratio or reserve-deposit ratio
()
=
()
bank reserves ()
=
bank checkable deposits ()
$
=
= . ( )
$
Creation of Money by Banks

Q: How does the bank affect the money supply?
A: The bank can affect the money supply by loaning out excess
reserves (reserves that exceed required reserves - a minimum
amount required by law) at some interest or by buying securities.
100-percent-reserve banking
All deposits are held as reserves: banks simply accept deposits,
place the money in reserves, and leave the money there until the
depositor makes a withdrawal or writes a check against the balance

If the banks hold 100 percent of deposits in reserves, the banking
system does not affect the supply of money.
Fractional-reserve banking
A system under which banks keep only a fraction of their deposits
in reserve
A system in which the reserve-deposit ratio is less than one
In a system of fractional-reserve banking, banks create money by
making loans.

Suppose that no one in the economy holds cash and banks lend to their
limits, and that the Fed buys $100 of securities from an investor.
Assets
Liabilities
Securities (bonds)
$900 + $100 Currency held by

= $1000
nonbank public
$700
Gold
$100
Vault cash held by banks
$100
Reserve deposits
$200 + $100
= $300
$1100
Total assets
$1100
Total liabilities

Private Bank (first stage)
Assets
Vault cash
$100
Reserve deposits
Loans
Total assets
$200 + $100
= $300
$2700
$3100
Liabilities
Deposits
Total liabilities
Excess reserves
= reserves ($100 + $300) required reserves
= $400 - $310 (=$3100*0.1) = $90
$3000 + $100
= $3100
$3100

Private Bank (second stage)
Assets
Vault cash
$100
Reserve deposits
$300
Loans
$2700 + $90
= $2790
$3190
Total assets
Liabilities
Deposits
Total liabilities
$3100 + $90
= $3,190
$3190
Excess reserves
= reserves ($100 + $300) required reserves ($3190 x 0.10)
= $400 - $319 = $81

Private Banks in the Banking Industry (final stage)
Assets
Liabilities
Vault cash
$100
Deposits
Reserve deposits $200 + $100
= $300
Loans
$2700 + $900
= $3600
Total assets
$4000
Total liabilities
$3000 + $1000
= $4000
$4000
Excess reserves
= $400 - $400 = $0

Initial deposit = $100
First bank lending = 1 $100
Second bank lending = 1 1 $100 = 1 2 $100
Third bank lending = 1 1 2 $100 = 1 3 $100
Total increase in money supply

= 1 + 1 + 1 2 + 1 3 + $100
=
(1
)
$100()
=0
1
1 1
$100 = $100 , given that no one holds cash

General formula:
4.11 : = , given that no one in the economy holds

cash
For example, =
1
0.1
$100 = $1,000.
Open-market purchases increase the monetary base (MB or H) and

thus money supply.
MB (or H) = reserve deposits + currency (including both currency
held by the nonbank public and vault cash held by banks)

Only banks have the legal authority to create assets (such as checking
accounts) that are part of the money supply.
Therefore, banks are the only financial institutions that directly
influence the money supply.
Note that although fractional-reserve banking system creates money,
it does not create wealth.
In other words, the creation of money by the banking system
increases the economys liquidity, not its wealth.

What determined in bond markets is not interest rates, but bond
prices. We want to show that the interest rate on a bond can be
inferred from the price of the bond.
The relationship between bond prices and interest rates depends on
an important concept called the present value.
Present value
The value of funds today that will be received in the future

4.8 : $ =
$
1+
or =
$$
$
or =
$
$
where $ is the present value of a bond and $ is future value.

The higher the price of the bond, the lower the interest rate;
the lower the price of the bond, the higher the interest rate.
Bond market went up (rallied) today

The price of bonds went up, and therefore interest rates went
down.
Treasury yields held lower, with the 10-year yield at 2.12% and the
2-year yield at 0.67%.
Example (4.3): Bond Price vs. Interest Rate

Suppose the bonds in the economy are one-year bonds bonds that
promises a payment of a given number of dollars, say $1000, a year
from now. What is the value of money received in the future equal to
the value of money today (called present value)?
(Ans.)
$ = $ (1 + ) $ =
$
1+
If = 0.01( 1%), then $ =

If = 0.111, then $ =
$1000
1+0.111
$1000
1+0.01
= $990.
= $900.

Q: Why does a lender charge the interest rate on loans?
(i) Compensation for inflation
(ii) Compensation for default risk the chance that the borrower will
not pay back the loan
(iii) Compensation for the opportunity cost of waiting to spend
money
Notice that these three factors vary from lender to lender and from
loan to loan.
Example (4.4): Present Value for Multiple Years

Suppose that you are willing to loan money for two years if you receive
10% interest in each of the two years. What is the present value of the
payment, $1,210 that will be paid back at the end of the second year?
(Ans.)
$1210
= $ 1 + 0.10 1 + 0.10
= $(1 + 0.10)2
$ =
$1210
(1+0.10)2
= $1,000
The $1,210 you would receive two years from now has a present
value of$1,000.

General formula: 4.6 : $ =
$
1+
1
$
(i) The higher the interest rate, the lower the present value of a
future payment; the lower the interest rate, the higher the present
value of a future payment: $ $ .
(ii) The longer an investor has to wait to receive a payment, the less
value it will have for him or her: $ .
$ =
$ =
$1,000,000
(1+0.10)10
$1,000,000
(1+0.10)25
=
=
$1,000,000
$385,543 and $ =
= $148,644
20
(1+0.10)
$1,000,000
$92,296 and $ =
= $295,303
(1+0.05)25

Economists use the term time value of money to refer to the fact that
the value of a payment changes depending on when the payment is
received.
Time value of money
The way the value of a payment changes depending on when the
payment is received
Anyone who buys a financial asset, such as a share of stock or a bond,
is really buying a promise to receive certain payments in the future.
Thus, the price of a financial asset should equal the present value of
the payments an investor expects to receive from owning that asset.
Example (4.5): Coupon and Interest Rate

Consider the case of a five-year coupon bond that pays an annual
coupon of $60 and has a face value of $1,000. What is the price of
the bond?
(Ans.)
Coupon
The interest on a bond, which is a flat dollar amount that is
regularly paid each time period and that does not change during the
life of the bond
$ =
$60
(1+)
$60
(1+)2
$60
+
(1+)3
$60
(1+)4
For = 5% (0.05), = $1,043.29.
$60
+
(1+)5
$1,000
(1+)5
Coupon and Interest Rate

General Formula for C:
A bond makes coupon payments, , has a face value (), and
matures in years.
4.7 :
=
(1+)
+
(1+)2
(1+)3
+ +
(1+)
$
(1+)
An increase in interest rates reduces the prices of existing financial

assets, and a decrease in interest rates increases the prices of existing
financial assets.

Suppose that you pay a price of $961.54 for a $1,000 face value oneyear Treasury bill. U.S. Treasury bills are discount bonds, which means
they do not pay a coupon but are sold at a discount to their face value.
a) What is the interest rate on the Treasury bill?
(Ans.)
$$
=
100
$
1000961.54
=
100
961.54
= 4%

b) Suppose that the day after you purchased your Treasury bill,
investors decided they will only buy one-year Treasury bill if they
receive an interest rate of 5% on their investment. What will be the
price at which you could sell your Treasury bill to another investor?
(Ans.)
$ =
$
(1+)
$1,000
(1+0.5)
= $952.38
As a result of an increase in the interest rate for Treasury bill from 4%

to 5%, you have suffered a capital loss of $9.16:
$952.38 - $961.54 = -$9.16.


Assets
Securities
$900
(bonds)
Gold
$100
Total assets
$1000
Liabilities
Currency held by
nonbank public
Vault cash held
by banks
Reserve deposits
Total liabilities
$700
$100
$200
$1000

= $200 + ($700 + $100)
= $1000

Private Bank
Assets
Vault cash
Liabilities
$100
Deposits
$3000
Total liabilities
$3000

Loans
$2700
Total assets
$3000

Reserves
reserves by a bank
= $100 + $200 = $300.
Bank Reserves
deposits
Bank Reserves
()
=
()
()
=
()
$
=
= . ( )
$


in reserve
making loans.

Assets
Liabilities
Securities (bonds)

= $1000
nonbank public
$700
Gold
$100
$100
Reserve deposits
$200 + $100
= $300
$1100
Total assets
$1100
Total liabilities

Assets
Vault cash
$100
Reserve deposits
Loans
Total assets
$200 + $100
= $300
$2700
$3100
Liabilities
Deposits
Total liabilities
Excess reserves
= $400 - $310 (=$3100*0.1) = $90
$3000 + $100
= $3100
$3100

Assets
Vault cash
$100
Reserve deposits
$300
Loans
$2700 + $90
= $2790
$3190
Total assets
Liabilities
Deposits
Total liabilities
$3100 + $90
= $3,190
$3190
Excess reserves
= $400 - $319 = $81

Assets
Liabilities
Vault cash
$100
Deposits
= $300
Loans
$2700 + $900
= $3600
Total assets
$4000
Total liabilities
$3000 + $1000
= $4000
$4000
Excess reserves
= $400 - $400 = $0

= $100
= 1 $100
= 1 1 $100 = 1 2 $100
= 1 1 2 $100 = 1 3 $100

= 1 + 1 + 1 2 + 1 3 + $100
=
(1
)
$100()
=0
1
1 1

General formula:
1

cash
For example, =
1
0.1
$100 = $1,000.

thus money supply.



Assets
Securities
$900
(bonds)
Gold
$100
Total assets
$1000
Liabilities
Currency held by
nonbank public
Vault cash held
by banks
Reserve deposits
Total liabilities
$700
$100
$200
$1000

= $200 + ($700 + $100)
= $1000

Private Bank
Assets
Vault cash
Liabilities
$100
Deposits
$3000
Total liabilities
$3000

Loans
$2700
Total assets
$3000

Reserves
reserves by a bank
= $100 + $200 = $300.
Bank Reserves
deposits
Bank Reserves
=
=
()
()
$
= . ( )
$


in reserve
making loans.

Assets
Liabilities
Securities (bonds)

= $1000
nonbank public
$700
Gold
$100
$100
Reserve deposits
$200 + $100
= $300
$1100
Total assets
$1100
Total liabilities

Assets
Vault cash
$100
Reserve deposits
Loans
Total assets
$200 + $100
= $300
$2700
$3100
Liabilities
Deposits
Total liabilities
Excess reserves
= $400 - $310 (=$3100*0.1) = $90
$3000 + $100
= $3100
$3100

Assets
Vault cash
$100
Reserve deposits
$300
Loans
$2700 + $90
= $2790
$3190
Total assets
Liabilities
Deposits
Total liabilities
$3100 + $90
= $3,190
$3190
Excess reserves
= $400 - $319 = $81

Assets
Liabilities
Vault cash
$100
Deposits
= $300
Loans
$2700 + $900
= $3600
Total assets
$4000
Total liabilities
$3000 + $1000
= $4000
$4000
Excess reserves
= $400 - $400 = $0

Initial deposit = $100
First bank lending = 1 $100
Second bank lending = 1 1 $100 = 1 2 $100
Third bank lending = 1 1 2 $100 = 1 3 $100
Total increase in money supply

= 1 + 1 + 1 2 + 1 3 + $100
=
=( ) $100()
1
1 1

General formula:

cash
For example, =
1
0.1
$100 = $1,000.

thus money supply.

The Supply and the Demand for Central Bank Money

The easiest way to think about how the interest rate in the economy
is determined is by thinking in terms of the supply and demand for
central bank money.
Demand for central bank money
= Demand for currency by people + Demand for reserves by

banks
(= Demand for checkable deposits by people)
The supply of central bank money is under the direct control of

the central bank.
The Supply and the Demand for Central Bank Money

Demand for central bank money = Supply of central bank
money
Equilibrium interest rate ()
Determinants of the Demand and the Supply of Central

Bank Money
Determinants of the Demand and the Supply of Central

Bank Money
What determines the demand for money the demand for currency
and checkable deposits?
What determines the demand for reserves by banks?
What determines the demand for central bank money?
How does the equilibrium condition determine the interest rate?
Demand for Money

When people can hold both currency and checkable deposits, the
demand for money involves two decisions:
(i) people decide how much money to hold, and
(ii) how much of this money to hold in currency and how much
money to hold in checkable deposits.
Assumption: People hold a fixed proportion of their money in
currency, denoted by c, and by implication hold a fixed proportion
in checkable deposits.
Demand for Money

Demand for currency: 4.12 : =
Demand for checkable deposits: 4.13 : =
Demand for Reserves: The larger the amount of checkable deposits,

the larger the amount of reserves the banks must hold, both for
precautionary and for regulatory reasons:
Reserves are proportional to deposits: 4.14 : = .
By combining equations (4.13) and (4.14),
Demand for reserves by banks: 4.15 : = ( )
Demand for Central Bank Money

4.16 : = +
= + 1
4.17 : = + 1
= + 1 [$ ]
Determination of the Interest Rate

4.18 : =
H or MB (central bank money)

High-powered money to reflect the fact that increases in H leads
to more than one-for-one increases in the overall money supply
The monetary base (MB) to reflect the fact that the overall
money supply depends in the end on a base the amount of
central bank money in the economy
4.19 : = + 1 $ ()
Supply and Demand for Central Bank Money

4.19 : = + 1 $ ()
If < 1, then + 1 < 1 means that the demand for central

bank money is less than the overall demand for money due to the
fact that the demand for reserves by banks is only a fraction of the
demand for checkable deposits.
= 1 (People hold only currency): + 1
= $ =
=1
Supply and Demand for Central Bank Money

4.19 : = + 1 $ ()
= 0 (People hold only checkable deposits):

+ 1 = and = 0.1.
= 0.1
The demand for central bank money would be equal to one-tenth
of the overall demand for money; i.e. the demand for reserves by
banks would be one-tenth of the overall demand for money.
Figure 4.7: Equilibrium in the Market for Central Bank Money

and the Determination of the Interest Rate
Equilibrium in the Market for Central Bank Money

The demand for central bank money = + is drawn for
a given level of nominal income $ .
A higher interest rate implies a lower demand for central bank money
for two reasons:
(1) The demand for currency goes down;
(2) the demand for checkable deposits by people also goes down
lower demand for reserves by banks.
Two Alternative Ways of Looking at the Equilibrium

Two other ways of looking at equilibrium will strengthen your
understanding of how monetary policy affects the interest rate.
The Federal Funds Market and the Federal Funds Rate
Instead of thinking in terms of the supply and the demand for central
bank money, we think the equilibrium in terms of the supply and the
demand for bank reserves.
Federal funds
The deposits that banks hold at the central bank

Federal funds market
The market in which banks can borrow or lend reserves, allowing
banks temporarily short of their required reserves to borrow reserves
from banks that have excess reserves
Federal funds rate
The interest rate determined in the federal funds market on
overnight loans
The interest rate at which banks that have excess reserves at the
end of day actively lend them to banks that have insufficient reserves,
usually overnight, on an uncollateralized basis

The federal funds rate is set by supply of and demand for reserves by
banks, not by the Fed.
The Fed can change the supply of federal funds through open market
operations, exerting a powerful indirect effect on the federal funds
rate.
The Fed targets the federal funds rate and carries out open market
operations to keep the actual rate near the target rate.
Open Market Operations and Bank Reserves

The central banks purchase of government securities raises the
supply of federal funds.
More federal funds mean they are cheaper to borrow, so a lower
federal funds rate.
The central banks purchase of government securities drives up the
price of those securities, which lowers their yield.
A lower yield means a lower interest rate on government
securities.
The central banks purchase of government securities leaves bank
flushes with reserves
Open Market Operations and Bank Reserves

Banks find it profitable to convert some of their new zero-interest earning reserves into loans, which in turn create more deposits,
raising the money supply
To get people/firms to borrow more, banks lower the interest rate
on the loans
Depository institution
A financial institutions in the U.S. that is legally allowed to accept
monetary deposits from consumers.
Discount rate
The interest rate a central bank charges depository institutions
when they borrow reserves from it
Because the Fed can in effect choose the federal funds rate it wants
by changing the supply of central bank money (H or MB), the federal
funds rate is typically thought as the main indicator of U.S. monetary
policy. In short, the Fed determines the federal funds rate.
Federal Funds Rate
Equilibrium in the Money Market

Supply of reserves ( )
= since = +
= Supply of central bank money Demand for currency by the public
Demand for reserves by banks:
Supply of reserves = Demand for reserves by banks
=
= + =
Supply & Demand for Money, and the Money Multiplier

From 4.19 , = + 1 $
4.20 :
1
+ 1
= $
Supply of Money = Demand for Money
Meaning: In equilibrium, the overall supply of money (currency +

checkable deposits) must equal the overall demand for money
(currency + checkable deposits).
4.20 :
1
+ 1
Remarks on Eq. (4.20)

= $ . 4.2 : = $ .
Equation (4.2) characterizes the equilibrium in an economy without

banks.
=
1
+ 1
is called the money multiplier .
The overall supply of money equals to the money multiplier times

central
bank money: = .
1
:
= 0 money multiplier =
An increase in a dollar of high-powered money leads to an increase of
dollars in the money supply.

The presence of a multiplier in equation (4.20) implies that a given
change in central bank money has a larger effect on the money
supply and in turn a larger effect on the interest rate in an economy
with banks than in an economy without banks.
Central bank money is sometimes called high-powered money or the
monetary base to reflect the fact the overall supply of money
depends in the end on the amount of central bank money
Alternative Money Multiplier

The Fed directly controls the monetary base but doesnt directly
control the money supply: The Fed uses open market operations to
change the size of the monetary base.
Lets examine the relationship between the monetary base and the
money supply: 4.21 : = +
The monetary base has two uses: Some of the monetary base is held
as currency by the public, and the rest is held as reserves by banks.
4.22 : = +

To relate the money supply to the monetary base, divide (4.21) by
(4.22):
+
+
=
=

+

+

+1
+
4.23 : =
+1
+
+

4.23 : =
+1
+
The money multiplier will be greater than 1 as long as < (that is,
with fractional reserve banking).
Each additional dollar of monetary base will increase the money
supply by more than one dollar, which is why the monetary base is
known as high-powered money.
The money supply is proportional to the monetary base.
Thus, an increase in the monetary base increases the money supply
by the same percentage.

4.23 : =
+1
+
An increase (or a decrease) in the reserve-deposit ratio causes

the money multiplier to fall (or to increase) and, if MB is unchanged,
it also causes the money supply to decline (or to increase). Role of
banks!
An increase (or a decrease) in the currency-deposit ratio causes
the money multiplier to fall (or to rise) and, if MB is unchanged, it
also causes the money supply to fall (or to rise). Role of the public!
Example (4.7): Money Multiplier

An economy has a monetary base of 1,000 $1 bills. Calculate the
money supply in scenarios (a) (d) and then answer part (e).
(a) All money is held as currency.
(Ans.)
Suppose all the money is held as currency: = 0.
$1000
0
0
0
+1
+
=
=
= and = = = 0 =
=
Then M (the money supply) = MB (the monetary base).
The money supply will be $1,000.
Method 2: =
1
+ 1
Then = = $1,000.
1
1+0
= 1.
+1
+0
= 1.

