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Lecture Notes
Macro
Dr. Stokes
Preliminary Lecture notes for Macro Economics by Hall and Taylor
Prepared by Houston H. Stokes.
Draft date: 6/26/17 12:22:14 AM
Goal of the Notes: Allow the student to have an outline of the key ideas and solutions to the
problems. Since the notes are distributed in WORD® 97 format, students can edit the notes.
I. Fundamentals of Macroeconomics:
Chapter 1 The Macroeconomy: Growth and Fluctuations
Macroeconomics studies the aggregate economy - how and why the economy grows and fluctuates over
time. Macro Theory provides a means by which an informed person can make predictions on the economic
future.
Theory sets up simplified models which can determine the direction or movement of focus variables using
(graphical models) or the numerical values of focus variables (numerical models). Econometric models can
be estimated using econometrics. In most cases the only statistics needed is mean, variance and OLS. OLS
models can be estimated using EXCEL, SPEAKEASY or B34S or many other systems.
Key facts:

Growth around 2.5 % for past 25 years.

Growth above average for 6 consecutive years between 1983-1988

Figure 1-1 shows 1968-1991 history, while figure 1-2 shows deviations from trend

Real gross domestic product (GDP) measures actual physical production. Figure 1-3 shows history since
1910.

Figure 1-4 Employment as a percentage of working age population

Figure 1-5 shows unemployment rate.

Figure 1-6 shows Inflation. Note 1974 and 1980 period. Look at figure
1-7.What is the relationship between inflation and interest rates?

Figure 1-8 shows that money supply "seems to decline" before recessions. In 1989 rate of increase
slowed.

Long run growth a function of population, capital (physical & human) and technology.
1
Lecture Notes
Macro
Dr. Stokes

Key terms: potential output or GDP, aggregate demand curve.

Assume fixed potential output, changes in prices occur after a change in aggregate demand. What
changes aggregate demand?

