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About
Me

Syllabus
Course
Objective
Macroeconomics
Macroeconomics
-
GDP
Macroeconomics
-
In
In
Macroeconomics
-
Recession
Macroeconomics
-
Interest
Rate
Macroeconomics
-
Growth
Macroeconomics
-
Government
De
Macroeconomics
-
De
Macroeconomics
-
The
Big
Picture
ation ation
cit cit
Suppose
in
an
imaginary
country,
the
basket
of
goods
only
contains
pizza,
Education
Availability
Teaching
Style
Final
Grade
Letter
Grade
Become
an
Economist
Become
Analytic
What?
GDP
GDP
Calculation
GDP
-
Production
Side
GDP
-
Income
Side
(Hyper)
In
In
Recession
Interest
Rate
Growth
Government
De
Money
Flow
ation
Computation
(Pt.1)
ation
Computation
(Pt.2)
ation
Computation
(Pt.3)
ation cit Quantity2018 Price2010 Price2018
Firms Quantity2010
beer,
coffee,
and
the
base
year
is
2010.
The
consumption
quantities
and
Markets: Pizza 50 xed
set
of
consumer
products
and
services.
cit
for
the
100
GDP
per
capita
is
closely
related
to
life
expectancy:
GDP
per
capita
is
closely
related
to
maternal
mortality
rate:
There
are
two
ways
to
calculate
GDP
Reverse
the
money

Ph.D.
student
in
the
Department
of
Economics
Of
I
bring
real-world
connections
Homework
28%:
Seven
Short
Homeworks:
Six
3.5%'s
and
one
7%
Bonus
5%:
Ten
In-class
Bonus
Questions:
0.5%
each,

The
letter
grade
is
what
matters
to
your
GPA.
Learn
Vocabulary
Think
Critically
Economics
is
a
social
science
that
studies
people
In
the
19th
century,
economists
had
no
measure
of
aggregate
activity.
GDP
Is
the
Sum
of
Value
Added
in
the
Economy
during
a
Given
Period.
GDP
Is
the
Sum
of
Incomes
in
the
Economy
during
a
Given
Period.
In
Price
(CPI)
measures
the
value
of
the
basket
of
goods
relative
to
the
The
basket
of
goods
is
a

A
period
of
temporary
economic
decline.
Characterized
by
lower
output
Is
growth
a
historical
trend?
The
U.S.
federal
budget
de
De
Why
do
we
need
Tax
ation
measures
the
price
change
in
percentage.
When
we
compute
ce
hours:
Tue
from
10:00
to
11:00am
and
Wed
from
2:30
to
3:30pm
cit
=
Government
Spending
-
Tax
Revenue
nition:
A
branch
of
economics
dedicated
to
understanding
an
ow,
you
get
the
goods/assets
 ow 8 ve
of
them
will
be
10
scal
year
2020
is
$1.103
trillion
prices
are
given
by
not
be
graded,
and
you
will
get
the
full
credit
for
simply
submitting
it.
I
economy
as
a
whole.
They
had
to
put
bits
and
pieces
of
information
such
as
the
shipments
the
in
base
year.
When
we
compute
the
CPI,
we
need
two
things:
and
higher
unemployment
than
what
we
normally
observe.
ation,
we
need
three
things:
Beer 100 200 4 5
Of
I
train
you
to
be
a
critical
thinker
In-class
Quizzes
8%:
Two
Quizzes:
4%
each
(redeemable)
Letter
grades
are
given
based
on
your
Final
Grade.
Depending
on
the
Use
and
Read
Data
Present
Arguments
At
the
end
of
the
day,
People
want
to
be
happy
Production
Side
This
basket
contains
what
an
average
consumer
consumes
for
that
What
makes
an
economy
grow
in
the

The
de
Why
do
we
need
Government
Spending
Goods
Market
-
Next
Two
Lectures
ce:
PLC
508
Suppose
there
are

Suppose
there
are
people
index
by

To
Finance
Government
Spending
cit
occurs
because
the
U.S.
government
spending
of
$4.746
rms
index
by
j,
and
there
are

M.A.
in
Economics
from
the
University
of
Oregon
Maternal mortality
won't
tell
you
which

ratio vs GDP per capita,rst
place?
Human
Capital,
i
and
there
are

1990
of
iron
ore
or
sales
at
some
department
stores
to
infer
what
was
to
1.
Value
of
Basket
of
Goods
Evaluated
at
the
Base
Year
Price:

ve
are
these.
2014 JI
of
them
in
the

of
them
in
the
Firms Quantity Price2010 Price2015 Price2018 V
Coffee 150 300
class
performance,
I
reserve
the
right
to
curve
the
letter
grades:
Aspects:
Performance,
Structure,
Behavior,
Decision-Making
year.
Recession
is
bad.
People
lose
their
jobs,
houses,
insurance.
Physical
Capital,
Technology,
Institution,
Culture
...
trillion
is
higher
than
its
tax
revenue
of
$3.422
trillion.
1.
Base
Year:

economy.
Firm

economy τ j
produces
good
j.
1 2 Africa
τ

happening
to
the
economy.
2.
Value
of
Basket
of
Goods
Evaluated
at
the
Year
of
Interest's
Price:
 Asia

Macroeconomics
Overview
Book
Chapter
1,
2
Course
Objective
About
Me
Syllabus
email:
jungangl@uoregon.edu
I
ask
questions,
and
I
expect
you
to
answer
Final
Project:
8%:
Topic
on
Universal
Basic
Income.
Understand
Human
Incentives
Transfer
Skills
&
Knowledge
Measuring
the
performance
of
an
economy
boils
down
to
how
happy
Income
Side
Money
Market
Boost
Economy
(That's
why
political
parties
overspend
on
purpose)
To
Provide
Incentives
(Externalities)
1,000 Pizza 50
B.A.
in
Computer
Science
from
Nanjing
University 8 8 10
Sierra
Leone Europe

2.
Start
Year:

Introduction
and
Overview
North America
T Central
African
Republic
0 Chad Nigeria Oceania
V
Compute
GDP
of
the
year
2018
measured
in
2010
dollar
the
people
are.
The
basket
is
updated,
and
CPI
will
need
revisions
as
long
as
there
are
Who
gets
hurt
the
most
when
a
recession
hits
the
economy?
Why
do
some
economies
grow
whereas
some
others
do
not?
The
de92
-
105:
A
The
quantity
of
good

Person
cit
is
18
percent
greater
than
last
year.
i
works
h 
hours
during
this
period
j
is
q 
during
this
period.
Burundi Liberia Democratic
Republic
of
Congo
T South America

Measures
of
aggregate
output
have
been
published
on
a
regular
basis
3.
End
Year:

Compute
GDP
of
the
year
2010
measured
in
2018
dollar

Niger

Beer 100 4 3 Y 5
Mozambiquei Kenya 2018
Congo j Angola
T 1990 2014
Theoretically,
these
two
sides
should
give
you
the
same
results.
Describe
Macroeconomic
Dynamics
(
Intuition
and
Models)
Read
Economics
News
Why
don't
we
like
Tax
Labor
Market
Details
available
after
the
midterm
Formula:

Provide
Public
Goods
Tanzania Swaziland
1 τ
Ethiopia Equatorial
Guinea
Economics
at
the
University
of
Sydney
and
the
University
of
Why?
CP I = V /V 2010
signi 90
-
92:
A-
cant
changes
in
consumer
buying
habits
or
shifts
in
population
Ghana
Maternal mortality (per 100,000 births)

EC
313,
Macroeconomics
T NepalT τ τ Namibia

in
the
United
States
since
October
1947.
Formula:

CP I Zambia

Good
Dynamics
T

300
and

τ
GDP
(Gross
Domestic
Production)
is
a
commonly
used
measure
for
Causes
for
recessions.
Can
the
less
prosperous
countries
learn
from
the
prosperous
countries?
Choose
a
year,
say
2010,
and
get
the
market
value
(price)
of
good

Person
 q i's
wage
(dollar
per
hour)
is
 1 w 
during
this
period.
Bangladesh
1 India
, q , Coffee 150 2 1 2
South
Africa
Π 100, = − 1 p ,p ,p
Cambridge
q1
100
=
distribution
or
demographics.
87
-
89:
B+
200,
q , q , q = 50, 100, 150
and
p , p , p = 10, 5, 2
2 3 = 8, 4,
T1 ,T0 j
CP I
τ Honduras Indonesia
1 2Botswana3i
Venezuela Bahamas

Evaluate
Policies
International
Financial
Market
Due
on
Mar
11
American
Traditional
Value
(Small
Government)
1
Flood
Control
in
the
Netherlands
v.s.
Hurricane
Katrina
happiness
(standard
of
living).
is
p 
for
that
year.
2 3
T
0 1
Guatemala 2 3

Intellectual
Curiosity:
Understand
(a
part
of)
the
World
Kyrgyzstan

Alex
Li
Syria Colombia Trinidad
and
Tobago

The
measure
of
aggregate
output
in
the
national
income
accounts
is
83
-
86:
B j

What
should
we
(as
you
and
me)
do?
(Consumption,
Saving,
Asset
The
GDP
is

Vietnam Iraq
Argentina

Raise
your
hand
and
ask
me
to
slow
down 2010 Brazil


Malaysia

Research
interests:
Macroeconomics
Theory,
Computational
Y = q pY + = qh pw ++ qh p w= + 100⋯× +8h + w200 × 4 + 300 × 1 = 1900 Uzbekistan Mexico

Check
out
the
full
list
through
this
link
Policies Y
2018
2018
Midterm
28%:
Monday,
Feb
10
at
4:00
pm
called
the
gross
domestic
product,
or
GDP,
for
short.
80
-
82:
B-
Market
Distortion
(Can
be
partially
avoided)
Education
2010
1
= q p + q p + q p = 50 × 10 + 100 × 5 + 150 × 2 = 1300
1
1
1
Tajikistan
21 2
2 2
1
Moldova 3
3 23
3
2Fiji
Ukraine
China
Thailand
Romania N
Russia
N
Brunei

If
a
country
produces
more
goods
in
value
during
a
period
(higher
GDP),
Portfolio)
The
GDP
measured
in
2010
dollar
is

Career:
Business
is
subject
to
the
impact
of
macroeconomics
Methods,
Heterogeneous
Agent
Modeling,
Monetary Y = q p + q p + ⋯ + q p Turkey
Oman
1
United
States
South
Korea
1 2Qatar2 J J

70
-
79:
C+
Ask
me
to
repeat
any
materials
you
didn't
get
10

in
general,
the
people
in
that
country
have
more
resources
to
be
Bulgaria
Macedonia
France
Netherlands
Singapore

Final
28%:
Monday,
Mar
16
at
2:45
pm
Monetary
Policy
Coporation
Lobbying
(Tax
Cuts

Policy. Defense ⟹ 
Ef ciency
 ⟹ 
More
Revenue)
What
should
policymakers
do?
(Monetary
Policy,
Fiscal
Policy)
60
-
69:
C
Japan

Life:
Make
better
life
decisions
Israel Switzerland
Italy Sweden Kuwait

happier. 0:00 Poland

Be
proactive
and
ask
for
help
whenever
you
need
0
-
59:
F
$1,000 $10,000 $100,000
GDP per capita
Fiscal
Policy
Source: Gapminder (2010) and World Bank (2015), Penn World Tables CC BY-SA

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/
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Book
Chapter
1,
2

2
/
44
About
Me

3
/
44
About
Me
Education
Ph.D.
student
in
the
Department
of
Economics

M.A.
in
Economics
from
the
University
of
Oregon

B.A.
in
Computer
Science
from
Nanjing
University

Economics
at
the
University
of
Sydney
and
the
University
of
Cambridge

Research
interests:
Macroeconomics
Theory,
Computational
Methods,
Heterogeneous
Agent
Modeling,
Monetary
Policy.

4
/
44
About
Me
Availability
Of ce
hours:
Tue
from
10:00
to
11:00am
and
Wed
from
2:30
to
3:30pm

Of ce:
PLC
508

email:
jungangl@uoregon.edu

5
/
44
About
Me
Teaching
Style
I
bring
real-world
connections

I
train
you
to
be
a
critical
thinker

I
ask
questions,
and
I
expect
you
to
answer

6
/
44
About
Me
Teaching
Style
I
bring
real-world
connections

I
train
you
to
be
a
critical
thinker

I
ask
questions,
and
I
expect
you
to
answer

Good
Dynamics
Raise
your
hand
and
ask
me
to
slow
down

Ask
me
to
repeat
any
materials
you
didn't
get

Be
proactive
and
ask
for
help
whenever
you
need

6
/
44
About
Me
Teaching
Style
I
bring
real-world
connections

I
train
you
to
be
a
critical
thinker

I
ask
questions,
and
I
expect
you
to
answer

Good
Dynamics
Raise
your
hand
and
ask
me
to
slow
down

Ask
me
to
repeat
any
materials
you
didn't
get

Be
proactive
and
ask
for
help
whenever
you
need

6
/
44
Syllabus

7
/
44
Syllabus
Final
Grade
Homework
28%:
Seven
Short
Homeworks:
Six
3.5%'s
and
one
7%

In-class
Quizzes
8%:
Two
Quizzes:
4%
each
(redeemable)

Final
Project:
8%:
Topic
on
Universal
Basic
Income.

Details
available
after
the
midterm

Due
on
Mar
11

Midterm
28%:
Monday,
Feb
10
at
4:00
pm

Final
28%:
Monday,
Mar
16
at
2:45
pm

8
/
44
Syllabus
Final
Grade
Bonus
5%:
Ten
In-class
Bonus
Questions:
0.5%
each,
 ve
of
them
will
be
not
be
graded,
and
you
will
get
the
full
credit
for
simply
submitting
it.
I
won't
tell
you
which
 ve
are
these.

9
/
44
Syllabus
Letter
Grade
The
letter
grade
is
what
matters
to
your
GPA.

Letter
grades
are
given
based
on
your
Final
Grade.
Depending
on
the
class
performance,
I
reserve
the
right
to
curve
the
letter
grades:

92
-
105:
A
90
-
92:
A-
87
-
89:
B+
83
-
86:
B
80
-
82:
B-
70
-
79:
C+
60
-
69:
C
0
-
59:
F

10
/
44
Course
Objective

11
/
44
Course
Objective
Become
an
Economist
Learn
Vocabulary

Use
and
Read
Data

Understand
Human
Incentives

Describe
Macroeconomic
Dynamics
(
Intuition
and
Models)

Evaluate
Policies

12
/
44
Course
Objective
Become
Analytic
Think
Critically

Present
Arguments

Transfer
Skills
&
Knowledge

Read
Economics
News

13
/
44
Macroeconomics
Overview

14
/
44
Macroeconomics
What?
De nition:
A
branch
of
economics
dedicated
to
understanding
an
economy
as
a
whole.

Aspects:
Performance,
Structure,
Behavior,
Decision-Making

15
/
44
Macroeconomics
What?
De nition:
A
branch
of
economics
dedicated
to
understanding
an
economy
as
a
whole.

Aspects:
Performance,
Structure,
Behavior,
Decision-Making

Why?
Intellectual
Curiosity:
Understand
(a
part
of)
the
World

Career:
Business
is
subject
to
the
impact
of
macroeconomics

Life:
Make
better
life
decisions

15
/
44
Macroeconomics
What?
De nition:
A
branch
of
economics
dedicated
to
understanding
an
economy
as
a
whole.

Aspects:
Performance,
Structure,
Behavior,
Decision-Making

Why?
Intellectual
Curiosity:
Understand
(a
part
of)
the
World

Career:
Business
is
subject
to
the
impact
of
macroeconomics

Life:
Make
better
life
decisions

15
/
44
Macroeconomics
-
GDP
GDP
GDP
per
capita
is
closely
related
to
life
expectancy:

16
/
44
Macroeconomics
-
GDP
GDP
GDP
per
capita
is
closely
related
to
maternal
mortality
rate:

Maternal mortality ratio vs GDP per capita, 1990 to 2014


Africa
Asia
Sierra
Leone Europe
1,000 North America
Central
African
Republic Chad Nigeria Oceania
Burundi Liberia Democratic
Republic
of
Congo
South America
Niger Kenya
Mozambique Angola
Congo 1990 2014
Tanzania Swaziland
Ethiopia Equatorial
Guinea
Ghana
Maternal mortality (per 100,000 births)

Nepal Namibia
Zambia
Bangladesh India South
Africa
Honduras Indonesia Botswana
100 Venezuela Bahamas
Guatemala
Kyrgyzstan
Syria Colombia Trinidad
and
Tobago
Vietnam Argentina
Iraq
Brazil
Malaysia
Uzbekistan Mexico
Tajikistan Fiji Romania
China
Moldova Ukraine Russia Brunei
Thailand
Oman
Turkey United
States
Qatar
South
Korea
10 Bulgaria Singapore
France
Macedonia
Netherlands
Japan
Israel Switzerland
Italy Sweden Kuwait
Poland
$1,000 $10,000 $100,000
GDP per capita

Source: Gapminder (2010) and World Bank (2015), Penn World Tables CC BY-SA

17
/
44
Macroeconomics
-
GDP
GDP
Economics
is
a
social
science
that
studies
people

At
the
end
of
the
day,
People
want
to
be
happy

Measuring
the
performance
of
an
economy
boils
down
to
how
happy
the
people
are.

GDP
(Gross
Domestic
Production)
is
a
commonly
used
measure
for
happiness
(standard
of
living).

If
a
country
produces
more
goods
in
value
during
a
period
(higher
GDP),
in
general,
the
people
in
that
country
have
more
resources
to
be
happier.

18
/
44
Macroeconomics
-
GDP
GDP
In
the
19th
century,
economists
had
no
measure
of
aggregate
activity.
They
had
to
put
bits
and
pieces
of
information
such
as
the
shipments
of
iron
ore
or
sales
at
some
department
stores
to
infer
what
was
happening
to
the
economy.

Measures
of
aggregate
output
have
been
published
on
a
regular
basis
in
the
United
States
since
October
1947.

The
measure
of
aggregate
output
in
the
national
income
accounts
is
called
the
gross
domestic
product,
or
GDP,
for
short.

19
/
44
Macroeconomics
-
GDP
GDP
Calculation
There
are
two
ways
to
calculate
GDP

Production
Side

Income
Side

Theoretically,
these
two
sides
should
give
you
the
same
results.

20
/
44
Macroeconomics
-
GDP
GDP
-
Production
Side
GDP
Is
the
Sum
of
Value
Added
in
the
Economy
during
a
Given
Period.

Suppose
there
are
 rms
index
by
j,
and
there
are
J 
of
them
in
the


economy.
Firm
j
produces
good
j.

The
quantity
of
good
j
is
q 
during
this
period.
j

Choose
a
year,
say
2010,
and
get
the
market
value
(price)
of
good
j
is
p 
for
that
year.
j

The
GDP
measured
in
2010
dollar
is
Y = q1 p1 + q2 p2 + ⋯ + qJ pJ

21
/
44
Macroeconomics
-
GDP
Firms Quantity2010 Quantity2018 Price2010 Price2018

Pizza 50 100 8 10
Beer 100 200 4 5
Coffee 150 300 1 2

22
/
44
Macroeconomics
-
GDP
Firms Quantity2010 Quantity2018 Price2010 Price2018

Pizza 50 100 8 10
Beer 100 200 4 5
Coffee 150 300 1 2

Compute
GDP
of
the
year
2010
measured
in
2018
dollar
Y 2018

2010

22
/
44
Macroeconomics
-
GDP
Firms Quantity2010 Quantity2018 Price2010 Price2018

Pizza 50 100 8 10
Beer 100 200 4 5
Coffee 150 300 1 2

Compute
GDP
of
the
year
2010
measured
in
2018
dollar
Y 2018

2010

q1 , q2 , q3 = 50, 100, 150 
and
p 1, p2 , p3 = 10, 5, 2

2018
Y = q1 p1 + q2 p2 + q3 p3 = 50 × 10 + 100 × 5 + 150 × 2 = 1300
2010

22
/
44
Macroeconomics
-
GDP
Firms Quantity2010 Quantity2018 Price2010 Price2018

Pizza 50 100 8 10
Beer 100 200 4 5
Coffee 150 300 1 2

23
/
44
Macroeconomics
-
GDP
Firms Quantity2010 Quantity2018 Price2010 Price2018

Pizza 50 100 8 10
Beer 100 200 4 5
Coffee 150 300 1 2

Compute
GDP
of
the
year
2018
measured
in
2010
dollar

23
/
44
Macroeconomics
-
GDP
Firms Quantity2010 Quantity2018 Price2010 Price2018

Pizza 50 100 8 10
Beer 100 200 4 5
Coffee 150 300 1 2

Compute
GDP
of
the
year
2018
measured
in
2010
dollar

q1 , q2 , q3 = 100, 200, 300 
and
p 1, p2 , p3 = 8, 4, 1

2010
Y = q1 p1 + q2 p2 + q3 p3 = 100 × 8 + 200 × 4 + 300 × 1 = 1900
2018

23
/
44
Macroeconomics
-
GDP
Firms Quantity2010 Quantity2018 Price2010 Price2018

Pizza 50 100 8 10
Beer 100 200 4 5
Coffee 150 300 1 2

Compute
GDP
of
the
year
2018
measured
in
2010
dollar

q1 , q2 , q3 = 100, 200, 300 
and
p 1, p2 , p3 = 8, 4, 1

2010
Y = q1 p1 + q2 p2 + q3 p3 = 100 × 8 + 200 × 4 + 300 × 1 = 1900
2018

23
/
44
Macroeconomics
-
GDP
GDP
-
Income
Side
GDP
Is
the
Sum
of
Incomes
in
the
Economy
during
a
Given
Period.