(b) All money is held as demand deposits. Banks hold 100 percent of
deposits as reserves.
(Ans.)
=

0
1000
= 0 =
1000
1000
+1
0+1
=
=
= 1.
+
0+1
=1
= 1 $1000 = $1,000 because 100 percent of money is held on

reserves and no loans are made.
Method 2: =
1
+ 1
1
0+1
= 1 $1000 = $1000.
=1

(c) All money is held as demand deposits. Banks hold 20 percent of
(Ans.)
=

0
= 0 and
1000
+1
0+1
=
=
+
0+0.2
200
1000
= 5.
= 5 $1000 = $5,000.
Method 2: =
1
+ 1
= 0.2
1
0+0.2
= 5 $1000 = $5000.
=5

(d) People hold equal amount of currency and demand deposits. Banks
hold 20 percent of deposits as reserves.
(Ans.)
= 1 and = 0.2
=
+1
+
1+1
1+0.2
= 1.67.
= 1.67 $1000 = $1,670.

Method 2: =
1
+ 1
1
0.5+0.2(10.5)
= 1.67 $1000 = $1,670.
= 1.67

(e) The central bank decides to increase the money supply by 10
percent. In each of the above four scenarios, how much should it
increase the monetary base?
(Ans.)
Recall: = % = % b/c % = 0
= ; the money supply is proportional to the monetary
base.
Since m is a constant number, a 10% increase in the monetary base
(MB) leads to a 10% increase in the money supply (M).
Federal Funds Rate

July 13, 1990 Sept. 4, 1992: 8.00% - 3.00% (Includes 1990 1991
recession)
Feb. 1, 1995 Nov. 17, 1998: 6.00% - 4.75%
May 16, 2000 June 25, 2003: 6.50% - 1.00% (includes 2001
recession)
June 29, 2006 Oct. 29, 2008: 5.25% - 1.00%
Dec. 16, 2008: 0.00% - 0.25%
Dec. 16, 2015: 0.25% - 0.50%
Next raise?: 0.50% - 0.75%
Equilibrium in the Money Market

Supply of reserves ( )
= since = +
= Supply of central bank money Demand for currency by the public
Demand for reserves by banks:
Supply of reserves = Demand for reserves by banks
=
= + =
Supply & Demand for Money, and the Money Multiplier

From 4.19 , = + 1 $
4.20 :
1
+ 1
= $
Supply of Money = Demand for Money
Meaning: In equilibrium, the overall supply of money (currency +

checkable deposits) must equal the overall demand for money
(currency + checkable deposits).
4.20 :
1
+ 1

= $ . 4.2 : = $ .
Equation (4.2) characterizes the equilibrium in an economy without

banks.
=
1
+ 1
is called the money multiplier .
The overall supply of money equals to the money multiplier times

central bank money: = .
= money multiplier =
1
:
An increase in a dollar of
high-powered money leads to an increase of

supply.
dollars in the money

The presence of a multiplier in equation (4.20) implies that a given
change in central bank money has a larger effect on the money
supply and in turn a larger effect on the interest rate in an economy
with banks than in an economy without banks.
Central bank money is sometimes called high-powered money or the
monetary base to reflect the fact the overall supply of money
depends in the end on the amount of central bank money.

The Fed directly controls the monetary base but doesnt directly
control the money supply: The Fed uses open market operations to
change the size of the monetary base.
Lets examine the relationship between the monetary base and the
money supply: 4.21 : = +
The monetary base has two uses: Some of the monetary base is held
as currency by the public, and the rest is held as reserves by banks.
4.22 : = +

To relate the money supply to the monetary base, divide (4.21) by
(4.22):
+
+
=
=

+

+

+1
+
4.23 : =
+1
+
+

4.23 : =
+1
+
The money multiplier will be greater than 1 as long as < (that is,
with fractional reserve banking).
Each additional dollar of monetary base will increase the money
supply by more than one dollar, which is why the monetary base is
known as high-powered money.
The money supply is proportional to the monetary base.
Thus, an increase in the monetary base increases the money supply
by the same percentage.

4.23 : =
+
+
An increase (or a decrease) in the reserve-deposit ratio causes

the money multiplier to fall (or to increase) and, if MB is unchanged,
it also causes the money supply to decline (or to increase).
Role of banks!
An increase (or a decrease) in the currency-deposit ratio causes
the money multiplier to fall (or to rise) and, if MB is unchanged, it
also causes the money supply to fall (or to rise).
Role of the public!

An economy has a monetary base of 1,000 $1 bills. Calculate the
money supply in scenarios (a) (d) and then answer part (e).
(a) All money is held as currency.
(Ans.)
All the money is held as currency: = 0.
=
$1000
=
= and
0
+1
+1
=
= 1.
+
+0
0
0
= =0
Then M (the money supply) = MB (the monetary base).

The money supply will be $1,000.

Method 2:
All the money is held as currency: = 0 = 1
=
1
+ 1
1
1+0
= 1.
Then = = $1,000.
(b) All money is held as demand deposits. Banks hold 100 percent of
(Ans.)
=
0
=
= 0 and
1000
+1
0+1
=
=1
+
0+1
1000
1000
=1

= 1 $1000 = $1,000 because 100 percent of money is held on
reserves and no loans are made.
Method 2:
All money is held as demand deposits; = 0 and = 1
=
1
+ 1
1
0+1
=1
= 1 $1000 = $1000.
(c) All money is held as demand deposits. Banks hold 20 percent of
(Ans.)
=
0
1000
= 0 and =
200
1000
= 0.2

=
+1
+
0+1
0+0.2
= 5.
= 5 $1000 = $5,000.
Method 2:
All money is held as demand deposits; = 0 and = 0.2
=
1
+ 1
1
0+0.2
=5
= 5 $1000 = $5000.
(d) People hold equal amount of currency and demand deposits. Banks
hold 20 percent of deposits as reserves.
(Ans.)
= 1 and =
= 0.2

=
+1
+
1+1
1+0.2
= 1.67.
= 1.67 $1000 = $1,670.

Method 2:
People hold equal amount of currency and demand deposits; = 0.5
=
1
+ 1
1
0.5+0.2(10.5)
= 1.67
= 1.67 $1000 = $1,670.

(e) The central bank decides to increase the money supply by 10
percent. In each of the above four scenarios, how much should it
increase the monetary base?
(Ans.)
Recall: = % = % b/c % = 0
= ; the money supply is proportional to the monetary
base.
Since m is a constant number, a 10% increase in the monetary base
(MB) leads to a 10% increase in the money supply (M).
Classical Economists View on Money

We saw how the money supply is determined by the banking system
together with the policy of the central bank, so can now start to
examine how the quantity of money is related to other economic
variables, such as the overall level of prices and incomes ().
The theory we would like to develop here, called the quantity theory
of money, has its root in the work of the early monetary theorists,
including the philosopher and economist David Hume.
It remains the leading explanation for how money affects the
economy in the long run.
Velocity and Quantity Theory of Money

The quantity theory of money allows us to make the connection
between money and inflation.
Quantity equation: . 4.24 = ,
where is the amount of money in circulation, is called the
velocity of money, denoted the price level, and denoted real GDP.
: nominal GDP the amount of goods and services purchased in
an economy, valued at current prices
: the effective amount of money used in purchases
Meaning: Nominal GDP is equal to the effective amount of
money used in purchases .

(Income) Velocity of Money, just called Velocity
The number of times the money stock (or money supply) is turned
over per year in financing the annual flow of income
The average number of times per year that each piece of paper
currency is used in a transaction
It measures how often the money stock turns over each period.
4.25 : =
nominal GDP
nominal money stock
Example: In 2009 nominal GDP was about $14,256 billion and the
money stock averaged $8,424 billion.
velocity =
nominal GDP
$,
$,
= . .
Meaning:
Each piece of is used, on average, in 1.7 transactions:
1.7 =
Each dollar of money balances financed on average $1.70 of
spending on final goods.
To put another way,
$8,424
$14,256
= 0.588 0.59; the public held an
average of 59 cents of per dollar of income.

The concept of velocity is important because it is a convenient way of
talking about money demand.
From 4.3
= , = + , the demand for real money
balances.
Substituting (4.3) into (4.25):
4.25 : =
since
= , = + in equilibrium.

Convenient assumption: money demand is proportional to income,
as is roughly true for long-run demand.
= , =
4.26
= ()
Real money demand is proportional to real income.

Plugging 4.26 into 4.25 :
=
4.27 :
1
=

1
=
()

4.27 : =
1
()
So, velocity is a quick way to summarize the effect of interest rate on

money demand high velocity means low demand for money:
at higher interest rates, holding money involves a higher opportunity
cost, and money therefore circulates fast.
Strong assumption: Velocity is a constant and does not depend on
income or interest rates: = .

From 4.25 : =
1
,=+
,=+
, = + =
4.28
where (a constant) tells how much money people want to hold for
every dollar of income.
4.28 says that the quantity demanded of real money balances is
proportional to real income.

This money demand function offers another way to view the quantity
equation:
In equilibrium,
From 4.28
= .
, =
= =
When people want to hold a lot of money for each dollar of income
( is large), money changes hands infrequently ( is small).
Conversely, when people want to hold a little money for each dollar
of income ( is small), money changes hands frequently ( is large).
Figure 4.8: Velocity of Money and Treasury Bill Rates
Question: Is velocity actually constant?

velocity is relatively stable between 1.5 and 2.2 over a 50-year
Period.
Velocity has a strong tendency to rise and fall with market interest
Rates.
Over the last decade velocity has become much less stable than
in the past
When the monetary aggregates all become relatively unstable,
the monetary authority should use the interest rate rather than the
money supply as the direct operating target.
velocity clearly is not constant.

=
% = % $ %
% < % $
% > 0 (velocity is rising)
% > % $
% < 0 (velocity is falling)
Figure 4.9: Growth Rates of , & NGDP, 1960 - 2012
Growth Rates of , , and Nominal GDP, 1960 - 2012
The growth rate of nominal was far higher in the early 1990s as a
result of increased demand for dollar by foreigners than that in
nominal GDP growth, so velocity fell substantially.
The growth rate of turned sharply negative in the mid-1990s as
new types of bank accounts encouraged consumers to reduce their
holdings of ; as a consequence, growth was lower than GDP
growth, so velocity grew during this period.
In the years since the financial crisis of 2008, the growth rate of
nominal was far higher than that in nominal GDP growth, so
velocity fell substantially.
Quantity Theory of Money

Since
= 4.24 : = ,
assuming that V is constant.

4.24 is the famous quantity equation, linking the price level and
the level of output to the money stock.
The quantity equation became the classical quantity theory of money
when it was argued that both and were fixed:
(i) Velocity was assumed not to change very much.
real output was taken to be fixed because the
(ii) = = ;
economy was at full employment level of output or potential output.

4.29 : =
Endogenous variable:
Exogenous variable: , ,
The classical quantity theory is the proposition that the price level is
proportional to the money stock: If is constant, changes in the
money supply translate into proportional changes in nominal GDP.
=
% + % = % + %
4.30 : % = + %
=

4.30 : =
The growth in the money supply determines the inflation rate.
In the classical case of (vertical) supply function - = = ,

changes in money translates into changes in the price level.
Milton Friedman says inflation is always and everywhere a
monetary phenomenon.
Conclusion: The quantity theory of money states that the central
bank, which controls the money supply, has ultimate control over the
rate of inflation. If the central bank keeps the money supply stable,
the price level will be stable. If the central bank increases the money
supply rapidly, the price level will rise rapidly.
Financial Market Equilibrium in the Long Run

Both classical and Keynesian economists agree that the full employment assumption is reasonable for analyzing the long-term
behavior of the economy: = = .

Financial market equilibrium condition:
= , +
Exogenous variables:
, and
Endogenous variables:
r and
4.31 : =
, = +
The price level is proportional to the nominal money supply, given
that the real demand for money is fixed.
A doubling of the money supply would double the price level, with
other variables held constant.
Money Growth and Inflation
We want to show how inflation rate, or the growth rate of the price
level, is determined.
=
,+
4.32
,+
,+
The rate of inflation equals the growth rate of the nominal money minus
the growth rate of real money demand
To use (4.30) to predict the behavior of inflation we must also

know how quickly real money demand is growing.
Since in the long run equilibrium with a constant growth rate of money,
the nominal interest rate will be constant, growth in income will be
considered as a source of growth in real money demand.
+
=
, +
=
=
,+
,+
4.33 : =

=
where is the income elasticity of money demand.
4.33 : =
Example: =
2
.
3

Meaning: The rate of inflation equals the growth rate of the nominal
money supply minus an adjustment for the growth rate of real money
demand arising from growth in real output.
(the income elasticity of money demand)
The percentage change in money demand resulting from a 1% increase
in real income
A 3% increase in real income will increase money demand
by = . An income elasticity of demand smaller than 1.0 implies

that money demand rises less than proportionally with income.

Example: Suppose that nominal money growth is 10% per year, real
income is growing by 3% per year, and the income elasticity of money
demand is 2/3.
=
= .
The inflation rate will be 8% per year.
Figure 4.10: Linkages among , , and Interest Rates
Linkages among Money, Prices, and Interest Rates

As the quantity theory of money explains, money supply and
money demand together determine the equilibrium price
Changes in the price level are, by definition, the inflation rate
Inflation , in turn, affects the nominal interest rate through the

Fisher effect.
The nominal interest rate feeds back to affect the demand for
money , since the nominal interest rate is the cost of holding
money.
= , =
,=+
The quantity theory of money says that todays money supply

determines todays price level .
This conclusion remains partly true: if and are held constant,
the price level moves proportionately with the money supply.
Yet, the is not constant; it depends on , which in turn depends on
growth in the money supply % .
The presence of in the money demand function yield an additional
channel through which money supply affects the price level.
This general money demand equation implies that depends not

only on todays money supply but also on the money supply
expected in the future +1 .
The central bank announces that it will increase in the future, but it
does not change the money supply today.
This announcement causes people to expect higher money growth

and higher inflation.
This increase in expected inflation raises through the Fisher

effect.

The higher increases the cost of holding money and thus reduces
the demand for real money balances.
Because the central bank has not changed money stock

available today, the reduced demand for real money balances leads to
a higher price level today.
Conclusion: Expectations of higher money growth in the future lead
to a higher price level today.

4.27 : =
1
()
So, velocity is a quick way to summarize the effect of interest rate on

money demand high velocity means low demand for money:
at higher interest rates, holding money involves a higher opportunity
cost, and money therefore circulates fast.
Strong assumption: Velocity is a constant and does not depend on
income or interest rates: = .

From 4.25 : =
,=+
,=+
, = + =
4.28
where (a constant) tells how much money people want to hold for
every dollar of income.
4.28 says that the quantity demanded of real money balances is
proportional to real income.

This money demand function offers another way to view the quantity
equation:
In equilibrium,
From 4.28
= .
, =
= =
When people want to hold a lot of money for each dollar of income
( is large), money changes hands infrequently ( is small).
Conversely, when people want to hold a little money for each dollar
of income ( is small), money changes hands frequently ( is large).
Figure 4.8: Velocity of Money and Treasury Bill Rates
Question: Is velocity actually constant?

velocity is relatively stable between 1.5 and 2.2 over a 50-year
period.
Velocity has a strong tendency to rise and fall with market
interest rates.
Over the last decade velocity has become much less stable than
in the past
When the monetary aggregates all become relatively unstable,
the monetary authority should use the interest rate rather than the
money supply as the direct operating target.
velocity clearly is not constant.

=
% = % $ % by approximation rule
% < % $
% > 0 (velocity is rising)
% > % $
% < 0 (velocity is falling)
Figure 4.9: Growth Rates of , & NGDP, 1960 - 2012
The growth rate of nominal was far higher in the early 1990s as a
result of increased demand for dollar by foreigners than that in
nominal GDP growth, so velocity fell substantially.
% > % $
The growth rate of turned sharply negative in the mid-1990s as
new types of bank accounts encouraged consumers to reduce their
holdings of ; as a consequence, growth was lower than GDP
growth, so velocity grew during this period.
% < % $
In the years since the financial crisis of 2008, the growth rate of
nominal was far higher than that in nominal GDP growth, so
velocity fell substantially.
% > % $

Since
= 4.24 : = ,
assuming that V is constant.

4.24 is the famous quantity equation, linking the price level and
the level of output to the money stock.
The quantity equation became classical quantity theory of money
when it was argued that both and were fixed:
(i) Velocity was assumed not to change very much.
; real output was taken to be fixed because the
(ii) = =
economy was at full employment level of output or potential output.

4.29 : =
Endogenous variable:
Exogenous variable: , ,
The classical quantity theory is the proposition that the price level is
proportional to the money stock: If is constant, changes in the
money supply translate into proportional changes in nominal GDP.
Or, as a famous phrase summarizes the quantity theory, inflation is
caused by too much money chasing too few goods.

=
= % + %
% + %
by approximation rule
4.30 : % = + %
=
The growth in the money supply determines the inflation rate.
In the classical case of (vertical) supply function - = =
% = 0; changes in money translates into changes in
the price level; % = .

The quantity theory implies that in the long run, changes in the
growth rate of money lead one-for-one to changes in the inflation
rate.
Milton Friedman says inflation is always and everywhere a
monetary phenomenon.
Conclusion: The quantity theory of money states that the central

bank, which controls the money supply, has ultimate control over the
rate of inflation. If the central bank keeps the money supply stable,
the price level will be stable. If the central bank increases the money
supply rapidly, the price level will rise rapidly.

Both classical and Keynesian economists agree that the full employment assumption is reasonable for analyzing the long-term
.
behavior of the economy: = =
Financial market equilibrium condition:
= , +
, and
r and
4.31 : =
, = +
The price level is proportional to the nominal money supply, given
that the real demand for money is fixed.
A doubling of the money supply would double the price level, with
other variables held constant.

We want to show how inflation rate, or the growth rate of the price
level, is determined.
=
,+
4.32
,+

,+
The rate of inflation equals the growth rate of the nominal money
minus the growth rate of real money demand

To use (4.30) to predict the behavior of inflation we must also
know how quickly real money demand is growing.
Since in the long run equilibrium with a constant growth rate of
money, the nominal interest rate will be constant, growth in income
will be considered as a source of growth in real money demand.
+
=
, +
=
=
,+
,+
4.33 : =

=
where is the income elasticity of money demand.