Assume prices are fixed. Under what conditions can changes in aggregate demand cause changes in
output? Output must below potential.
Work analytical problem # 3 page 23. In addition to the questions asked, calculate the correlation between
the actual rate of inflation and the two forecasts. Where needed, numerical problems have been solved using
SPEAKEASY. SPEAKEASY is available on icarus at uic. Inspection of the SPEAKEASY code will allow
the reader to see the logic of the problem. Once the logic is seen, the problem can be placed in Excel ® or
other system. The b34s® MATRIX command is an alternative to SPEAKEASY. There is a free student
version of B34S. B34S is also available on icarus.
:_list p1d3
LISTING OF PROGRAM P1D3
1 PROGRAM
2 YEAR=INTEGERS(1977,1995)
3 P=60.6 65.2 72.6 82.4 90.9 96.5 99.6 103.9 107.6 109.6 113.6 118.3
4 P(13)=124.0 130.7 136.2 140.3 144.5 148.2 152.4
5 INT=5.5 7.6 10 11.4 13.8 11.1 8.8 9.8 7.7 6 8.1 6.9 8.0 7.5 5.5
6 INT(16)=3.6 3.1 4.7 5.7
7 TABULATE YEAR P INT
8 J=INTEGERS(NOROWS(P)-1)
9 INF=ARRAY(NOROWS(P):)
10 FINF=ARRAY(NOROWS(P):)
11 $ THIS GETS INFLATION
12 INF(J+1)=(P(J+1)-P(J))/P(J)
13 J=INTEGERS(NOROWS(P)-3)
14 $ THIS GETS INFLATION FORECAST
15 FINF(J+3)=.5*(INF(J+1)+INF(J+2))
16 INT=INT/100.
17 TABULATE YEAR P INT INF FINF INT-INF, INT-FINF
18 FREEIF X
19 FREEIF Y
20 $ GET SERIES WITH SAME NUMBER OF OBSERVATIONS
21 X(J)=FINF(J+3)
22 Y(J)=INF(J+3)
23 TABULATE X Y
24 CORRELATE X Y
25 END
2
Lecture Notes
Macro
Dr. Stokes
:_p1d3
EXECUTION STARTED
YEAR
P
INT
YEAR
P
INT
**** ***** ****
**** ***** ****
1977
60.6
5.5
1987 113.6
8.1
1978
65.2
7.6
1988 118.3
6.9
1979
72.6 10
1989 124
8
1980
82.4 11.4
1990 130.7
7.5
1981
90.9 13.8
1991 136.2
5.5
1982
96.5 11.1
1992 140.3
3.6
1983
99.6
8.8
1993 144.5
3.1
1984 103.9
9.8
1994 148.2
4.7
1985 107.6
7.7
1995 152.4
5.7
1986 109.6
6
YEAR
P
INT
INF
FINF
**** ***** **** ******** ********
1977
60.6 .055 0
0
1978
65.2 .076
.075908 0
1979
72.6 .1
.1135
0
1980
82.4 .114
.13499
.094702
1981
90.9 .138
.10316
.12424
1982
96.5 .111
.061606
.11907
1983
99.6 .088
.032124
.082381
1984 103.9 .098
.043173
.046865
1985 107.6 .077
.035611
.037649
1986 109.6 .06
.018587
.039392
1987 113.6 .081
.036496
.027099
1988 118.3 .069
.041373
.027542
1989 124
.08
.048183
.038935
1990 130.7 .075
.054032
.044778
1991 136.2 .055
.042081
.051107
1992 140.3 .036
.030103
.048057
1993 144.5 .031
.029936
.036092
1994 148.2 .047
.025606
.030019
1995 152.4 .057
.02834
.027771
X
Y
******* *******
.094702 .13499
.12424
.10316
.11907
.061606
.082381 .032124
.046865 .043173
.037649 .035611
.039392 .018587
.027099 .036496
.027542 .041373
.038935 .048183
.044778 .054032
.051107 .042081
.048057 .030103
.036092 .029936
.030019 .025606
.027771 .02834
CORRELATE X Y = .71194
MANUAL MODE
:_journal off
3
INT-INF
*********
.055
9.2409E-5
-.013497
-.020986
.034845
.049394
.055876
.054827
.041389
.041413
.044504
.027627
.031817
.020968
.012919
.0058972
.0010641
.021394
.02866
INT-FINF
*********
.055
.076
.1
.019298
.013758
-.0080708
.0056192
.051135
.039351
.020608
.053901
.041458
.041065
.030222
.0038926
-.012057
-.0050919
.016981
.029229
Lecture Notes
Chapter 2
Macro
Dr. Stokes
Measuring Economic Performance: Output and Income

Gross Domestic Product => Production during a particular period of time. Can be measured as spending
on goods and services, or production in different industries or income earned by different groups.

GDP = Y = C + I + G + X

X = exports – imports

C = durable goods + nondurable goods + services

I = fixed investment + inventory investment

fixed investment = nonresidential + residential

Investment is a flow of new capital added to stock of capital. Net investment = gross investment depreciation.
Kt  Kt 1

Investment = (Capital stock)t – (capital stock)t-1 =

Inventory investment = change in stock of inventories

X > (<) 0 => trade surplus (trade deficit)

Real GDP vs nominal GDP. How would these terms be used?

GDP =  value added =  final products =  income

GNP = GDP + net payments of factor incomes from abroad.
Accounting








F = Government transfers to the private sector
N'= interest on government debt
T = taxes
X = net exports
V = factor income and transfer payments from abroad (net)
Sp = Private Savings
Sg= Government savings
Sr= Rest of World savings

Sp = (Y + V + F + N' -T) - C
4
Lecture Notes
Macro
Dr. Stokes



Sg = (T - F - N') - G
Sg > (<) => budget surplus (budget deficit)
Sr = - X - V = net foreign investment of the United States







Sp+Sg+Sr
=(Y + V + F + N' - T) - C +(T - F - N' - G) - V - X
=Y-C-G-X
M = money, M = Mt - Mt-1
B = government bonds, B = Bt - Bt-1
Sg = -(M + B), Gov deficit => sell bonds and or print money
Sp = I + M + Bp (Bp = private bonds)
Sr = Br (Br = foreign holdings of U. S. government bonds)
Sp+Sg+Sr =I + M + Bp + - M -B + Br

Figure 2-1 lists investment and national savings in the US.