Suppose
there
are
people
index
by
i
and
there
are
I 
of
them
in
the
economy

Person
i
works
h 
hours
during
this
period
i

Person
i's
wage
(dollar
per
hour)
is
w 
during
this
period.
i

The
GDP
is
Y = h1 w 1 + h2 w 2 + ⋯ + hN w N

24
/
44
Macroeconomics
-
In ation
(Hyper)
In ation

25
/
44
Macroeconomics
-
In ation
(Hyper)
In ation

26
/
44
In ation
In ation
Computation
(Pt.1)
In ation
measures
the
price
change
in
percentage.
When
we
compute
the
in ation,
we
need
three
things:

1.
Base
Year:
τ
2.
Start
Year:
T 0

3.
End
Year:
T 1
τ
CP I

Formula:
Π
T
τ 1
= τ − 1
T1 ,T0 CP I
T
0

27
/
44
In ation
In ation
Computation
(Pt.2)
Price
(CPI)
measures
the
value
of
the
basket
of
goods
relative
to
the
base
year.
When
we
compute
the
CPI,
we
need
two
things:
1.
Value
of
Basket
of
Goods
Evaluated
at
the
Base
Year
Price:
V τ

2.
Value
of
Basket
of
Goods
Evaluated
at
the
Year
of
Interest's
Price:

VT

Formula:
CP I τ
T
= VT /Vτ

28
/
44
In ation
In ation
Computation
(Pt.3)
The
basket
of
goods
is
a
 xed
set
of
consumer
products
and
services.

This
basket
contains
what
an
average
consumer
consumes
for
that
year.

The
basket
is
updated,
and
CPI
will
need
revisions
as
long
as
there
are
signi cant
changes
in
consumer
buying
habits
or
shifts
in
population
distribution
or
demographics.

Check
out
the
full
list
through
this
link

29
/
44
In ation
Suppose
in
an
imaginary
country,
the
basket
of
goods
only
contains
pizza,
beer,
coffee,
and
the
base
year
is
2010.
The
consumption
quantities
and
prices
are
given
by

Firms Quantity Price2010 Price2015 Price2018

Pizza 50 8 8 10
Beer 100 4 3 5
Coffee 150 1 2 2

30
/
44
Macroeconomics
-
Recession
Recession

31
/
44
Macroeconomics
-
Recession
Recession
A
period
of
temporary
economic
decline.
Characterized
by
lower
output
and
higher
unemployment
than
what
we
normally
observe.

Recession
is
bad.
People
lose
their
jobs,
houses,
insurance.

Who
gets
hurt
the
most
when
a
recession
hits
the
economy?

Causes
for
recessions.

What
should
we
(as
you
and
me)
do?
(Consumption,
Saving,
Asset
Portfolio)

What
should
policymakers
do?
(Monetary
Policy,
Fiscal
Policy)

32
/
44
Macroeconomics
-
Interest
Rate
Interest
Rate

33
/
44
Macroeconomics
-
Growth
Growth

34
/
44
Macroeconomics
-
Growth
Growth

0:00

35
/
44
Macroeconomics
-
Growth
Growth
Is
growth
a
historical
trend?

What
makes
an
economy
grow
in
the
 rst
place?
Human
Capital,
Physical
Capital,
Technology,
Institution,
Culture
...

Why
do
some
economies
grow
whereas
some
others
do
not?

Can
the
less
prosperous
countries
learn
from
the
prosperous
countries?

36
/
44
Macroeconomics
-
Government
De cit
Government
De cit

37
/
44
Macroeconomics
-
De cit
Government
De cit

38
/
44
Macroeconomics
-
De cit
Government
De cit

39
/
44
Macroeconomics
-
De cit
Government
De cit
The
U.S.
federal
budget
de cit
for
the
 scal
year
2020
is
$1.103
trillion

The
de cit
occurs
because
the
U.S.
government
spending
of
$4.746
trillion
is
higher
than
its
tax
revenue
of
$3.422
trillion.

The
de cit
is
18
percent
greater
than
last
year.

40
/
44
Macroeconomics
-
De cit
Government
De cit
De cit
=
Government
Spending
-
Tax
Revenue

Why
do
we
need
Government
Spending

Boost
Economy
(That's
why
political
parties
overspend
on
purpose)

Provide
Public
Goods

Flood
Control
in
the
Netherlands
v.s.
Hurricane
Katrina

Education

Defense

41
/
44
Macroeconomics
-
De cit
Government
De cit
Why
do
we
need
Tax

To
Finance
Government
Spending

To
Provide
Incentives
(Externalities)

Why
don't
we
like
Tax

American
Traditional
Value
(Small
Government)

Market
Distortion
(Can
be
partially
avoided)

Coporation
Lobbying
(Tax
Cuts
 ⟹ 
Ef ciency
 ⟹ 
More
Revenue)

42
/
44
Macroeconomics
-
The
Big
Picture
Money
Flow
Reverse
the
money
 ow,
you
get
the
goods/assets
 ow

43
/
44
Macroeconomics
-
The
Big
Picture
Money
Flow
Markets:

Goods
Market
-
Next
Two
Lectures

Money
Market

Labor
Market

International
Financial
Market

Policies

Monetary
Policy

Fiscal
Policy
44
/
44
Overview- Aggregate
Demand
Supply
Short-Run Consumption
Investment
Government
Net
Equilibrium
ExportDemand
Spending
Consumption
Questions
Short-run
Production,
Mathematical
The
Consumption
Average
MPC
Linear
Investment
Government
Net
Aggregate
Short-Run
Equilibrium
Why Export
Demand
Varies
c
decisions
Consumption
Changes
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Supply
(X-IM)
Across
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v.s. areand
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debt. This
an increasing average
0 0 NX
1

is why household
function
= X − IM
running and
in Ymultiplier rm as the
a persistent de cit is
This
record It magic
is numbers." number
reasonable to
1
is what
assume, on weaverage,
call D
households save some in and
representatives
dangerous. Long-run: Time Horizon
1−c1
over which there is a constant change
if the spendgovernment some of starts
their a trade war with a major trading partner?
income.
aggregate output. Typically thought of like 20+ years (Ch. 10-13).
More assumptions
Institution Driven along Economy.the way...

40
30
44
20
38
28
36
26
34
39
29
43
42
35
33
24
25
10
23
22
32
18
16
14
19
37
27
15
13
12
41
31
21
17
11
8
6
45327 / 44
9
Book Chapter 3

2 / 44
Overview

3 / 44
Overview
Questions
By studying the goods market, we can answer the following questions.

What happens to the GDP in the short run

if households save more?

if the rms make less investiment?

if the government cuts government spending?

if the government transfers some wealth from the rich to the poor?

if the government starts a trade war with a major trading partner?

4 / 44
Overview
Questions
Before we can answer these questions, we need to

know what the short-run means in economics

the demand side behavior in the short run

the supply side behavior in the short run

the equilibrium in the short run

5 / 44
Overview
Short-run v.s. Medium-run v.s. Long-run
Fluctuation in GDP:

Short-run: Time horizon over which the price level is xed. Typically
anything less than one or two years (Ch. 3-5). Demand Driven
Economy.

Medium-run: Time Horizon over which the price level does vary.
Typically thought of as 5-10 years (Ch. 6-9). Supply Driven Economy.

Growth in GDP

Long-run: Time Horizon over which there is a constant change in


aggregate output. Typically thought of like 20+ years (Ch. 10-13).
Institution Driven Economy.
6 / 44
Overview
Production, Income, and Demand
When economists think about economic uctuations in the short-run, they
focus on the interactions among production, income, and demand:

Increase in the demand for goods leads to increase in production

Increase in production leads to increase in income

Increase in income leads to increase in the demand for goods

7 / 44
Overview
Production, Income, and Demand

8 / 44
Overview
Mathematical Models
Model: A method of simulating real-life situations with mathematical
equations to forecast future behavior.

Q: How can we possibly represent all of the human behavior (the goal of
economics) with equations?

A: We can't - so we make simplifying and mostly innocuous assumptions!

9 / 44
Overview
Mathematical Models
A few dif culties in describing the reality with a model of a few equations
and the corresponding assumptions we make for the rest of the lecture
(and the course)

Reality 1: So many different commodities

Assumption 1: Use Dollar as the unit to sum up different goods

Reality 2: There are so many households and rms

Assumption 2: Use the average household and rm as the


representatives

More assumptions along the way...

10 / 44
Demand

11 / 44
Demand
The Demand for Goods
Comsumption (C) by the households

Investment (I) by the rms

Government Spending (G) by the government

Net Export (X - IM) from a broad.

12 / 44
Demand
The Demand for Goods

13 / 44
Demand - Consumption
Consumption decisions are made by ordinary people (households)

Why do we want to consume?

Why don't we want to consume?

It is a trade off between present happiness and future happiness.

14 / 44
Demand - Consumption
Consumption
Largest component of GDP (70% in 2010)

The goods and services purchased by consumers. Ranging from food to


airplane tickets, to new cars, and services

In general, consumption is a function of disposable income, which is


the income after taxes. We can denote the function as C = f (Y )
C
D

where Y = Y − T . Here Y is income and T is tax.


D

Here f (⋅) is the consumption function and Y is the disposable


C
D

income. f is an increasing function in Y


C
D

15 / 44
Demand - Consumption
Consumption
It is reasonable to assume a linear functional form for
f (Y ) = c + c Y , where c and c are the parameters that have
C
D 0 1 D 0 1

speci c economic meanings.

Parameter c denotes the amount of goods an average household


0

consumes when they have no disposable income.

Parameter c denotes the marginal propensity to consume (MPC). For


1

each dollar an average household makes, they consume c out of the


1

one dollar.

16 / 44
Demand - Consumption
Consumption
Q: What boundaries should we place on c and c
0 1

c0 is positive

c1 is between 0 and 1

Q: Why are these restrictions made?

If c < 0, we would have negative consumption when Y


0 D = 0 , which
is impossible.

It is reasonable to assume, on average, households save some and


spend some of their income.

17 / 44
Demand - Consumption
Linear Consumption Function

18 / 44
Demand - Consumption
Average MPC v.s. Individual MPC
Note that the consumption function characterizes an average
household in the economy.

In reality, each individual probably has a different personal


consumption function. Think about yourself for a second.

In general, a richer household has a lower MPC parameter of c . Why?


1

19 / 44
Demand - Consumption
MPC Varies Across Individuals

20 / 44
Demand - Consumption
Linear Consumption Function
We are interested in National Income Y , which is the variable of
interest.

Consumption itself is a function of the variable of interest

C
C = f (YD ) = c0 + c1 (Y − T )

In this case, we call consumption C an endogeneouns variable. A


model has the power to explain the behaviors of the endogeneous
variables.

21 / 44
Demand - Investment
Investment
Account for 12% of the GDP in 2010

Nonresidential investment: purchases by rms of new plants or new


machines.

Residential investment: purchases by people of new houses or


apartments.

22 / 44
Demand - Investment
Investment
To simplify the model, we treat investment I as a constant number, and
write I = I¯. Is this a realistic assumption? If it is not realistic, why
should we still use this model?

We will relax this assumption when we discuss the nancial market in


the future

Since I is a constant number that does not depend on the variable of


interest Y , we call I an exogenous variable. A model does not have the
power to explain the exogenous variables.

23 / 44
Demand - Government Spending
Government Spending
The purchases of goods and services by the federal, state, and local
governments.

This measure does not include direct government transfers like social
security, food stamps, Medicaid, etc.

24 / 44
Demand - Government Spending
Government Spending
Together with taxes T , government spending G describes scal policy

Just as we did for investment, we will take T and G as exogeneous,


because

T and G do not have the same regularity as consumers or rms.

We don't want the model to decide T and G; we want to answer


questions like "If the government were to choose these values for G
and T, this is what would happen"

25 / 44
Demand - Net Export
Net Export (X-IM)
Also known as the trade balance, this is the difference between goods
American companies sell consumers in other countries and goods
purchased by American citizens from rms located in other countries.

Q: Do you think America typically has a trade surplus (X>IM) or a trade


de cit (X<IM)?

26 / 44
Demand - Net Export
Net Export (X-IM)

27 / 44
Demand - Net Export
Net Export (X-IM)
Net Export is mainly in uenced by the economic condition of the world,
interest rates, and exchange rates.

Our model has no power to explain the uctuations in Net Export. (Not
our focus)

Again, we treat Nex Export as exogeneous

Let X be the export and IM be the import, we have

N X = X − IM

28 / 44
Demand - Aggregate Demand
Aggregate Demand
Adding up all of the demand components, we get the aggregate demand
denoted as Z

Z = C + I + G + NX

Substitute in C , we get

Z = c0 + c1 (Y − T ) + I + G + N X

29 / 44
Supply

30 / 44
Supply
Short-Run Supply
In the short-run

Supply is the passive side of the economy. We assume that rms will
supply any amount of consumption goods for a given price level P.

Y = Z

Demand is the driving side of the economy.

"Production and sales of automobiles were higher last month due to a


surge in consumer con dence, which drove consumers to showrooms in
record numbers."

31 / 44
Short-Run Equilibrium

32 / 44
Short-Run Equilibrium
Equilibrium
Demand:

Demand Component: Z ¯ + G + NX
:= C + I

Linear Consumption Function: C = c0 + c1 Y D

Disposable Income De nition: Y D = Y − T

Supply:

Short-Run Supply: Y = Z

33 / 44
Short-Run Equilibrium
Equilibrium
Demand:

Demand Component: Z ¯ + G + NX
:= C + I

Linear Consumption Function: C = c0 + c1 Y D

Disposable Income De nition: Y D = Y − T

Combining these three equations:

Short-Run Demand Z ¯ + G + NX
= c0 + c1 (Y − T ) + I

34 / 44
Short-Run Equilibrium
Equilibrium Analysis - Model
Equilibrium

Combine these four equations and solve for Y , we get the following
equilibrium relation

c0 c1 1
Y = − T + ¯ + G + N X)
(I
1 − c1 1 − c1 1 − c1

Now we can answer the questions raised at the beginning of the class

35 / 44
Short-Run Equilibrium
Equilibrium Analysis - Model
1 c1
Y = (c0 ¯ + G + N X) −
+ I T
1 − c1 1 − c1

What if households save less? i.e. higher c 0

c0 increases by 1 unit, Y increases by 1−c1


1
units.

What if rms make more investment? i.e. higher I¯

¯
I increases by 1 unit, Y increases by 1−c1
1
units.

36 / 44
Short-Run Equilibrium
Equilibrium Analysis - Model
1 c1
Y = (c0 ¯ + G + N X) −
+ I T
1 − c1 1 − c1

What if the government increases the spending? i.e. higher G

G increases by 1 unit, Y increases by 1

1−c1
units.

What if there is more Net Export? i.e. higher N X

NX increases by 1 unit, Y increases by 1

1−c1
units.

This magic number 1−c1


1
is what we call multiplier

37 / 44
Short-Run Equilibrium
Equilibrium Analysis - Model
1 c1
Y = (c0 ¯ + G + N X) −
+ I T
1 − c1 1 − c1

The only element that does not work with the multiplier is income tax

The tax multiplier is − , which means if tax goes up by 1 dollar, GDP will
c1

1−c1

decrease by − dollars.
c1

1−c1

If the government has accumulated a lot of debt, they eventually need to


raise the tax, and the increased tax is not used on government spending
but on paying off the debt. This is why running a persistent de cit is
dangerous.

38 / 44
Short-Run Equilibrium
Equilibrium Analysis - Model
1 c1
Y = (c0 ¯ + G + N X) −
+ I T
1 − c1 1 − c1

What happens to GDP if the government takes 1 dollar tax and spends this
1 dollar?

Hint: two things are going on:

T goes up by 1 dollar

G goes up by 1 dollar

39 / 44
Short-Run Equilibrium
Equilibrium Analysis - Graphics

40 / 44
Short-Run Equilibrium
Equilibrium Analysis - Graphics

41 / 44
Short-Run Equilibrium
Equilibrium Analysis - Words
Production depends on demand, which depends on income, which is itself
equal to production. An increase in demand, such as an increase in
government spending, leads to an increase in production and a
corresponding increase in income. This increase in income leads to a
further increase in demand, which leads to a further increase in
production, and so on.

42 / 44
Short-Run Equilibrium
Why c Changes
0

Why would consumers increase or decrease consumption if their


disposable income has not changed?

Or, in terms of the linear consumption function, why might c increase


0

or decrease leading in turn to an increase or decrease in demand,


output, and so on?

Why do you think?

43 / 44
Short-Run Equilibrium
Why c Changes
0

Many economists use the word "animal spirit" to explain the changes in
c .
0

For example, when people saw the bankruptcy of Lehman in 2008, they
started to worry that the economy would be going down and hence cut
their consumption, even though at that particular moment their income
hadn't gone down yet.

This change in animal spirit is a self-ful lling prophecy - think about


what happens to GDP after c goes down...
0

44 / 44
Review
Overview
IS
Savings
Investment
Equilibrium
Application
Relation -Consumption
Computation
Responsive
Crowding Out
Tax
In
Consider
the last
Goals
Equilibrium
Why?
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Aggregate
Investment
Solve
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Paradox
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that
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−))
+ G(+ c
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1)
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i the 0ismultiplier
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and
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for
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(
1
0.5
1 − c
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I0
= N CI
F
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1 − c
1 T) 1

1 1

f) What is demand when c = 100 NX ? Does


= −N itCI
equal output?
2) tIf i= increases
d) 0 and c = (crowding
0.5 out effect is more intense), how does the
0

HereUse
1
NCIgraphs
1
is the net
andcapital
words in
1
ow and N
to describe the
CIbehavior
= CI − of
CO the goods market.
multiplier for c changes? How does the multiplier for G change?
0

40
30
20
38
28
36
26
34
39
29
43
42
35
33
24
25
10
23
22
32
18
16
14
19
37
27
15
13
12
41
31
21
17
11
8
6
45327 / 43
9
Book Chapter 3

2 / 43
Review

3 / 43
Review
In the last lecture, we studied the goods market in the short-run.

Demand

Linear Consumption Function

Disposable Income

Supply

Equilibrium

Multipliers for c , I¯, G, N X


0

The multiplier for T

Use graphs and words to describe the behavior of the goods market.

4 / 43
Overview

5 / 43
Overview
Goals of this lecture
In the last lecture, we derived the equilibrium output equation by studying
the goods market. In this lecture, we will:

Derive the equation for equilibrium consumption equation.

6 / 43
Overview
Goals of this lecture
In the last lecture, we derived the equilibrium output equation by studying
the goods market. In this lecture, we will:

Derive the equation for equilibrium consumption equation.

Derive the Investment-Equal-Saving (IS) relation from the goods


market equilibrium

6 / 43
Overview
Goals of this lecture
In the last lecture, we derived the equilibrium output equation by studying
the goods market. In this lecture, we will:

Derive the equation for equilibrium consumption equation.

Derive the Investment-Equal-Saving (IS) relation from the goods


market equilibrium

Discuss the Fiscal Policy

6 / 43
Overview
Goals of this lecture
In the last lecture, we derived the equilibrium output equation by studying
the goods market. In this lecture, we will:

Derive the equation for equilibrium consumption equation.

Derive the Investment-Equal-Saving (IS) relation from the goods


market equilibrium

Discuss the Fiscal Policy

Analyze more real-life examples and applications using the short-run


goods market model.

6 / 43
Equilibrium Consumption

7 / 43
Equilibrium Consumption
Equilibrium Consumption
Consumption is an endogeneous variable in the Goods Market Model,
which means the model can be used to explain consumption.

8 / 43
Equilibrium Consumption
Equilibrium Consumption
Consumption is an endogeneous variable in the Goods Market Model,
which means the model can be used to explain consumption.

Let's derive the equilibrium consumption equation.

8 / 43
Equilibrium Consumption
Equilibrium Consumption
Recall

C = c0 + c1 (Y − T )

9 / 43
Equilibrium Consumption
Equilibrium Consumption
Recall

C = c0 + c1 (Y − T )

Also in equilibrium

1 c1
Y = ¯ + G + N X) −
(c0 + I T
1 − c1 1 − c1

9 / 43
Equilibrium Consumption
Equilibrium Consumption
Recall

C = c0 + c1 (Y − T )

Also in equilibrium

1 c1
Y = ¯ + G + N X) −
(c0 + I T
1 − c1 1 − c1

The equilibrium consumption is

1 c1
C = c0 + c1 ( ¯ + G + N X) −
(c0 + I T − T)
1 − c1 1 − c1

9 / 43
Equilibrium Consumption
Equilibrium Consumption
The equilibrium consumption is

1 c1
C = c0 + c1 ( (c0 ¯ + G + N X) −
+ I T − T)
1 − c1 1 − c1

10 / 43
Equilibrium Consumption
Equilibrium Consumption
The equilibrium consumption is

1 c1
C = c0 + c1 ( (c0 ¯ + G + N X) −
+ I T − T)
1 − c1 1 − c1

1 1
= c0 + c1 ( ¯ + G + N X) −
(c0 + I T)
1 − c1 1 − c1

11 / 43
Equilibrium Consumption
Equilibrium Consumption
The equilibrium consumption is

1 c1
C = c0 + c1 ( (c0 ¯ + G + N X) −
+ I T − T)
1 − c1 1 − c1

1 1
= c0 + c1 ( ¯ + G + N X) −
(c0 + I T)
1 − c1 1 − c1

12 / 43
Equilibrium Consumption
Equilibrium Consumption
The equilibrium consumption is

1 c1
C = c0 + c1 ( (c0 ¯ + G + N X) −
+ I T − T)
1 − c1 1 − c1

1 1
= c0 + c1 ( ¯ + G + N X) −
(c0 + I T)
1 − c1 1 − c1

c1
= c0 + ( ¯ + G + N X − T ))
(c0 + I
1 − c1

13 / 43
Equilibrium Consumption
Equilibrium Consumption
The equilibrium consumption is

1 c1
C = c0 + c1 ( (c0 ¯ + G + N X) −
+ I T − T)
1 − c1 1 − c1

1 1
= c0 + c1 ( ¯ + G + N X) −
(c0 + I T)
1 − c1 1 − c1

c1
= c0 + ( ¯ + G + N X − T ))
(c0 + I
1 − c1

1 c1
= c0 + ¯ + G + NX − T )
(I
1 − c1 1 − c1

14 / 43
Equilibrium Consumption
Equilibrium Consumption
The equilibrium consumption is

1 c1
C = c0 + ¯ + G + NX − T )
(I
1 − c1 1 − c1

15 / 43
Equilibrium Consumption
Equilibrium Consumption
The equilibrium consumption is

1 c1
C = c0 + ¯ + G + NX − T )
(I
1 − c1 1 − c1

When c goes up by $1, equilibrium consumption goes up by $


0
1

1−c1

15 / 43
Equilibrium Consumption
Equilibrium Consumption
The equilibrium consumption is

1 c1
C = c0 + ¯ + G + NX − T )
(I
1 − c1 1 − c1

When c goes up by $1, equilibrium consumption goes up by $


0
1

1−c1

When either I¯, or G or N X goes up by $1, equilibrium consumption


goes up by
c1

1−c1

15 / 43
Equilibrium Consumption
Equilibrium Consumption
The equilibrium consumption is

1 c1
C = c0 + ¯ + G + NX − T )
(I
1 − c1 1 − c1

When c goes up by $1, equilibrium consumption goes up by $


0
1

1−c1

When either I¯, or G or N X goes up by $1, equilibrium consumption


goes up by
c1

1−c1

When T goes up by $1, equilibrium consumption goes down by


c1

1−c1

15 / 43
IS Relation
Why?
Investment Equal Savings is just another way to describe the goods
market. Since our object of interest is still the same, the equilibrium should
be the same as well.