4.33 : =
Meaning: The rate of inflation equals the growth rate of the nominal
money supply minus an adjustment for the growth rate of real money
demand arising from growth in real output.
(the income elasticity of money demand)
The percentage change in money demand resulting from a 1%
increase in real income

Example: =
A 3% increase in real income will increase money
demand by =
= . An income elasticity of demand
smaller than 1.0 implies that money demand rises less than
proportionally with income.
Example: Suppose that nominal money growth is 10% per year, real
income is growing by 3% per year, and the income elasticity of money
demand is 2/3.
=
= .
The inflation rate will be 8% per year.
Figure 4.10: Linkages among , , and Interest Rates

As the quantity theory of money explains, money supply and
money demand together determine the equilibrium price
Changes in the price level are, by definition, the inflation rate
Inflation , in turn, affects the nominal interest rate through the

Fisher effect.
The nominal interest rate feeds back to affect the demand for
money , since the nominal interest rate is the cost of holding
money.
= , =
,=+
The quantity theory of money says that todays money supply

determines todays price level .
This conclusion remains partly true: if and are held constant,
the price level moves proportionately with the money supply.
Yet, the is not constant; it depends on , which in turn depends on
growth in the money supply % .
The presence of in the money demand function yield an additional
channel through which money supply affects the price level.
This general money demand equation implies that depends not

only on todays money supply but also on the money supply
expected in the future +1 .
The central bank announces that it will increase in the future, but it
does not change the money supply today.
This announcement causes people to expect higher money growth

and higher inflation.
This increase in expected inflation raises through the Fisher

effect.

The higher increases the cost of holding money and thus reduces
the demand for real money balances.
Because the central bank has not changed money stock

available today, the reduced demand for real money balances leads to
a higher price level today.
Conclusion: Expectations of higher money growth in the future lead
to a higher price level today.
Keynesian Economics: Great Depression

In the worst year 1933, one-fourth (25%) of the U.S. labor force was
unemployed, and real GDP was 30% below its 1929 level.
This devastating episode caused many economists to questions the
validity of Classical economic theory. Classical theory seemed
incapable of explaining the Depression.
According to Classical theory, national income (Y) depends on factors
of production supplied and the available technology, neither of which
changed substantially from 1929 to 1933.

Keynesian Revolution: In 1936, the British economist John Maynard
Keynes revolutionized economics with his book The General Theory
of Employment, Interest, and Money.
Keynes proposed a new way to analyze the economy, which he
presented as an alternative to Classical theory.
Keynes proposed that low AD (aggregate demand) is responsible for
the low income and high unemployment that characterize economic
downturns.

He criticized Classical theory for assuming that AS (aggregate supply)
alone capital (K), labor (L), and technology determines national
income ().
Economists today reconcile these two views with the model of AD
and AS. In the long run, prices are flexible, and AS determines
national income (Y).
But in the short run, prices are sticky, so changes in AD influence
national income. The model of AD, called IS LM, is the leading
interpretation of Keyness theory.
Investment (I)
Investment spending plays a key role not only in long-run growth but
also in the short-run business cycles because it is the most volatile
component of GDP.
Even though investment is only about 15% of GDP, in the typical
recession half or more of the total fall in spending is reduced
investment.
Three Types of Investment Spending

Business fixed investment: equipment and structures that firms buy
to use in production. In recent years, this component accounts for
about two-thirds of investment, about 11% of GDP.
Residential investment: new housing that people buy to live in and
that landlords buy to rent out.
Inventory investment: those good that firms put aside in storage,
including materials and supplies, work in progress, and finished
goods.
Three Types of Investment Spending

Inventory investment is a small but very cyclical component of
investment. In a booming economy, inventory investment is usually
positive firms are producing more goods than they are selling - but
turns negative during recession; firms cut production sharply and run
down their inventories.
Neoclassical Model of Investment

It examines the benefits and costs to firms of owning capital goods.
The model shows how the level of investment the addition to the
stock of capital is related the marginal product of capital
, the interest rate, income, and the tax rules affecting
firms.
The capital stock changes over time through two opposing channels:
First, the purchase or construction of new capital goods, called gross
investment, increases the capital stock.
Second, the capital stock depreciates or wears out, which reduces
The capital stock.

Whether the capital stock increases or decreases over the course of a
year depends on whether gross investment is greater or less than
depreciation during the year.
: gross investment during year
: capital stock at the beginning of year
+1 : capital stock at the beginning of year + 1(equivalently, at the
end of year )
: depreciation rate the fraction of capital that depreciates each
year

. : Capital accumulation equation
+ (+ ) =
Net investment = Gross investment - Depreciation
5.2 : = + +
Thus, gross investment has two parts:
(i) Net increase in the capital stock over the year (+ )
(ii) Investment needed to replace depreciated capital ( )
. : Capital accumulation equation
+ = + = +
Tomorrows capital is increased by investing today less depreciation.
User Cost of Capital

Q: What is the optimal/desired capital stock?
A: It is the amount of capital that allows firms to earn largest
expected profit.
According to neoclassical model of investment, optimal capitals stock
depends on costs and benefits of additional capital.
Since investment becomes capital stock with a lag, the benefit of
investment is the future marginal product of capital .

Q: How much capital should a firm install to maximize profit?
A: For the optimal/desired capital stock, a firm should keep investing
in physical capital until the (future benefit of one more unit of
capital, called marginal benefit) falls to equal the cost of an
additional unit of capital, called the marginal cost.
Real purchase price of capital per unit: To see what variables affect
the equilibrium price of capital, lets consider the Cobb-Douglas
production function, a function many economists believe a good
approximation of how the actual economy turns capital and labor
into goods and services.

Cobb-Douglas production function: = ,
where = output, = capital, = labor,
= a parameter of measuring the level of technology,
and 0 < < 1. measures capitals share of output.
5.4 :
=
= = ()
=

Because the real price of capital
5.5
= equals in equilibrium,
The firm demands a factor of production until marginal product of

capital equals its real factor price; i.e. MB (MPK) = MC ( ).
The lower the stock of capital, the higher the real price of capital:

The greater amount of labor employed, the higher the real price of
capital:
The better the technology, the higher the real price of capital:


Events that reduce the capital stock (a natural disaster), or raise
employment (an expansion in aggregate demand), or improve
technology (a scientific discovery) raise the equilibrium real price of
capital.
Regardless of whether to borrow to buy equipment or to use retained
earnings, firms give up the interest income they would have received
if they invested that money instead of buying new equipment.
Assumption: borrowing rate = lending rate = i or r

Cost of owning a capital: A firm bears three costs for each period of
time.
Interest payment on loans:
Cost of capital loss or gain: (b/c we are measuring costs, not
benefits) where = ,+1 , .
Cost of depreciation: where = depreciation rate.
Example: A firm starts the year with a capital worth $10,000,
but in the beginning of the next year it is only worth $8,000.
= $, ,+ $, , = $, (capital
loss), so = . . The price declined by 20 percent.

5.6 : User cost of capital (uc)
= + =
Meaning: The user cost of capital depends on the price of capital,

the interest rate, the rate at which capital prices are changing, and
the depreciation rate.
User cost of capital
The expected cost of using a unit of capital for a specified period of
time

Assumption: The price of capital goods rises with the prices of other
goods:
= .
5.6 5.7 : = + = +
Meaning: The user cost of capital depends on the price of capital,
the real interest rate, and the depreciation rate.
5.8 : =
+ = + = +
Meaning: Real cost of using a unit of capital for each period of time is
the sum of real interest cost and depreciation.
Example (5.1): User Costs in Nominal Terms
Consider the cost of capital to a car-rental company. The company buys

cars for $30,000 each and rents them out to other businesses. The
company faces an interest rate of 10 percent per year. Car prices are
rising at 6 percent per year, excluding wear and tear. Cars depreciate at
20 percent per year? What is the companys cost of capital?
(Ans.)
the interest cost = 0.1 $30,000 = $3,000
capital gain = 0.06 $30,000 = $1,800
loss due to depreciation = 0.2 $30,000 = $6,000
= + = $3,000 $1,800 + $6,000 = $7,200.
The cost to the car-rental company of keeping a car in its capital stock
is $7,200 per year.
Example (5.2): User Costs in Real Terms
Consider a bread company that produces specialty cookies and that is

considering investing in a new solar-powered oven that will allow it to
produce more cookies in the future. In making a decision, it has the
following information:
A new oven can be purchased in any size at a price of $100 per cubic
foot, measured in real (base-year) dollars.
Because the oven is solar powered, using it does not involve energy
costs. The oven also does not require maintenance expenditures.
However, the oven becomes less efficient as it ages: With each year
that passes, the oven produces 10% fewer cookies. Because of this
depreciation, the real value of an oven falls 10% per year.
Example (5.2): User Costs in Real Terms

The company can borrow (from a bank) or lend (to the government, by
buying a 1 year government bond) at the prevailing interest rate of 10%
per year. The price level is expected to rise at 2%.
What is the companys user cost of an oven per cubic foot per year?
(Ans.)
real interest cost = 0.08 $100 = $8
depreciation cost = 0.1 $100 = $10
= + = $8 + $10 = $18.
The companys user cost is $18 per cubic foot per year.
Determination of the Optimal Capital Investment

Now consider a firms decision about whether to increase or decrease
its capital stock.
Revenue: = (, ) where = (, ).
Cost: + +
Profit = Revenue Cost
= , +
First-order necessary condition for profit maximization:
+ =
5.9 : = ( + )

= ( + )
A firm should invest until the value of extra output that capital
produces falls to equal the user cost.
Benefits of investing are more output tomorrow so, it is future MPK
that is important. Investment decisions today have effects on the
capital stock tomorrow.
Divide 5.9 by :
. : =

> ( > )
Profits rise as K is reduced: Invest less than what necessary to
replace the depreciated capital.
< ( < )
Profits rise as K is added: Invest more than what necessary to
replace the depreciated capital.
A firms optimal/desired capital stock is where =
( = ): Profits are maximized.
Figure 5.1: Determination of the Optimal Capital Stock

Q:Why does the curve slope downward?
A: falls as the capital stock (K) is increased due to diminishing
marginal productivity (or decreasing returns to capital).
Mathematically, =
2
2
= 1 1
= 2 1 < 0 since 0 < < 1.
Q: Why is the user cost curve a horizontal line?

A: Because the user cost doesnt depend on the amount of capital:
uc doesnt vary with K. Mathematically,
(+)
= (zero slope horizontal line)

The desired/optimal amount of capital for the firm to own occurs at
the intersection of the marginal product with the user cost of capital:
= . At this point, the extra output produced by one
additional unit of capital is precisely enough to cover the extra cost of
owning a unit of capital, the user cost.
When the capital stock reaches a steady-state level
= ( + ). Thus, in the long run, the marginal product of
capital equals the real cost of capital.

The speed of adjustment toward the steady state depends on how
quickly firms adjust their capital stock which in turn depends on how
costly it is to build, deliver, and instill new capital.
Changes in the Optimal/Desired Capital Stock

Factors that shifts the curve or change the user cost of capital
cause the optimal/desired capital stock to change.
An increase (or a decrease) in interest rate leads to a decrease
(or an increase) in the optimal capital stock.
Figure 5.2: An Increase in Interest Rate
An Increase in Interest Rate

The interest rate rises from to
The rise in the user cost leads to an upward shift of the user cost
line, from 1 to 2
After that shift, the at the initial optimal capital is less than
the user cost of capital: < < .
The optimal capital stock decreases from to .
Summary: Any other change that increases (or decrease) the user
cost of capital decrease (or increases) the optimal capital stock.

The desired/optimal amount of capital for the firm to own occurs at
the intersection of the marginal product with the user cost of capital:
= . At this point, the extra output produced by one
additional unit of capital is precisely enough to cover the extra cost of
owning a unit of capital, the user cost.
When the capital stock reaches a steady-state level
= ( + ). Thus, in the long run, the marginal product of
capital equals the real cost of capital.

The speed of adjustment toward the steady state depends on how
quickly firms adjust their capital stock which in turn depends on how
costly it is to build, deliver, and instill new capital.
Changes in the Optimal/Desired Capital Stock

Factors that shifts the curve or change the user cost of capital
cause the optimal/desired capital stock to change.
An increase (or a decrease) in interest rate leads to a decrease
(or an increase) in the optimal capital stock.
Figure 5.2: An Increase in Interest Rate
An Increase in Interest Rate

The interest rate rises from to
line, from 1 to 2
Changes in the Optimal Capital Stock

An increase in future total factor productivity (TFP) or technology
leads to an increase in optimal capital stock.
Figure 5.3: An increase in Technology
An increase in Technology
Technological changes affect the
A technological advance causes the to shift upward from
to
2 .
After that shift, the at the initial optimal capital is more

than the user cost of capital: > > .
If the user cost remains unchanged, the technological advance
causes the optimal capital stock to rise from to .
Summary: With the user cost of capital held constant, an increase in
the at any level of capital raises the optimal capitals stock.
Changes in the Optimal Capital Stock

Taxes and the Optimal Capital Stock
So far we have ignored the role of taxes in the investment decision.
But a firm must take into account taxes in evaluating the desirability
of an additional unit of capital.
Suppose that = the tax rate on firm revenue.
Then the optimal capital stock is the one at which the after-tax future
marginal product of capital equals the user cost:
5.10 : =
Taxes and the Optimal Capital Stock

In 5.10 , the term
is called the tax-adjusted user cost of
capital, which shows how large the before-tax future marginal

product of capital must be for a firm to willingly add another unit of
capital.
An increase in tax rate raises the tax-adjusted user cost and thus
reduces the optimal capital stock.
Figure 5.4: An Increase in Tax on a Firms Revenue
Changes in Taxes
The tax rate rises from = 0 to > 0
line, from 1 to 2
Some caveats on the tax-adjusted user cost of capital:
In reality, profits are taxed even though we assumed that firm revenues
were taxed. The corporate income tax is a tax on corporate profits.
Depreciation allowances reduce the tax paid by firms, because they
reduce profits.
Depreciation allowances
Tax deductions that allow firms to reduce its total tax payment by
deducting the purchase price of capital from its taxable profit in both the
year of purchase and in subsequent years
Investment tax credits reduce taxes when firms make new investments.

Investment tax credits
Tax provision in which a firm is permitted to subtract a certain
percentage of the purchase price of new capital directly from its tax
bill
Economists summarizes the many provisions of the tax code
affecting investment by a single measure of the tax burden on capital
called the effective tax rate.
Effective tax rate
The tax rate on firm revenue that would have the same effect on
the optimal capital stock as do the actual provisions of the tax code.

Changes in the tax law that raise the effective tax rate are equivalent
to an increase in tax on firm revenue and a rise in the tax-adjusted
user cost of capital. Thus, all else being equal, an increase in the
effective tax lowers the optimal capital stock.
Example (5.3): Optimal Capital Stock

Hula hoop fabricator cost $100 each. The Hi-Ho Hula Hoop
Company (HHHHC) is trying to decide how many of these machines to
buy. HHHHC expects to produce the following number of hoops
each year for each level of capital stock shown in the table.
Hula hoops have a price of $1 each. HHHHC has no
other costs besides the cost of fabricators.
100
150
180
195
205
210
=
+
$0
1
$0

a) If = 12% ( 0.12) per year and = 20%(0.20) per year, find
the user cost of capital (in dollars per fabricator per year). How many
fabricator should HHHHC buy?
(Ans.)
HHHHC should buy two fabricators, since at two fabricators,
= $ > = $.
But at the third fabricator, = $ < = $.
You want to add capital only if > .
Since < for the third fabricator, so it should not be added.

b) If = 12% ( 0.12) per year, = 20%(0.20) per year and =
40% ( 0.4) on HHHHCs sales revenue, how many fabricator should
HHHHC buy?
(Ans.)
HHHHC should buy just one fabricator,
since = $ > = $.
It shouldnt buy the second one
since = $ < = $.
100
150
=
+
$0
$50
$100(0.12+0.2)
= $32
$32
(1 0.4)$100
= $60
0.6(50) = $30
180
$30
$32
0.6(30) = $18
195
$15
$32
0.6(15) = $9
205
$10
$32
0.6(10) = $6
210
$5
$32
0.6(5) = $3
$100
$0
Example (5.4): From Desired Capital to Investment

Cobb-Douglas production function: = 1/3 2/3
Show that the marginal product of capital declines as capital increases
this is the diminishing returns to capital or the diminishing
marginal product of capital.
(Ans.)
=
2/3
1
1
= 2/3 2/3 =
3
3
= =
< > .
From Desired Capital to Investment

From 5.1 : +1 =
From 5.9 : =
1
= 2/3 2/3 =
3
=
=
3
= 3 = 3
+ (in real terms)
1 / /
Dividing both sides of (5.1) by :
+1
From Desired Capital to Investment
Substitute for and solve for :
+
5.11 : ( ) =
Intuition: The investment rate inversely depends on the user cost:

a higher user cost of capital leads to a lower investment.
For example, higher taxes reduce the investment rate (via the user
cost of capital).
The Stock Market and Financial Investment

In macroeconomics, capital and investment usually refer to the
accumulation of physical capital. However, these words are used
frequently in finance while these are different uses.
The Arbitrage Equation and the Price of Stock
Suppose a (financial) investor has some extra money to invest.
Option 1: Put the money into a saving account that pays an interest
rate .
Option 2: Purchase a stock at price , hold the stock for a year, and
then sell it.

Assumption: Both investments are perfectly safe. That is, the investor
knows what the dividend and capital gain will be; these are not
uncertain.
The arbitrage equation tells someone investing dollars in either
the bank account or the stock must get the same financial return.
= +

dividend+

5.12 : =

()

()
Meaning: The only way there is no arbitrage opportunity is if these

two investments have the same return.
5.13 : =
dividend
dividend
capital gain
Example (5.5)
a) A stock may pay a dividend of $10 per share forever. If the capital
gain is zero and the interest rate is 5%, what is the price of the stock?
(Ans.)
=
$
.
$
..
= $
b) Suppose the initial dividend is $10, the interest rate is 5%, and the
growth rate of dividend (and, therefore, the stock price) is 2%. What
is the price of stock?
(Ans.)
$
Investment and the Stock Market

Many economists see a link between fluctuations in investment and
fluctuations in the stock market. Economic theory suggests that rises
and falls in the stock market should lead firms to change their rates of
capital investment in the same direction: Firms change investment in
the same direction as the stock market.
The relationship between stock prices and firms investment in
physical capital is captured by the q theory of investment, called
Tobins q, developed by James Tobin.
5.11 : =
where is stock market value of firm (the value of the economys

capital as determined by the stock market = stock price x the number
of shares), is firms capital and is price of new capital.
The denominator is the price of that capital if it were purchased
today.
Tobin reasoned that net investment should depend on whether q is
greater or less than 1.

> 1
>
Managers can raise the market value of firms stock by buying
more capital. Invest more!
< 1
<
Managers will not replace capital as it wears out. Dont invest!
Booming stock market raises V, causing q to rise, increasing
investment.
Figure 5.5: Investment and Tobins q, 1987 - 2012

Tobins q and real private non-residential investment are closely
related; they rose together throughout the 1990s and then both fell
sharply in 2000 and 2008. But the relationship isnt strong in the 1987
stock market crash and the mid-2000s because many other things
change at the same time.
Relationship b/w the q theory of investment and neoclassical theory
of investment:
Higher
Higher future earnings
Increases V and so q.

of investment:
A falling real interest rate
raise stock prices and hence q as investors substitute away from
low-yielding bonds and bank deposits and buy stocks instead.
A decrease in the purchase price of capital
Lower replacement cost of installed capital
Raise q.
Because all three types of change increase Tobins q, they also
increase the optimal capital stock and investment.