Exchange rate = dollar price of one unit of the foreign currency. Can be calculated as a trade weighted
exchange rate

Figure 2-4 Exchange rate data
Monitoring the Economy; Inflation and Employment

Inflation =  t  ( pt  pt 1 ) / pt 1

CPI measures cost of a basket of consumer goods.

PPI measures cost of a basket of producer goods.

Measuring Price The CPI measures price changes by buying a market basket of goods at different
times. Three known problems are:
1. Tastes may change over time but same basket is bought.
2. Relative prices may change but the same basket is bought
3. Price changes involve subtle income changes that give rise to income effects that will alter
the mix of goods bought.
5
Lecture Notes

Macro
Dr. Stokes
The CPI for period t, Pt is calculated with the Laspeyres formula:
n
n
i 1
i 1
Pt   pti q1i /  p1i q1i

If in place of the above equation the quantities could have been adjusted every year as in the Paasche
formula
n
n
i 1
i 1
Pt   pti qti /  p1i qti
which is not possible to calculate but would avoid the tastes bias and the relative price bias.

Laspeyre overstates price increase due to:

Not changing basket as relative prices change.

Not controlling for quality changes.

Not adjusting for taste changes

Paasche price index cannot be used historically. Why?

Figure 2.5 shows CPI. Contrast with deflator in figure 1-6.

Nominal GDP / real GDP = GDP deflator

GDP deflator does not include oil import prices, CPI does.

Since hours per week varies, employment is not a perfect measure of economic activity since hours per
week changes. HHS found that in Detroit there was great % change in employment versus % change in
hours than in Chicago. => more labor
hoarding in Chicago. # employed * hours per week is a
better measure BUT this does not take into account differences in overtime.

Key labor terms:

Labor force = # of persons GE 16 who are working or unemployed.

Unemployment rate = % of labor force that is unemployed.
6
Lecture Notes
Macro
Dr. Stokes

Labor force participation rate = % of working-age population that is in labor force.

Figure 5-2 shows unemployment rate 1950-1991. 1983 was highest unemployment rate. Cannot
directly compare this data with 30's since in later period there were fewer two wage earner families.