In the end, we should get the same equilibrium equation:

1 c1
Y = (c0 ¯ + G + N X) −
+ I T
1 − c1 1 − c1

The only difference is: instead of using Goods Demand = Goods Supply, we
use Investment = Savings.

16 / 43
IS Relation
Why?
We already have a way to model the goods market equilibrium.

Demand for Goods = Supply for Goods

However, our ultimate goal is to describe the whole economy, which also
contains the money market.

To establish the connection, we need to nd another perspective to look at


the goods market.

This alternative perspective is the Investment-Equal-Saving (IS) relation

17 / 43
IS Relation
Why?

18 / 43
Savings

19 / 43
Savings
Savings
Just like when we consider the components of consumption, we rst
consider the components of saving.

Consumers: S C

Government: S G

Foreigners: S F

Think about the question, who saves in the economy? The answer is
whoever consumes saves

20 / 43
Savings
Savings - Consumers
The consumers has the disposable income Y and spends C , their saving
D

would be S = Y − C , recall Y = Y − T . Hence we have the following


C D D

consumer saving equation

SC = Y − T − C

Also, note the consumption is endogenous in the model because C


depends on Y , i.e. the linear consumption funciton C = c + c (Y − T ),
0 1

and thus we can further write

SC = Y − T − (c0 + c1 (Y − T ))

21 / 43
Savings
Savings - Government
The government has a tax revenue of T and spends G. Hence we have the
following government saving equation

SG = T − G

Note that in macroeconomics government saving is also called government


surplus

22 / 43
Savings
Savings - Foreigners
Foreigners also save, and some of their savings end up coming into our
economy, and that is the part we are interested in when we study an
economy. The part of foreign saving that ows into our economy is called
capital in ow (CI)

Just like export and import, when there is capital in ow, there is also
capital out ow (CO), which is domestic saving that goes abroad.

The true saving from broad that ows into the economy is the difference
between in ow and out ow, and thus we have the following condition:

SF = N CI

Here NCI is the net capital in ow and N CI = CI − CO

23 / 43
Savings
Aggregate Savings
The aggregate saving available in the economy can be computed as follows.

S = SC + SG + SF

= Y − T − (c0 + c1 (Y − T )) + T − G + N CI

= Y − (c0 + c1 (Y − T )) − G + N CI

24 / 43
Investment

25 / 43
Investment
Investment
The aggregate investment is straightforward, and you have seen this
already.

26 / 43
Investment
Investment
The aggregate investment is straightforward, and you have seen this
already.

¯
I = I

That is to say; investment is exogeneous to the model we are considering.

26 / 43
Equilibrium

27 / 43
Equilibrium
Solve for the equilibrium
The equilibrium is de ned by equating savings to investment

I = S

¯ = Y − (c + c (Y − T )) − G + N CI
I 0 1

Solving for Y, we get the following equation that characterizes the goods
marker equilibrium

1 c1
Y = (c0 ¯ + G − N CI ) −
+ I T
1 − c1 1 − c1

Does this look familiar? It does!

28 / 43
Equilibrium
Comparing Two Methods
Using Goods Demand = Goods Supply, we get (from the last lecture)

1 c1
Y = ¯ + G + N X) −
(c0 + I T
1 − c1 1 − c1

Using Investment = Savings, we get

1 c1
Y = (c0 ¯ + G − N CI ) −
+ I T
1 − c1 1 − c1

Theoretically, these two equations should be the same. How would we


make these two equations identical?

29 / 43
Equilibrium
Comparing Two Methods
Using Goods Demand = Goods Supply, we get (from the last lecture)

1 c1
Y = ¯ + G + N X) −
(c0 + I T
1 − c1 1 − c1

Using Investment = Savings, we get

1 c1
Y = (c0 ¯ + G − N CI ) −
+ I T
1 − c1 1 − c1

Theoretically, these two equations should be the same. How would we


make these two equations identical?

N X = −N CI

29 / 43
Equilibrium
Comparing Two Methods
What does this equation mean?

N X = −N CI

The amount of the net export one economy is equal to the amount of net
capital out ow

The Lucas paradox: the observation that capital does not ow from
developed countries to developing countries, although developing
countries have lower levels of capital per worker.

30 / 43
Equilibrium
Paradox of Saving
"Those who save are promised a happy life."

This saying does not apply to our short-run model.

31 / 43
Equilibrium
Paradox of Saving
"Those who save are promised a happy life."

This saying does not apply to our short-run model.

What happens if people choose to save more - c decrease?


0

What happens to the equilibrium output?

What happens to equilibrium consumption?

What happens to equilibrium consumer saving?

31 / 43
Equilibrium
Paradox of Saving - Output
Let's say c goes down by one dollar.
0

32 / 43
Equilibrium
Paradox of Saving - Output
Let's say c goes down by one dollar.
0

Recall the equilibrium output equation from the goods market.

1 c1
Y = (c0 ¯ + G + N X) −
+ I T
1 − c1 1 − c1

Equilibrium Output Y would go down by 1

1−c1

32 / 43
Equilibrium
Paradox of Saving - Consumption
Let's say c goes down by one dollar.
0

33 / 43
Equilibrium
Paradox of Saving - Consumption
Let's say c goes down by one dollar.
0

Recall the equilibrium consumption equation from the goods market.

1 c1
C = c0 + ¯ + G + NX − T )
(I
1 − c1 1 − c1

Equilibrium Consumption C would go down by 1

1−c1

33 / 43
Equilibrium
Paradox of Saving - Consumer Saving
Let's say c goes down by one dollar.
0

34 / 43
Equilibrium
Paradox of Saving - Consumer Saving
Let's say c goes down by one dollar.
0

In equilibrium, the households/consumers' saving is

SC =YD − C

=Y − T − C

1 c1
=( ¯ + G + N X) −
(c0 + I T) − T
1 − c1 1 − c1

1 c1
− ( c0 + ¯ + G + N X − T ))
(I
1 − c1 1 − c1

¯ + G + NX − T
=I

34 / 43
Equilibrium
Paradox of Saving - Consumer Saving
Let's say c goes down by one dollar.
0

In equilibrium, the households/consumers' saving is

¯ + G + NX − T
SC = I

The equilibrium S does not depend on c !!


C 0

35 / 43
Equilibrium
Paradox of Saving - Consumer Saving
Let's say c goes down by one dollar.
0

In equilibrium, the households/consumers' saving is

¯ + G + NX − T
SC = I

The equilibrium S does not depend on c !!


C 0

This means if c goes down by one dollar, consumer saving doesn't


0

change!!

35 / 43
Application - Computation

36 / 43
Application - Computation
Consider an economy that has the following setup:

c0 = 100 c1 = 0.6 ¯ = 150


I

G = 140 N X = 10 T = 100

a) What is the net capital in ow (NCI)?

b) What is the equilibrium output?

c) What is disposable income

d) What is consumption

e) If c decreases to 50, what is the change in equilibrium output?


0

f) What is demand when c 0 = 100 ? Does it equal output?

37 / 43
Application - Responsive Tax

38 / 43
Application - Responsive Tax
Responsive Tax
Consider a close economy with reponsive ( scal) tax policy where tax T is a
function of output Y.

Z = C + I + G

C = c 0 + c 1 YD

T = t0 + t1 Y

a) Solve for the equilibrium output interms of the exogeneous variables.

b) What is the multiplier for c 0

c) Is the multiplier for c higher or lower when t is 0 or when t is positive?


0 1 1

39 / 43
Application - Responsive Tax
Responsive Tax
Consider a closed economy (NX = 0) with reponsive ( scal) tax policy where
tax T is a function of output Y.

Z = C + I + G

C = c 0 + c 1 YD

T = t0 + t1 Y

d) What is your intuition for your answer to c)

e) Suppose c increase by $300. What is the change in equilibrium Y when


0

1) t 1 = 0.2 and c 1 = 0.5

2) t 1 = 0 and c 1 = 0.5

40 / 43
Application - Crowding Out

41 / 43
Application - Crowding Out
Crowding Out
Consider a closed economy (NX = 0) where government spending crowds
out investment.

Z = C + I + G

C = c 0 + c 1 Yd

I = i0 − i1 G

a) Solve for the equilibrium output interms of the exogeneous variables.

b) What is the multiplier for c 0

c) What is the multiplier for G

d) If i increases (crowding out effect is more intense), how does the


1

multiplier for c changes? How does the multiplier for G change?


0

42 / 43
Application - Crowding Out
Crowding Out
Consider a closed economy (NX = 0) where government spending crowds
out investment.

Z = C + I + G

C = c 0 + c 1 Yd

I = i0 − i1 G

e) Suppose G increase by $300. What is the change in equilibrium Y when

1) i 1 = 0.2 and c 1 = 0.5

2) i 1 = 0 and c 1 = 0.5

43 / 43
Overview
Money
Demand
Money
Supply
Money
Market
Equilibrium
Overview
Money
Demand
Money
Demand
-
Graph
Money
Supply
Equilibrium
-
Math
Model
Equilibrium
-
Graphs
Demo
Equilibrium
-
Intuition
Equilibrium
-
Recession
and
QE
Choosing
Money
Or
Choosing
the
Interest
Rate
Why
study

Recall
that
the
goods
market
model
is
built
to
study
one
speci
There
are
two
types
of
money:
Now
Money:
Future
Money:
Note:
bond
price
goes
up,
the
interest
rate
goes
down.
For
example,
you
go
to
the
bonds
market
and
buy
a
piece
of
paper
that
will
We
will
focus
on
the
(now)
money
market
and
analyze
the
behavior
of
the
Why
does
an
average
household
hold
a
mixture
of
bonds
and
money?
What
determines
an
average
household's
proportion
of
bond
holdings
Use

Q:
What
happens
when
the
interest
rate
increases
or
decreases
in
our
Interest
Rate
on
Bonds:
the
higher
the
interest
rate
on
bonds,
the
more
In
the
real
world,
there
are
two
types
of
money:
Recall
that
both
the
Federal
Reserve
and
Commercial
Banks
can
supply
In
this
lecture,
let's
make
a
simplifying
assumption:
Q:
If
the
money
supply
is
exogenous,
what
will
the
equation
for
MS
look
In
equilibrium,
we
have
the
following
equations.
Q:
What
happens
to
equilibrium

During
the
great
recession
(around
2008),
we
witnessed
that
interest
rates
We
have
described
the
central
bank
as
choosing
the
money
supply
and
Now
we
can
characterize
money
supply

M
D

to
denote
money
demand.
This
can
be
thought
of
as
the
demand
nancial
markets? i
when
money
supply
(M)
decreases?

when
nominal
income
($Y)
decreases?
M .
Since
the
money
supply
is
S
c
macroeconomic
variable
-
aggregate
output.
The

give
you
a
claim
of
$1000
in
a
year
at
the
price
of
$900.
The
yearly
interest
economy
at
equilibrium
and
money
holdings?
for
liquidity
by
all
indivisuals:
graph?
bonds
and
less
money
I
will
hold
(for
a

money.
like?
dropped
in
most
countries.
Use
what
we
learned
in
today's
class
(math
letting
the
interest
rate
be
determined
at
the
point
where
money
supply
entirely
determined
by
the
central
bank,
it
is
reasonable
to
assume
the
xed
level
of
transactions).
nancial
market
model
A:
To
understand
how
the
interest
rate
is
determined
in
the
short
run!
Now
Money
-
we
also
call
this
money.
It
is
the
money
we
use
to
buy
goods
(Now)
Money,
which
you
can
use
for
transactions,
pays
no
interest.
Demand
for
(now)
money
comes
from
each
individual.
At
the
end
of
the
Supply
for
(now)
money
comes
from:
There
are
lots
of
types
of
future
money
(assets)
one
can
buy.
Bonds
are,
simply
put,
IOUs
(read:
I
owe
yous)
whose
price
is
less
than
the
Assumption:
There
are
no
commercial
banks
in
our
economy.
A:
Recall
Now
money
is
used
to
ful
I
need
to
make
transactions!
Ex:
I
buy
food
and
beer
almost
every
day.
I
Currency:
Money
supplied
by
central
banks.
This
is
the
paper
(or
coin)
Checkable
Deposits:
Money
supplied
by
commercial
banks.
Households
need
less
money
because
the
level
of
transactions
goes
There
is
less
money
supply
from
the
central
bank.
ll
the
transactions
they
need
to
make.
M
D
= $Y L(i)
we
are
going
to
build
is
intended
to
study
the
behavior
of
another
rate
of
this
bond
is:
model,
graphs,
and
intuitions)
to
explain
this
phenomenon.
equals
money
demand.
money
supply
is
exogeneous
like
groceries,
services,
food.
day,
it
is
people
who
need
cash
to
complete
transactions.
face
value.
A:
We
move
along
the
curve
MD.
cannot
use
bonds
to
purchase
beer,
so
I
make
sure
that
I
have
some
Level
of
Transactions:
the
more
purchases
I
make,
the
more
money
(and
The

money
that
we
use
daily.
The
Federal
Reserve
supplies
money
by
providing
central
bank
money
down. M
D

curve
is
graphed
for
a

M
DD
M
S
xed
level
of
nominal
income.
S
Money
Demand
=
Money
Supply
MM (i) = =
$Y M
$YL(i)
L(i)
macroeconomics
variable
-
interest
rate. = M

Money
Market
Equilibrium
Money
Demand
Book
Chapter
4
Money
Supply
Overview
The
goods
market
we
outlined
in
Chapter
3
did
not
include
an
interest
rate,
The
federal
reserve
bank
and
commerical
banks
We
will
relax
this
assumption
in
the
next
lecture
by
including
the
Currency:
paper
money,
coins,
etc.
The
more
transactions
they
need
to
make,
the
more
now
money
they
Government
bonds
To
meet
the
needs
of
the
money
demand,
households
need
to
sell
their
When
your
paycheck
is
directly
deposited
to
your
bank
account,
this
commercial
banks
in
our
model.
need.
M
M = $Y L(i)
Hint:
During
the
recession,
most
central
banks
around
the
world
also
money.
fewer
bonds)
I
will
hold
(for
a

Money
supply
being
exogenous
means
it
doesn't
depend
on
the
Money
Market
-
Part
1
$1000 − $900D
M = xed
interest
rate).
= M
$Y L(i) S

Recall,
M,
is
assumed
to
be
exogenous.
We
assume
the
Central
Bank
Notice
the
supply
for
money
comes
from
the
Central
Bank
(the
Fed).
This
but
in
the
real
world,
the
interest
rate
is
mentioned
in
the
news
almost
Future
Money
-
we
call
this
asset.
It
is
just
like
the
other
commodities,
it
is
Money
can
be
used
for
transactions
because
money
is
liquid
compared
to
Suppose
the
price
for
a
one-year
bond
is

Q:
What
happens
when
nominal
GDP
increases
or
decreases
in
our
graph?
Therefore,
a
change
in
the
interest
rate
moves
us
along
the
MD
curve!
The
Commerical
Banks
supply
money
by
money
recreation.
Households
want
to
buy
future
money
(bonds).
future
money
(bonds).
Currency
is
the
physical
money
that
we
carry
around.
is
a
checkable
deposit.
( )
P 
and
the
face
value
is
F ,
the
∗ 100% = 11.11%
where
"$Y"
is
nominal
GDP,
and
"i"
is
the
nominal
interest
rare.
where
"$Y"
is
nominal
income,
and

increased
their
money
supply
as
a
response. i
is
the
nominal
interest
rare.
Just
like
any
other
market
where
selling
and
buying
happens,
the

variable
of
interest
in
our
model,
which
is
the
interest
rate.
$900 b
nancial
The
left-hand
side

(Monetary
Policy) M 
goes
down.

is
unchanged.
Checkable
Deposits:
deposits
you
have
stored
with
a
bank.
Houses
arbitrarily
chooses
M,
and
its
choice
is
independent
of
interest
rates,
model
gives
us
insight
into
how
the
central
bank
can
in uence
the
money
It
is
useful
to
think
about
the
central
bank
as
choosing
the
interest
rate.
Given
the
nominal
GDP
$Y
and
function

every
day!
something
we
can
buy
using
money
today.
assets
(future
money).
interest
rate
is
given
by L(⋅),
the
government
can
achieve
Thankfully,
I
do
not
spend
ALL
of
my
money
on
beer
and
food.
If
I’m
not
Interest
Rate
on
Bonds:
the
higher
the
interest
rate
on
bonds,
the
more
Solve
these
equations,
we
get
EC
313,
Macroeconomics
market
has
its
own
commodity
-
money.
A:
We
shift
the
MD
curve!
What
is
the
opportunity
cost
of
now
money?
-
having
less
future
Also,
i
is
on
our
vertical
axis.
If
a
variable
is
on
one
of
the
axes
of
a
Demand
for
bonds
for
future
money
goes
up.
The
supply
for
bonds
goes
up.
The
Federal
Reserve
in
the
U.S
supplies
currency.
This
is
money
that
you
can
spend
with
a
check
(hence
checkable
"$Y"
captures
the
fact
that
money
holdings
depend
on
the
level
of
Q:
Do
you
think
 L(i)
is
increasing
or
decreasing
in
i?
output,
consumption,
government
spending,
investment,
etc.
market.
(almost)
any


is
a
very
high
interest
rate
in
the
United
States
i
they
want
by
choosing
the
right
amount
of

=
M M .
using
all
of
my
money,
I
should
buy
bonds
so
that
I
can
earn
interest.
bonds
I
would
like
to
purchase.
The
interest
rate
is
determined
by
setting

11.11%
D S

The
right-hand
side
should
also
be
unchanged.
The
right-hand
side
should
also
go
down. M
Money
is
used
to
make
transactions,
but
it
earns
no
interest.
Stock
Investments
(Securities)
When
you
listen
to
the
news,
you
do
not
hear:
“The
Fed
decided
to
increase
The
Goods
Market
model
does
not
have
a
role
for
a
Central
Bank
like
the
Each
household
decides
on
how
much
now
money
they
should
hold
and
money
graph,
changing
that
variable
moves
us
along
a
curve.
deposit)
or
your
debit
card.
transactions,
which
is
proportional
to
nominal
income.
Alex
Li
F − P
M = $Y L(i)
F
How
many
types
of
money
are
there?
b
i = = − 1
The
bond
price
goes
up.
The
price
for
bonds
goes
down.
A:
DECREASING!
We
use
the
word
"arbitrarily"
because
the
model
can't
predict
what
the
money
supply
today.”
Instead,
you
hear:
“The
Fed
decided
to
decrease
Federal
Reserve.
In
short,
we
study

how
much
future
money
they
should
hold. P nancial
markets
to
understand
a
P
$Y
goes
down
$Y
is
unchanged
etc
b b

The
above
equation
is
known
as
the
LM
(L
for
liquidity,
M
for
Money)
Nominal
GDP:
used
because
both
higher
real
income
and
a
higher
price
money
supply
the
federal
reserve
bank
is
going
to
choose,
but
we
can
the
interest
rate
today.”
realistic
element
of
our
economic
activity!
How
can
we
sell
and
buy
money?
The
interest
rate
goes
down.
The
interest
rate
goes
up.
Note:
bond
price
goes
up,
the
interest
rate
goes
down.
relationship,
and
it
characterizes
money
market
equilibrium
in
our
model.
level
lead
to
increased
money
demand!
still
use
the
model
to
predict
the
effects
of
their
choices
on
interest
L(i)
goes
up
L(i)
must
go
down
However,
to
simplify
our
analysis,
we
abstract
from
these
various
types
of
What
happens
to
equilibrium
 i
when
nominal
income
($Y)
decreases?
What
do
you
use
to
buy
money?
rate.
assets
and
only
focus
on
a
simple
asset
-
bond.
How
should
i
change
for
L(i)
to
go
up?
Recall
that
L(i)
is
a
decreasing
How
should
i
change
for
L(i)
to
go
down?
What
happens
to
equilibrium
 i
when
money
supply
(M)
decreases?
Who
buys
money?
function
in
i. 40
/
40
30
/
40
20
/
40
38
/
40
28
/
40
36
/
40
26
/
40
34
/
40
39
/
40
29
/
40
35
/
40
33
/
40
24
/
40
25
/
40
10
/
40
23
/
40
22
/
40
32
/
40
18
/
40
16
/
40
14
/
40
19
/
40
37
/
40
27
/
40
15
/
40
13
/
40
12
/
40
31
/
40
21
/
40
17
/
40
11
/
40
8
/
40
6
/
40
4
/
40
9
/
40
5
/
40
3
/
40
2
/
40
7
/
40
Book
Chapter
4

2
/
40
Overview

3
/
40
Overview
Overview
Why
study
 nancial
markets?

A:
To
understand
how
the
interest
rate
is
determined
in
the
short
run!

The
goods
market
we
outlined
in
Chapter
3
did
not
include
an
interest
rate,
but
in
the
real
world,
the
interest
rate
is
mentioned
in
the
news
almost
every
day!

The
Goods
Market
model
does
not
have
a
role
for
a
Central
Bank
like
the
Federal
Reserve.
In
short,
we
study
 nancial
markets
to
understand
a
realistic
element
of
our
economic
activity!