Q: What is the advantage of Tobins q as a measure of the incentive to
invest?
A: Tobins reflects the expected future profitability of capital as well
as the current profitability. For example, Congress legislates
a reduction in the corporate income tax beginning next year
Greater profits for the owners of capital
Higher expected profits raise the value of stock today
Increase Tobins q
Raise investment today.

Tobins q theory of investment emphasizes that investment decisions
depend not only on current economic policies but also on policies
expected to prevail in the future.

Many economists see a link between fluctuations in investment and
fluctuations in the stock market. Economic theory suggests that rises
and falls in the stock market should lead firms to change their rates of
capital investment in the same direction: Firms change investment in
the same direction as the stock market.
The relationship between stock prices and firms investment in
physical capital is captured by the q theory of investment, called
Tobins q, developed by James Tobin.
5.11 : =
where is stock market value of firm (the value of the economys

capital as determined by the stock market = stock price x the number
of shares), is firms capital and is price of new capital.
The denominator is the price of that capital if it were purchased
today.
Tobin reasoned that net investment should depend on whether q is
greater or less than 1.

> 1
>
Managers can raise the market value of firms stock by buying
more capital. Invest more!
< 1
<
Managers will not replace capital as it wears out. Dont invest!
Booming stock market raises V, causing q to rise, increasing
investment.
Figure 5.5: Investment and Tobins q, 1987 - 2012

Tobins q and real private non-residential investment are closely
related; they rose together throughout the 1990s and then both fell
sharply in 2000 and 2008. But the relationship isnt strong in the 1987
stock market crash and the mid-2000s because many other things
change at the same time.
of investment:
Higher
Higher future earnings
Increases V and so q.

of investment:
A falling real interest rate
raise stock prices and hence q as investors substitute away from
low-yielding bonds and bank deposits and buy stocks instead.
A decrease in the purchase price of capital
Lower replacement cost of installed capital
Raise q.
Because all three types of change increase Tobins q, they also
increase the optimal capital stock and investment.

Q: What is the advantage of Tobins q as a measure of the incentive to
invest?
A: Tobins reflects the expected future profitability of capital as well
as the current profitability. For example, Congress legislates
a reduction in the corporate income tax beginning next year
Greater profits for the owners of capital
Higher expected profits raise the value of stock today
Increase Tobins q
Raise investment today.

Tobins q theory of investment emphasizes that investment decisions
depend not only on current economic policies but also on policies
expected to prevail in the future.

Q: Does the stock market work as an economic indicator?
A: Paul Samuelson says The stock market has predicted nine out of
the last five recessions. According to Paul Samuelsons famous quip,
the stock market is reliable as an economic indicator, but it is in fact
quite volatile, and it can give false signal about the future of the
economy. Yet we should not ignore the link between the stock market
and the economy.
Figure 5.6: The stock market and the economy

Q: Why do stock prices and economic activity tend to fluctuate
together?
A: (i) Tobins theory
For instance, suppose that you observe a fall in the stock prices.
Because the replacement cost of capital is fairly stable, a fall in the
stock market is usually associated with a fall in Tobins q. A fall in
Tobins q reflects investors pessimism about the current and future
profitability of capital, meaning that the investment function shifts
inward: investment is lower at any given interest rate. As a result,
the AD for goods and services contracts, leading to lower output and
employment.

(ii) Because stock is part of household wealth, a fall in stock prices
makes people poorer and thus depresses consumer spending, which
also reduces AD.
(iii) A fall in stock prices might reflect bad news about technological
progress and long-run economic growth. If so, this means that the
natural level of output and thus AS will be growing more slowly in
the future than it was previously expected.

The stock market is a closely watched economic indicator. A case in
point is the deep economic downturn in 2008 and 2009:
the substantial declines in production and employment coincided
with a steep decline in stock prices.
Inventory Investment
Inventory investment (the goods that businesses put aside in storage)
is negligible and of great significance. It is one of the smallest
components of spending, averaging 1 percent of GDP. Yet its
remarkable volatility makes it central to the study of economic
fluctuations. In a typical recession, more than half the fall in spending
comes from a decline in inventory investment.
Q: Why do businesses hold inventories?
A: Inventories serve many purposes.
(i) Production smoothing
One use of inventories is to smooth the level of production over time.
When a firm experiences temporary booms and busts in sales, it may
find it cheaper to produce goods at a steady rate rather than
adjusting production to match the fluctuations in sales. When sales
are low, the firm produces more than it sells and puts the extra goods
into inventory. When sales are high, the firm produces less than it
sells and takes goods out of inventory.
(ii) Inventories as a factor of production: the larger the stock of
inventories a firm holds, the more output it can produce.
Inventories may allow a firm to operate more efficiently.
For example, manufacturing firms keep inventories of spare parts to
reduce the time that the assembly line is shut down when a machine
breaks.
(iii) Stock-out avoidance: avoid running out of goods when sales are
unexpectedly high.
If demand exceeds production and there are no inventories, the good
will be out of stock for a period, and the firm will lose sales and profit.
Inventories can prevent this from happening.
(iv) Work-in-process
Many goods require a number of production steps and, therefore,
take time to produce. When a product is only partly completed, its
components are counted as part of a firms inventory.
Q: How do the real interest rate and credit conditions affect inventory
investment?
A: (i) Inventory investment depends on the real interest rate.
When a firm holds a good inventory and sells it tomorrow rather than
selling it today, it gives up the interest it could have earned between
today and tomorrow. Thus, the real interest rate measures the
opportunity cost of holding inventories. When the real interest rate
rises, holding inventories becomes more costly, so rational firms try
to reduce their stock.
Therefore, an increase in the real interest rate depresses inventory
investment. For example, in the 1980s many firms adopted just-in time production plans, which were designed to reduce the amount
of inventory by producing goods just before sale.
(ii) Inventory investment also depends on credit conditions. Because
many firms rely on bank loans to finance their purchases of
inventories, they cut back when these loans are hard to come by.
For instance, during the financial crisis of 2008 2009, firms reduced
their inventory holdings substantially. During this severe recession, as
in many economic downturns, the decline in inventory investment
was a key part of the decline in AD.
The Goods Market and the IS Relation

Summary of the Goods Market:
production demand , called the IS relation
= + + + ,
where I, G, TR and T were taken as given.
We considered the factors that moved equilibrium output; we looked
at the effects of changes in G and of shifts in consumption demand.
The main simplification of this first model was that the interest rate
did not affect demand for goods. Our first task in this note is to
abandon this simplification and introduce the interest rate in the
model of equilibrium in the goods market.
Investment (I)
5.12 : = , = + where 0 , 1 , 2 > 0.
+
Y = the level of sales = production, assuming that inventory

investment is zero,
i = the (nominal) interest rate,
1 measures the responsiveness of investment spending to income,
2 measures the responsiveness of investment spending to the
interest rate,
and 0 denotes autonomous investment spending that is
independent of both income and the interest rate.
Investment (I)
5.12 : = , or = 0 + 1 2
+,
The higher the interest rate, the less attractive a firm is to borrow and
invest since the interest rate is the cost of borrowing to finance
investment projects. At a high enough interest rate, the additional
profits from using the new machine will not cover interest payment
and the new machine will not be worth buying.
Investment (I)
5.12 : = , or = 0 + 1 2
+,
Q: What determines the position of the investment curve?

A: The position of the investment curve is determined by the slope
and by the level of autonomous investment spending .
If investment is highly responsive - 2 is large to the interest rate,
a small decline in interest rates will lead to a large increase in
investment, so the investment curve is almost flat.
Conversely, if investment responds little to interest rate,
the investment curve will be relatively steep.
Investment (I)
Changes in autonomous investment spending 0 shift the
investment line.
An increase in 0 means that at each level of the interest rate, firms
plan to invest at a higher rate. This means a rightward shift of the
investment line.
Determination of Output
5.13 : = = + + , +
income and so
.
In short, ( ) through its effect on both consumption
and investment.
This relation between demand and output, for a given interest rate,
is represented by the upward-sloping curve ZZ.
Deriving the IS Curve

The initial equilibrium is at point A.

The demand curve shifts down to : At a given level of
output, demand is lower.
The new equilibrium is at point .
The equilibrium level of output is now equal to 2 .

In words: The increase in the interest rate decreases investment.
The decrease in investment leads to a decrease in output, which
further decreases consumption and investment, through the
multiplier effect.
In essence, the IS curve combines the interaction between ( )
and expressed by the investment function and the interaction
between and demonstrated by the Keynesian cross.
Figure 5.6: The Derivation of IS Curve
The IS Curve
The IS curve shows the combination of the interest rate and
the equilibrium level of income in the goods market.
An increase (a decrease) in i leads to a fall (or a rise) in Y: IS curve is
downward sloping i and the equilibrium output (Y) is negatively
related. That is, the IS curve illustrates how the equilibrium level of
income depends on the interest rate.
The IS curve shows for any given interest rate the level of income that
brings the goods market into equilibrium.
Keep in mind that each point on the IS curve represents the
equilibrium output in the goods market for the given interest rate.
The IS Curve
Q: Why does the IS curve slope downward?

A: Because an increase in the interest rate causes investment to fall,
which in turn causes equilibrium income to fall, the IS curve slopes
downward.
Mathematical Derivation of the IS Curve

=
= + +
= 0 + 1 + + 0 + 1 2 +
1 1 1 = 0 + 0 + 1 + 2
1 1 1 1 = 0 + 0 + 1 + 2
5.14 : =
1
11 1 1
0 + 0 + 1 +
11 1 1
1
1 1 1 1
5.14 : =
0 + 0 + 1 +
2
2
Meaning: The IS curve gives all the combination of and that cause
the market for goods to clear (i.e. to be in equilibrium).

The initial equilibrium is at point A.

The demand curve shifts down to : At a given level of
output, demand is lower.
The new equilibrium is at point .
The equilibrium level of output is now equal to 2 .
In words: The increase in the interest rate decreases investment.

The decrease in investment leads to a decrease in output, which
further decreases consumption and investment, through the
multiplier effect.
In essence, the IS curve combines the interaction between ( )
and expressed by the investment function and the interaction
between and demonstrated by the Keynesian cross.
Figure 5.6: The Derivation of IS Curve
The IS Curve
The IS curve shows the combination of the interest rate and

the equilibrium level of income in the goods market.
An increase (a decrease) in i leads to a fall (or a rise) in Y: IS curve is
downward sloping i and the equilibrium output (Y) is negatively
related. That is, the IS curve illustrates how the equilibrium level of
income depends on the interest rate.
The IS curve shows for any given interest rate the level of income that
brings the goods market into equilibrium.
Keep in mind that each point on the IS curve represents the
equilibrium output in the goods market for the given interest rate.
The IS Curve
Q: Why does the IS curve slope downward?

A: Because an increase in the interest rate causes investment to fall,
which in turn causes equilibrium income to fall, the IS curve slopes
downward.
Mathematical Derivation of the IS Curve

=
= + +
= 0 + 1 + + 0 + 1 2 +
1 1 1 = 0 + 0 + 1 + 2
1 1 1 1 = 0 + 0 + 1 + 2
5.14 : =
1
11 1 1
0 + 0 + 1 +
11 1 1
1
1 1 1 1
5.14 : =
0 + 0 + 1 +
2
2
Meaning: The IS curve gives all the combination of and that cause
the market for goods to clear (i.e. to be in equilibrium).
IS Curve
5.14 : =
1
11 1 1
0 + 0 + 1 +
11 1 1
(5.14) is called the IS relation that represents combinations of

interest rates and income (or output) at which the goods market
clears.
A higher interest rate implies a lower level of equilibrium income (or
output) for a given autonomous spending.
IS Curve
5.14 : =
1
11 1 1
0 + 0 + 1 +
11 1 1
The steepness of the IS curve depends on how sensitive investment

spending is to changes in the interest rate and also depends on the
multiplier.
If is large investment is very sensitive to , the IS curve becomes
very flat, but if is small investment is not very sensitive to ,
the IS curve is relatively steep.
Shifts of the IS Curve

An increase or a decrease in the interest rate results in a movement
along the IS curve.
Other Factors That Shift the IS Curve
Consumer confidence 0
Business confidence 0
Higher expected income (output) or Wealth
Effective tax rate on capital
Shifts of the IS Curve: Increase in T
T (taxes): to

: the equilibrium level of output falls from to
At any given interest rate, the equilibrium level of output is lower
than it was before the increase in taxes the IS curve shifts to the
left.
The equilibrium output falls by =
rate.
at any given interest
Figure 5.7: An Increase in T Shifts the IS Curve Leftward
Shifts of the IS Curve: Increase in G

G (government purchases): to
at a given

: the equilibrium level of output rises from to :
At any given interest rate, the equilibrium level of output is higher
than it was before the increase in government purchases the IS
curve shifts to the right.
The equilibrium output rises by =
rate.
at any given interest
Figure 5.8: An Increase in G Shifts the IS Curve to the Right
Financial Markets and the LM Relation

5.15 : =
=
= $ ()
Let = 0 + 1 2
where 0 > 0 represents exogenous changes to ;
1 > 0 and 2 > 0.
It will be more convenient here to rewrite (5.15) as a relation
among real money (that is, money in terms of goods), real income
(that is, income in terms of goods), and the interest rate.
LM Relation
5.16 :
Real money supply = Real money demand
5.16 is referred to as the LM relation.

Real money supply is the money stock in terms of goods, not dollars.
For a given level of (real) income, Y, demand for real balances (or just
real balances) is a decreasing function of the interest rate.
Derivation of the LM Curve

An increase in income from to
An increase in demand for money at any given interest rate
Money demand shifts to the right, to
The new equilibrium is at , with a higher interest rate, .
The LM curve is upward sloping: For a given money stock,

the interest rate is an increasing function of the level of income.
Figure 5.9: The Derivation of the LM Curve
Derivation of the LM Curve

Q: Why does an increase in income lead to an increase in the interest
rate?
A: When income increases, money demand increases for the given
money supply.
Thus, the interest rate must go up until the two opposite effects on
the demand for money cancel each other:
(i) The increase in income that leads people to hold more money
(ii) The increase in the interest rate that leads people to hold less
money
At that point, = , and financial markets are again in
equilibrium.
The LM Curve
The higher the level of output (income), the higher the demand for
money, and therefore the higher the equilibrium interest rate.
Remember that each point on the LM curve represents equilibrium in
the financial market for the given output (income); that is, the LM
curve illustrates how equilibrium interest rate depends on the level of
income.
Mathematical Derivation of the LM Curve
where = +
= +
2 = 0
1
2
+ 1
1
5.17 : =
0
+
2
1
Slope of the LM curve: =
>0
2
The LM curve is sloping upward
The LM Curve
Meaning: Given the level of money supply, if income is high,
then demand for money will be high (because when output
increases, there are more transactions in the economy).
For money demand to be equal to money supply, interest rates also
need to be high in order to reduce money demand.
When income is low, for a given level of money supply, demand for
money is low. So, in order to equilibrate money demand and money
supply, interest rates have to be low to increase money demand.
LM Relation
5.17 : =
1
2
(5.17) is called the LM relation.

The greater the responsiveness of the demand for money to income,
as measured by , and the lower the responsiveness of the demand
for money to the interest rate, measured by , the steeper the LM
curve will be: a given change in income has a larger effect on
when 1 is large and 2 is smaller.
LM Relation
5.17 : =
1
2
If the demand for money is relatively insensitive to the interest rate

and thus 2 is close to zero, the LM curve is almost vertical.
If the demand for money is very sensitive to the interest rate and
thus 2 is large, the LM curve is close to horizontal. In that case, a
small change in the interest rate must be accompanied by a large
change in the level of income in order to maintain money
market equilibrium.
Shifts of the LM Curve

In deriving the LM curve we changed output but held constant other
factors such as the price level and money supply: and are
exogenous variables.
Changes in any of these other factors will cause the LM curve to shift.
Changes in monetary policy
Changes in price level
Changes in expected inflation

For a given level of , from to
For a given ,
from
to
At any given level of , from to

The curve shifts down from to

For a given level of &, from P to
For a given & ,
from
to
At any given level of & , from to

The LM curve down from to

For a given ,

The curve from to
Figure 5.10: Shifts in the LM Curve

Q: Why do we think about shifts of the IS curve to the left or to the
right but about shifts of the LM curve up or down?
A: The goods market determines given ; so we want to know what
happens to when an exogenous variable changes.
is on the horizontal axis, and moves right or left.
The financial markets determine given ; so we want to know what
is on the vertical axis, and moves up or down.

In deriving the LM curve we changed output but held constant other
factors such as the price level and money supply: and are
exogenous variables.
Changes in any of these other factors will cause the LM curve to shift.

For a given ,
from
to

The curve shifts down from to

For a given level of &, from P to
For a given & ,
from
to
At any given level of & , from to

The LM curve down from to

For a given ,

The curve from to
Figure 5.10: Shifts in the LM Curve

Q: Why do we think about shifts of the IS curve to the left or to the
right but about shifts of the LM curve up or down?
A: The goods market determines given ; so we want to know what
is on the horizontal axis, and moves right or left.
The financial markets determine given ; so we want to know what
is on the vertical axis, and moves up or down.
Combining the IS and the LM Relations Together

The relation tells how the interest rate affects output.
The relation tells how output in turn affects the interest rate.
Because the interest rate influences both investment and money
demand, it is the variable that links the two halves of the IS LM
model.
Figure 5.11: Structure of the IS-LM Model
Combining IS & LM Together

: = + , + where = +

= ()
fiscal policy variables (G and T), M, and the price level (P)
i and Y
The task now is to determine how these markets are brought into
simultaneous equilibrium. For simultaneous equilibrium, interest
rates and output (or income) have to be such that both the goods
market and the financial (or money) market are in equilibrium.
Combining IS & LM Together

For simultaneous equilibrium, interest rates and output (or income)
have to be such that both the goods market and the financial (or
money) market are in equilibrium.
Assumption: At the equilibrium point, the price level is fixed and
so firms are willing to supply whatever output is demanded at that
price level. That is, The intersection of the IS-LM curves determines
and in the short run for a given price level .
Figure 5.12: The IS-LM Model
Figure 5.12: The IS-LM Model
The IS-LM Model

Only at point A are both goods and financial markets in equilibrium:
only at point A are both equilibrium conditions are satisfied.
Point , with the associated level of output and interest rate , is
the overall equilibrium.
Example (5.4): IS-LM Model

Consider the following IS LM model:
= 200 + 0.25
= 150 + 0.25 1000
= 250 and = 200

= 2 8000
= 3200, and = 2
a) Derive the IS relation.
(Ans.)
= + , +
= + . + + . + 250

= 550 + 0.5 1000
relation Goods market in equilibrium = ( )
=
= 550 + 0.5 1000
0.5 = 550 1000
=
1
(550 1000)
0.5
relation: = 1100 2000 = 0.55 0.0005

Slope of the IS equation:
= 2000

b) Derive the relation.
(Ans.)
relation Financial (or money) market in equilibrium
=
3200
=
2
2 8000
1600 = 2 8000
8000 = 1600 + 2

=
1600
8000
8000
1
relation: = 0.2 +

4000
1
Slope of the LM relation: =
4000
= 800 + 4000
c) Solve for equilibrium real output, equilibrium interest rate, & .