Even when real GDP = potential GDP, unemployment is not zero.
Numerical problem # 1 and # 2 page 53.
Problem 2-1
Net rental income of persons Depreciation
Compensation of employees
Personal Consumption expenditures
Sales and excise taxes
Business transfer payments
Statistical discrepancy
Gross Private domestic investment
Exports of goods and services
Net subsidies of government business
Government purchases of goods and services
Imports of goods and services
Net interest
Proprietor's income
Corporate profits
Net factor income from rest of world
a. GDP = C+I+G+EX-IM = 4378.2 + 882.0 + 1148.4 + 659.1 - 724.3 = 6343.4
b. NDP = GDP - depreciation = 6343.4 - 669.1 = 5674.3
c NI via expenditure method:
NI = NDP
- indirect business tax and nontax liability
- business transfer payments
- statistical discrepancy
+ government subsidy
+ net factor income from rest of world
= 5674.3 – 525.3 - 28.7 – 2.3 + 9.0 + 5.7 = 5132.7
NI via adding the incomes of different people
NI = compensation of employees + proprietors' income
+ net rental income
+ corporate profits
+ net interest
= 3780.4 + 441.6 + 24.1 + 485.8 + 399.5 = 5131.4
Problem 2 a. Budget deficit = private savings + rest of world savings – investment.
= $1050 + $100 - $1100 = $50.00
7
24.1
669.1
3780.4
4378.2
525.3
28.7
2.3
882.0
659.1
9.0
1148.4
724.3
399.5
441.6
485.8
5.7
Lecture Notes
Macro
Dr. Stokes
b. $50
c. $7000 - $80 = $6920
Numerical problem # 5 page 55
:_list p2d5
LISTING OF PROGRAM P3D2
1 PROGRAM
2 YEAR=INTEGERS(1978,1982)
3 CPI=65.2 72.6 82.4 90.9 96.5
4 GDPDIF=60.3 65.5 71.7 78.9 83.8
5 TABULATE YEAR CPI GDPDIF
6 ICPI=ARRAY(4:)
7 IGDPDIF=ARRAY(4:)
8 I=INTEGERS(4)
9 ICPI(I)=(CPI(I+1)-CPI(I))/CPI(I)
10 IGDPDIF(I)=(GDPDIF(I+1)-GDPDIF(I))/GDPDIF(I)
11 YEAR2=INTEGERS(1979,1982)
12 "Problem 2a"
13 TABULATE YEAR2 ICPI IGDPDIF
14 "Note: housing and oil make cpi show higher inflation"
15 "
"
16 "Problem 2b & 2c"
17 PCW1=.03 + .5 * ICPI
18 PCW2=0.0 + 1.0* ICPI
19 WAGE1=ARRAY(4:)
20 WAGE2=ARRAY(4:)
21 RWAGE1=ARRAY(4:)
22 RWAGE2=ARRAY(4:)
23 WAGE1(1)=12.00
24 WAGE2(1)=12.00
25 FOR I=1,3
26 WAGE1(I+1)=WAGE1(I)*(1.0+PCW1(I+1))
27 WAGE2(I+1)=WAGE2(I)*(1.0+PCW2(I+1))
28 NEXT I
29 I=INTEGERS(4)
30 RWAGE1(I)=100.0*WAGE1(I)/CPI(I+1)
31 RWAGE2(I)=100.0*WAGE2(I)/CPI(I+1)
32 TABULATE YEAR2 PCW1 PCW2 WAGE1 RWAGE1 WAGE2 RWAGE2
33 "For case 1 % change in wage < % change in CPI"
34 "Employer likes first arrangement."
35 END
:_p3d2
EXECUTION STARTED
YEAR
CPI GDPDIF
**** **** ******
1978 65.2
60.3
1979 72.6
65.5
1980 82.4
71.7
8
Lecture Notes
Macro
Dr. Stokes
1981 90.9
78.9
1982 96.5
83.8
Problem 2a
YEAR2
ICPI
IGDPDIF
***** ******* *******
1979
.1135
.086235
1980
.13499
.094656
1981
.10316
.10042
1982
.061606 .062104
Note: housing and oil make cpi show higher inflation
Problem
YEAR2
*****
1979
1980
1981
1982
2b & 2c
PCW1
*******
.086748
.097493
.081578
.060803
PCW2
*******
.1135
.13499
.10316
.061606
WAGE1
******
12
13.17
14.244
15.11
RWAGE1
******
16.529
15.983
15.67
15.658
WAGE2
******
12
13.62
15.025
15.95
RWAGE2
******
16.529
16.529
16.529
16.529
For case 1 % change in wage < % change in CPI
Employer likes first arrangement.
Note: SPEAKEASY code has been shown to illustrate the logic of the calculation which for problems such
as this is usually done with Excel.
9
Lecture Notes
Macro
Dr. Stokes
Chapter 3 The Long-Run Growth Model

Determinants of long run growth are labor, capital, and technology.

Since Civil war growth in South .5% greater than in north.

At time of Civil War per capita income in south 40% of North. Now it is about even. If growth in the
70's and 80's in the US had been what it was in the 50's and 60's => production in US up $4000 per
capita or about 3 times national defense budget. Growth matters.

Labor increased in 70's and 80's, will slow in the years ahead as the country gets older.

Labor participation rate has increased. (Role of women in labor force since WWII)

The natural rate of unemployment is about 5-6%, part is due to frictional unemployment. A small group
of individuals accounts for the majority of the unemployment. The natural rate of unemployment can
change over time due to changing characteristics of the labor force. Older workers
typically have
less unemployment.

If net investment > 0 => the capital stock will increase.

Difficult to measure capital utilization rate. Can use max electric power generation or (1-u) where u =
rate of unemployment. Why is measuring capital utilization rate so important? Unless be know this
value we do not know if the economy is getting “over heated.” An over heated economy => potential for
inflation since an increase in demand cannot be met by an increase in supply. Under what conditions
can this occur? (Wars (demand shocks). Oil crisis (supply shock).

Mass production is a technological advance. Modern factories that allow quick change-overs from one
good to another are an example of technology.

Technological change increases total factor productivity.

Production function Y = F(N, K, A)


N = Labor, K = capital and A = technology.
Cobb-Douglas form Y = AetNK

Marginal product of labor = dY/dN = AetN-1K = Y/N


Marginal product of capital = dY/dK = AetNK-1 = Y/K
10
Lecture Notes
Macro
Dr. Stokes
From the marginal product equation we note that:
k =  and l = 
( + ) is greater (less) that one, when there is increasing (decreasing) returns to scale.