4
/
40
Overview
Overview
Recall
that
the
goods
market
model
is
built
to
study
one
speci c
macroeconomic
variable
-
aggregate
output.
The
 nancial
market
model
we
are
going
to
build
is
intended
to
study
the
behavior
of
another
macroeconomics
variable
-
interest
rate.

Just
like
any
other
market
where
selling
and
buying
happens,
the
 nancial
market
has
its
own
commodity
-
money.

How
many
types
of
money
are
there?

How
can
we
sell
and
buy
money?

What
do
you
use
to
buy
money?

Who
buys
money?
5
/
40
Overview
Overview
There
are
two
types
of
money:

Now
Money
-
we
also
call
this
money.
It
is
the
money
we
use
to
buy
goods
like
groceries,
services,
food.

Future
Money
-
we
call
this
asset.
It
is
just
like
the
other
commodities,
it
is
something
we
can
buy
using
money
today.

Each
household
decides
on
how
much
now
money
they
should
hold
and
how
much
future
money
they
should
hold.

6
/
40
Overview
Overview
Now
Money:

(Now)
Money,
which
you
can
use
for
transactions,
pays
no
interest.

Currency:
paper
money,
coins,
etc.

Checkable
Deposits:
deposits
you
have
stored
with
a
bank.

Money
is
used
to
make
transactions,
but
it
earns
no
interest.

7
/
40
Overview
Overview
Now
Money:

Demand
for
(now)
money
comes
from
each
individual.
At
the
end
of
the
day,
it
is
people
who
need
cash
to
complete
transactions.

Money
can
be
used
for
transactions
because
money
is
liquid
compared
to
assets
(future
money).

8
/
40
Overview
Overview
Now
Money:

Supply
for
(now)
money
comes
from:

9
/
40
Overview
Overview
Now
Money:

Supply
for
(now)
money
comes
from:

The
federal
reserve
bank
and
commerical
banks

(Monetary
Policy)

9
/
40
Overview
Overview
Now
Money:

Now
money
is
used
to
ful ll
the
transactions
they
need
to
make.

The
more
transactions
they
need
to
make,
the
more
now
money
they
need.

What
is
the
opportunity
cost
of
now
money?
-
having
less
future
money

10
/
40
Overview
Overview
Future
Money:

There
are
lots
of
types
of
future
money
(assets)
one
can
buy.

Government
bonds

Houses

Stock
Investments
(Securities)

etc

However,
to
simplify
our
analysis,
we
abstract
from
these
various
types
of
assets
and
only
focus
on
a
simple
asset
-
bond.

11
/
40
Overview
Overview
Future
Money:

Bonds
are,
simply
put,
IOUs
(read:
I
owe
yous)
whose
price
is
less
than
the
face
value.

Suppose
the
price
for
a
one-year
bond
is
P 
and
the
face
value
is
F ,
the


b

interest
rate
is
given
by

F − Pb F
i = = − 1
Pb Pb

Note:
bond
price
goes
up,
the
interest
rate
goes
down.

12
/
40
Overview
Overview
Note:
bond
price
goes
up,
the
interest
rate
goes
down.

13
/
40
Overview
Overview
For
example,
you
go
to
the
bonds
market
and
buy
a
piece
of
paper
that
will
give
you
a
claim
of
$1000
in
a
year
at
the
price
of
$900.
The
yearly
interest
rate
of
this
bond
is:

$1000 − $900
( ) ∗ 100% = 11.11%
$900

11.11% 
is
a
very
high
interest
rate
in
the
United
States

14
/
40
Overview
Overview
We
will
focus
on
the
(now)
money
market
and
analyze
the
behavior
of
the
economy
at
equilibrium

Money
Demand
=
Money
Supply

Notice
the
supply
for
money
comes
from
the
Central
Bank
(the
Fed).
This
model
gives
us
insight
into
how
the
central
bank
can
in uence
the
money
market.

15
/
40
Money
Demand

16
/
40
Money
Demand
Money
Demand
Why
does
an
average
household
hold
a
mixture
of
bonds
and
money?

17
/
40
Money
Demand
Money
Demand
Why
does
an
average
household
hold
a
mixture
of
bonds
and
money?

I
need
to
make
transactions!
Ex:
I
buy
food
and
beer
almost
every
day.
I
cannot
use
bonds
to
purchase
beer,
so
I
make
sure
that
I
have
some
money.

17
/
40
Money
Demand
Money
Demand
Why
does
an
average
household
hold
a
mixture
of
bonds
and
money?

I
need
to
make
transactions!
Ex:
I
buy
food
and
beer
almost
every
day.
I
cannot
use
bonds
to
purchase
beer,
so
I
make
sure
that
I
have
some
money.

Thankfully,
I
do
not
spend
ALL
of
my
money
on
beer
and
food.
If
I’m
not
using
all
of
my
money,
I
should
buy
bonds
so
that
I
can
earn
interest.

17
/
40
Money
Demand
Money
Demand
What
determines
an
average
household's
proportion
of
bond
holdings
and
money
holdings?

Level
of
Transactions:
the
more
purchases
I
make,
the
more
money
(and
fewer
bonds)
I
will
hold
(for
a
 xed
interest
rate).

Interest
Rate
on
Bonds:
the
higher
the
interest
rate
on
bonds,
the
more
bonds
I
would
like
to
purchase.

18
/
40
Money
Demand
Money
Demand
Use
M 
to
denote
money
demand.
This
can
be
thought
of
as
the
demand
D

for
liquidity
by
all
indivisuals:

D
M = $Y L(i)

where
"$Y"
is
nominal
GDP,
and
"i"
is
the
nominal
interest
rare.

19
/
40
Money
Demand
Money
Demand
Use
M 
to
denote
money
demand.
This
can
be
thought
of
as
the
demand
D

for
liquidity
by
all
indivisuals:

D
M = $Y L(i)

where
"$Y"
is
nominal
GDP,
and
"i"
is
the
nominal
interest
rare.

"$Y"
captures
the
fact
that
money
holdings
depend
on
the
level
of
transactions,
which
is
proportional
to
nominal
income.

19
/
40
Money
Demand
Money
Demand
Use
M 
to
denote
money
demand.
This
can
be
thought
of
as
the
demand
D

for
liquidity
by
all
indivisuals:

D
M = $Y L(i)

where
"$Y"
is
nominal
GDP,
and
"i"
is
the
nominal
interest
rare.

"$Y"
captures
the
fact
that
money
holdings
depend
on
the
level
of
transactions,
which
is
proportional
to
nominal
income.

Nominal
GDP:
used
because
both
higher
real
income
and
a
higher
price
level
lead
to
increased
money
demand!

19
/
40
Money
Demand
Money
Demand
Use
M 
to
denote
money
demand.
This
can
be
thought
of
as
the
demand
D

for
liquidity
by
all
indivisuals:

D
M (i) = $Y L(i)

where
"$Y"
is
nominal
income,
and
i
is
the
nominal
interest
rare.

Q:
Do
you
think
L(i)
is
increasing
or
decreasing
in
i?

A:
DECREASING!

20
/
40
Money
Demand
Money
Demand
-
Graph

21
/
40
Money
Demand
Money
Demand
-
Graph
Q:
What
happens
when
the
interest
rate
increases
or
decreases
in
our
graph?

A:
We
move
along
the
curve
MD.

Q:
What
happens
when
nominal
GDP
increases
or
decreases
in
our
graph?

A:
We
shift
the
MD
curve!

22
/
40
Money
Demand
Money
Demand
-
Graph
Interest
Rate
on
Bonds:
the
higher
the
interest
rate
on
bonds,
the
more
bonds
and
less
money
I
will
hold
(for
a
 xed
level
of
transactions).

23
/
40
Money
Demand
Money
Demand
-
Graph
Interest
Rate
on
Bonds:
the
higher
the
interest
rate
on
bonds,
the
more
bonds
and
less
money
I
will
hold
(for
a
 xed
level
of
transactions).

The
M 
curve
is
graphed
for
a
 xed
level
of
nominal
income.


D

23
/
40
Money
Demand
Money
Demand
-
Graph
Interest
Rate
on
Bonds:
the
higher
the
interest
rate
on
bonds,
the
more
bonds
and
less
money
I
will
hold
(for
a
 xed
level
of
transactions).

The
M 
curve
is
graphed
for
a
 xed
level
of
nominal
income.


D

Therefore,
a
change
in
the
interest
rate
moves
us
along
the
MD
curve!

23
/
40
Money
Demand
Money
Demand
-
Graph
Interest
Rate
on
Bonds:
the
higher
the
interest
rate
on
bonds,
the
more
bonds
and
less
money
I
will
hold
(for
a
 xed
level
of
transactions).

The
M 
curve
is
graphed
for
a
 xed
level
of
nominal
income.


D

Therefore,
a
change
in
the
interest
rate
moves
us
along
the
MD
curve!

Also,
i
is
on
our
vertical
axis.
If
a
variable
is
on
one
of
the
axes
of
a
graph,
changing
that
variable
moves
us
along
a
curve.

23
/
40
Money
Supply

24
/
40
Money
Supply
Money
Supply
In
the
real
world,
there
are
two
types
of
money:

Currency:
Money
supplied
by
central
banks.
This
is
the
paper
(or
coin)
money
that
we
use
daily.

Currency
is
the
physical
money
that
we
carry
around.

The
Federal
Reserve
in
the
U.S
supplies
currency.

25
/
40
Money
Supply
Money
Supply
In
the
real
world,
there
are
two
types
of
money:

Checkable
Deposits:
Money
supplied
by
commercial
banks.

When
your
paycheck
is
directly
deposited
to
your
bank
account,
this
is
a
checkable
deposit.

This
is
money
that
you
can
spend
with
a
check
(hence
checkable
deposit)
or
your
debit
card.

26
/
40
Money
Supply
Money
Supply
Recall
that
both
the
Federal
Reserve
and
Commercial
Banks
can
supply
money.

The
Federal
Reserve
supplies
money
by
providing
central
bank
money

The
Commerical
Banks
supply
money
by
money
recreation.

27
/
40
Money
Supply
Money
Supply
In
this
lecture,
let's
make
a
simplifying
assumption:

Assumption:
There
are
no
commercial
banks
in
our
economy.

We
will
relax
this
assumption
in
the
next
lecture
by
including
the
commercial
banks
in
our
model.

28
/
40
Money
Supply
Money
Supply
Now
we
can
characterize
money
supply
M .
Since
the
money
supply
is
S

entirely
determined
by
the
central
bank,
it
is
reasonable
to
assume
the
money
supply
is
exogeneous

Money
supply
being
exogenous
means
it
doesn't
depend
on
the
variable
of
interest
in
our
model,
which
is
the
interest
rate.

The
interest
rate
is
determined
by
setting
M 
=
M
D S

29
/
40
Money
Supply
Money
Supply
Q:
If
the
money
supply
is
exogenous,
what
will
the
equation
for
MS
look
like?

S
M = M

Recall,
M,
is
assumed
to
be
exogenous.
We
assume
the
Central
Bank
arbitrarily
chooses
M,
and
its
choice
is
independent
of
interest
rates,
output,
consumption,
government
spending,
investment,
etc.

We
use
the
word
"arbitrarily"
because
the
model
can't
predict
what
money
supply
the
federal
reserve
bank
is
going
to
choose,
but
we
can
still
use
the
model
to
predict
the
effects
of
their
choices
on
interest
rate.

30
/
40
Money
Market
Equilibrium

31
/
40
Money
Market
Equilibrium
Equilibrium
-
Math
Model
In
equilibrium,
we
have
the
following
equations.

D
M = $Y L(i)

S
M = M

D S
M = M

Solve
these
equations,
we
get

M = $Y L(i)

The
above
equation
is
known
as
the
LM
(L
for
liquidity,
M
for
Money)
relationship,
and
it
characterizes
money
market
equilibrium
in
our
model.

32
/
40
Money
Market
Equilibrium
Equilibrium
-
Math
Model
Q:
What
happens
to
equilibrium
i
when
nominal
income
($Y)
decreases?

A:
Recall

M = $Y L(i)

The
left-hand
side
M 
is
unchanged.

The
right-hand
side
should
also
be
unchanged.

$Y
goes
down

L(i)
goes
up

How
should
i
change
for
L(i)
to
go
up?
Recall
that
L(i)
is
a
decreasing
function
in
i. 33
/
40
Money
Market
Equilibrium
Equilibrium
-
Math
Model
Q:
What
happens
to
equilibrium
i
when
money
supply
(M)
decreases?

A:
Recall

M = $Y L(i)

The
left-hand
side
M 
goes
down.

The
right-hand
side
should
also
go
down.

$Y
is
unchanged

L(i)
must
go
down

How
should
i
change
for
L(i)
to
go
down?
34
/
40
Money
Market
Equilibrium
Equilibrium
-
Graphs
Demo

What
happens
to
equilibrium
i
when
nominal
income
($Y)
decreases?

What
happens
to
equilibrium
i
when
money
supply
(M)
decreases?
35
/
40
Money
Market
Equilibrium
Equilibrium
-
Intuition
Q:
What
happens
to
equilibrium
i
when
nominal
income
($Y)
decreases?

Households
need
less
money
because
the
level
of
transactions
goes
down.

Households
want
to
buy
future
money
(bonds).

Demand
for
bonds
for
future
money
goes
up.

The
bond
price
goes
up.

The
interest
rate
goes
down.

36
/
40
Money
Market
Equilibrium
Equilibrium
-
Intuition
Q:
What
happens
to
equilibrium
i
when
money
supply
(M)
decreases?

There
is
less
money
supply
from
the
central
bank.

To
meet
the
needs
of
the
money
demand,
households
need
to
sell
their
future
money
(bonds).

The
supply
for
bonds
goes
up.

The
price
for
bonds
goes
down.

The
interest
rate
goes
up.

37
/
40
Money
Market
Equilibrium
Equilibrium
-
Recession
and
QE
During
the
great
recession
(around
2008),
we
witnessed
that
interest
rates
dropped
in
most
countries.
Use
what
we
learned
in
today's
class
(math
model,
graphs,
and
intuitions)
to
explain
this
phenomenon.

Hint:
During
the
recession,
most
central
banks
around
the
world
also
increased
their
money
supply
as
a
response.

38
/
40
Money
Market
Equilibrium
Choosing
Money
Or
Choosing
the
Interest
Rate
We
have
described
the
central
bank
as
choosing
the
money
supply
and
letting
the
interest
rate
be
determined
at
the
point
where
money
supply
equals
money
demand.

M = $Y L(i)

It
is
useful
to
think
about
the
central
bank
as
choosing
the
interest
rate.

When
you
listen
to
the
news,
you
do
not
hear:
“The
Fed
decided
to
increase
the
money
supply
today.”
Instead,
you
hear:
“The
Fed
decided
to
decrease
the
interest
rate
today.”

39
/
40
Money
Market
Equilibrium
Choosing
Money
Or
Choosing
the
Interest
Rate
We
have
described
the
central
bank
as
choosing
the
money
supply
and
letting
the
interest
rate
be
determined
at
the
point
where
money
supply
equals
money
demand.

M = $Y L(i)

Given
the
nominal
GDP
$Y
and
function
L(⋅),
the
government
can
achieve
(almost)
any
i
they
want
by
choosing
the
right
amount
of
M .

40
/
40
Overview
Commercial
Banks
(Central
Bank)
Money
Market
Federal
Funds
Market
Overview
What
Banks
Do?
Why
Banks?
Reserves
Checkable
Deposits
Demand
for
Central
Bank
Money
Supply
for
Central
Bank
Money
Connection
to
the
Money
Market
Monetary
Multiplier
Federal
Funds
Market
Equilibrium
Equilibrium
-
Example
Discount
Rate
Interest
Rate
on
Reserves
(IOR)
Upper
and
Lower
Bound
The
Fed
pays
interests
to
the
reserves
commercial
banks
hold
in
their
vault.
In
the
last
lecture,
we
derived
the
LM
equation,
which
describes
the
In
this
lecture,
we
will
go
over.
Commercial
Banks
are
the
most
important

Why
do
we
need
these
commercial
banks
as
intermediaries?
Why
can't
Alex
borrow
money
directly
from
Allen?
-
The
bank
gets
to
pocket
Why
can't
Maria
borrow
money
directly
from
Mary?
-
The
bank
gets
to
If
there
were
no
commercial
banks,
Alex
wouldn't
be
able
to
buy
the
road
How
much
reserves
does
a
bank
need
to
keep
in
their
vault?
Here
is
the
question,
how
much
checkable
deposits
are
demanded
by
Central
Bank
Money
can
be
used
as
Supply
for
Central
Bank
Money
is
achieved
by
Open
Market
Operations
Through
OMO,
the
Fed
can
control
the
supply
of
Central
Bank
Money

Demand
for
Central
Bank
Money
=
Supply
for
Central
Bank
Money
Now
the
Equilibrium
for
the
Central
Bank
Money
Market
is
as
follows.
To
understand
monetary
multiplier,
let's
make
a
simplifying
assumption:
Neither
Money
Market
nor
Central
Bank
Money
Market
physically
exists
in
Each
commercial
bank
is
required
to
hold
a
minimum
reserves,

However,
each
bank
can't
predict
exactly
how
much
extra
reserves
they
The
Federal
Funds
Market
Equilibrium
can
be
derived
from
the
Central
The
Fed
also
supplies
reserves
in
the
federal
funds
market.
Question:
when
the
market
rate
is
higher
than
the
discount
rate,
who
will
Each
commercial
bank
wants
to
lend
out
as
much
money
(buy
future
The
FOMC
buys
1
dollar
worth
of
bond
in
the
open
market
from
Seller
1.
Seller
3
doesn't
hold
cash,
so
they
deposit
this

Seller
1
holds

Central
Bank
bought

1
dollar
checkable
deposits
H 1
dollar
worth
of
bonds
d
= CU
Money
Demand + R
d
nancial
intermediaries
in
an
d
(1 − θ) 
dollar
at
Bank
Money
Supply

θ ∗ DH ,
in
in 2 d S


interest
rate
at
the
equilibrium
of
the
money
market.
economy.
A
few
things
to
note:
$1000
from
this
transaction.
pocket
$0.07
million
from
this
transaction.
(A
lot
of
money!)
bike
(at
least
sooner),
and
Maria
wouldn't
be
able
to
realize
her
business
households

(OMO)
by
the
Federal
Open
Market
Committee
(FOMC).
the
economy.
the
United
States.
These
markets
are
constructed
to
facilitate
the
their
vault.
need
for
that
day.
Bank
Money
Market
Equilibrium.
First
recall
be
the
only
supply
for
reserves
in
the
federal
funds
market?
This
rate
is
called
Interest
Rate
on
Reserves
(IOR).
money)
as
possible
C. D ?
d
= cM D
+ θD
d
1
d

Why
can't
Alex
borrow
money
directly
from
Allen?
Commercial
Banks
can
always
buy
reserves
from
the
Fed
through
the
Adding
Commercial
Banks
in
our
Money
Market
Model
Reserves
are
used
for
people
to
withdraw
cash.
currency
held
by
households
households
only
want
to
hold
checkable
deposits
and
no
cash.
Seller
1
doesn't
hold
cash,
so
they
deposit
this

Seller
2
holds

Bank
A
bought
 (1
(1− −θ)θ)
checkable
deposits
[cM

dollar
worth
of
bonds
+ θ(1H − = c)]$Y
= HH L(i)=
idea.
GDP
suffers!
We
will
get
back
to
this
in
a
few
weeks.
equilibrium
theory
and
conduct
equilibrium
analysis.[c +
d
θ(1
D


=H H1H
c)]

dollar
at
Bank
A.
S D
d
S

= cM + θ(1 − c)M
Recall
that
checkable
deposits
is
just
a
form
of
money,
and
the
other
form
In
the
morning,
all
commercial
banks
get
prepare
in
their
vault:
Some
banks
have
extra
reserves,
and
some
banks
have
insuf
"discount
window"
Answer:
The
Fed
This
sounds
a
little
odd,
but
doing
this
gives
the
Fed
the
power
to
set
the
Commercial
Banks
sell
future
money
(bonds)
of
different
liquidity
with
Commercial
Banks
buy
future
money
(bonds)
of
different
liquidity
with
It
takes
time
for
them
to

But
each
bank
also
wants
to
(and
also
is
required
to)
keep
some
cash
in
FOMC
decides
how
much
government
securities
they
want
to
sell
to
or
Again,
since
the
model
doesn't
explain
the
level
of

Bank
C
now
has
 (1 − [c
H θ)+ 
dollar
checkable
deposits,
so
it
is
required
to
nd
each
other.
θ(1
2
M− =c)]$Y
$Y
= ∗L(i) L(i) CU= H+ RH ,
we
say
it
is cient
d d S

(Central
Bank)
Money
Market
Federal
Funds
Market
Commercial
Banks
Book
Chapter
4
Overview
Recall
the
Money
Demand
is
d
Monetary
Policy:
Open
Market
Operations
The
bank
gets
to
pocket
$1000
from
this
transaction.
People
withdraw
cash
from
their
checkable
deposits.
reserves
held
by
commercial
banks
in
their
vaults
That
is
to
say
c
=
0,
and
multiplier
is