(Ans.)
Simultaneous equilibrium =
1100 2000 = 800 + 4000
6000 = 300
300
6000
= . ( )

Plug = 0.05 either into relation or into relation:
= 800 + 4000 0.05 =
= 200 + 0.25 1000 200 =
= 150 + 0.25 1000 1000 0.05 =
Check the answer using the identity:
= + +
1000 = 400 + 350 + 250 = 1000
=
350 = = 1000 400 250 = 350
Fiscal Policy and Interest Rate

Fiscal contraction or fiscal consolidation
A reduction in the budget deficit (or a decrease in ) either
due to a decrease in government spending or to an increase in taxes
Fiscal expansion
An increase in the budget deficit (or a rise in ) either due to
an increase in government spending or to a decrease in taxes
Example: Expansionary Fiscal Policy
Suppose that the government decides to increase the budget deficit
by increasing government purchases while keeping taxes unchanged.
Figure 5.13: Increase in Government Purchases (G)

Step 1:
i.e. At any interest rate, higher G leads to higher output.
The IS curve shifts to the right at any interest rate.
Since G does not appear in the LM relation, G does not affect the LM
curve government purchases do not shift the curve.
(At the goods market is in equilibrium in that aggregate demand
equals output. But the financial market is no longer in equilibrium.
Income has increased, and so the quantity of money demanded is
larger.

Because there is an excess demand for money, the interest rate rises.
Investment decreases at a higher interest rate, and thus aggregate
demand falls off.)
Step 2:
As the curve shifts, the economy moves along the curve.
Step 3: The new equilibrium is at the intersection of the new IS curve
and the unchanged LM curve, or at point .

Q: What happens to other components of demand?
A:
but
The effect of higher on is ambiguous

The new equilibrium is at point B.

Note that it is not at (i.e. output does not increase all the way to
2 ) because interest rates are not constant in the IS-LM model.
Crowding Out
In other words, the rise in i reduces the effect of higher G on the
demand for goods but does not completely offset it.
Crowding out of investment by the deficit
The case where investment falls as deficit rises
Expansionary fiscal policy causes interest rates to rise, thereby
reducing private spending, particularly investment
Crowding in of investment by the deficit
The case where investment rises as deficit rises
Crowding Out
Q: Is there any crowding out of investment if the economy is in the
liquidity trap, and thus the LM curve is horizontal?
A: There is no change in the interest rate associated with the change
in government purchases, and thus no investment is cut off.
There is no dampening of the effects of increased government
purchases on income an increase in government purchases has its
full multiplier effect on equilibrium income.
Therefore, monetary policy has no impact on the equilibrium of the
economy and fiscal policy has a maximal effect.
Crowding Out in the Classical Economics

If the LM curve is vertical, an increase in G has no effect on Y and
increases only the interest rate.
In this case, the increase in the interest rate crowds out an amount of
private (particularly investment) spending equal to the increase in G.
Thus, there is complete crowding out if the LM curve is vertical.
Caution on Budget Deficit and Investment!

A reduction in the budget deficit does not necessarily lead to an
increase in investment.
= + = +
"Given , " .
The crucial part of this statement is given private saving.

The point is that a fiscal contraction affects private saving, too:
.

Private saving may go down by more than the reduction in the
budget deficit, leading to a decrease rather than an increase in
investment: > .
Summary: A fiscal contraction may reduce investment.

Or a fiscal expansion may actually increase
investment.
The Phillips Curve

Two goals of economic policymakers are low and stable inflation and
low unemployment which are sometimes referred to as the twin
evil of macroeconomics since they are among the most difficult and
politically sensitive economic issues that policymakers face.
There is a long-standing idea in macroeconomics that there is a
trade-off between unemployment and inflation.
This trade-off , a negative or inverse relationship between inflation
and unemployment , is called the Phillips curve.
The History of Modern Phillips Curve

(i) The Phillips curve is named after New Zealand economist A.W.
Phillips. In 1958 Phillips observed a negative relationship between
the unemployment rate and the rate of nominal wage inflation in 97
years of data for the U.K., 1861 -1957 and published an article in the
British journal Economica.
Figure 8.1: The Original Phillips Curve

(ii) In 1960, economists Paul Samuelson (1970) and Robert Solow
(1987) published an article in the American Economic Review called
Analytics of Anti-inflation Policy in which they showed a similar
negative correlation between inflation and unemployment in data for
the United States.
Samuelson and Solow substitute price inflation for wage inflation
because low unemployment was associated with high aggregate
demand, which in turn put upward pressure on wages and prices
through the economy.

Price inflation and wage inflation are closely related; in periods when
wages are rising quickly, prices are rising quickly as well.
Samuelson and Solow dubbed the negative association between
inflation and unemployment the Phillips curve.
Figure 8.2: Phillips Curve in U.S.

The Phillips Curve and the U.S. Economy during the 1960s.
(iii) Friedman (1976) and Phelps (2006) introduced a new variable:

expected inflation . Expected inflation measures how much
people expect the overall price level to change. In developing early
versions of the imperfect information model or misperception theory
in the early 1960s, these two economists emphasized the importance
of expectations for AS.
Friedman and Phelps claimed that the cyclical unemployment rate
depends only on unanticipated inflation a negative relationship between unanticipated inflation and cyclical
unemployment holds only in the short run, but it cannot be used by
policymakers in the long run.

In other words, policymakers can pursue expansionary monetary
policy to achieve lower unemployment for a while, but eventually
unemployment returns to its natural rate , and more
expansionary policy leads to higher inflation.

(iv) The modern Phillips curve includes supply shocks .
Credits for this addition goes to OPEC, the Organization of Petroleum
Exporting Countries. In the 1970s OPEC caused large increases in the
price of oil, which made economists more aware of the importance of
shocks to aggregate supply (AS).
Extended Classical Model of the Augmented Phillips Curve

Explain how Friedman and Phelps arrived at their conclusions by
using the extended classical model, which includes the misperception
or imperfect information theory.
Consider an economy at full employment with steady, fully
anticipated inflation: this economy is in full-employment equilibrium
in which money supply has been growing at 10% per year for many
years and is expected to continue to grow at this rate indefinitely.
Extended Classical Model of the Phillips Curve

The money supply grows by 10% per year
The AD curve shifts up by 10% each year from 1 to 2
The AS curve shifts up by 10% each year from 1 to 2
since with the growth in money fully anticipated, there are no
misperceptions: people expect the price level to rise by 10% per year
(a 10% inflation rate)
At , = and = : zero unanticipated inflation and zero
cyclical unemployment.
Conclusion: rises inflation rises with no change in unemployment
(Y unchanged).
Figure 8.4: Ongoing Inflation in the Extended Classical Model

Consider an economy at full employment with unanticipated
inflation: suppose now that in year 2 the money supply grows by 15%
rather than by the expected 10%.
2
AD expected to shift up to
(the money supply expected to rise
10%), but money unexpectedly rises by 15%
2
AD shifts further up to
AS shifts up to 2 , based on 10% rise in the money supply
At , = 13% > = 10%
Unanticipated inflation = 3% in year 2 and 2 >
( > at )

Cyclical unemployment is negative
Conclusion: rises ( higher inflation) occurs with lower

unemployment ( rises) as misperceptions or imperfect
information occur in the short run.
In the medium run or in the long run, rises further, declines to
a natural level of output or a full-employment level of output .
Figure 8.5: Unanticipated Inflation in the Extended Classical Model
Conclusion: In the short run, unexpected monetary changes lead to

unexpected fluctuations in output, prices, unemployment, and
inflation. In this way, Friedman and Phelps explained the Phillips
curve that Phillips, Samuelson, and Solow had documented.
Yet the central banks ability to create unexpected inflation by
unexpectedly increasing money supply exists only in the short run.
In the medium/long run, people come to expect whatever inflation rate
the central bank chooses to produce. Because wages, prices, and
perceptions will eventually adjust to the inflation rate, the long-run
AS curve is vertical. In this case, changes in AD, such as those due to
changes in the money supply, do not affect the economys output.
Inflation, Expected Inflation, and Unemployment

Our first step is to rewrite the AS relation as a relation between
inflation , expected inflation , and unemployment rate .
Recall 7.1 : = 1 + (, )
The function comes from the WS relation:
6.1 = (, )
Assumption: , = 1 +
Meaning: The higher the unemployment rate, the lower the wage;
the higher , the higher the wage.
The parameter measures the strength of the effect of
unemployment on wage.

8.1 : = 1 + 1 +
= 1 + 1 +
Dividing both sides by last years price level 1 to express in terms of
inflation:
On
On
1 + 1 +

the left side,
=
=
+
=1
1
1

the right side,
=
=
+
=
1
1
1 + = 1 + 1 + 1 +
1 +

Dividing both sides by 1 + 1 + :
1+
1+ 1+
= 1 +
1+
1+
Note that
1+
1+ 1+
1+ +
1 + = 1 +
. : = + +
. : = + +
( +)

. : = + +
An increase in leads to an increase in actual inflation :
From 8.1 : = 1 + 1 + , ,
that is, an increase in leads to an one-for-one increase in the
actual price .
If wage setters expect a higher price level, they set a higher nominal
wage, which leads to an increase in the price level.
Given , an increase in the markup , or an increase in the
factors that affect wage determination an increase in leads to
an increase in inflation .

Given , an increase in the unemployment rate leads to
a decrease in inflation : Given the expected price level ,
an increase in the unemployment rate leads to a lower nominal
wage, which leads to a lower price level P.
The Early Version of the Phillips Curve

Imagine an economy where inflation is positive in some years,
negative in others, and is on average zero. Average inflation was close
to zero during the much of the period Phillips, Samuelson, and Solow
were studying.
Q: If average inflation was close to zero, how will wage setters choose
nominal wages for the coming year?
A: With the average inflation rate equal to zero in the past, it is
reasonable for the wage setters to expect that inflation will be equal
to zero over the next year as well.
Assumption: =
The Early Version of the Phillips Curve

8.2 : = + +
. : = +
Phillips and Samuelson-Solow model precisely shows the negative or
inverse relation between unemployment () and inflation .
Wage-Price Spiral Mechanism

Given the expected price level ( = 1 ), lower unemployment
, which is called the wage-price spiral.
Lower unemployment leads to a higher nominal wage.
In response to the higher nominal wage, firms increase their
prices, and so the price level rises.
In response to the higher price level, workers ask for a higher
nominal wage the next time the wage is set.
The higher nominal wage leads firms to further increase their
prices. As a result, the price level increases further.
Wage-Price Spiral Mechanism

In response to this further increase in the price level, workers,
when they set the wage again, demand a further increase in the
nominal wage.
So, the race between prices and wages results in steady wage and
price inflation.
Variations of the Early Phillips Curve

During the 1960s, U.S. macroeconomic policy was aimed at maintaining
unemployment rate in the range that appeared consistent with
moderate inflation.
Figure 8.6: Inflation vs. Unemployment in the United Sates, 1948
1969
Figure 8.7: Inflation vs. Unemployment in the U.S. Since 1970
Breakdown of the Phillips Curve

Q: Why did the original Phillips curve disappear since 1970?
A: (i) An increase in non-labor costs such as a large increase in the
price of oil forced firms to increase their prices relative to the wages
they were paying. An increase in leads to an increase in inflation,
even at a given unemployment rate, and this happened twice in the
1970s in the United States.
(ii) The persistent inflation led workers and firms to revise the way
they formed their expectation.
Breakdown of the Phillips Curve

As inflation became consistently positive and persistent, people,
when forming expectations, start taking into account the presence
and the persistence of inflation.
This change in expectation formation changed the nature of
the relation between unemployment and inflation.
Figure 8.8: U.S. Inflation Since 1914
Formation of Expectation of Inflation

8.5 : = where the parameter measures the effect
of last years inflation rate 1 on this years expected inflation
.
Meaning: The higher the value of , the more last years inflation
leads workers and firms to revise their expectations of what inflation
will be this year, and so the higher the expected inflation is.
As long as inflation was low and not very persistent, it was

reasonable for workers and firms to ignore past inflation and to
assume that the price level this year would be roughly the same as
the price level last year: . Before the 1970s, inflation was
low and not very persistent, , so = .
In the mid-1970s, as inflation became more persistent, workers and
firms started assuming that if inflation had been high last year,
inflation was likely to be high this year as well. The parameter
increased. The evidence suggests that, by the mid-1970s, people expected
this years inflation rate to be the same as last years inflation rate: = .

Consider the implication of different values of for the relation
between inflation and unemployment:
8.6 : = + +
: = + , the original Phillips curve
> : = 1 + + .
The inflation depends not only on the unemployment rate but also
on last years expectation.
= = 1 + +
. : = +

When = 1, the unemployment rate affects not the inflation rate,
but rather the change in the inflation rate: Higher unemployment
rate leads to decreasing inflation rate; low unemployment rate leads
to increasing inflation rate.
As increased from 0 to 1, the simple relation between
unemployment rate and the inflation rate disappeared from 1970
onward, but a new relation a relation between the unemployment
rate and the change in inflation rate emerged:
. : = +
. : = . .

. : = +
It is called the modified Phillips curve, or the expectation-augmented
Phillips curve (to indicate that stands for expected inflation),
or the accelerationist Phillips curve (to indicate that a low
unemployment rate leads to an increase in inflation rate and thus
an acceleration of the price level).
Figure 8.9: Change in Inflation vs. Unemployment in the U.S.,

1970 2010
For low unemployment rate, the change in inflation rate is positive.

For high unemployment rate, the change in inflation is negative.
Example (5.5): Continuation of Example (5.4)
Let increases to 400. What happens to , , , and ?

(Ans.)
relation: = 1100 2000 = 0.55 0.0005
1
relation: = 0.2 +
= 800 + 4000
4000
1
1
=
=
150 = 2 150 =
1 1 +1
1(0.25+0.25)
300
curve will shift to the right by 300 at initial interest rate:

Thus, new (1 ): = 1100 + 2000 = 1400 2000
= 0.7 0.0005
In new equilibrium, 1 = .

1400 2000 = 800 + 4000
6000 = 600
=
600
6000
= . ( )
= 800 + 4000 0.1 =

= 200 + 0.25 1200 200 =
= 150 + 0.25 1200 1000 0.1 =
Expansionary fiscal policy increases , , and , but remains
constant.
Q: Why is the net effect on investment equal to zero?

A: = 150 + 0.25 1000
Totally differentiate the investment function:
= 0.25 1000 ( )
increase in
due to
fall in
due to
=
= 0.25 200 1000 0.05

= 50 50 = 0
An increase in investment due to higher output is completely
offset by a fall in investment due to higher interest rate, so no
change in investment.
Crowding Out
Q: Is there any crowding out of investment if the economy is in the
liquidity trap, and thus the LM curve is horizontal?
A: There is no change in the interest rate associated with the change
in government purchases, and thus no investment is cut off.
There is no dampening of the effects of increased government
purchases on income an increase in government purchases has its
full multiplier effect on equilibrium income.
Therefore, monetary policy has no impact on the equilibrium of the
economy and fiscal policy has a maximal effect.
Crowding Out in the Classical Economics

If the LM curve is vertical, an increase in G has no effect on Y and
increases only the interest rate.
In this case, the increase in the interest rate crowds out an amount of
private (particularly investment) spending equal to the increase in G.
Thus, there is complete crowding out if the LM curve is vertical.

A reduction in the budget deficit does not necessarily lead to an
increase in investment.
= + = +
"Given , " .
The crucial part of this statement is given private saving.

The point is that a fiscal contraction affects private saving, too:
.

Private saving may go down by more than the reduction in the
budget deficit, leading to a decrease rather than an increase in
investment: > .
Summary: A fiscal contraction may reduce investment.

Or a fiscal expansion may actually increase investment.
Tight (or Contractionary) Fiscal Policy

Suppose the government decides to reduce the budget deficit by
increasing taxes while keeping government spending unchanged.
Step 1: At any interest rate, higher
taxes lead to lower output.
Consequently, the IS curve shifts to the left at any interest rate from
to .
Because taxes do not appear in the LM relation, they do not affect the
LM curve: Taxes do not shift the curve.
Figure 5.14: The Effects of an Increase in Taxes
Step 2:
As the curve shifts, the economy moves along the curve.
Step 3: The new equilibrium is at the intersection of the new IS curve

and the unchanged LM curve, or at point .
Note that the fall in i reduces the effect of higher on the demand
for goods but does not completely offset it.
Q: What happens to other components of demand?
A: ( ) but
The effect of higher on is ambiguous


Q: Why is the change in income = is clearly less than
1
?
11 1
A: An increase in taxes leads to a fall in income.

A fall in income tends to decrease the demand for money
With the money supply fixed, the interest rate has to fall to ensure
that the demand for money equals the fixed money supply
When the interest rate falls, investment increases and so output
rises
Accordingly, the equilibrium change in income is less than the
horizontal shift of the IS curve
Tight (or Contractionary) Fiscal Policy: Increases in Taxes

Note that at D the goods market is in equilibrium in that aggregate
demand equals output.
But the financial (or money) market is no longer in equilibrium.
Income has decreased, and so the quantity of money demanded is
lower.
Because there is an excess supply of money, the interest rate falls.
Investment increases at a lower interest rate, and thus aggregate
demand and output rise.
Decrease in Proportional Income Tax Rate

Q: Suppose that the government decides to cut proportional income
tax rate . Analyze the effects of this expansionary fiscal policy using
a diagram.
A:
Decrease in Proportional Income Tax Rate

Smaller increases C.
Note that the IS curve does not shift out in a parallel fashion in this
case because enters into the slope of the IS equation.
IS relation: =
1
2
0 + 0 + 1 +
A smaller makes the IS curve flatter.
11 1 1
Monetary Policy and the Interest Rate

Monetary expansion
An increase in money supply by open market purchases of
government securities
Monetary contraction (or monetary tightening)
A decrease in the money supply by open market sales of
government securities
Expansionary (or Loose) Monetary Policy

Suppose that the central bank increase nominal money , given
that the price level is fixed in the short run.
Step 1: An increase in nominal money leads to one-for-one
increase in real money supply
The LM curve shifts down to .

The money supply does not directly affect either the supply of or
the demand for goods.
In other words, does not appear in the relation.
Thus, a change in does not shift the curve.
Expansionary (or Loose) Monetary Policy

Step 2: At a given level of income, an increase in money leads to a fall
in the interest rate to .
Step 3: . The economy moves along the IS
curve, and the equilibrium moves to .
Output increases to and the interest rate falls to .
Q: What happens to other components of aggregate demand?
A: ( fixed) : and
Thus, monetary expansion is more investment friendly that fiscal
expansion.
Figure 5.15: The Effects of an Expansionary Monetary Policy
Process of Adjustment to the Monetary Expansion

At the initial equilibrium point , the increase in the money supply
creates an excess supply of money.
At the initial interest rate 0 and income 0 , people are holding
more money than they want.
This causes the public to attempt to reduce their money holdings
by buying other assets, thereby asset prices increase and yields fall.
Because money and asset markets adjust rapidly, it moves
immediately to point 1 .
At point 1 , there is an excess demand for goods.
Process of Adjustment to the Monetary Expansion

Given the initial income level 0 , a fall in the interest rate leads
to an increase in aggregate demand.
Because the increase in output raises the demand for money, the
greater demand for money leads to higher interest rate moving up
along the curve.
Thus, the increase in the money stock first causes interest rate fall
as the public adjusts its portfolio and then as a result of the decline
in interest rates increases aggregate demand.