Bank
A
now
has

Seller
3
holds

Bank
B
bought
 (1
(11−
dollar
checkable
deposits,
so
it
is
required
to
hold

−θ) θ) 
checkable
deposits
22

dollar
worth
of
bonds
 = [c + θ(1 − c)]M
. 
1

Which
banks
got
bailed
out
in
2008?
is
currency.
In
the
equilibrium,
the
money
supply
is
Although
our
former
analysis
still
holds,
we
still
should
consider
the
reserves.
lower
bound
for
FFR.
different
interest
rate
to
households.
Commercial
Banks
themselves
different
interest
rate
from
households
and

their
vault
(reserves)
to
avoid
bank
run
(a
Self-ful
buy
in
the
open
market.
These
government
securities
are
very
safe
exogeneous.
hold
 θ ∗ (1 − θ) 
dollars
as
reserves
in
the
vault
and
uses
the
rest
of

rms,
and
this
helps
lling
Prophecy).
This
Money
Market
-
Part
2
2
θ
Central
Bank
Money
Supply Central
Bank
Money
Demand
However,
we
made
a
simplifying
assumption
-
there
are
no
commercial
Note
that
 
is
still
a
decreasing
function
in

Required
reserves
θ ∗ 1
dollars
as
reserves
in
the
vault
and
uses
the
rest
of

H
D
= [c + θ(1 − c)]$Y i,
we
have
the
following
The
discount
rate
refers
to
the
interest
rate
charged
to
the
commercial
The
Discount
Rate
is
the
upper
bound
for
the
FFR
in
the
federal
funds
Alex
would
have
to
build
a
few
ATM's
for
Allen,
depending
on
where
Mary
has
to
make
sure
Maria
won't
escape
with
the
$1
million! L(i) (1 − θ) ∗ 1
market
that
actually
exists,
which
is
the
Federal
Funds
Market.
are
not
the
source
of
the
now
money.
increase
consumption
and
investment
in
the
economy.
is
for
both
precautionary
and
for
regulatory
reasons.
assets.
(1 − θ) ∗ (1 − θ) 
dollars
to
buy
bonds
from
Seller
4.
2
d d
Why
can't
Maria
borrow
money
directly
from
Mary?
Monetary
Policy:
Reserve
Requirement
If
a
bank
has
larger
checkable
deposits,
it
needs
to
prepare
more
Seller
4
holds

Bank
C
bought
 θ) 
checkable
deposits

dollar
worth
of
bonds
D
H −
33 CU
M =
= $Y L(i) R
banks,
which
means
there
is
currency
but
no
checkable
deposits.
Equilibrium
Graph.
 (1
(1− −θ)
H 
is
independent
from
the
interest
rate

"Lehman
Brothers
went
bankrupt.
Merrill
Lynch,
AIG,
Freddie
Mac,
Fannie
Also,
recall
the
money
demand
is

All
the
commercial
banks
"get
together"
in
a
place
called
Federal
Funds
banks.
market,
and
the
Fed
has
control
over
the
upper
bound.
Question:
when
the
market
rate
is
lower
than
IOR,
will
there
be
any
Allen
wants
to
go
in
Southeast
Asia.
dollars
to
buy
bonds
from
Seller
2
S

-
let's
assume
people
hold:
1 SD
i.
EC
313,
Macroeconomics 
M =
HM =
S H 
H
Maria
probably
needs
to
borrow
against
her
house,
which
requires
reserves.
Some
extra
reserves
for
households
to
withdraw. Reserves
Demand
Mae,
HBOS,
Royal
Bank
of
Scotland,
Bradford
&
Bingley,
Fortis,
Hypo
and
Market.
supplies
for
reserves?
When
FOMC
buys
government
securities,
they
inject
central
bank
money
Seller
4
doesn't
hold
cash,
so
they
deposit
this

Allen
has
$6000
left
in
the
bank
with
0%
annual
interest
rate
with
Mary
has
$1
million
saved
in
the
bank
with
3%
annual
interest
rate
Alex
needs
to
buy
a
road
bike
for
$5000
(C),
but
he
doesn't
have
Maria
has
an
excellent
business
idea,
and
she
wants
to
borrow (1 − θ) 
dollar
at
Bank
Reserves
Supply
[c + θ(1 − c)] 3

We
have
Among
Commercial
Banks:
Reserve
Market
The
bank
gets
to
pocket
$0.07
million
from
this
transaction.
(A
lot
of
OMO
is
one
of
the
most
important
tools
for
the
Federal
Reserve
Bank.
Also,
we
talked
about
the
central
bank
has
the
power
to
decide
the
money
⋯      
c
proportion
of
their
money
in
currency
Allen
needs
to
do
a
background
check
on
Alex
if
he
can
pay
back
the
some
expensive
legal
service.
Seller
2
doesn't
hold
cash,
so
they
deposit
this

H − c$Y L(i) = θ(1 − c)$Y L(i) (1 − θ)
dollar
at
Bank
B.
Alex
Li
Alliance
&
Leicester
all
came
within
a
whisker
of
doing
so
and
had
to
be
into
the
economy
(Expansionary
OMO).
D. high
liquidity.
He
is
backpacking
in
Southeast
Asia
for
a
year
and
with
low
liquidity.
According
to
the
contract,
she
can't
use
the
$1
enough
money
right
now.
He
took
a
loan
from
a
local
commercial
some
money
from
the
bank
to
realize
the
idea.
After
checking
her
money!)  d
  d
 
Money
Multiplier

supply,
but
we
still
don't
know
the
mechanism
of
injecting
money
into
the
R = θD
Banks
with
extra
reserves
sell
the
excess
reserves
to
the
market.
Answer:
No
money.
rescued"
The
total
money
supply
(which
only
contains
checkable
deposits
in
this
Ultimate
increase
in
the
money
supply
is
a
result
of
successive
rounds
of
Monetary
Policy:
Discount
Rate
plans
to
spend
$500
every
month.
million
for
the
next
12
months
but
will
receive
$1.03
million
bank
to

nancial
status,
the
local
bank
decides
to
give
her
$1
million
to
buy
nance
his
purchase.
The
loan
requires
him
to
pay
the
bank
D
[c + θ(1 − c)]M
Reserves
Supply = H Reserves
Demand
1 − Bank
B
now
has

c
proportion
of
their
money
in
checkable
deposits.
(1 − θ)
dollar
checkable
deposits,
so
it
is
required
to
economy.
When
FOMC
sells
government
securities,
they
take
central
bank
money
According
to
this
equation,
when
the
central
bank
increases
central
bank

R
d

is
the
reserves
demand
from
banks.
world
because

purchases
of
bonds:
afterward.
$500
every
month
for
the
next
12
months.
equipments
(I)
to
start,
and
she
needs
to
pay
the
bank
$1.1
million
c = 0)
is
as
follows:
Banks
with
insuf
Or Allen
needs
to
pay
a
lawyer
lots
of
money
(more
than
$1000)
to
write
a
hold

Recall
 cient
reserves
buy
reserves
from
the
market.

dollars
as
reserves
in
the
vault
and
uses
the
rest
of


is
decreasing
in

θ ∗ (1 − θ)
Monetary
Policy:
Interest
On
Reserves
out
of
the
economy
(Contractionary
OMO).
money
(H)
by
1
dollar,
the
actual
money
supply
goes
up
by

Demand
for
Central
Bank
Money:
L(i)
The
demand
for
checkable
deposits
is

in
a
year.
i
D = (1 − c)M
d 
dollars. d
1

very
detailed
contract.
− θ) ∗ (1 − θ)
dollars
to
buy
bonds
from
Seller
3
[c+θ(1−c)]
(1
θ
is
the
reserve
ratio.
First,
the
Fed,
in
its
open
market
operation. 1 1
Note
that
the
money
mulitipler
is
larger
than
1.
The
equilibrium
interest
rate
is
called
Federal
Funds
Rate
(FFR)
What
happens
to
Federal
Funds
Rate
(FFR)
if
the
FOMC
conducts
an
+ (1 − θ) + (1 − θ) + (1 −
2
Left-hand
Side:
Reserve
Supply
is
increasing
in

1 θ)
d1 +. . .d=
3
i d =
The
demand
for
currency
is
CU = cM
M
H
=
D
= CU + R d
H 1 − (1 − θ)
d θ
expansionary
open
market
operation?
D 
is
the
dollar
amount
of
checkable
deposits
demand
from
households.
d
and
then,
the
following
rounds
by
commercial
banks.
(Money
Creation)
[c + θ(1 − c)]
40
/
47
46
/
47
30
/
47
44
/
47
20
/
47
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/
47
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/
47
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/
47
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/
47
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/
47
45
/
47
39
/
47
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/
47
43
/
47
42
/
47
35
/
47
33
/
47
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/
47
25
/
47
10
/
47
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/
47
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/
47
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/
47
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/
47
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/
47
47
/
47
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/
47
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/
47
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/
47
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/
47
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/
47
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/
47
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/
47
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/
47
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/
47
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/
47
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/
47
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/
47
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/
47
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/
47
4
/
47
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/
47
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/
47
3
/
47
2
/
47
7
/
47
Right-hand
Side:
Reserve
Demand
is
decreasing
in
i
Book
Chapter
4

2
/
47
Overview

3
/
47
Overview
Overview

4
/
47
Overview
Overview
In
the
last
lecture,
we
derived
the
LM
equation,
which
describes
the
interest
rate
at
the
equilibrium
of
the
money
market.

M = $Y ∗ L(i)

However,
we
made
a
simplifying
assumption
-
there
are
no
commercial
banks,
which
means
there
is
currency
but
no
checkable
deposits.

Also,
we
talked
about
the
central
bank
has
the
power
to
decide
the
money
supply,
but
we
still
don't
know
the
mechanism
of
injecting
money
into
the
economy.

5
/
47
Overview
Overview
In
this
lecture,
we
will
go
over.

Adding
Commercial
Banks
in
our
Money
Market
Model

Monetary
Policy:
Open
Market
Operations

Monetary
Policy:
Reserve
Requirement

Among
Commercial
Banks:
Reserve
Market

Monetary
Policy:
Discount
Rate

Monetary
Policy:
Interest
On
Reserves

6
/
47
Commercial
Banks

7
/
47
Commercial
Banks

8
/
47
Commercial
Banks
What
Banks
Do?
Commercial
Banks
are
the
most
important
 nancial
intermediaries
in
an
economy.
A
few
things
to
note:

Commercial
Banks
sell
future
money
(bonds)
of
different
liquidity
with
different
interest
rate
to
households.
Commercial
Banks
themselves
are
not
the
source
of
the
now
money.

Allen
has
$6000
left
in
the
bank
with
0%
annual
interest
rate
with
high
liquidity.
He
is
backpacking
in
Southeast
Asia
for
a
year
and
plans
to
spend
$500
every
month.

9
/
47
Commercial
Banks
What
Banks
Do?
Commercial
Banks
are
the
most
important
 nancial
intermediaries
in
an
economy.
A
few
things
to
note:

Commercial
Banks
sell
future
money
(bonds)
of
different
liquidity
with
different
interest
rate
to
households.
Commercial
Banks
themselves
are
not
the
source
of
the
now
money.

Mary
has
$1
million
saved
in
the
bank
with
3%
annual
interest
rate
with
low
liquidity.
According
to
the
contract,
she
can't
use
the
$1
million
for
the
next
12
months
but
will
receive
$1.03
million
afterward.

10
/
47
Commercial
Banks
What
Banks
Do?
Commercial
Banks
are
the
most
important
 nancial
intermediaries
in
an
economy.
A
few
things
to
note:

Commercial
Banks
buy
future
money
(bonds)
of
different
liquidity
with
different
interest
rate
from
households
and
 rms,
and
this
helps
increase
consumption
and
investment
in
the
economy.

11
/
47
Commercial
Banks
What
Banks
Do?
Commercial
Banks
are
the
most
important
 nancial
intermediaries
in
an
economy.
A
few
things
to
note:

Commercial
Banks
buy
future
money
(bonds)
of
different
liquidity
with
different
interest
rate
from
households
and
 rms,
and
this
helps
increase
consumption
and
investment
in
the
economy.

Alex
needs
to
buy
a
road
bike
for
$5000
(C),
but
he
doesn't
have
enough
money
right
now.
He
took
a
loan
from
a
local
commercial
bank
to
 nance
his
purchase.
The
loan
requires
him
to
pay
the
bank
$500
every
month
for
the
next
12
months.

11
/
47
Commercial
Banks
What
Banks
Do?
Commercial
Banks
are
the
most
important
 nancial
intermediaries
in
an
economy.
A
few
things
to
note:

Commercial
Banks
buy
future
money
(bonds)
of
different
liquidity
with
different
interest
rate
from
households
and
 rms,
and
this
helps
increase
consumption
and
investment
in
the
economy.

Maria
has
an
excellent
business
idea,
and
she
wants
to
borrow
some
money
from
the
bank
to
realize
the
idea.
After
checking
her
nancial
status,
the
local
bank
decides
to
give
her
$1
million
to
buy
equipments
(I)
to
start,
and
she
needs
to
pay
the
bank
$1.1
million
in
a
year.

12
/
47
Commercial
Banks
Why
Banks?
Why
do
we
need
these
commercial
banks
as
intermediaries?

Why
can't
Alex
borrow
money
directly
from
Allen?

The
bank
gets
to
pocket
$1000
from
this
transaction.

13
/
47
Commercial
Banks
Why
Banks?
Why
do
we
need
these
commercial
banks
as
intermediaries?

Why
can't
Alex
borrow
money
directly
from
Allen?

The
bank
gets
to
pocket
$1000
from
this
transaction.

Why
can't
Maria
borrow
money
directly
from
Mary?

The
bank
gets
to
pocket
$0.07
million
from
this
transaction.
(A
lot
of
money!)

13
/
47
Commercial
Banks
Why
Banks?
Why
can't
Alex
borrow
money
directly
from
Allen?
-
The
bank
gets
to
pocket
$1000
from
this
transaction.

14
/
47
Commercial
Banks
Why
Banks?
Why
can't
Alex
borrow
money
directly
from
Allen?
-
The
bank
gets
to
pocket
$1000
from
this
transaction.

It
takes
time
for
them
to
 nd
each
other.

14
/
47
Commercial
Banks
Why
Banks?
Why
can't
Alex
borrow
money
directly
from
Allen?
-
The
bank
gets
to
pocket
$1000
from
this
transaction.

It
takes
time
for
them
to
 nd
each
other.

Alex
would
have
to
build
a
few
ATM's
for
Allen,
depending
on
where
Allen
wants
to
go
in
Southeast
Asia.

14
/
47
Commercial
Banks
Why
Banks?
Why
can't
Alex
borrow
money
directly
from
Allen?
-
The
bank
gets
to
pocket
$1000
from
this
transaction.

It
takes
time
for
them
to
 nd
each
other.

Alex
would
have
to
build
a
few
ATM's
for
Allen,
depending
on
where
Allen
wants
to
go
in
Southeast
Asia.

Allen
needs
to
do
a
background
check
on
Alex
if
he
can
pay
back
the
money.

14
/
47
Commercial
Banks
Why
Banks?
Why
can't
Alex
borrow
money
directly
from
Allen?
-
The
bank
gets
to
pocket
$1000
from
this
transaction.

It
takes
time
for
them
to
 nd
each
other.

Alex
would
have
to
build
a
few
ATM's
for
Allen,
depending
on
where
Allen
wants
to
go
in
Southeast
Asia.

Allen
needs
to
do
a
background
check
on
Alex
if
he
can
pay
back
the
money.

Allen
needs
to
pay
a
lawyer
lots
of
money
(more
than
$1000)
to
write
a
very
detailed
contract.

14
/
47
Commercial
Banks
Why
Banks?
Why
can't
Maria
borrow
money
directly
from
Mary?
-
The
bank
gets
to
pocket
$0.07
million
from
this
transaction.
(A
lot
of
money!)

15
/
47
Commercial
Banks
Why
Banks?
Why
can't
Maria
borrow
money
directly
from
Mary?
-
The
bank
gets
to
pocket
$0.07
million
from
this
transaction.
(A
lot
of
money!)

It
takes
time
for
them
to
 nd
each
other.

15
/
47
Commercial
Banks
Why
Banks?
Why
can't
Maria
borrow
money
directly
from
Mary?
-
The
bank
gets
to
pocket
$0.07
million
from
this
transaction.
(A
lot
of
money!)

It
takes
time
for
them
to
 nd
each
other.

Mary
has
to
make
sure
Maria
won't
escape
with
the
$1
million!

15
/
47
Commercial
Banks
Why
Banks?
Why
can't
Maria
borrow
money
directly
from
Mary?
-
The
bank
gets
to
pocket
$0.07
million
from
this
transaction.
(A
lot
of
money!)

It
takes
time
for
them
to
 nd
each
other.

Mary
has
to
make
sure
Maria
won't
escape
with
the
$1
million!

Maria
probably
needs
to
borrow
against
her
house,
which
requires
some
expensive
legal
service.

15
/
47
Commercial
Banks
Why
Banks?
If
there
were
no
commercial
banks,
Alex
wouldn't
be
able
to
buy
the
road
bike
(at
least
sooner),
and
Maria
wouldn't
be
able
to
realize
her
business
idea.
GDP
suffers!
We
will
get
back
to
this
in
a
few
weeks.

Which
banks
got
bailed
out
in
2008?

"Lehman
Brothers
went
bankrupt.
Merrill
Lynch,
AIG,
Freddie
Mac,
Fannie
Mae,
HBOS,
Royal
Bank
of
Scotland,
Bradford
&
Bingley,
Fortis,
Hypo
and
Alliance
&
Leicester
all
came
within
a
whisker
of
doing
so
and
had
to
be
rescued"

16
/
47
Commercial
Banks
Reserves
Each
commercial
bank
wants
to
lend
out
as
much
money
(buy
future
money)
as
possible

But
each
bank
also
wants
to
(and
also
is
required
to)
keep
some
cash
in
their
vault
(reserves)
to
avoid
bank
run
(a
Self-ful lling
Prophecy).
This
is
for
both
precautionary
and
for
regulatory
reasons.

17
/
47
Commercial
Banks
Reserves
How
much
reserves
does
a
bank
need
to
keep
in
their
vault?

Reserves
are
used
for
people
to
withdraw
cash.

People
withdraw
cash
from
their
checkable
deposits.

If
a
bank
has
larger
checkable
deposits,
it
needs
to
prepare
more
reserves.

d d
R = θD

R
d

is
the
reserves
demand
from
banks.

θ 
is
the
reserve
ratio.

D
d

is
the
dollar
amount
of
checkable
deposits
demand
from
households.18
/
47
Commercial
Banks
Checkable
Deposits
Here
is
the
question,
how
much
checkable
deposits
are
demanded
by
households
D ?d

Recall
that
checkable
deposits
is
just
a
form
of
money,
and
the
other
form
is
currency.

19
/
47
Commercial
Banks
Checkable
Deposits
Here
is
the
question,
how
much
checkable
deposits
are
demanded
by
households
D ? d

Recall
that
checkable
deposits
is
just
a
form
of
money,
and
the
other
form
is
currency.

Also,
recall
the
money
demand
is
M 
-
let's
assume
people
hold:
D

c 
proportion
of
their
money
in
currency

1 − c 
proportion
of
their
money
in
checkable
deposits.

The
demand
for
checkable
deposits
is
D d
= (1 − c)M
d

The
demand
for
currency
is
CU d
= cM
d

19
/
47
(Central
Bank)
Money
Market

20
/
47
(Central
Bank)
Money
Market
Demand
for
Central
Bank
Money
Central
Bank
Money
can
be
used
as

currency
held
by
households

reserves
held
by
commercial
banks
in
their
vaults

Demand
for
Central
Bank
Money:

d d d
H = CU + R

21
/
47
(Central
Bank)
Money
Market
Demand
for
Central
Bank
Money
d d d
H = CU + R
d d
= cM + θD

d d
= cM + θ(1 − c)M

d
= [c + θ(1 − c)]M

= [c + θ(1 − c)]$Y L(i)

22
/
47
(Central
Bank)
Money
Market
Supply
for
Central
Bank
Money
Supply
for
Central
Bank
Money
is
achieved
by
Open
Market
Operations
(OMO)
by
the
Federal
Open
Market
Committee
(FOMC).

FOMC
decides
how
much
government
securities
they
want
to
sell
to
or
buy
in
the
open
market.
These
government
securities
are
very
safe
assets.

23
/
47
(Central
Bank)
Money
Market
Supply
for
Central
Bank
Money
Supply
for
Central
Bank
Money
is
achieved
by
Open
Market
Operations
(OMO)
by
the
Federal
Open
Market
Committee
(FOMC).

FOMC
decides
how
much
government
securities
they
want
to
sell
to
or
buy
in
the
open
market.
These
government
securities
are
very
safe
assets.

When
FOMC
buys
government
securities,
they
inject
central
bank
money
into
the
economy
(Expansionary
OMO).

23
/
47
(Central
Bank)
Money
Market
Supply
for
Central
Bank
Money
Supply
for
Central
Bank
Money
is
achieved
by
Open
Market
Operations
(OMO)
by
the
Federal
Open
Market
Committee
(FOMC).

FOMC
decides
how
much
government
securities
they
want
to
sell
to
or
buy
in
the
open
market.
These
government
securities
are
very
safe
assets.

When
FOMC
buys
government
securities,
they
inject
central
bank
money
into
the
economy
(Expansionary
OMO).

When
FOMC
sells
government
securities,
they
take
central
bank
money
out
of
the
economy
(Contractionary
OMO).

23
/
47
(Central
Bank)
Money
Market
Supply
for
Central
Bank
Money
Through
OMO,
the
Fed
can
control
the
supply
of
Central
Bank
Money
H 
in S

the
economy.

Again,
since
the
model
doesn't
explain
the
level
of
H ,
we
say
it
is
S

exogeneous.

S
H = H

OMO
is
one
of
the
most
important
tools
for
the
Federal
Reserve
Bank.

24
/
47
(Central
Bank)
Money
Market
Equilibrium
Demand
for
Central
Bank
Money
=
Supply
for
Central
Bank
Money

D S
H = H

25
/
47
(Central
Bank)
Money
Market
Equilibrium
Demand
for
Central
Bank
Money
=
Supply
for
Central
Bank
Money

D S
H = H

26
/
47
(Central
Bank)
Money
Market
Equilibrium
Demand
for
Central
Bank
Money
=
Supply
for
Central
Bank
Money

D S
H = H

[c + θ(1 − c)]$Y L(i) = H

Note
that
H 
is
still
a
decreasing
function
in
i,
we
have
the
following
D

Equilibrium
Graph.
H 
is
independent
from
the
interest
rate
i.
S

27
/
47
(Central
Bank)
Money
Market
Connection
to
the
Money
Market
Now
the
Equilibrium
for
the
Central
Bank
Money
Market
is
as
follows.

[c + θ(1 − c)]$Y L(i) = H

28
/
47
(Central
Bank)
Money
Market
Connection
to
the
Money
Market
Now
the
Equilibrium
for
the
Central
Bank
Money
Market
is
as
follows.

[c + θ(1 − c)]$Y L(i) = H

Recall
the
Money
Demand
is

D
M = $Y L(i)

28
/
47
(Central
Bank)
Money
Market
Connection
to
the
Money
Market
Now
the
Equilibrium
for
the
Central
Bank
Money
Market
is
as
follows.

[c + θ(1 − c)]$Y L(i) = H

Recall
the
Money
Demand
is

D
M = $Y L(i)

We
have

D
[c + θ(1 − c)]M = H

28
/
47
(Central
Bank)
Money
Market
Connection
to
the
Money
Market
Now
the
Equilibrium
for
the
Central
Bank
Money
Market
is
as
follows.

[c + θ(1 − c)]$Y L(i) = H

Recall
the
Money
Demand
is

D
M = $Y L(i)

We
have

D
[c + θ(1 − c)]M = H

Or

1
D
M = H
[c + θ(1 − c)]
28
/
47
(Central
Bank)
Money
Market
Connection
to
the
Money
Market
Money
Supply
Money
Demand 

1
D
M = H
[c + θ(1 − c)]

In
the
equilibrium,
the
money
supply
is

1
S
M = H
[c + θ(1 − c)]

Money
Multiplier

According
to
this
equation,
when
the
central
bank
increases
central
bank
money
(H)
by
1
dollar,
the
actual
money
supply
goes
up
by
 
dollars.
1

[c+θ(1−c)]

Note
that
the
money
mulitipler
is
larger
than
1.

29
/
47
(Central
Bank)
Money
Market
Monetary
Multiplier
To
understand
monetary
multiplier,
let's
make
a
simplifying
assumption:

households
only
want
to
hold
checkable
deposits
and
no
cash.

That
is
to
say
c
=
0,
and
multiplier
is
 .
1

30
/
47
(Central
Bank)
Money
Market
Monetary
Multiplier
The
FOMC
buys
1
dollar
worth
of
bond
in
the
open
market
from
Seller
1.

31
/
47
(Central
Bank)
Money
Market
Monetary
Multiplier
The
FOMC
buys
1
dollar
worth
of
bond
in
the
open
market
from
Seller
1.

Seller
1
doesn't
hold
cash,
so
they
deposit
this
1
dollar
at
Bank
A.

Bank
A
now
has
1
dollar
checkable
deposits,
so
it
is
required
to
hold

θ ∗ 1
dollars
as
reserves
in
the
vault
and
uses
the
rest
of
(1 − θ) ∗ 1

dollars
to
buy
bonds
from
Seller
2

31
/
47
(Central
Bank)
Money
Market
Monetary
Multiplier
The
FOMC
buys
1
dollar
worth
of
bond
in
the
open
market
from
Seller
1.

Seller
1
doesn't
hold
cash,
so
they
deposit
this
1
dollar
at
Bank
A.

Bank
A
now
has
1
dollar
checkable
deposits,
so
it
is
required
to
hold

θ ∗ 1
dollars
as
reserves
in
the
vault
and
uses
the
rest
of
(1 − θ) ∗ 1

dollars
to
buy
bonds
from
Seller
2

Seller
2
doesn't
hold
cash,
so
they
deposit
this
(1 − θ)
dollar
at
Bank
B.

Bank
B
now
has
(1 − θ)
dollar
checkable
deposits,
so
it
is
required
to
hold
θ ∗ (1 − θ)
dollars
as
reserves
in
the
vault
and
uses
the
rest
of

(1 − θ) ∗ (1 − θ)
dollars
to
buy
bonds
from
Seller
3

31
/
47
(Central
Bank)
Money
Market
Monetary
Multiplier

32
/
47
(Central
Bank)
Money
Market
Monetary
Multiplier
Seller
3
doesn't
hold
cash,
so
they
deposit
this
(1 − θ) 
dollar
at
Bank
2

C.

Bank
C
now
has
(1 − θ) 
dollar
checkable
deposits,
so
it
is
required
to
2

hold
θ ∗ (1 − θ) 
dollars
as
reserves
in
the
vault
and
uses
the
rest
of

2

(1 − θ) ∗ (1 − θ) 
dollars
to
buy
bonds
from
Seller
4.
2

32
/
47
(Central
Bank)
Money
Market
Monetary
Multiplier
Seller
3
doesn't
hold
cash,
so
they
deposit
this
(1 − θ) 
dollar
at
Bank
2

C.

Bank
C
now
has
(1 − θ) 
dollar
checkable
deposits,
so
it
is
required
to
2

hold
θ ∗ (1 − θ) 
dollars
as
reserves
in
the
vault
and
uses
the
rest
of

2

(1 − θ) ∗ (1 − θ) 
dollars
to
buy
bonds
from
Seller
4.
2

Seller
4
doesn't
hold
cash,
so
they
deposit
this
(1 − θ) 
dollar
at
Bank
3

D.

32
/
47
(Central
Bank)
Money
Market
Monetary
Multiplier
Seller
1
holds
1
dollar
checkable
deposits

33
/
47
(Central
Bank)
Money
Market
Monetary
Multiplier
Seller
1
holds
1
dollar
checkable
deposits

Seller
2
holds
(1 − θ)
checkable
deposits

33
/
47
(Central
Bank)
Money
Market
Monetary
Multiplier
Seller
1
holds
1
dollar
checkable
deposits

Seller
2
holds
(1 − θ)
checkable
deposits

Seller
3
holds
(1 − θ) 
checkable
deposits
2

33
/
47
(Central
Bank)
Money
Market
Monetary
Multiplier
Seller
1
holds
1
dollar
checkable
deposits

Seller
2
holds
(1 − θ)
checkable
deposits

Seller
3
holds
(1 − θ) 
checkable
deposits
2

Seller
4
holds
(1 − θ) 
checkable
deposits
3

33
/
47
(Central
Bank)
Money
Market
Monetary
Multiplier
Seller
1
holds
1
dollar
checkable
deposits

Seller
2
holds
(1 − θ)
checkable
deposits

Seller
3
holds
(1 − θ) 
checkable
deposits
2

Seller
4
holds
(1 − θ) 
checkable
deposits
3

The
total
money
supply
(which
only
contains
checkable
deposits
in
this
world
because
c = 0)
is
as
follows:

1 1
2 3
1 + (1 − θ) + (1 − θ) + (1 − θ) +. . . = =
1 − (1 − θ) θ

33
/
47
34
/
47
(Central
Bank)
Money
Market
Monetary
Multiplier
Central
Bank
bought
1
dollar
worth
of
bonds

35
/
47
(Central
Bank)
Money
Market
Monetary
Multiplier
Central
Bank
bought
1
dollar
worth
of
bonds

Bank
A
bought
(1 − θ)
dollar
worth
of
bonds

35
/
47
(Central
Bank)
Money
Market
Monetary
Multiplier
Central
Bank
bought
1
dollar
worth
of
bonds

Bank
A
bought
(1 − θ)
dollar
worth
of
bonds

Bank
B
bought
(1 − θ) 
dollar
worth
of
bonds
2

35
/
47
(Central
Bank)
Money
Market
Monetary
Multiplier
Central
Bank
bought
1
dollar
worth
of
bonds

Bank
A
bought
(1 − θ)
dollar
worth
of
bonds

Bank
B
bought
(1 − θ) 
dollar
worth
of
bonds
2

Bank
C
bought
(1 − θ) 
dollar
worth
of
bonds
3

35
/
47
(Central
Bank)
Money
Market
Monetary
Multiplier
Central
Bank
bought
1
dollar
worth
of
bonds

Bank
A
bought
(1 − θ)
dollar
worth
of
bonds

Bank
B
bought
(1 − θ) 
dollar
worth
of
bonds
2

Bank
C
bought
(1 − θ) 
dollar
worth
of
bonds
3

35
/
47
(Central
Bank)
Money
Market
Monetary
Multiplier
Central
Bank
bought
1
dollar
worth
of
bonds

Bank
A
bought
(1 − θ)
dollar
worth
of
bonds

Bank
B
bought
(1 − θ) 
dollar
worth
of
bonds
2

Bank
C
bought
(1 − θ) 
dollar
worth
of
bonds
3

Ultimate
increase
in
the
money
supply
is
a
result
of
successive
rounds
of
purchases
of
bonds:

First,
the
Fed,
in
its
open
market
operation.

and
then,
the
following
rounds
by
commercial
banks.
(Money
Creation)35
/
47
Federal
Funds
Market

36
/
47
Federal
Funds
Market
Federal
Funds
Market
Neither
Money
Market
nor
Central
Bank
Money
Market
physically
exists
in
the
United
States.
These
markets
are
constructed
to
facilitate
the
equilibrium
theory
and
conduct
equilibrium
analysis.

37
/
47
Federal
Funds
Market
Federal
Funds
Market
Neither
Money
Market
nor
Central
Bank
Money
Market
physically
exists
in
the
United
States.
These
markets
are
constructed
to
facilitate
the
equilibrium
theory
and
conduct
equilibrium
analysis.

Although
our
former
analysis
still
holds,
we
still
should
consider
the
market
that
actually
exists,
which
is
the
Federal
Funds
Market.

37
/
47
Federal
Funds
Market
Federal
Funds
Market
Each
commercial
bank
is
required
to
hold
a
minimum
reserves,
θ ∗ D ,
in
d

their
vault.

38
/
47
Federal
Funds
Market
Federal
Funds
Market
Each
commercial
bank
is
required
to
hold
a
minimum
reserves,
θ ∗ D ,
in
d

their
vault.

In
the
morning,
all
commercial
banks
get
prepare
in
their
vault:

Required
reserves

Some
extra
reserves
for
households
to
withdraw.

38
/
47
Federal
Funds
Market
Federal
Funds
Market
However,
each
bank
can't
predict
exactly
how
much
extra
reserves
they
need
for
that
day.

Some
banks
have
extra
reserves,
and
some
banks
have
insuf cient
reserves.

39
/
47
Federal
Funds
Market
Federal
Funds
Market
However,
each
bank
can't
predict
exactly
how
much
extra
reserves
they
need
for
that
day.

Some
banks
have
extra
reserves,
and
some
banks
have
insuf cient
reserves.

All
the
commercial
banks
"get
together"
in
a
place
called
Federal
Funds
Market.

39
/
47
Federal
Funds
Market
Federal
Funds
Market
However,
each
bank
can't
predict
exactly
how
much
extra
reserves
they
need
for
that
day.

Some
banks
have
extra
reserves,
and
some
banks
have
insuf cient
reserves.

All
the
commercial
banks
"get
together"
in
a
place
called
Federal
Funds
Market.

Banks
with
extra
reserves
sell
the
excess
reserves
to
the
market.

39
/
47
Federal
Funds
Market
Federal
Funds
Market
However,
each
bank
can't
predict
exactly
how
much
extra
reserves
they
need
for
that
day.

Some
banks
have
extra
reserves,
and
some
banks
have
insuf cient
reserves.

All
the
commercial
banks
"get
together"
in
a
place
called
Federal
Funds
Market.

Banks
with
extra
reserves
sell
the
excess
reserves
to
the
market.

Banks
with
insuf cient
reserves
buy
reserves
from
the
market.

39
/
47
Federal
Funds
Market
Federal
Funds
Market
However,
each
bank
can't
predict
exactly
how
much
extra
reserves
they
need
for
that
day.

Some
banks
have
extra
reserves,
and
some
banks
have
insuf cient
reserves.

All
the
commercial
banks
"get
together"
in
a
place
called
Federal
Funds
Market.

Banks
with
extra
reserves
sell
the
excess
reserves
to
the
market.

Banks
with
insuf cient
reserves
buy
reserves
from
the
market.

The
equilibrium
interest
rate
is
called
Federal
Funds
Rate
(FFR)

39
/
47
Federal
Funds
Market
Equilibrium
The
Federal
Funds
Market
Equilibrium
can
be
derived
from
the
Central
Bank
Money
Market
Equilibrium.
First
recall

d d
H = CU + R
 
Central
Bank
Money
Supply Central
Bank
Money
Demand

d d
H − CU = R
 

Reserves
Supply Reserves
Demand

H − c$Y L(i) = θ(1 − c)$Y L(i)


 
Reserves
Supply Reserves
Demand

40
/
47
Federal
Funds
Market
Equilibrium
The
Federal
Funds
Market
Equilibrium
can
be
derived
from
the
Central
Bank
Money
Market
Equilibrium.
First
recall

d d
H = CU + R
 
Central
Bank
Money
Supply Central
Bank
Money
Demand

d d
H − CU = R
 

Reserves
Supply Reserves
Demand

H − c$Y L(i) = θ(1 − c)$Y L(i)


 
Reserves
Supply Reserves
Demand

Recall
L(i)
is
decreasing
in
i

40
/
47
Federal
Funds
Market
Equilibrium
The
Federal
Funds
Market
Equilibrium
can
be
derived
from
the
Central
Bank
Money
Market
Equilibrium.
First
recall

d d
H = CU + R
 
Central
Bank
Money
Supply Central
Bank
Money
Demand

d d
H − CU = R
 

Reserves
Supply Reserves
Demand

H − c$Y L(i) = θ(1 − c)$Y L(i)


 
Reserves
Supply Reserves
Demand

Recall
L(i)
is
decreasing
in
i

Left-hand
Side:
Reserve
Supply
is
increasing
in
i

40
/
47
Federal
Funds
Market
Equilibrium
The
Federal
Funds
Market
Equilibrium
can
be
derived
from
the
Central
Bank
Money
Market
Equilibrium.
First
recall

d d
H = CU + R
 
Central
Bank
Money
Supply Central
Bank
Money
Demand

d d
H − CU = R
 

Reserves
Supply Reserves
Demand

H − c$Y L(i) = θ(1 − c)$Y L(i)


 
Reserves
Supply Reserves
Demand

Recall
L(i)
is
decreasing
in
i

Left-hand
Side:
Reserve
Supply
is
increasing
in
i

40
/
47
Right-hand
Side:
Reserve
Demand
is
decreasing
in
i
Federal
Funds
Market
Equilibrium
-
Example

41
/
47
Federal
Funds
Market
Equilibrium
-
Example

What
happens
to
Federal
Funds
Rate
(FFR)
if
the
FOMC
conducts
an
expansionary
open
market
operation?
41
/
47
Federal
Funds
Market
Discount
Rate
The
Fed
also
supplies
reserves
in
the
federal
funds
market.

Commercial
Banks
can
always
buy
reserves
from
the
Fed
through
the
"discount
window"

The
discount
rate
refers
to
the
interest
rate
charged
to
the
commercial
banks.

42
/
47
Federal
Funds
Market
Discount
Rate
Question:
when
the
market
rate
is
higher
than
the
discount
rate,
who
will
be
the
only
supply
for
reserves
in
the
federal
funds
market?

Answer:
The
Fed

The
Discount
Rate
is
the
upper
bound
for
the
FFR
in
the
federal
funds
market,
and
the
Fed
has
control
over
the
upper
bound.

43
/
47
Federal
Funds
Market
Interest
Rate
on
Reserves
(IOR)
The
Fed
pays
interests
to
the
reserves
commercial
banks
hold
in
their
vault.
This
rate
is
called
Interest
Rate
on
Reserves
(IOR).

This
sounds
a
little
odd,
but
doing
this
gives
the
Fed
the
power
to
set
the
lower
bound
for
FFR.

Question:
when
the
market
rate
is
lower
than
IOR,
will
there
be
any
supplies
for
reserves?

Answer:
No

44
/
47
Federal
Funds
Market
Upper
and
Lower
Bound

45
/
47
Federal
Funds
Market
Upper
and
Lower
Bound

46
/
47
Federal
Funds
Market
Upper
and
Lower
Bound

47
/
47
ReviewPolicy
General
Fiscal
Monetary
Applications
Equilibrium
Policy
in General
in General
Equilibrium
Equilibrium
The LM
General
Comparative
Solution
Fiscal
Monetary
Describing
Describe
Why
Equilibrium
Government
Policy
IS
General
Policy
Mix
relation:
relation:
Equilibrium
Methods
What
Policy
What
Changes
Spending
Equilibrium
Equilibrium?
Statics
Happens
Happens
in(Method
(IS-LM)
Bonds
(Method
Market
1) 2)
2) 1)
When
The
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Note:
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There
Recall:
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If
By
Q: we
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exploring
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budget
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30
44
20
38
28
36
26
34
45
39
29
43
42
35
33
24
25
10
23
22
32
18
16
14
19
37
27
15
13
12
41
31
21
17
11
8
6
45327 / 45
9
Book Chapter 5

2 / 45
Review

3 / 45
Review
The IS relation:
The IS relation: Y = f
C
(Y − T , i) + f
I
(Y , i) + G

The IS relation follows from the goods market equilibrium (Y = Z). It tells
us how the interest rate affects output.

The IS curve is constructed by varying i and analyzing the goods market


equilibrium change in Y.

4 / 45
Review
The LM relation:
The LM relation: M

P
= Y L(i)

The LM relation follows from the real money market equilibrium. It tells
us how output affects the interest rate.

The LM curve is constructed by varying Y and analyzing the money


market equilibrium change in i.

5 / 45
General Equilibrium

6 / 45
General Equilibrium
General Equilibrium
General Equilibrium (or economy-wide equilibrium) requires both the
goods market and money market to be in equilibrium!

Every point on the IS curve represents a unique Goods Market


Equilibrium.

Every point on the LM curve represents a unique Money Market


Equilibrium.

7 / 45
General Equilibrium
General Equilibrium
General Equilibrium (or economy-wide equilibrium) requires both the
goods market and money market to be in equilibrium!

8 / 45
General Equilibrium
General Equilibrium
Note: All shifts of the IS and LM graphs can be constructed by analyzing the
Goods Market and Money Market as we have in class. However, the
following table should help you to check your intuition:

9 / 45
General Equilibrium
General Equilibrium
By exploring equilibrium in the goods market (IS relation) and the money
market (LM relation), we can derive the IS and LM Curves to study Short
Run General Equilibrium.

Q: Why should we care about General Equilibrium?

10 / 45
General Equilibrium
General Equilibrium
By exploring equilibrium in the goods market (IS relation) and the money
market (LM relation), we can derive the IS and LM Curves to study Short
Run General Equilibrium.

Q: Why should we care about General Equilibrium?

Recall: Fiscal Policy refers to changes in taxes (T) or government


spending (G) initiated by the government.

10 / 45
General Equilibrium
General Equilibrium
By exploring equilibrium in the goods market (IS relation) and the money
market (LM relation), we can derive the IS and LM Curves to study Short
Run General Equilibrium.

Q: Why should we care about General Equilibrium?

Recall: Fiscal Policy refers to changes in taxes (T) or government


spending (G) initiated by the government.

Recall: Monetary Policy refers to changes in the Money Supply (M)


initiated by the Central Bank.

10 / 45
General Equilibrium
Comparative Statics
Comparative Statics refers to analyzing the change in endogenous
variables (Y, i) when exogenous variables change!

Initially: We are in equilibrium, and then some exogenous variable (G, T, M,


or P) changes:

Ask yourself how the change affects equilibrium in the goods market
and how it affects equilibrium in the money market.

11 / 45
General Equilibrium
Comparative Statics
Comparative Statics refers to analyzing the change in endogenous
variables (Y, i) when exogenous variables change!

Initially: We are in equilibrium, and then some exogenous variable (G, T, M,


or P) changes:

Ask yourself how the change affects equilibrium in the goods market
and how it affects equilibrium in the money market.

That is, does it shift the Goods Demand, Money Demand, or Money
Supply?

11 / 45
General Equilibrium
Comparative Statics
Comparative Statics refers to analyzing the change in endogenous
variables (Y, i) when exogenous variables change!

Initially: We are in equilibrium, and then some exogenous variable (G, T, M,


or P) changes:

Characterize the effect of these shifts on the IS and LM curve.

12 / 45
General Equilibrium
Comparative Statics
Comparative Statics refers to analyzing the change in endogenous
variables (Y, i) when exogenous variables change!

Initially: We are in equilibrium, and then some exogenous variable (G, T, M,


or P) changes:

Characterize the effect of these shifts on the IS and LM curve.

Does the IS shift? Does the LM shift? If so, by how much?

12 / 45
General Equilibrium
Comparative Statics
Comparative Statics refers to analyzing the change in endogenous
variables (Y, i) when exogenous variables change!

Initially: We are in equilibrium, and then some exogenous variable (G, T, M,


or P) changes:

Find the new equilibrium where IS and LM intersect after, taking into
account all shifts!

13 / 45
General Equilibrium
Solution Methods
There are several ways to solve comparative statics problems. Exam
questions may prompt you to use a speci c method, or you may be given
the choice of your favorite:

Draw or describe the initial effect of an exogenous change in the Goods


Market and Money Market. Show how this effect impacts the IS and LM
curve. Find the new IS-LM equilibrium.

14 / 45
General Equilibrium
Solution Methods
There are several ways to solve comparative statics problems. Exam
questions may prompt you to use a speci c method, or you may be given
the choice of your favorite:

Draw the initial effect of an exogenous change in the Goods Market and
Money Market. Show how this effect impacts the IS and LM curve. Find
the new IS-LM equilibrium. Show that the Goods Market and Money
Market are in equilibrium at this new point.

15 / 45
General Equilibrium
Solution Methods
There are several ways to solve comparative statics problems. Exam
questions may prompt you to use a speci c method, or you may be given
the choice of your favorite:

Look at the IS relation and LM relation equations. Show how a change


in some exogenous variables impacts the IS curve and LM curve. Find
the new IS-LM equilibrium.

16 / 45
Fiscal Policy in General Equilibrium

17 / 45
Fiscal Policy in General Equilibrium
Fiscal Policy
Recall: The budget de cit is the difference between government revenue
(Taxes) and Government spending. In our model, T − G.

Fiscal Policy can be divided into two types:

Fiscal contraction: Government policies that reduce the budget de cit.

Increase Taxes

A decrease in Government Spending

18 / 45
Fiscal Policy in General Equilibrium
Fiscal Policy
Recall: The budget de cit is the difference between government revenue
(Taxes) and Government spending. In our model, T − G.

Fiscal Policy can be divided into two types:

Fiscal expansion: Government policies that increase the budget de cit.

Decrease Taxes

Increase in Government Spending

19 / 45
Fiscal Policy in General Equilibrium
Describing What Happens (Method 1)
Shock: The government wants to reduce the budget de cit, so taxes
increase.