Let (real money supply) increases to 1840. What happens to
, , and when the Fed increases money supply through open
market purchase?
(Ans.)
relation: = 1100 2000 = 0.55 0.0005
1
relation: = 0.2 +

4000
1
( ) =
= 800 + 4000
=
8000
240 =
100
curve will shift down by 3100 at any given output.
Thus, new ( ): =
= 920 + 4000
In new equilibrium, = .
1100 2000 = 920 + 4000
6000 = 180 =
180
6000
4000
= . ( )
23
100
4000
= 920 + 4000 0.03 =

= 200 + 0.25 1040 200 =
= 150 + 0.25 1040 1000 0.03 =
Expansionary monetary policy reduces , but increases , , and .
Current Labor Market

Unemployment rate: = 5.1%
The Bureau of Labor Statistics reports that a record 94,610,000
people (ages 16 and over) were not in the labor force in September
in 2015. In other words they were neither employed nor had made
specific efforts to find work in the prior four weeks.
Septembers participation rate dropped to 62.4 percent, matching the
lowest level seen since October 1977.
Technology will leave a large chunk of the US labour force in the lurch.
A growing number of people are choosing the Robo-advisor, on the
belief that algorithms can provide rational and dispassionate advice at
a cost well below that of traditional financial advisors.
Labor Market in the Medium Run

As our attention turns to the medium run, we must now abandon
the assumption that the price level is fixed and explore how prices
and wages adjust over time, and how this, in turn, affect output.
Every month, the U.S. BLS (Bureau of Labor Statistics) computes
the unemployment rate and many other statistics that economists
and policymakers are to monitor developments in the labor market.
The data come from a survey of 60,000 households called the Current
Population Survey.
Flows of Workers
Finding out what reality hides behind the aggregate unemployment
rate requires data on the movements of workers.
Job-losing rate or Job separation rate ()
The percentage of employed workers who lose or leave their job
either voluntarily or involuntarily in a given time
Job-finding rate ()
The percentage of unemployed workers who find a job in a given
time
Together, the rate of job separation and the rate of job finding
determine the rate of unemployment in the medium run.
Average monthly flows between employment, unemployment,

and non-participation in the United States, 1994 to 2011
(million):
Flows of Workers
=
total separation
.+.
.
.+.+.
.
.
.
= . ( . )
= . ( . )
About three-fourths of separations are usually quits - workers

leaving their jobs for what they perceive as a better alternative.
The remaining one-fourth are layoffs. Layoffs come from changes in
employments across firms.
Flows of Workers
=
total finding
25% =
2.1
8.4
.
.
= . ( )
of the unemployed in a typical month will be employed
the following month.

22.6% =
1.9
8.4
will be out of the labor force the next month.
The remaining 52.4% of the unemployed will remain unemployed

the next month.
Flows of Workers
Flows out of the labor force = 3.6m + 1.9m = 5.5m
Flows into the labor force = 3.3m + 1.8m = 5.1m
The sharp focus on the unemployment rate by economists, policy
makers, and news media is partly misdirected.
Some of the people discouraged workers -classified as out of the
labor force are very much like the unemployed since, while they are
not actively looking for a job, they will take it if they find one.
This is why economists sometimes focus on the employment rate.
Employment rate or Employment to population ratio
139
=
=
= 58.5%
adult population 237.8
Flows of Workers
Remember that the unemployment is not the best indicator of the
state of the labor market!
Unemployment spell
The period of time that an individual is continuously unemployed
(Average) Duration of unemployment
The length of time that an unemployment spell lasts
The average length of time people spend unemployed
Proportion of unemployed leaving unemployment
=
.+.
.
= . ( . )
Flows of Workers
Duration of unemployment equals the inverse of the proportion of
unemployed leaving unemployment each month:
Duration =
= . .
The duration of unemployment spell in the U.S. is characterized by

two seemingly contradictory statements:
(i) Most unemployment spells are of short duration, about two
months or less.
(ii) Most people who are unemployed on a given day are experiencing
unemployment spells with long duration
Example (6.1): Duration of Unemployment Spells

Consider an economy with 100 people in the labor force.
Suppose that at the beginning of every month, two workers become
unemployed and remain unemployed for one month before finding
new jobs. In addition, at the beginning of every year four workers
become unemployed and remain unemployed for the entire year.
Q: How many unemployment spells are during a year? Find the
proportion of spells that are short.
A: 28 spells = 24 spells (1 month) + 4 spells (1 yr)
= . ( . ) of the spells last only 1 month, consistent
with the first statement: Most spells are short.

Q: How many people are unemployed on a given day?
A: 6 = 2 (short-term) + 4 (long-term)
= . ( ) of the unemployed are experiencing one-year
spells of unemployment, consistent with the second statement:

Most people who are unemployed on a given date are experiencing
long spells of unemployment.

Q: What is the average duration of an unemployment spell?
A: A complete spell of unemployment begins when someone
becomes unemployed and ends when that person is no longer
unemployed, either by becoming employed or by leaving the labor
force.
Average duration =
=
= 2.57 months
+( )

Q: What is the mean or the average duration of unemployment on
May 15?
A: Ongoing or incomplete spells of unemployment are spells that
have not yet ended.
On any given day, all of the unemployed are experiencing incomplete
spells of unemployment because they have not yet become employed
or left the labor force.
The measured duration of an incomplete spell of unemployment is
the length of time the person has been continuously unemployed up
to the current date.

Average duration of unemployment on a given day
2
6
= 0.5 months since May 1

= 3.17 months
4
+
6
4.5 months since Jan. 1
Figure 6.1: Median Duration of Unemployment
Median Duration of Unemployment

The median duration of unemployment typically rises during
recessions, but its spike upward during the recession of 2008 2009
was unprecedented.
Some economists believe that the increase in long-term
unemployment is a result of government policies. In particular,
in February 2009, Congress extended the eligibility for unemployment
insurance from the normal 26 weeks to 99 weeks.
Movements in Unemployment
Year-to-year movements in the unemployment rate are closely
associated with recessions and expansions.
Periods of higher unemployment are associated with much lower
proportions of unemployed workers finding jobs.
Higher unemployment implies a higher separation rate that is, a
higher chance of employed workers losing their jobs.
The Classical Labor Market

The classical economists assumed that the labor market is similar to
the goods market in that the price of labor (or wages) would adjust to
ensure that quantity demanded of labor equals quantity supplied of
labor.
To put another, the classical idea that wages adjust to clear the labor
market is consistent with the view that wages respond quickly to
price changes.
Classical economists believe that most unemployment that occur
during recessions, arises from mismatches between workers and jobs
(frictional and structural unemployment).
The Classical Labor Market

In classical and neoclassical economics the demand and supply of
labor determines the real wage rate.
There cannot be involuntary unemployment in equilibrium.
(Neoclassical) Production Function

The prices set by firms depend on the costs they face.
These costs depend in turn the nature of the production function and
on the prices of inputs.
The available production technology determines how much output is
produced from given amounts of capital (K) and labor (N or L).
Production function
Relation between the inputs used in production and the quantity
of output produced
Cobb-Douglas Production Function

6.1 : = , = 1 where : output,
: a parameter > 0 measuring overall productivity of the available
technology,
: the amount of capital,
: the amount of labor (or employment),
0 < < 1 : a constant that determines what share of income goes
to capital and what shares foes to labor.
In words: . 6.1 states that output is a function of capital and
labor.
The production function reflects the available technology for turning
capital and labor into output.
Cobb-Douglas Production Function

The Cobb-Douglas production function has constant returns to scale.
Constant returns to scale
If K and N increase by the same proportion, then output increases
by that same proportion as well
Mathematically, for any > 0 ,
= 1
= 1
= 1
= 1
= .
The Firms Demand for Labor

Simple assumption: A typical firm is competitive.
A competitive firm is small relative to the markets in which it trades,
so it has little influence on market prices.
The competitive firm takes the product price (P) and the factor prices
(W and R) as given and chooses K and N that maximize profit.
Profit = revenue labor costs capital costs
6.2 : Profit =

Marginal product of labor
Extra (or additional) output the firm gets from hiring one extra
unit of labor, holding capital fixed
6.3 : =
(,)
>0
In words: MPN is the slope of the production function and is positive,

meaning that as labor increases, more output can be produced.

Diminishing marginal product of labor
The marginal product of labor decreases as labor increases,
holding capital fixed
6.4
2 (,)
2
<0
In words: The slope of the production function becomes flatter and

flatter as labor is added: although more labor always leads to more
output, output increases at a decreasing rate.
Figure 6.2: Production Function

Consider the marginal product of labor for the Cobb-Douglas
production function:
6.5 : =
but
but
and
6.6 : =
1 = 1
1 1
= 1
In words: MPN is proportional to output per worker (or average

labor productivity).

Q: How many units of labor should the competitive firm hire to
maximize profit?
A: The firm compares the extra revenue (MB) from increased
production with the extra cost (MC) from hiring the additional labor
and continues to hire labor until = .
Differentiate (6.2) with respect to and set it equal to zero:
6.2 : Profit =
Profit
= = 0

6.7 : =
( = in nominal terms)
6.7 :
=
( = in real terms)
Conclusion: To maximize profit, the firm hires up to the point at which

= .
Value of marginal product of labor (VMPN or VMPL) or marginal
revenue product of labor (MRPN or MRPL) measures the benefit of
hiring an extra worker in terms of extra revenue generated.

Comparing the benefits and costs of changing the amount of labor:
To maximize
profits,
the firm should:
Real terms:
Nominal terms:
Increase employment if,

for an extra worker
Decrease employment if, for

the last worker employed
>
>
>
( > )
= price of output, = nominal wage, and =
<
<
<
( < )
= real wage
Figure 6.3: The Determination of Labor Demand
A decrease in the real wage increases the amount of labor

demanded. Similarly, an increase in the real wage decreases the
amount of labor demanded.
Keynesian View of the Labor Market

In contrast to the classical, Keynesians are less optimistic about
the ability of free-market economies to respond quickly and
efficiently to shocks.
One of the central ideas of Keynesianism is that wages and prices are
rigid or sticky and do not adjust quickly to market-clearing levels.
Wage and price rigidity implies that the economy can be away from
its general (or long-run) equilibrium for significant periods of time.
Thus, a deep recession is not an optimal response of the free market
to outside shocks; rather, it is a disequilibrium situation in which high
unemployment reflects an excess of labor supplied over labor
demanded.
As wage and price rigidity is the basis for Keynesian theory and policy
recommendations, understanding the potential causes of rigidity is
important.
Keynesians dont dispute that mismatch is a major source of
unemployment, but they are skeptical that it explains all
unemployment.
Keynesians are particularly unwilling to accept the classical idea that
recessions are periods of increased mismatch between workers and
jobs. They believe that recessions are periods of generally low
demand for both output and workers.

If the real wage is above the level that clears the labor market,
unemployment (an excess of labor supplied over labor demanded)
will result.
That is, for a rigid real wage to be the source of unemployment,
the real wage that firms are paying must be higher than the market clearing real wage.
Figure 6.4: Nominal Wage Rigidity

Wage bargaining is about money (or nominal) wages, not real
wages.
Bargaining cannot determine the real wage as price level changes
may occur.
Workers resist nominal wage cuts.
Involuntary unemployment exists because of downwardly inflexible
nominal wage rates.
Classical Economists Question about Wage Rigidity

Q: If the real wage is higher than necessary to attract workers,
why dont firms save labor costs by simply reducing the wage they
pay?
Possible Economic Reasons for Sticky Wages, called the

Downward Rigidity of Wages:
Social, or implicit, contracts
These contracts are unspoken agreements between workers and
firms that firms will not cut wages.
Relative-wage explanation of unemployment
Workers are concerned about their wages relative to the wages of
other workers in other firms and industries. They may be unwilling to
accept wage cuts unless they know other workers are receiving
similar cuts

Explicit contracts such as union contracts
Employment contracts stipulate workers wages, usually for a period
of one to three years. Wages set in this way do not fluctuate with
economic conditions.
Reduction of the firms turnover costs, or the costs associated with
hiring and training new workers
By paying a high wage, the firm can keep more of its current workers,
which saves the firm the cost of hiring and training replacement.

Cost of Living Adjustments (COLAs)
Contract provisions tie wages to changes in the cost of living.
The greater the inflation rate, the more wages are raised.
Imperfect Information
If firms have imperfect information, they may simply set wages wrong
wages that do not clear the market.
Minimum Wage Law
It sets a floor for wage rates, and explains at least a fraction of
unemployment.

The Efficiency Wage Theory
If workers productivity increases with the wage rate, firms may have
an incentive to pay wages above the market-clearing rate.
Reduction in adverse selection and improvement in the average
quality of the firms workforce
By paying a wage above the equilibrium level, the firm can keep the
best employees and so increase productivity.

Adverse selection
The tendency of people with more information (in this case, the workers
who know their own outside opportunities) to self-select in a way that
disadvantages people with less information (in this case, the firm)
Decrease in the problem of moral hazard
By paying a higher wage, the firm induces more of its employees not to
shirk and so increases their productivity.
Moral hazard
The tendency of people to behave inappropriately when their behavior is
imperfectly monitored.
Wage Determination
Lets turn to wage determination, and to the relation between wages

and unemployment. Wages are set in many different ways.
Collective bargaining
Bargaining between a union (a group of unions) and a firm (a group
of firms)
Two common forces at work in wage determination in all countries
Workers are usually paid a wage that exceeds their reservation
wage.
Reservation wage
The wage that would make workers indifferent between working
and being unemployed
Wage Determination
Two common forces at work in wage determination in all countries
Wages typically depend on conditions in labor market. The lower
the unemployment rate, the higher the wages.
Economists Have Focused on Two Broad Lines of Explanation to
Think of These Facts
Even in the absence of collective bargaining, workers have some
bargaining power.
The degree of a workers bargaining power depends on two factors:
(i) The nature of a job how costly it would be for a firm to replace
a worker, were he/she to leave the firm;
Wage Determination
Economists Have Focused on Two Broad Lines of Explanation to
Think of These Facts
the higher the skills needed to do a job, the more likely there is to be
bargaining. Wages offered for entry-level jobs are on a take-it-or leave-it basis.
(ii) conditions in labor market when the unemployment is low, it is
more difficult for firms to find acceptable replacement workers.
Efficiency wage theory
Paying a wage above the reservation wage makes it more attractive
for workers to stay. It decreases turnover and increases productivity.
Wages, Prices, and Unemployment

6.8 : = ,
,+
The aggregate nominal wage depends on three factors:

The expected price level
The unemployment rate
All other variables that may affect wage setting
(i) The expected price level
Q: Why does the price level affect nominal wages?
A: Because both firms and workers care about real wages = how
many goods can be purchased with wages =

Q: Why do wages depend on the expected price level , rather
than the actual price level ?
A: Because wages are set in nominal terms, and when they are set,
the relevant price level is not yet known.
(ii) The unemployment rate
Higher unemployment weakens workers bargaining power, forcing
them to accept lower wages. Also, higher unemployment allows firms
to pay lower wages and still keep workers willing to work.

(iii) The other factors
Unemployment insurance, an increase in minimum wage, and
an increase in employment protection lead to an increase in wage.
Unemployment insurance: the payment of unemployment benefits
to workers who lose their jobs - allows unemployed workers to hold
out for higher wages.
An increase in the minimum wage leads to an increase in
the average wage, .
An increase in employment protection is likely to increase
the bargaining power of workers covered by this protection.
Price Determination
The prices set by firms depend on the costs they face. These cost, in turn,
depend on the nature of the production function and on the prices of
the inputs used in production.
Simplest Cobb-Douglas Production Function
Firms produce goods using labor () as the only factor of production:
= =
= : per (called labor prodiuctivity)
= 1 One worker produces one unit of output.
Thus, 6.9 : = =
= : The cost of producing one more unit of output, called
the marginal cost, is the cost of employing one more worker at wage W.
Price Determination
Profit = Revenue Cost
= (), where = .
(i) Price Determination in Competitive Markets
Profit
= = 0

=
=
=0
Price Determination
(ii) Price Determination in imperfectly competitive market
(such as monopoly and monopolistic competition):
Profit =
Profit
+
1 +
1 +
1
=
=0
Price Determination
=
1
1+
1+
1=
1=
1
1+
1+
1+
1 =
= 1 +
= 1 +
1
1+
Price Determination
. : = +
Meaning: Now that goods markets are not competitive and firms
have market power, m is positive, and the price will exceed the cost
W by a factor equal to 1 + .