(1) What is the initial impact of this effect on the goods market and money
market? What is the general equilibrium effect of this policy?

Goods Market and IS:

Increased T leads to decrease in the goods demand.

For every value of i, equilibrium output is now lower.

The IS curve Shifts Left.

20 / 45
Fiscal Policy in General Equilibrium
Describing What Happens (Method 1)
Shock: The government wants to reduce the budget de cit, so taxes
increase.

(1) What is the initial impact of this effect on the goods market and money
market? What is the general equilibrium effect of this policy?

Money Market and LM:

T does not affect M D


or M , so nothing changes in the money
S

market.

The LM curve Doesn't Shift.

21 / 45
Fiscal Policy in General Equilibrium
Describing What Happens (Method 1)

22 / 45
Fiscal Policy in General Equilibrium
Describing What Happens (Method 1)

23 / 45
Fiscal Policy in General Equilibrium
Describing What Happens (Method 2)
Shock: The government wants to reduce the budget de cit, so taxes
increase.

(2) What is the general equilibrium effect of this policy on Output and the
interest rate? Hint: Look at the IS and LM relation equations!

C I
IS : Y = f (Y − T , i) + f (Y , i) + G

LM : M = Y L(i)

If T increases, then f (Y − T , i) decreases, and Y is lower for all values


C

of i. Thus, IS shifts left to IS′.

LM curve is unaffected by a change in T, so the LM does not shift.

24 / 45
Fiscal Policy in General Equilibrium
Describing What Happens (Method 2)

25 / 45
Fiscal Policy in General Equilibrium
Describing What Happens (Method 2)

26 / 45
Fiscal Policy in General Equilibrium
Why General Equilibrium (IS-LM)

27 / 45
Fiscal Policy in General Equilibrium
Why General Equilibrium (IS-LM)
If we only look at the goods market:

A tax decrease would appear to have a signi cant impact on output,


reducing equilibrium from Y to Y '.
0

If we only look at the money market:

A tax decrease would appear not to affect interest rates.

28 / 45
Fiscal Policy in General Equilibrium
Why General Equilibrium (IS-LM)
By looking at the IS-LM SR equilibrium:

A tax decrease leads to output decreasing from Y to Y (a smaller


0 A

change than the goods market alone predicts).

A tax decrease leads to the interest rate decreasing (a larger change


than the money market alone predicts).

NOTE: The general equilibrium output decreases by less than what the
goods market alone predicts exactly because the interest rate decreases in
general equilibrium!

29 / 45
Fiscal Policy in General Equilibrium
Equilibrium Changes
Q: When taxes increase, what happens to the components of demand?

G : by assumption, G is unchanged.

30 / 45
Fiscal Policy in General Equilibrium
Equilibrium Changes
Q: When taxes increase, what happens to the components of demand?

G : by assumption, G is unchanged.

Y : In equilibrium, income is lower, and taxes are higher, so disposable


D

income has decreased.

30 / 45
Fiscal Policy in General Equilibrium
Equilibrium Changes
Q: When taxes increase, what happens to the components of demand?

G : by assumption, G is unchanged.

Y : In equilibrium, income is lower, and taxes are higher, so disposable


D

income has decreased.

C : consumption f (Y , i) depends on both disposable income (+) and


C
D

interest rate (-). First, disposable income decreases, consumption


decreases. Second, interest rate decreases, consumption increases.
Change in Consumption is unclear.

30 / 45
Fiscal Policy in General Equilibrium
Equilibrium Changes
Q: When taxes increase, what happens to the components of demand?

G : by assumption, G is unchanged.

Y : In equilibrium, income is lower, and taxes are higher, so disposable


D

income has decreased.

C : consumption f (Y , i) depends on both disposable income (+) and


C
D

interest rate (-). First, disposable income decreases, consumption


decreases. Second, interest rate decreases, consumption increases.
Change in Consumption is unclear.

I: investment f (Y , i) depends on both income (+) and interest rate (-).


I

First, income decreases, investment decreases. Second, interest rate


decreases, investment increases. Change in Investment in unclear. 30 / 45
Monetary Policy in General Equilibrium

31 / 45
Monetary Policy in General Equilibrium
Monetary Policy
Recall: Monetary Policy can be divided into two types:

Monetary contraction: The Fed decreases money supply M .

Monetary expansion: The Fed increases money supply M .

32 / 45
Monetary Policy in General Equilibrium
Describe What Happens (Method 1)
Shock: The Fed decides to increase the Money Supply. What Happens? (Be
sure you understand how to apply both two solution methods!)

Goods Market and IS:

M does not affect goods market demand.

The IS curve is unaffected.

Money Market and LM:

Increased M leads to increased Money Supply.

For every value of Y, equilibrium interest is now lower.

The LM curve Shifts Down. 33 / 45


Monetary Policy in General Equilibrium
Describe What Happens (Method 1)

34 / 45
Monetary Policy in General Equilibrium
Describe What Happens (Method 1)

35 / 45
Monetary Policy in General Equilibrium
Describing What Happens (Method 2)
Shock: The Fed decides to increase the Money Supply.

(2) What is the general equilibrium effect of this policy on Output and the
interest rate? Hint: Look at the IS and LM relation equations!

C I
IS : Y = f (Y − T , i) + f (Y , i) + G

M
LM : = Y L(i)
P

IS curve is unaffected by a change in M, so the IS does not shift.

M increases, given a xed level of Y, interest rate i decreases. LM curve


shifts down.

36 / 45
Monetary Policy in General Equilibrium
Describe What Happens (Method 2)

37 / 45
Monetary Policy in General Equilibrium
Describe What Happens (Method 2)

38 / 45
Monetary Policy in General Equilibrium
Why General Equilibrium

39 / 45
Monetary Policy in General Equilibrium
Why General Equilibrium?
If we only look at the goods market:

A money supply increases would appear not to affect equilibrium


output.

If we only look at the money market:

A money supply increases would appear to have a signi cant impact on


interest rates, reducing equilibrium interest from i to i'.
0

40 / 45
Monetary Policy in General Equilibrium
Why General Equilibrium?
By looking at the IS-LM SR equilibrium:

An increase in M leads to output increasing (a larger change than the


goods market alone predicts).

An increase in M leads to interest rates decreasing from i to i (a


0 A

smaller change than the money market alone predicts).

NOTE: The general equilibrium interest rate decreases by less than what the
money market alone predicts exactly because output increases in general
equilibrium!

41 / 45
Monetary Policy in General Equilibrium
Equilibrium Changes
Q: When the money supply increases, what happens to the components of
demand?

Y : In equilibrium, income is higher, and taxes are unchanged, so


D

disposable income increases.

42 / 45
Monetary Policy in General Equilibrium
Equilibrium Changes
Q: When the money supply increases, what happens to the components of
demand?

Y : In equilibrium, income is higher, and taxes are unchanged, so


D

disposable income increases.

C : consumption f (Y , i) depends on both disposable income (+) and


C
D

interest rate (-). First, disposable income increases, consumption


increases. Second, the interest rate decreases consumption increases.
Consumption must increase.

42 / 45
Monetary Policy in General Equilibrium
Equilibrium Changes
Q: When the money supply increases, what happens to the components of
demand?

Y : In equilibrium, income is higher, and taxes are unchanged, so


D

disposable income increases.

C : consumption f (Y , i) depends on both disposable income (+) and


C
D

interest rate (-). First, disposable income increases, consumption


increases. Second, the interest rate decreases consumption increases.
Consumption must increase.

I: investment f (Y , i) depends on both income (+) and interest rate (-).


I

First, income increases, investment increases. Second, interest rate


decreases, investment increases. Investment must increase
42 / 45
Applications

43 / 45
Applications
Government Spending in Bonds Market
Q: What is the effect of an increase in Government Spending (or a decrease
in Taxes) on Bond Prices in the Short Run?

Step 1: An increase in government spending will increase goods


demand. It will not change the money demand or money supply.

Step 2: Following Step 1, we know the IS curve shifts right, and the LM
curve stays the same. This means equilibrium output and equilibrium
interest rates are higher.

Step 3: P B =
F

1+i
. Thus, if equilibrium i increases, then in equilibrium
bond prices must fall!

44 / 45
Applications
Policy Mix
When Bill Clinton was elected President in 1992, he prioritized reducing the
budget de cit by reducing Government spending and increasing taxes.

Q: What is the effect of this policy on output?

Q: Would this be a popular policy?

To combat the reduction in output that would occur from contractionary


scal policy, the Fed performed expansionary monetary policy (M
increased).

Q: What is the net effect of contractionary Fiscal Policy and expansionary


Monetary Policy on Y and i?

45 / 45
Overview
Unemployment
Labor Supply Equilibrium
Demand
Market
Motivation
What
Objective
Measurement
De
Calculation
U.S.
Collective
Labor
Price-Setting
Equilibrium
nitions
Labor
happens
Supply:
Bargaining:
Market
Example
Real
Relation
Wage-Setting
in Wage
the
Features:
medium Relation
run?
Question:
Answer
Not
Population:
Suppose
We
Note:
When
Collective
In
Q:
Do
The
To
Consider
Labor
the
How
Why
Who
produce
you
typically
Employment
Before
The
in
unemployment
wage
production
The
unemployment
Supply
Demand
short
end,
the
did
think
can
supplies
demands
questions
prices
the
setting
unemployment
Bargaining:
What
labor
1940,
the
we
one
weThe
run
treat
US
general
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orcare
that
labor
create
orfunction
happens
extra
only
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total
force:
models
labor
(N):
equation
labor
unemployment
Price-Setting
about
productivity
aabout
rate
force
The
people
case
unit
number
bargaining
is
arm
in
Anyone
in
general
high:
we
in
the
is
the
number
to
rate
sets
is
the
of
with
participation
(comes
given
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goods
comprised
medium
registered
production,
economy?
economy?
real
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of
is
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who
US
Imperfect
Relation
function
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correlated
people
by:
between
considered
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from
does
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people
usually
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statistic
(WS):
(WS):
of
at
on
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20
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with
describe
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who
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thus
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have
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46
30
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45327 / 46
9
fewer employed person
Unemployment Rate=in u the economy!!!
8.4/(132.4 + 8.4) ≈ 5.966%
Book Chapter 6

2 / 46
Overview

3 / 46
Overview
Motivation
In the short run models we have considered thus far (Ch. 3-5), we assumed
that the price, P, was xed, and rms will supply any level of output at this
price.

4 / 46
Overview
Motivation
In the short run models we have considered thus far (Ch. 3-5), we assumed
that the price, P, was xed, and rms will supply any level of output at this
price.

IS-LM model incorporating the Goods Market Equilibrium and Money


Market Equilibrium gives us insight about what is happening in the short-
run.

4 / 46
Overview
Motivation
In the short run models we have considered thus far (Ch. 3-5), we assumed
that the price, P, was xed, and rms will supply any level of output at this
price.

IS-LM model incorporating the Goods Market Equilibrium and Money


Market Equilibrium gives us insight about what is happening in the short-
run.

In the medium run, prices change!

goods price (price)

labor price (wage)

4 / 46
Overview
What happens in the medium run?
Question: What happens to goods prices over time (medium-run) when
rms increase output?

5 / 46
Overview
What happens in the medium run?
Question: What happens to goods prices over time (medium-run) when
rms increase output?

More workers are hired.

5 / 46
Overview
What happens in the medium run?
Question: What happens to goods prices over time (medium-run) when
rms increase output?

More workers are hired.

As more workers are hired, unemployment falls.

5 / 46
Overview
What happens in the medium run?
Question: What happens to goods prices over time (medium-run) when
rms increase output?

More workers are hired.

As more workers are hired, unemployment falls.

As unemployment falls, wages rise.

5 / 46
Overview
What happens in the medium run?
Question: What happens to goods prices over time (medium-run) when
rms increase output?

More workers are hired.

As more workers are hired, unemployment falls.

As unemployment falls, wages rise.

As total wages rise, production costs rise.

5 / 46
Overview
What happens in the medium run?
Question: What happens to goods prices over time (medium-run) when
rms increase output?

More workers are hired.

As more workers are hired, unemployment falls.

As unemployment falls, wages rise.

As total wages rise, production costs rise.

As production costs rise, goods prices increase!

5 / 46
Overview
Objective
Answer questions about the medium run.

Model the relationship between the price level, P, wages, W, and


employment to show how prices and output are determined over time!

Building block for (aggregate-demand and aggregate-supply) AD-AS model.

6 / 46
Unemployment

7 / 46
Unemployment
Calculation
Employment (N): The number of people who have a job.

8 / 46
Unemployment
Calculation
Employment (N): The number of people who have a job.

Unemployment (U): The number of people who do not have a job but
are looking for one.

8 / 46
Unemployment
Calculation
Employment (N): The number of people who have a job.

Unemployment (U): The number of people who do not have a job but
are looking for one.

Labor Force (L): The sum of all employed and unemployed people.

L = N + U
  
LaborF orce employment unemployment

8 / 46
Unemployment
Calculation
Employment (N): The number of people who have a job.

Unemployment (U): The number of people who do not have a job but
are looking for one.

Labor Force (L): The sum of all employed and unemployed people.

L = N + U
  
LaborF orce employment unemployment

Unemployment Rate (u): The ratio of the number of people


unemployed to the number of people in the labor force.

U
u =
L

8 / 46
Unemployment
Measurement
Before 1940, only people registered at unemployment of ces were
counted as unemployed.

9 / 46
Unemployment
Measurement
Before 1940, only people registered at unemployment of ces were
counted as unemployed.

People who had exhausted their unemployment bene ts did not


register. Unemployment was drastically underestimated (and still is in
many countries).

9 / 46
Unemployment
Measurement
Before 1940, only people registered at unemployment of ces were
counted as unemployed.

People who had exhausted their unemployment bene ts did not


register. Unemployment was drastically underestimated (and still is in
many countries).

Current Population Survey (CPS) is used in the US. Fifty thousand


households are interviewed each month.

9 / 46
Unemployment
Measurement
Before 1940, only people registered at unemployment of ces were
counted as unemployed.

People who had exhausted their unemployment bene ts did not


register. Unemployment was drastically underestimated (and still is in
many countries).

Current Population Survey (CPS) is used in the US. Fifty thousand


households are interviewed each month.

Who is unemployed?

Anyone who does not have a job has been looking for a job in the
last four weeks and is currently available for work.
9 / 46
Unemployment
Measurement
Not in the labor force: Anyone who does not have a job and has not tried
to get a job in the last four weeks. These individuals do not count towards
our unemployment measure.

One type of individual who is not in the labor force is a discouraged


worker.

Discouraged workers: People who stop looking for a job because they
fear that they won’t be able to nd a job even if they look.

10 / 46
Unemployment
De nitions
Population: The total number of people that are residents of a country.

Non-institutionalized Civilian Population: The total civilian population that


is available for work: calculated as total population minus individuals
under the age of 16, in prison, or the armed forces.

Labor Force: The sum of non-institutionalize individuals either working or


looking for work.

Unemployment Rate: The ratio of unemployed individuals to the total labor


force.

Participation Rate: The ratio of the labor force to the non-institutionalized


civilian population. This is the ratio of individuals working or trying to work
for all individuals capable of working. 11 / 46
Unemployment
Calculation Example
Suppose the US Economy is comprised of 20 non-institutionalized
individuals. 5 people have jobs. 5 people don’t have jobs but are looking.
10 people don’t have jobs and aren’t looking for a job. Calculate:

Labor Force (LF):

5 + 5 = 10

12 / 46
Unemployment
Calculation Example
Suppose the US Economy is comprised of 20 non-institutionalized
individuals. 5 people have jobs. 5 people don’t have jobs but are looking.
10 people don’t have jobs and aren’t looking for a job. Calculate:

Labor Force (LF):

5 + 5 = 10

Unemployment Rate (u):

5/(LF) = 5/10 = 50%

12 / 46
Unemployment
Calculation Example
Suppose the US Economy is comprised of 20 non-institutionalized
individuals. 5 people have jobs. 5 people don’t have jobs but are looking.
10 people don’t have jobs and aren’t looking for a job. Calculate:

Labor Force (LF):

5 + 5 = 10

Unemployment Rate (u):

5/(LF) = 5/10 = 50%

Labor Force Participation Rate (LFP):

(LF)/20 = 50%
12 / 46
Unemployment
Calculation Example
Suppose the US Economy is comprised of 20 non-institutionalized
individuals. 5 people have jobs. 5 people don’t have jobs but are looking.
10 people don’t have jobs and aren’t looking for a job. Now 3 people who
were unemployed stop looking for work and 1 person who was employed
loses their job (but continues looking for a job).

What is the unemployment rate now?

employment: 5 - 1 = 4

unemployment: 5 + 1 - 3 = 3

unemployment rate: 3 / (4 + 3) = 42.9%

The Unemployment Rate has decreased even though there is actually one
13 / 46
fewer employed person in the economy!!!
Unemployment
U.S. Labor Market Features:

14 / 46
Unemployment
U.S. Labor Market Features:

From the previous graph, we can see that of the 8.4 million, unemployed
workers, each month, nearly half (2.1 million nd jobs + 1.9 million leave LF)
are no longer unemployed at the end of the month.

15 / 46
Unemployment
U.S. Labor Market Features:

Compute the unemployment rate in the U.S from this graph.

16 / 46
Unemployment
U.S. Labor Market Features:

Compute the unemployment rate in the U.S from this graph.

Em = 132.4

U nem = 8.4

U nem
u =
Em + U nem

= 8.4/(132.4 + 8.4) ≈ 5.966%


16 / 46
Unemployment
U.S. Labor Market Features:
The unemployment rate in the US is usually much lower than in the
European Union. The average duration of unemployment in the U.S. is 2-3
months, which is also much shorter than the European Union.

17 / 46
Unemployment
U.S. Labor Market Features:
The unemployment rate in the US is usually much lower than in the
European Union. The average duration of unemployment in the U.S. is 2-3
months, which is also much shorter than the European Union.

Mobility (Language Barrier)

Unemployment Bene ts

Participation Rate

...

18 / 46
Unemployment
U.S. Labor Market Features:
We typically treat unemployment as a statistic that applies to the entire
economy, but do different groups experience different unemployment
rates?

19 / 46
Unemployment
U.S. Labor Market Features:
We typically treat unemployment as a statistic that applies to the entire
economy, but do different groups experience different unemployment
rates?

19 / 46
Unemployment
U.S. Labor Market Features:
We typically treat unemployment as a statistic that applies to the entire
economy, but do different groups experience different unemployment
rates?

20 / 46
Unemployment
U.S. Labor Market Features:
We typically treat unemployment as a statistic that applies to the entire
economy, but do different groups experience different unemployment
rates?

20 / 46
Unemployment
U.S. Labor Market Features:
Note: The unemployment rate is correlated with recessions (the grey
vertical lines).

21 / 46
Unemployment
U.S. Labor Market Features:
Note: The unemployment rate is correlated with recessions (the grey
vertical lines).

22 / 46
Unemployment
U.S. Labor Market Features:
When unemployment is high:

Employed workers face a higher probability of losing their job.

Unemployed workers face a lower probability of nding a new job.

This means: the likelihood of becoming unemployed and the duration


of unemployment are both increased when unemployment is high!

23 / 46
Unemployment
U.S. Labor Market Features:
When unemployment is high:

Employed workers face a higher probability of losing their job.

Unemployed workers face a lower probability of nding a new job.

This means: the likelihood of becoming unemployed and the duration


of unemployment are both increased when unemployment is high!

By focusing on unemployment and not employment, we miss the impact


of discouraged workers. Is this a problem?

23 / 46
Unemployment
U.S. Labor Market Features:
number of people in the labor force
Recall: The LFPR= non-institutionalized civilian population

24 / 46
Unemployment
U.S. Labor Market Features:
Q: Why did the labor force participation rate increase so steadily from the
1960s to the 1990s?

25 / 46
Unemployment
U.S. Labor Market Features:
Q: Why did the labor force participation rate increase so steadily from the
1960s to the 1990s?

26 / 46
Unemployment
Collective Bargaining:
Collective Bargaining: bargaining between a union (or group of unions) and
a rm (or industry).

In the U.S., only 10% of workers have wages set by collective bargaining.
In much of Europe, collective bargaining plays a much bigger role in
wage determination.

27 / 46
Unemployment
Collective Bargaining:
Collective Bargaining: bargaining between a union (or group of unions) and
a rm (or industry).

In the U.S., only 10% of workers have wages set by collective bargaining.
In much of Europe, collective bargaining plays a much bigger role in
wage determination.

In the U.S., most workers have their wages set by individual bargaining.
In general, the more skills a job requires, the more bargaining power
individuals have.

27 / 46
Unemployment
Collective Bargaining:
Collective Bargaining: bargaining between a union (or group of unions) and
a rm (or industry).

In the U.S., only 10% of workers have wages set by collective bargaining.
In much of Europe, collective bargaining plays a much bigger role in
wage determination.

In the U.S., most workers have their wages set by individual bargaining.
In general, the more skills a job requires, the more bargaining power
individuals have.

College graduates have a greater ability to negotiate their contracts


than workers in retail or food services.

27 / 46
Labor Supply

28 / 46
Labor Supply
Labor Supply: Wage-Setting Relation
Q: Who supplies labor in the economy?

29 / 46
Labor Supply
Labor Supply: Wage-Setting Relation
Q: Who supplies labor in the economy?

29 / 46
Labor Supply
Labor Supply: Wage-Setting Relation
Q: Who supplies labor in the economy?

To understand the labor demand, we need to understand how workers


ask for a wage rate.

29 / 46
Labor Supply
Labor Supply: Wage-Setting Relation
Q: Who supplies labor in the economy?

To understand the labor demand, we need to understand how workers


ask for a wage rate.

Workers consider

Expected Price

Labor Market Condition

Other Factors

29 / 46
Labor Supply
Labor Supply: Wage-Setting Relation
Q: How can we create a general function to describe the supply side of
labor?

Expectation Price: P (+)


e

P is the price expectation for an average person in the economy. This


e

average person could be an employer or employee.

If people in the economy expect the price to be high in the future.

The employees would want to ask for a higher wage, because they
expect things are more expensive in the future, so they need a higher
wage to match the expected higher price.

Assumption: Expected Future Price equals Current Price: P e


= P
30 / 46
Labor Supply
Labor Supply: Wage-Setting Relation
Q: How can we create a general function to describe the supply side of
labor?

Unemployment Rate: u

As the unemployment rate goes up, more people are looking for jobs
and fewer rms hiring.

It's harder for people to nd a job

The unemployed would ask for a lower wage.

31 / 46
Labor Supply
Labor Supply: Wage-Setting Relation
Q: How can we create a general function to describe the supply side of
labor?

Other things: z (+)

Workers have a reservation wage: The lowest wage workers would


accept to do a job. This is a mathematical simpli cation of
unemployment bene ts.

The other factors: bargaining power/skills.

...

32 / 46
Labor Supply
Labor Supply: Wage-Setting Relation
The wage setting equation (comes from workers):

W = P F (u, z)

(−,+)

This means Wage, W , is a function of :

Current Price P

The unemployment rate u

Other factors z.

33 / 46
Labor Supply
Labor Supply: Wage-Setting Relation
In the end, we care about the real wage W

P
, according to the labor supply,
we have the following Wage-Setting Relation

W
= F (u, z)
P 
(−,+)

When unemployment rate, u, is high, workers demand a lower real wage

When the other factor, skills or reservation wage, is high, workers


demand a higher real wage.

34 / 46
Labor Demand

35 / 46
Labor Demand
Price-Setting Relation
Q: Who demands labor in the economy?

36 / 46
Labor Demand
Price-Setting Relation
Q: Who demands labor in the economy?

36 / 46
Labor Demand
Price-Setting Relation
Q: Who demands labor in the economy?

To understand the labor demand, we need to understand rms


incentives.

36 / 46
Labor Demand
Price-Setting Relation
Q: Who demands labor in the economy?

To understand the labor demand, we need to understand rms


incentives.

Firms do two things

Buy input factor, such as labor at price w

Sell nal products at price P

36 / 46
Labor Demand
Price-Setting Relation
The prices that a rm sets depends on the costs they face.

These costs depend on the production function, the relation between


inputs used in production, and the quantity of output produced.

Assumption: Labor (N) is the only factor of production. The quantity of


output is a linear function of labor.

Q = A ∗ N

where we assume A is the labor productivity, which scales the ability of a


worker to produce output. Together A ∗ N is called the effective labor.

37 / 46
Labor Demand
Price-Setting Relation
Do you think labor productivity is constant over time?

What do you think labor productivity depends on?

Education

Skills

Technology

...

38 / 46
Labor Demand
Price-Setting Relation
The production function is given by: Q = A ∗ N , or N =
1

A
∗ Q

Q: If the rm wants to increase production, Q, by 1 unit, how much more


labor would the rm have to hire?

A: 1

A
units of labor

Q: How much would the rm have to pay this much labor?

A: 1

A
∗ W =
W

A
dollars

A
is the marginal cost for the rm.

39 / 46
Labor Demand
Price-Setting Relation
To produce one extra unit of production, Q, the rm has to pay extra W

dollars for labor. This unit of production is worth P dollars in the market.

Under Perfect Competition

W
P =
A

Under Imperfect Competition (more general case)

The rm can make a pro t, so that

P> W

A
, more speci cally, P = (1 + m)
W

A
where m is called the mark-up
m > 0 .

If the rms are perfectly competative, then m = 0.


40 / 46
Labor Demand
Price-Setting Relation
Consider the general case with Imperfect Competition, the real wage, W

P
,
according to Price-Setting Relation from Labor Demand is:

W A
=
P 1 + m

This relation says:

If the rm has access to better technology A, the rm can give a higher


real wage to workers.

If the rm has higher monopoly power, the rm gives a lower real wage
to workers.

41 / 46
Labor Market Equilibrium

42 / 46
Labor Market Equilibrium
Equilibrium Real Wage
Labor Supply or Wage-Setting Relation (WS):

W
= F (u, z)
P 
(−,+)

Labor Demand or Price-Setting Relation (PS):

W A
=
P 1 + m

43 / 46
Labor Market Equilibrium
Equilibrium Real Wage
Labor Supply or Wage-Setting Relation (WS):

W
= F (u, z)
P 
(−,+)

Labor Demand or Price-Setting Relation (PS):

W A
=
P 1 + m

This labor market model is trying to explain two variables of interest in our
economy:

Real Wage W

43 / 46
Unemployment Rate u
Labor Market Equilibrium
Equilibrium Real Wage
Labor Supply or Wage-Setting Relation (WS):

W
= F (u, z)
P 
(−,+)

Real Wage W

P
decreases as Unemployment Rate u increases

44 / 46
Labor Market Equilibrium
Equilibrium Real Wage
Labor Demand or Price-Setting Relation (PS):

W A
=
P 1 + m

Real Wage W

P
does not change as Unemployment Rate u increases

45 / 46
Labor Market Equilibrium
Equilibrium Real Wage

The Equilibrium Wage is equal to A

1+m

The Equilibrium Unemployment Rate is u , which is also called the natural


n

unemployment rate.

46 / 46
Review
Applications
Application
Medium-Run Output
Labor"Natural"
Unemployment
Anti-trust
Technology
Derive
Why
Conclusion
Market
Output
Enforcement
Advancement
Equilibrium
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Using
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This
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  where WS = PS with the
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Labor Market Part 2


n n
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Question:
The
employeed.
Note:
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increases,
Is output
Unemployment
prices. z Labor
Demand)WS:
Market
an endogeneou
Rate W
PS
u = determines
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, Aggregate
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When
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Demand natural rate of unemployment
Price-Setting
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P

In
The the
n
medium
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Demand) PS Curve shifts output up is entirely determined by the
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We need
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= WS:PS
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,output
where
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labor
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move output:
force.
wage or unemployment
labor m
market! L P
=
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P
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1+m
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Transform
Q: What's
output. next?
u =
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using
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Y P
n = A(11−
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IS-LM
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is called the
n natural level of output.
A: Look at the interaction
Note: Goods and Money of Market
Short Run
Eqm
Y = A ∗ N = A ∗ (1 − u)L
Policy (IS-LM)Aggregate
Determine and the Medium
Demand
Equilibrium
RunbecauseReal
(Labor Wage
Market)!
they doesn't
increases.
capture change behavior!
consumer
Equilibrium Real Wage increases.
Natural Rate of Unemployment Rate decreases.
increases. (Think about Europe)
20
24
10
23
22
18
16
14
19
15
13
12
21
17
11
8
6
45327 / 24
9
Natural Rate of Unemployment Rate decreases.
Book Chapter 6

2 / 24
Review

3 / 24
Review
Labor Market Equilibrium
Labor Supply or Wage-Setting Relation (WS):

W
= F (u, z)
P 
(−,+)

Labor Demand or Price-Setting Relation (PS):

W A
=
P 1 + m

4 / 24
Review
Labor Market Equilibrium
This labor market model is trying to explain two variables of interest in our
economy:

Real Wage W

Unemployment Rate u

5 / 24
Review
Labor Market Equilibrium
The Equilibrium Real Wage W

P
=
A

1+m

The Equilibrium Unemployment Rate u called the natural rate of


n

unemployment.

6 / 24
Applications

7 / 24
Applications
Unemployment Bene ts
Question: What happens to equilibrium real-wage and the natural rate of
unemployment if unemployment bene ts increase?

8 / 24
Applications
Unemployment Bene ts
Question: What happens to equilibrium real-wage and the natural rate of
unemployment if unemployment bene ts increase?

The (Labor Supply) WS Curve shifts up

z increases, WS: W

P
= F (u, z) , W

P
increases for a given u.

The (Labor Demand) PS Curve doesn't move

8 / 24
Applications
Unemployment Bene ts
Question: What happens to equilibrium real-wage and the natural rate of
unemployment if unemployment bene ts increase?

9 / 24
Applications
Unemployment Bene ts
Question: What happens to equilibrium real-wage and the natural rate of
unemployment if unemployment bene ts increase?

10 / 24
Applications
Unemployment Bene ts
Question: What happens to equilibrium real-wage and the natural rate of
unemployment if unemployment bene ts increase?

Equilibrium Real Wage doesn't change

Natural Rate of Unemployment Rate increases. (Think about Europe)


10 / 24
Applications
Anti-trust Enforcement
Question: What happens to equilibrium real-wage and the natural rate of
unemployment if a country increases its anti-trust enforcement (meaning
government reduces monopoly power)?

11 / 24
Applications
Anti-trust Enforcement
Question: What happens to equilibrium real-wage and the natural rate of
unemployment if a country increases its anti-trust enforcement (meaning
government reduces monopoly power)?

The (Labor Supply) WS Curve doesn't move

The (Labor Demand) PS Curve shifts up

m decreases, WS: W

P
=
A

1+m
, W

P
increases.

11 / 24
Application
Anti-trust Enforcement
Question: What happens to equilibrium real-wage and the natural rate of
unemployment if a country increases its anti-trust enforcement (meaning
government reduces monopoly power)?

12 / 24
Application
Anti-trust Enforcement
Question: What happens to equilibrium real-wage and the natural rate of
unemployment if a country increases its anti-trust enforcement (meaning
government reduces monopoly power)?

13 / 24
Application
Anti-trust Enforcement
Question: What happens to equilibrium real-wage and the natural rate of
unemployment if a country increases its anti-trust enforcement (meaning
government reduces monopoly power)?

Equilibrium Real Wage increases.


13 / 24
Natural Rate of Unemployment Rate decreases.
Application
Technology Advancement
Question: What happens to equilibrium real-wage and the natural rate of
unemployment if a country experiences a major technology advancement?

14 / 24
Application
Technology Advancement
Question: What happens to equilibrium real-wage and the natural rate of
unemployment if a country experiences a major technology advancement?

The (Labor Supply) WS Curve doesn't move

The (Labor Demand) PS Curve shifts up

m decreases, WS: W

P
=
A

1+m
, W

P
increases.

14 / 24
Application
Technology Advancement
Question: What happens to equilibrium real-wage and the natural rate of
unemployment if a country experiences a major technology advancement?

15 / 24
Application
Technology Advancement
Question: What happens to equilibrium real-wage and the natural rate of
unemployment if a country experiences a major technology advancement?

16 / 24
Application
Technology Advancement
Question: What happens to equilibrium real-wage and the natural rate of
unemployment if a country experiences a major technology advancement?

Equilibrium Real Wage increases.

Natural Rate of Unemployment Rate decreases.


16 / 24
Medium-Run Output

17 / 24
Medium-Run Output
Derive Output
Recall: the Labor Market Model is a medium-run model.

The variables of interest in the labor market model are: real wage and
unemployment rate.

Question: Is output an endogeneou variable?

We need to know whether output depends on real wage or unemployment


rate. If output depends on either one of them, the output is endogeneous.

18 / 24
Medium-Run Output
Derive Output
The answer is that output is indeed endogeneous.

Recall:

Output is Y = A ∗ N where N is the number of people who are


employeed.

By de nition u = L−N

L
, where L is the labor force.

Transform u = L−N

L
, we get N = (1 − u)L

In conclusion, Y = A ∗ N = A ∗ (1 − u)L

19 / 24
Medium-Run Output
Derive Output
The answer is that output is indeed endogeneous. In conclusion,

Y = A ∗ (1 − u)L

Hence Y depends on u which is one of the variables of interest.

When u is the natural rate of unemployment (equilibrium unemployment


n

rate), we have the following relation for equilibrium output:

Yn = A(1 − un )L

Here Y is called the natural level of output.


n

20 / 24
Medium-Run Output
Why "Natural"
Takeaway: The natural level of output, Yn, associated with a given natural
rate of unemployment, un, is such that the Price Setting and Wage Setting
relations are equal!

Yn and u are both natural because we assumed prices equal expected


n

prices.

21 / 24
Medium-Run Output
Conclusion
Labor Market Equilibrium is determined where WS = PS
 
LaborSupply LaborDemand

The Medium Run Equilibrium is determined where WS = PS with the


assumption Price equals Expected Price! ( P = P ).
e

In the medium run, equilibrium output is entirely determined by the


labor market!

Q: What's next?

A: Look at the interaction of Short Run Policy (IS-LM) and the Medium
Run (Labor Market)!

22 / 24
Medium-Run Output
Conclusion
We have now covered two cases:

(Short-run) IS-LM equilibrium (Ch. 5) - Goods Market and Money Market

(Medium run) Labor Market Equilibrium (Ch. 6)

23 / 24
Medium-Run Output
Conclusion
Using these four markets, we can derive (after the midterm):

Aggregate Supply Relation: captures the effect of output on the price


level. Derived using Labor Market Equilibrium.

Note: Labor Market determines Aggregate Supply because


Y = A ∗ N

Aggregate Demand Relation: captures the effect of price level on


output. Derived using the IS-LM Equilibrium.

Note: Goods and Money Market Eqm Determine Aggregate Demand


because they capture consumer behavior!

24 / 24
Review
Overview
Aggregate Supply Relation
Demand Relation
Every point
Wage-Setting
Price-Setting
Medium
Short
What's
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30
20
28
36
26
34
29
35
33
24
25
10
23
22
32
18
16
14
19
37
27
15
13
12
31
21
17
11
8
6
45327 / 37
9
Book Chapter 7

2 / 37
Review

3 / 37
Review
Wage-Setting Relation:
Workers (Labor Supply) ask wage based on W = P
e
F (u, z)

We assumed P e
. This simpli es the WS equations to
= P

W = P F (u, z) and it is this assumption that allows us to solve for u .


n

Under this assumption, the equilibrium unemployment rate is called


the natural rate of unemployment.

This assumption allows us to get the real wage asked by workers


W
= F (u, z)
P

4 / 37
Review
Price-Setting Relation:
We assume that Y = AN, where A is technology, and N is the number of
workers.

For one extra unit of product, rms need to hire 1/A more units of
labor.

Therefore, the marginal cost of production is W/A.

Firms hold monopoly power: P = (1 + m) W/A, where m is the mark-up.

We can write the real wage offered by rms is W/P = (1 + m)/A

5 / 37
Review
Labor Market Equilibrium
Set the real wage asked workers equal to offered by rms:

A
F (u, z) =
1 + m

6 / 37
Review
Labor Market Equilibrium
Set the real wage asked workers equal to offered by rms:

A
F (un , z) =
1 + m

un is the natural rate of unemployment

According to the equilibrium equation, we can study how u responds to


n

changes in z, A, m

z increases u increases
n

A increases u decreases
n

m increases u increases
n

7 / 37
Overview

8 / 37
Overview
Medium Run
Now we want to study the behavior of the economy in the medium run.

A hallmark of the medium run is that prices change!

We need to have a model to incorporate price as a variable of interest.

The other variable of interest is output (GDP).

We need to build a model for Aggregate Supply that models the


behaviors of price and output.

9 / 37
Overview
Short Run v.s Medium Run
Short-run story For aggregate supply:

Demand goes up

Firms produce more to meet the demand...

...without changing

i) the number of people they hire

ii) prices of their products

iii) wages they offer to their employees.

10 / 37
Overview
Short Run v.s Medium Run
Medium run story For aggregate supply:

Demand goes up

Firms produce more to meet the demand by hiring more workers.

Conseuqences:

i) Nominal wage goes up

ii) More costly to produce, so the price goes up.

iii) Higher price makes workers ask for a higher nominal wage.

goes back to i) ...


11 / 37
Overview
What's Next
We have now covered two cases:

(Short-run) IS-LM equilibrium (Ch. 5) - Goods Market and Money Market

(Medium run) Labor Market Equilibrium (Ch. 6)

12 / 37
Overview
What's Next
(Short-run) IS-LM equilibrium (Ch. 5) - Goods Market and Money Market

Gives us Aggregate Demand Relation: captures the effect of price level


on output.

Note that IS-LM captures consumer behaviors, that's why it's called AD
(aggregate demand) relation.

13 / 37
Overview
What's Next
(Medium run) Labor Market Equilibrium (Ch. 6)

Gives us Aggregate Supply Relation: captures the effect of output level


on price.

Note that Labor Market captures rms behaviors, that's why it's called
AS (aggregate supply) relation.

14 / 37
Aggregate Supply Relation

15 / 37
Aggregate Supply Relation
Labor Market Equilibrium Revisited
The AS Relation represents (medium run) equilibrium in the Labor Market.

Recall labor supply (WS) and labor demand (PS):


e
WS : W = P F (u, z)

PS : P = (1 + m)W /A

Before we assumed P = P to solve for a speci c equilibrium, u . We now


e
n

drop this assumption!

Why?

16 / 37
Aggregate Supply Relation
Labor Market Equilibrium Revisited
The AS Relation represents (medium run) equilibrium in the Labor Market.

Recall labor supply (WS) and labor demand (PS):


e
WS : W = P F (u, z)

PS : P = (1 + m)W /A

Before we assumed P = P to solve for a speci c equilibrium, u . We now


e
n

drop this assumption!

Why?

Because we want to model the behavior of price P , which is one of the


variables of interest in the AS-AD model.

16 / 37
Aggregate Supply Relation
Labor Market Equilibrium Revisited
The AS Relation represents (medium run) equilibrium in the Labor Market.

From now on, let's make a simplifying assumption: technology A = 1. This


assumption is good for the medium run.

Recall labor supply (WS) and labor demand (PS):


e
WS : W = P F (u, z)

PS : P = (1 + m)W

Combining the above two equations, we get the labor market equilibrium
equation:
e
P = (1 + m)P F (u, z)

17 / 37
Aggregate Supply Relation
Labor Market Equilibrium Revisited
We get the labor market equilibrium equation:
e
P = (1 + m)P F (u, z)

Q: We want an equation for P and Y . How do we get there?

A: Note u is related to Y. Sub in for u!

By de nition u = L−N

L
= 1 −
N

L
.

Also Y = N

Hence u = 1 − Y

18 / 37
Aggregate Supply Relation
AS Relation
We get the labor market equilibrium equation in terms of P and Y. This is
the AS Relation:

Y
e
P = (1 + m)P F (1 − , z)
L

19 / 37
Aggregate Supply Relation
AS Relation
Y
e
P = (1 + m)P F (1 − , z)
L

Q: If Y increases, what happens to P?

A: P increases.

20 / 37
Aggregate Supply Relation
AS Relation
Y
e
P = (1 + m)P F (1 − , z)
L

Q: If Y increases, what happens to P?

A: P increases.

Mathematically

Y increases

1 −
Y

L
goes down

F (1 −
Y

L
, z) goes up

P goes up
20 / 37
Aggregate Supply Relation
AS Relation
Y
e
P = (1 + m)P F (1 − , z)
L

Q: If Y increases, what happens to P?

A: P increases.

21 / 37
Aggregate Supply Relation
AS Relation
Y
e
P = (1 + m)P F (1 − , z)
L

Q: If Y increases, what happens to P?

A: P increases.

Intuitively

Y increases

Unemployment rate decreases

Workers ask for a higher wage

More expensive for rms to produce goods


21 / 37
Aggregate Supply Relation
AS Relation - Moving Along
Y
e
P = (1 + m)P F (1 − , z)
L

Q: If Y increases, what happens to P?

A: P increases. (Moving Along the AS Curve)

22 / 37
Aggregate Supply Relation
AS Relation - Shifting
Y
e
P = (1 + m)P F (1 − , z)
L

Q: If monopoly power m increases, what happens to P?

A: P increases. Shifting Up

23 / 37
Aggregate Supply Relation
AS Relation - Shifting
Y
e
P = (1 + m)P F (1 − , z)
L

Q: If expected price P increases, what happens to P?


e

A: P increases. Shifting Up

24 / 37
Aggregate Supply Relation
AS Relation - Shifting
Y
e
P = (1 + m)P F (1 − , z)
L

Q: If Labor Force increases, what happens to P?

A: P decreases Shifting Down

25 / 37
Aggregate Supply Relation
AS Relation - Shifting
Y
e
P = (1 + m)P F (1 − , z)
L

Q: If reservation wage, z, increases, what happens to P?

A: P increases Shifting Up

26 / 37
Aggregate Demand Relation

27 / 37
Aggregate Demand Relation
IS-LM Equilibrium Revisited
The IS-LM model captures the (short-run) equilibrium in the Goods and
Money Market.

Recall IS-LM:

C I
Goods Market IS : Y = f (Y − T , i) + f (Y , i) + G

M
Money Market LM : = Y L(i)
P

28 / 37
Aggregate Demand Relation
C I
Goods Market IS : Y = f (Y − T , i) + f (Y , i) + G

M
Money Market LM : = Y L(i)
P

29 / 37
Aggregate Demand Relation
Every point on the AD Curve represents a potential SR Equilibrium in the
IS-LM model!

30 / 37
Aggregate Demand Relation
AD Relation
Q: If P increases, what happens to Y

A: Y decreases

31 / 37
Aggregate Demand Relation
AD Relation
Q: If P increases, what happens to Y

A: Y decreases

P increases

Nominal GDP increases

Money Demand increases

More people sell bonds, bonds price goes down, the interest rate goes
up

Consumption and Investment goes down

Output Y goes down 31 / 37


Aggregate Demand Relation
AD Relation - Moving Along
C I
Goods Market IS : Y = f (Y − T , i) + f (Y , i) + G

M
Money Market LM : = Y L(i)
P

Q: If P increases, what happens to Y

A: Y decreases

32 / 37
Aggregate Demand Relation
AD Relation - Shifting
C I
Goods Market IS : Y = f (Y − T , i) + f (Y , i) + G

M
Money Market LM : = Y L(i)
P

Q: If T increases, what happens to Y

A: Y decreases, Shift Left

33 / 37
Aggregate Demand Relation
AD Relation - Shifting
C I
Goods Market IS : Y = f (Y − T , i) + f (Y , i) + G

M
Money Market LM : = Y L(i)
P

Q: If G increases, what happens to Y

A: Y increases, Shift Right

34 / 37
Aggregate Demand Relation
AD Relation - Shifting
C I
Goods Market IS : Y = f (Y − T , i) + f (Y , i) + G

M
Money Market LM : = Y L(i)
P

Q: If M increases, what happens to Y

A: Y increases, Shift Right

35 / 37
Aggregate Demand Relation

36 / 37
Aggregate Demand Relation

37 / 37
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