The excess of the price over the marginal cost
The ratio of the price to the (marginal) cost which can be used as
a measure of market power across firms, industries, or economies
The Natural Rate of Unemployment
Consider the implications of wage and price determination for

unemployment. Under the assumption of = ,wage setting and
price setting determine the equilibrium (also called natural) rate of
unemployment.
Wage-Setting Relation
Relation between the real wage and the rate of unemployment
Given the assumption of = , = , .
6.11 :
= , , wage-setting (WS) relation

,+
Wage-Setting Relation
6.11 :
= , , wage-setting (WS) relation

,+
The higher the unemployment rate, the lower the real wage chosen
by wage setter: The higher the unemployment rate, the weaker
the workers bargaining position, and the lower the real wage will be.
Wage setters
Unions and firms if wages are set by collective bargaining or
Individual workers and firms if wages are set on a case-by-case
basis or
Firms if wages are set on a take-it-or-leave basis
Figure 6.5: Wages, Prices, and the Natural Rate of Unemployment
Downward-sloping wage-setting (PS) curve: The higher

the unemployment rate, the lower the real wage.
Price-Setting Relation
Recall 6.10 : = 1 + 6.12 :
= +
Now invert 6.12 to get the implied real wage:

6.13 :
,
+
price-setting (PS) relation
Meaning: Price-setting decisions determine the real wage paid by

firms. An increase in the markup leads firms to increase their prices,
given the wage they have to pay; equivalently, it leads to a decrease
in the real wage: , given
The real wage implied by price setting (PS) is

independent of .
1
,
1+
which is
Equilibrium Real Wage and Unemployment

Equilibrium condition in the labor market: =
The real wage chosen in the wage setting should be equal to
the real wage implied by price setting.
6.14 : , =
The equilibrium unemployment rate is such that real wage

chosen in wage setting (WS) is equal to the real wage implied by price
Setting (PS).
Equilibrium Unemployment Rate
Natural rate of unemployment or full-employment rate of

unemployment
The rate of unemployment when output and employment are at
the full-employment level

The unemployment rate that prevails if =
The rate of unemployment toward which the economy gravitates in
the long run, given all the labor-market imperfections that prevent
workers from instantly finding jobs
Frictional unemployment + Structural unemployment
Equilibrium Unemployment Rate
The labor market is considered to be: overheating when < and

cooling off when > .
That's definitely not the case for January 2012, with a natural rate of
unemployment of 7.87% and an official rate of unemployment of
8.26%.
Because of the combination of frictional and structural
unemployment, an economys unemployment rate is never zero.
Cyclical unemployment =
Cyclical Unemployment
Cyclical unemployment =
(i) When > , < and < .
Positive cyclical unemployment.
(ii) When < , > and > .
Negative cyclical unemployment.
(iii) When = , = , = .
Cyclical unemployment is zero. In other words, the economy is at full
employment. The term full employment does not mean that every
worker has a job.
Figure 6.6: Unemployment rate and Natural Rate of

Unemployment in the United States
Positions of WS and PS, and thus Equilibrium Unemployment

Rate
Increase in unemployment benefits

from WS to
Since an increase in benefits makes the prospect of unemployment
less painful, it increases the wage set by wage setters at a given
unemployment rate.
The economy moves along the PS line from to
The natural rate of unemployment increases from to
Figure 6.7: Unemployment Benefits and the Natural Rate of

Unemployment
Unemployment Benefits and Natural Rate of Unemployment

At a given unemployment rate, higher unemployment benefits lead
to a higher real wage.
A higher unemployment is needed to bring the real wage back to
what firms are willing to pay.
Positions of WS and PS, and thus Equilibrium Unemployment

Rate
A less stringent enforcement of existing antitrust regulation
It allows firms to collude more easily and increase their market
power
An increase in m
leads to an increase in P
given W
from PS to
The economy moves along the WS line from to
The natural rate of unemployment increases from to
Figure 6.8: Markups and the Natural Rate of Unemployment
Markups and Natural Rate of Unemployment

By letting firms increase their prices (P) given wage (W),
less stringent enforcement of antitrust legislation leads to a decrease
in real wage.
Higher unemployment is required to make workers accept this lower
real wage, leading to an increase in the natural rate of
unemployment.
From Unemployment to Employment

Natural level of employment is associated with
the natural rate of unemployment .
Natural level of employment or full employment
The level of employment that prevails when unemployment is
equal to its natural rate ( = )
( = )
Let denote the labor force, the number of workers employed

(employment), and the number of workers unemployed
(unemployment). = + .
From Unemployment to Employment

= + .

= 1
=1
= 1
= if =
For example, = 150 and = 5% 0.05

= 150 1 0.05 = 142.5 .
From Employment to Output

The natural level of output is associated with the natural level of
employment.
Natural level of output or full-employment level of output
The level of production when employment is equal to the natural
level of employment
Given the simplest production function = ,
= ( ) = 1 .
Using 6.14 : , =
1
1+
and = 1
=1
From Employment to Output

6.15 : 1
1
1+
The real wage chosen in wage setting is equal to the real wage
implied by price setting
Job Separation, Job Finding, and
We will develop a model of labor-force dynamics that shows what

determines the natural rate of unemployment.
We assume that the labor force L is fixed and focus on
the transition of workers in the labor force between employment E
and unemployment U.
If the unemployment rate is neither rising nor falling that is, if
the labor market is in a steady state 6.16 : = ,
the steady-state condition.
In a boom, > ; In a recession, <
Job Separation, Job Finding, and
Derivation of Steady-State (Medium-run) Unemployment Rate:

= + +1 =
In steady state, +1 = 0
0 =
0 = since =
0 = +
=
(the
+
=
(+)
number of the unemployed in steady state)
. : =
Steady-State Unemployment Rate
Intuition of . : This equation holds in the steady state

(the medium run or the long run) to determine the natural rate of
unemployment: the rate that prevails when the economy is neither in
a boom nor a recession.
The steady-state unemployment rate depends on the rate of job
separation and the rate of job finding .
The higher the rate of job separation, the higher the unemployment
rate. Mathematically, take the derivative of (6.17) w.r.t. ;
+
+
>
The higher the rate of job finding, the lower the unemployment rate.
Mathematically,
(+)
+
< .
Example (6.2): Suppose that in the long run, 1.5 percent of the
employed lose their jobs each month ( = 0.015), which means that
the average spell of employment lasts =
= . months.
Suppose further that in the long run, 25 percent of the unemployed

find a job each month ( = 0.25), so that the average spell of
unemployment is =
= months.
Thus, the steady-state unemployment rate or natural rate of

unemployment is =
.
.+.
= . . .
Public Policy Implications of (6.17)
Any policy aimed at lowering the natural rate of unemployment must

either reduce the rate of job separation or increase the rate of job
finding. Similarly, any policy that affects the rate of job separation or
job finding also changes the natural rate of unemployment.
Lower minimum wage
Better information
Better training of workers
Remove disincentives to work
Reducing in payroll taxes
Public Policy Implications of (. )
Unfortunately, well-intentioned policies to change the job-finding rate

and the job-separation rate can have unintended consequences.
For example, policymakers may try to reduce the job separation by
imposing firing costs on firms; any firm that fires a worker must pay
one years salary as a severance package, and this would indeed
reduce the natural rate of unemployment.
But firms could then become reluctant to hire new workers, reducing
the job-finding rate. The net of these effects could be to increase
the natural rate of unemployment than to decrease it.
Unemployment and Okuns Law

We can use the concept of cyclical unemployment to provide a more
precise link between the state of the labor market and aggregate
output (Y).
Q: What relationship should we expect to find between
unemployment and real GDP (Y)?
A: Increases in the unemployment rate should be associated with
decreases in real GDP (Y); i.e., if output growth is very high,
unemployment will fall.
This negative relationship between unemployment and GDP is called
Okuns law, after Arthur Okun.
The Growth Rate Form of Okuns Law, Assuming is Constant:
6.18
= .
% = 3% 2 %
is actual output or real GDP
is actual unemployment rate
is the average annual growth rate of natural-level of output
is a factor relating changes in unemployment to changes in output
Meaning of =2
1% increase in the unemployment rate, on average, decreases real
GDP growth by 2 percent.
The Growth Rate Form of Okuns Law, Assuming is Constant
= 0
Real GDP grows by about 3%; this normal growth in the production
of goods is due to growth in the labor force, capital accumulation,
and technological progress.
For example, if the unemployment rises from 5 to 7 percent,
then % = 3% 2 % = 3% 2 7% 5% = 1%.
Okuns law says that GDP would fall by 1 percent, indicating that
the economy is in a recession.
Figure 6.9: Okuns Law in the United States: 1951 - 2011
The Gap Version of Okuns Law

6.19
Interpretation: The deviation of output from its natural level is

inversely related to the deviation of unemployment from its natural
level; that is, when > , < .
The gap between an economys full-employment output and its
actual level of output increases by 2 percentage points for each
percentage point the unemployment increases
The percentage gap between potential and actual output equals
2 times the cyclical unemployment
Example (6.3): Okuns Law

= 6%, = $15,000 billion $15 trillion and = 7%.
What is the current level of output?
(Ans.)
Cyclical unemployment = = 7% 6% = 1%
Okuns law predicts that actual output (Y) will be 2%(= 2 1%)
lower than
= 0.98 $15,000 billion = $14,700 billion
Okuns Law
Q: Why doe s a 1% point increase in unemployment lead to twice as
large a drop in output?
A: When cyclical unemployment increases, other factors that
determine output the number of people in the labor force,
the number of hours each worker works, the average labor
productivity also fall, which magnifies the effect of the increase
in unemployment.
Derivation of the Growth Rate Form of Okuns Law
= 2( )
= 2 + 2
1 = 2 + 2
Calculate the change from the previous year to the current year
for each side of the equation:
= 2 1 + 2 ,
assuming that is constant
Derivation of the Growth Rate Form of Okuns Law
= 2
= 2
Rule 2:
X
Z
X
Z
X
Z
In the United States, the average growth rate of
3% = 2
= 3% 2
, ,
is 3%.
The AS AD Model
We are now ready to put the determination of output in the short run
and the determination of output in the medium run together, looking
at the determination of output both in the short run and in the
medium run.
This chapter is designed to build up the basic AS-AD model to think
about output fluctuation (sometimes called business cycles)
movement in output around its trend.
Derivation of the Aggregate Supply (AS)

The aggregate supply relation is derived from the behavior of wages
and prices described in Chapter 6.
Wage determination: 6.1 = (, )
Price determination: 6.3 = 1 +
Derivation of the Aggregate Supply Relation:
Step 1: Replace the nominal wage in 6.3 by its expression from
6.1 . 7.1 : = + (, )
Assumption: Both and are constant and in the short run.
Step 2: Replace the unemployment rate with its expression in
terms of output.
Derivation of the AS Curve

Step 2: =
( )
=1
( )
=1
because of the production function, = .

For a given labor force , the higher the output, the lower
the unemployment rate: .
Step 3: 7.2 = +
relation or AS relation.
, aggregate supply
Two important properties of the AS relation
7.2 = 1 + 1
( ) :
Given the expected price level , an increase in output leads
to an increase in the price level .
:
Given unemployment , an increase in the expected price level
leads, one for one, to an increase in the actual price level.
Figure 7.1: The Aggregate Supply (AS) Curve
Properties of the AS Curve

The AS curve is sloping upward:
> , i.e., an increase in output
() leads to an increase in the price level P: Higher economic activity

puts upward pressure on prices.
The aggregate supply curve goes through point A, where = and
= : When = , the price level turns out to be exactly
equal to the expected price level because we defined in Chap 6
(and by implication ) as the rate of unemployment ()
(and by implication ) if = .
> > ; < <
The Effect of an Increase in on the AS Curve
The AS curve is drawn for a given expected price level.

An increase in the expected price level shifts the AS curve up;
a decrease in the expected price level shifts the AS curve down.
At a given level of output (correspondingly, at a given unemployment
rate), .
Figure 7.2: The Effect of an Increase in on the AS Curve
In short, the AS relation captures the effect of output () on

the price level ;
> .
Aggregate Supply (AS) Curve in Classical Case

The classical AS curve is vertical, indicating that the same amount of
goods will be supplied whatever the price level: see Figure 7.3(b).
The classical supply curve is based on the assumption that the labor
market is in equilibrium with full employment of the labor force and
perfect flexibility for wages (or prices).
The level of output corresponding to full employment of the labor
force is full-employment of output or potential output .
grows over time as the economy accumulates resources and as

technology improves: see Figure 7.4.
Aggregate Supply (AS) Curve in Keynesian Case

The Keynesian AS curve is horizontal, indicating that firms will supply
whatever amount of goods is demanded at the existing price level.
The Keynesian AS curve is based on the idea that in the short run,
firms are reluctant to change prices (and wages) perfect rigidity for
prices when demand shifts.
On a Keynesian AS curve, the price level does not depend on output
.
Figure 7.3: Keynesian and Classical AS Functions
Figure 7.4: Growth of Output over Time and Shifts of AS Curve
Long-Run Aggregate Supply (LRAS) Curve

It is important to note that while full-employment of output or
potential output changes each year, the changes do not depend
on the price level: full-employment output is exogenous with
respect to the price level.
Since changes in potential output over a short period are usually
relatively small, we can draw a single vertical line at and call it
long-run aggregate supply (LRAS).
Two Models of Aggregate Supply Curve

The following two models explain why the short-run aggregate supply
curve is upward sloping rather than vertical or horizontal:
i.e., each model highlights a particular reason why unexpected
movements in the price level are associated with fluctuations in
aggregate output .
The Sticky-Price Model

The most widely accepted explanations for the upward-sloping AS
curve is called the stick-price model, which implies that firms do not
instantly adjust the prices they charge in response to changes in
demand.
Prices are set by long-term contracts between firms and customers
Even without formal agreements, firms may hold prices steady to
avoid annoying their regular customers with frequent price changes.
Some prices are sticky because of the way certain markets are
structured : once a firm has printed and distributed its catalog, it is
costly to alter prices.

Sticky prices can be a reflection of sticky wages: firms base their
prices on the costs of production.
First consider the pricing decisions of individual firms and then
aggregate the decisions of many firms to explain the behavior of t
the economy as a whole.
Assumption: Firms have a markup > 0 .
7.3 : = + , where is the firms desired price,
the overall level of prices such as CPI and GDP deflator.
The parameter > measures how much the firms desired price
responds to the output.

7.3 : = +
The firms desired price "" depends on two macroeconomic variables:
The overall level of prices P:
A higher price level
the firms higher marginal costs
The firm would like to charge more for its product.
The aggregate income or output Y:
A higher income
A higher demand for the firms product
A higher firms desired price to cover the higher marginal costs

Now assume that there are two types of firms:
(i) Some have flexible prices: they always set their prices according to
(7.3).
(ii) Others have sticky prices: they announce their prices in advance
based on what they expect economic conditions to be.
Firms with sticky prices set prices according to:
. : = + .
Assumption: For simplicity, =
These firms expect output to be at its full-employment or at its
natural level.

7.4 . : = .
Meaning . : Firms with sticky prices set their prices based on
what they expect other firms to charge.
Now we can use the pricing rules of the two types of firms to derive
the AS equation.
The overall price level in the economy is the weighted average of
the prices set by the two groups.
. : = + + , where is
the fraction of firms with sticky prices and 1 is the fraction
with flexible prices.

= + 1 +
= + +
= + 1
=
. : = +
When firms expect a higher price level, they expect high costs. Those
firms that fix prices in advance set their prices high. These high prices
cause the other firms to set high prices also. Hence, .

When output is high, the demand for goods is high. Those firms with
flexible prices set their prices high, which leads to a high price level.
The effect of output on the price level depends on the proportion of
firms with sticky prices;
> .
The more firms that have sticky prices, the less the price level
responds to the output;
becomes smaller.
Hence, the overall price level depends on the expected price level
and on the level of output.

Let =
.
1
7.7 : =
= +
= +
. : = + ( )
Meaning . : The deviation of output from its natural level

or full-employment level is positively associated with
the deviation of the actual price level from its expected price
level .
The Imperfect-Information Model or The Misperception Theory

This model assumes that markets clear that is prices and wages are
free to adjust to balance supply and demand.
In this model, SRAS and LRAS curves differ because of temporary
misperceptions about prices: This model attributes the positively
sloped AS curve to temporary misperceptions about prices.
Assumption: Each supplier in the economy produces a single good
and consumes many goods. Because the number of goods is so large,
suppliers cannot observe all prices at all times.

They closely monitor the prices of what they produce but less closely
the prices of all the goods they consume.
Supply of each good depends on its relative price: the nominal price
of the good divided by the overall price level.
Supplier doesnt know the price level at the time she makes her
production decision, so uses the expected price level, .
Suppose rises but does not. Then the supplier thinks her
relative price has risen, so produces more.
With many producers thinking this way, will rise whenever rises
above .

The positive relationship between P and Y means AS curve slopes
upward.
Because of imperfect information, suppliers sometimes confuse
changes in the overall level of prices with changes in relative prices.
This confusion affects decisions on how much to supply, and it leads
to a positive relationship between P and Y in the short run.
The positive relationship between P and Y means AS curve slopes
upward: According to the misperceptions theory, > > .
7.8 : = + ( ): Y deviates from when deviates
from .

Recent work on imperfect-information models of AS stresses
the limited ability of individuals to incorporate information about
the economy into their decisions the limited ability of people
to absorb and process information that is widely available.
This information-processing constraint causes price-setters
to respond slowly to macroeconomic news.
Two Models of Upward-Sloping SRAS

As a conclusion, two models of AS differ in their assumptions and
emphases, but their implications for aggregate output are similar.
Both can be summarized by the equation: = + ( ).
> will rise and be higher next period >
< will fall and be lower next period <
Prices will continue to rise or fall over time until output returns to
the natural level. Tomorrows price level equals todays price level,
= , if, and only if, = .
Figure 7.5: The Short-Run Aggregate Supply (SRAS) Curve
Todays Class (11/19/2015)

Lecture Note #7: The AS-AD Model
7.3 Equilibrium in the Short Run and in the Medium Run
a) The Keynesian Case
b) The Classical Case
c) Equilibrium in the Short Run in Upward-sloping AS
d) From the Short Run to the Medium Run in Upward-sloping AS
7.4 The Effects of a Monetary Expansion
Next Class: Read Chapter 8 from the Textbook!
Review of the Test #2 on Dec. 6 (Sunday) at 2pm!
Price Adjustment Mechanism
7.7 : =
The speed of price adjustment is controlled by the parameter .
The slope of the AS curve: =

is small
a relatively steep AS curve
changes in output and employment have a large effect on the price
level.
is large
a relatively flat AS curve
changes in output and employment have a small effect on the
price level.
Price Adjustment Mechanism

The aggregate supply (AS) curve describes the price adjustment
mechanism of the economy.
Figure 7.6: Dynamic Return to LRAS
Derivation of Aggregate Demand (AD)

The AD relation captures the effect of the price on output.
It is derived from the equilibrium conditions in the goods and
financial or money markets. That is, the AD curve shows
the combination of the price level () and output at which
goods and money markets are simultaneously in equilibrium.
Goods market equilibrium (IS relation): = + , +
The IS relation is downward sloping because
for given values of and .
Derivation of Aggregate Demand (AD)

Equilibrium in financial markets (LM relation):
= ()
The LM relation slopes upward because for a given value of

in order to maintain the equality of and
the (unchanged) money supply .
Step 1: to
, given the stock of money
The LM curve shifts upward
Step 2: At a given level of output ,
Step 3: The economy moves upward along the IS curve, and

the equilibrium moves from to : .
AD Relation
In short, an increase (or a decrease) in leads to a decrease
(or an increase) in : The AD relation slopes downward.
The downward-sloping AD curve represents equilibrium in both
goods and money markets.
AD relation or AD curve: . 7.9 : =
, ,
+, +,
Output is an increasing function of the real money stock ,

an increasing function of government spending , and a decreasing
function of taxes .
Figure 7.7: Derivation of the Aggregate Demand Curve
Figure 7.8: Shifts of the AD curve
Shifts of the AD Curve

Any variable other than the price level that shifts the IS curve or
the LM curve also shifts the aggregate demand relation.
Expansionary policies such as increase in government spending,
cuts in taxes, and increase in money supply move the AD curve
to the right.
Consumer confidence 0 and investor confidence 0 also affect
the AD curve.
Algebraic Derivation of the AD Relation

= 0 + 1 1 where = , represents a proportional
income tax rate.
= 0 + 2
=
relation: =
0 + 0 +
= 0 + 1 2 and =
relation: =
0
+
1
Let
= for simplicity.
11 1 1
Algebraic Derivation of the AD Relation

To derive the AD relation, substitute in for from the relation into
relation:
= 0 + 0 +
2
2
+ 1
2 1
2
+
= 0 + 0 +
0
2
2
2 +2 1
2
= 0 + 0 +
0
2
2
2
2
=
0 + 0 +
0
2 +2 1
2 +2 1
, relation
The AD Relation
Q: What is the slope of the AD relation?
A: =
<
+
Intuition:
This implies that the relation between Y and P is negative, which is

exactly what the AD curve captures.
The AD Relation
Q: Show mathematically that output is an increasing function of
the real money stock or real money balance.
A:
Intuition:
> .
in order to clear the money market
Q: Show mathematically that output is an increasing function of

government purchases.
A:
> .
Intuition: .
Equilibrium in the Short Run and in the Medium Run
AS relation: = 1 + 1
AD relation: =
, ,
For a given value of and for given values of the monetary and fiscal
policy variables , , and , and determine the equilibrium
values of and .
Exogenous variables: , , , and
Endogenous variables: and
Equilibrium in the Short Run and in the Medium Run

Note that the equilibrium depends both on the position of AS curve
(and therefore on the value of ) and on the position of the AD
curve (and therefore on the values of , , and ).
In the short run, we can take as given. But, over time, is likely
to change, shifting the AS curve and changing the equilibrium.
The Keynesian Case: SR Equilibrium

We combine the AD curve with the Keynesian horizontal AS curve.
The Keynesian Case: SR Equilibrium

The horizontal AS curve means that all prices are stuck
at predetermined level 0 and at these prices, firms are willing
to supply any amount of output.
Thus, expansion of AD has no effect on the overall price level in
the short run, but output and employment increase.
The Classical Case: SR Equilibrium

We combine the AD curve with the Classical vertical AS curve.
Dynamic Adjustment of The Classical Case

In the classical case, the AS curve is vertical at the full-employment
level of output or at the natural level of output .
Under the classical assumption, firms supply the full-employment
level of output at any level of prices.
The AD increases from AD to
At the initial price level 0 , spending in the economy would rise to

As firms try to hire more workers, they bid up wages and their cost
of production
Firms must charge higher prices for their output
Dynamic Adjustment of The Classical Case
As prices increase, the real money supply

falls, given the stock
of money

The economy moves upward along the
At , the AD is once again equal to AS: = ( )
The Classical Case: SR Equilibrium

According to the classical model, output does not depend on
the price level.
Changes in AD affect prices but not output.
The vertical AS curve satisfies the classical dichotomy because it
implies the level of output independent of the money supply.
Equilibrium in the Short Run in Upward-Sloping AS

Figure 7.11: The Short-Run Equilibrium in Upward-Sloping AS
Equilibrium in the Short Run in Upward-Sloping AS

At point A, the intersection of AS and AD curves, the goods market,
the financial markets, and the labor market are all in equilibrium.
AS curve is drawn for a given .
(or N ) and the position of the curve
depends on .
AS curve always goes through point B: If = , = .
AD curve is drawn for given values of M, G, and T.
.
In the short run, there is no reason why output () should equal
the natural level of output .
Dynamic Adjustment: From the SR to the Medium Run

Question: Suppose, in the short run, > . What will happen over
time? Will output eventually return to ? If so, how?
In the short-run equilibrium (point A), >
> : Higher than the price level wage setters expected when
they set W
Wage setters revise upward their expectations of what the price
level will be
> , next time they set W
The AS curve shifts from to : At a given level of output, wage
setters expects a higher price level


The economy moves upward along the AD curve
The equilibrium moves from to
Equilibrium output decreases from to .
At , >
>
Wage setters continue to revise upwards their expectations of ,
meaning that as long as equilibrium > , keeps increasing,
shifting the AS curve upward and the economy moves upward along
the AD curve, equilibrium output continues to fall

This adjustment process ends when = and = at .
Wage setters have no reason to change their expectations;
the AS curve no longer shifts, and the economy stays at .
Figure 7.12: The Adjustment of Output over Time
Summary
> >
Wage setters revise their expectations of the price level upward
AS curve shifts up

The adjustment stops when = and =

No change in expectations.
In the medium run or long run, actual output returns to the natural
level of output: = .
Example (7.1): AS-AD Model

Consumption: = 0 + 1 1 = 200 + 0.5 1
Investment: = 0 2 = 300 0.4
Money demand: = 0 + 1 2
= 400 + 0.8
= 0, = 100; = 200.
Full-employment output: = 550
a) Find an equation describing the IS curve.
(Ans.)
Equilibrium condition in the goods market: =

= + +
= 200 + 0.5 + 300 0.4 + 100
0.5 = 600 0.4
0.5 = 600 0.4
= . = .
Slope of the IS relation:
= .
b) Find an equation describing the LM curve.

(Ans.)
Equilibrium condition in the money market:
200
= 400 + 0.8
200
0.8 = 400 +
= + .
Slope of the LM relation:
= .
c) Derive the aggregate demand (AD) equation.

(Ans.)
Substitute in for from LM relation into IS relation:
= 1200 0.8 + .

= 1200 400 +
200
2 = 800 +
= +
Slope of the AD
200
relation: =

<
d) Suppose that the aggregate supply takes the following form:
= +
1
50
and = 1.
Assume we are in the short-run for now. What is the equilibrium

output ? What is the expected price level ?
Draw the AS-AD diagram.

In the equilibrium, = .
If = 1, = 400 + 100 = 500.
1 = +
1
50
500 550
= 2
Since = 1 < = 2, = 500 < = 550, meaning that
the economy is in recession.
The short-run equilibrium in the economy is at point A, where

= . At this point, the goods market, the financial market, and
the labor market are all in equilibrium. If = (and if = ),
the equilibrium would be at point B.
The Effects of a Monetary Expansion

Question: What are the short-run and medium-run effects of
an unexpected increase in AD attributable to an unexpected monetary
expansion?
Dynamics of Adjustment
Assumption: Initially (before the change in nominal money),
1 = = : = = at .
In other words, the economy is initially in the long-run equilibrium or
in a general equilibrium at A, where = = .
Recall: 7.9 =
, ,
Dynamic Adjustment from the SR to the Medium Run

The central bank unexpectedly and without any publicity increase
the money supply M
For a given , leads to

(The curve shifts down from to : One is due to the
increase in . The other is due to the increase in even in the short
run. This increase in shifts the curve from to ,
partially offsetting the effect of the increase in . curve shifts
down initially to if the price level did not change)
shifts to the right from 1 to 2
to 2 and to 2 in the short run
Because wage setters didnt expect this increase in the price level
and the AS curve remains unchanged, the expected price level
remains at = and in the short run, > and > at .
Thus, the unexpected expansion in AD causes the economy to boom.
Over time, wage setters revise their expectations upward:
shifts upward over time to 2
The economy moves upward along the
(Since > , continues to increase.
The curve
shifts up The economy moves up along the curve)

In the medium run or in the long run,
2 = 2 = at : 3 = and 3 = 3 .

The economy returns to the natural level of output in the medium run
or in the long run, but at a much higher price level.
(In the medium run or in the long run, the curve eventually
returns to where it was before the increase in . The interest rate is
back to its initial value, )
Note that if output is back to the natural level of output ,
the real money stock
must also be back to its initial level; i.e.,
the proportional increase in prices must be equal to the same

proportional increase in the nominal money stock.

is unchanged with G and T being unchanged

must also remain unchanged: M and P each increase in
the same proportion.
Figure 7.13: Dynamic Effects of a Monetary Expansion on

Output and Interest Rate
This analysis demonstrates an important principle:

(i) Short-run monetary non-neutrality (from A to B): in the short run,
the increase in the money supply leads to a rise in output, money isnt
neutral in this sense, since producer mistakes the higher nominal price of
their output for an increase in its relative price, rather than an increase in
the overall price level, ending up producing more than they would have.
(ii) Long-run monetary neutrality (from A to C): an unanticipated
increase in the money supply is neutral in the long run since people
obtain information about the true price level and adjust their expectations
accordingly.
Monetary Neutrality or Neutrality of Money

In the short run, a monetary expansion leads to , , and
Question: How much of the effect of a monetary expansion falls
initially on output and how much on the price level?
Answer: It depends on the slope of the AS curve.
In the medium run or in the long run, the increase in nominal money is
reflected in a proportional increase in the price level. The increase in
nominal money has no effect on output or on the interest rate;
that is, over time, the price level increases, and the effects of the
monetary expansion on output and on the interest rate disappears.
Neutrality of Money
We need to explain how monetary policy is related to other
macroeconomic variables, such as prices, interest rates, output, and
employment.
The theory we want to develop is called the quantity theory of
money, which explains how money affects the economy in
the medium run or in the long run.
7.10 : =
nominal GDP
For example, = $5,200, = 2 = $10,400; a money

supply of $5,200 billion turning over 2 times a year would support
a nominal GDP of $10,400 billion.
Neutrality of Money: Quantity Theory of Money

Assumption: (i) is constant.
(ii) The factors of production and the production function have
already determined output .
7.11 : = % + % = % + %
+ = + (%) = (%).
Meaning: According to the quantity theory of money, the price level

is proportional to the money supply.
Neutrality of Money
Neutrality of money in the medium run or in the long run
The absence of a medium-run or a long-run effect of money on
output and on the interest rate
A change in the nominal money supply changes the price level
proportionately but has no effect on real variables such as output,
employment, the relative prices, or the real interest rate
The practical relevance of monetary neutrality is much debated by
classical economists and Keynesians.
The basic issue is the speed of price adjustment.
Neutrality of Money: Classic vs. Keynesian

Classical economists believe that the economy possesses powerful
self-correcting forces that guarantee the natural rate of employment
(= full employment) and prevent the output from falling below
the natural level of output for more than a short run. These
forces consist of flexible wages and prices, which could adjust rapidly
to absorb the impact of shifts in aggregate demand : In the
classical view, a monetary expansion is rapidly transmitted into prices
and has, at most, a transitory effect on real variables the economy
moves quickly back to the natural level of output. So, they see no
need for the government to engage in stabilization policy.
Neutrality of Money: Classic vs. Keynesian

Keynesians agree that money is neutral after prices fully adjust
but believe that, because of slow price adjustment, the economy may
be for long in disequilibrium. During this period the increased money
supply causes output and employment to rise and the real interest
rate to fall.
Warning on Neutrality of Money

The neutrality of money in the medium run does not mean that
monetary policy cannot or should not be used to affect output.
An expansionary monetary policy can help the economy move out of
a recession and return more quickly to the natural level of output.
It is a warning that monetary policy cannot sustain higher output
forever.
A Decrease in Budget Deficit

Suppose that the government is running a budget deficit and decides
to reduce it by decreasing its spending from to while leaving
taxes unchanged.
Question: How will this affect the economy in the short run and in the
medium run?
Assumption: = at point initially

=
The economy is initially in the long-run or general equilibrium

falls to : < 0
curve shifts to the left from to
(The curve shifts the left to . If didnt change, the economy
would move from to B)
In the short run, falls to and falls to
(Since in response to , and the curve shifts down to

, a partially offsetting shift of the curve)
In the short run, the economy moves from to
(The initial effect of the deficit reduction triggers lower output a recession and the lower interest rate. is uncertain in the short
run.)

Over time, since < the curve keeps shifting down
(As long as < , continue to decline, leading to
. The
curve continues to shift down.)

The economy moves down along the until =
(The economy moves down along until = )
At , = : The recession is over.
(At , the interest rate is lower than it was before the deficit
reduction, down from to )
Figure 7.14: Dynamic Effects of a Decrease in the Budget Deficit

on the Output and the Interest Rate
Change in Money vs. Change in Deficit
is back to the natural level of output , but are lower

than before the shift since we are assuming that is constant, not
growing, and there is no sustained inflation.
The composition of output is also different.
New relation at : = + , +
stays the same because income and taxes are unchanged.
is lower than before.
must be higher than before the deficit reduction higher by an amount
exactly equal to the decrease in . Put another way, in the medium run,
a fall in the budget deficit unambiguously leads to a decrease in
the interest rate and an increase in investment.
Summary: Decrease in the Budget Deficit

In the short run, without an accompanying change in
monetary policy and uncertain .
In the medium run, = , , and .
In the long run, if a lower government budget deficit leads to more
investment, it will lead to a higher capital stock, and the higher
capital stock will lead to higher output.
Different Opinions about Budget Deficit Reduction

Disagreement among economists about the effects of measures
aimed at increasing saving (a fall in the budget deficit) often comes
from differences in time frame.
Those who are concerned with short-run effects worry that
measures to increase saving might create a recession and decrease
saving and investment for some time.
Those who look beyond the short run see the eventual increase in
saving and investment and emphasize the favorable medium-run and
long-run effects on output.
Increase in the Price of Oil
Increase in the Price of Oil

Two Incidents in an Increase in the Price of Oil:
Changes in supply: The formation of OPEC and disruptions of oil
supply due to wars and revolutions in the Middle East in the 1970s
Changes in demand: Fast growth of emerging economies in
the 2000s
The implication for U.S. firms and consumers was the same:
more expensive oils, more expensive energy.
Changes in the Price of Oil

A drawback in using our current model: The price of oil appears
neither in the AD relation nor in AS relation since, until now, we have
assumed that labor was only an input to the production.
Solution: One way to extend our current model using only labor
would be to recognize explicitly that output is produced using labor
and other inputs (including energy).
Changes in the Price of Oil

Q: What effect an increase in the price of oil has on the price set by
firms and on the relation between output and employment?
A: An easier way is to capture the increase in the price of oil by an
increase in - the markup of the price over the nominal wage :
given wage, an increase in the price of oil increases the cost of
production, forcing firms to increase prices.
Track the dynamic effects of an increase in the markup on output and
the price level by working backward in time.
Effects of an Increase in the Price of Oil

Question: What happen to the natural rate of unemployment
when the (real) price of oil increases?
Initial equilibrium at and

to
(The higher the markup, the lower the real wage implied by )
The equilibrium moves from to
The real wage
is lower
The natural rate of unemployment is higher: Getting workers to

accept the lower real wage requires an increase in unemployment
Effects of an Increase in the Price of Oil

The increase in the natural rate of unemployment leads to
a decrease in the natural level of output , assuming that each
unit of output still requires one worker in addition to the energy input
and that the increase in the price of oil is permanent.
Figure 7.15: Effects of an Increase in the Price of Oil on the

Natural Rate of Unemployment
Dynamic Adjustment to an Increase in the Price of Oil

Before the increase in the price of oil, = at with
= and = ; ie, the economy is initially in the long-run or
general equilibrium.
In the short run (given ), relation: = 1 + 1

Effect of an increase in the price of oil is captured by
at any level of
curve shifts upward
The economy moves along the curve
to and to

Recall that the curve always goes through the point such that
= and = .
After the increase in the price of oil, the new curve goes through
point B.
In the short run, the increase in the price of oil leads firms to increase
their prices, leading to the decrease in output and demand.
In the medium run, > and > at
curve continue to shift up
The economy moves over time along the curve from to
At , = and is higher than before the oil shock

Summary: Increase in the price of oil decreases output and increases
prices in the short run.
If the increase in the price of oil is permanent, then output is lower
both in the short run and in the medium run.
Figure 7.16: Dynamic Effects of an Increase in the Price of Oil
Two Incidents of an Increase in the Price of Oil
Two Incidents of an Increase in the Price of Oil

The increase in the price of oil in the 1970s was followed by major
increases in inflation and in unemployment. This fits out summary
very well.
The increase in the price of oil in the 2000s was associated with
neither an increase in inflation nor an increase in unemployment.
Final Words
We think about output fluctuation (sometimes called business cycle)
movements in output around its trend (potential GDP ) in this
chapter.
Each shock has dynamic effects on output and its components.
These dynamic effects are called the propagation mechanism of the
shock. Propagation mechanisms are different for different shocks.

Econ Course 202 Academy Say

Transféré par

Informations du document

Copyright

Formats disponibles

Partager ce document

Partager ou intégrer le document

Options de partage

Avez-vous trouvé ce document utile ?

Ce contenu est-il inapproprié ?

Droits d'auteur :

Formats disponibles

Econ Course 202 Academy Say

Transféré par

Droits d'auteur :

Formats disponibles

LearningObjectives

Changesinincome resultinchangesinthedemand forgoods

inventory investment firms accumulate inventories

inventory investment firms inventories

EconomistscallEq(3.1)abehavior equation toindicatethatthe

=incomeincludingtransfer payments taxes

falls,andsotheaverage propensity toconsume falls.

Output isdeterminedbyequilibriuminthegoods market.

3.8 characterizesequilibriumoutput(endogenous variable),

Thecloser isto1,thelarger themultiplier;thehigher MPC,the

falls,andsotheaverage propensity toconsume falls.

Output isdeterminedbyequilibriuminthegoods market.

3.8 characterizesequilibriumoutput(endogenous variable),

Thecloser isto1,thelarger themultiplier;thehigher MPC,the

Demanddependsonautonomous spending andonincome

$1 billion becauseofthemultiplier effect

$0.3 trillion $300 billion

TheslopeoftheZZ lineisflatter becausehouseholdsnowhaveto

0.2 20% and

Demanddependsonautonomous spending andonincome

$1 billion becauseofthemultiplier effect

TheslopeoftheZZ lineisflatter becausehouseholdsnowhaveto

0.2 20% and

Investmentisanegative functionoftheinterest rate.

Investmentisanegative functionoftheinterest rate.

Aconsumerisborrowing,and isless thanzero.

Aconsumerisborrowing,and isless thanzero.

Meaning:Thepresent value ofconsumption mustequalthepresent

where $ is the dollar amount received in year and is

Example (3B.2):ContinuationofExample (3B.1)

Example (3B.2):ContinuationofExample (3B.1)

10.39 15.59 162.

Example (3B.2):ContinuationofExample (3B.1)

d)Findtheoptimalconsumptionof and ,locatethispointonthe

Example (3B.2):ContinuationofExample (3B.1)

Example (3B.2):ContinuationofExample (3B.1)

Example (3B.2):ContinuationofExample (3B.1)

10.39 15.59 162.

Example (3B.2):ContinuationofExample (3B.1)

d)Findtheoptimalconsumptionof and ,locatethispointonthe

Example (3B.2):ContinuationofExample (3B.1)

Example (3B.5):Continuation ofExample(3B.3)

Example (3B.5):Continuation ofExample(3B.3)

Transitoryincome isthecomponentofincomethatdoesnot persist

inincomeliftsboth and ,liftinglifetimeresourcesand

Currency (coins and bills in the hands of the public)

curveshowstherelationb/wthedemand formoney andthe

4.3 givestheliquidity demand function orthedemandforreal

4.3 givestheliquidity demand function orthedemandforreal

andbonds ornonmonetary assets

Anincrease innominalincomeleadstoanincrease intheinterestrate.

$100 0.25 0.15

Monetary Policy and Open Market Operations

Monetary Policy and Open Market Operations

Figure 4.4: The Effect of an Increase in the Money Supply on the

Effect of an Increase in the Money Supply on the Interest Rate

curve shifts rightward from to .

Effect of an Increase in the Money Supply on the Interest Rate

Example(4.1): Money Market Equilibrium

Example(4.1): Money Market Equilibrium

Example (4.2): Money Market Equilibrium

Suppose that the money demand function is

500 = 1000 100

Example (4.2): Money Market Equilibrium