Figure 3-1 shows output as a function of N given other inputs. The shape is due to diminishing marginal
product of labor. Contrast “diminishing marginal product of labor” with “diminishing returns to scale.”

Demand for Labor. In equilibrium marginal product of labor =

Figure 3-2 shows maximum profit position for employment. If wages increase => wage bill equation
will be steeper and max profit position will be where there is less labor. The analysis assumes that the
other factors are fixed. If the other factors are not fixed, what will happen?

Marginal product schedule => demand for labor function => (figure 3-3) where employment is a
negative function of the real wage. What assumptions have to be made to draw this curve?

The supply of labor is a positive function of the real wage. The supply of labor is effected by the
substitution effect (as the real wage increases leisure time away from work
gets more expensive)
and the income effect (as income increases people everything else equal work less).

Employment is where supply of labor = demand for labor (see
figure 3-5). N* = full
employment. Full employment is not max amount of work people would do, only what they would do
for the level of the real wage prevailing. Define full employment as Y* where
real wage.
Y* = f(N*,K,A)
where A = technology.
capital (K) measure.
Another approach would put the technology directly in the labor (N) and

Balanced growth => rate of growth of capital = rate of growth of labor.

Solow model has n = rate of growth of labor

Net investment = nK

Given s = savings rate, net saving = sY

Balanced growth => sY = nK or K/Y = s/n

Capital output ratio = ratio of savings rate to rate of growth of labor force.

What happens if sY > nK? = > capital grows, MPPk = Mk falls as K /Y
11
increases. More capital is
Lecture Notes
Macro
Dr. Stokes
needed for each unit of output.

The growth rate depends on growth of labor (capital) not the savings rate.

Figure 3-6 indicates effect of increasing savings rate. Steady state point is where savings is just enough
to keep capital per worker constant.

During old growth path, growth = growth of labor. Then savings rate increased making s/n > K/Y. As
K/Y increased growth was faster until in equilibrium it slowed to again equal the rate of growth of
labor.

Technological change => workers get more productive by factor g. Now capital must increase by n+g or
K/Y = s/(n+g)

Growth = technology growth plus weighted growth of capital and labor. How does technology increase?
Equation 3.8 postulates a production function for technology
A = T(NA,KA,A)
or the increase in technology, A , depends on the amount of labor producting technology NA and the
amount of capital producing technology KA.

Neutral technological change => F(N,K,A)=Af(N,k)

Y/Y
= A/A + f(N,K)/f(N,K)

f(N,K)/f(N,K)
= MNN/Y + MkK/Y

Y/Y
= A/A + MnN/Y + MkK/Y

In equilibrium the marginal product of labor equals the real wage, Mn = W/P, and the marginal product
of capital is the real rental price of capital, Mk = Rk / P (real wage & rental price of capital)

Y/Y
= A/A + (W/P)N/Y + (Rk/P)K/Y

Y/Y
= A/A + (WN/PY)N/N + (RkK/PY)K/K

WN/PY
= fraction of revenue paid out to labor assumed to be .7

RkK/PY
= fraction of revenue paid out to capital assumed to be .3

Figure 3-8 lists sources of growth. Effect of technical change is less in 80's than in 60's. Effect of labor
12
Lecture Notes
Macro
Dr. Stokes
is greater. Is this correct? Will this continue? What long run implications does a lower role for
technological change have?

The only need for governmental intervention is in cases of market failure. Specific policies are
investment tax credit and government support of research.

Given RkK/PY ~ .3 => 3.3% growth of capital to increase output 1%. Growth in capital was at 7% in
1966, then went down. In 1994 it would have taken a 22% increase in the amount of investment to raise
the capital stock by 3.3 percent. This rate of increase could not be sustained.

Since WN/PY ~ .7 => growth of labor has 2 times the effect of growth of capital. Reductions in taxes
stimulate work effort, increase employment via a shift in supply of labor schedule (see figure 3-12).

The last 30 years have seen a marked slowdown in real wage growth. (See Figure 3.13-14). Causes
include labor productivity slowdown. Total factor productivity is a general measure of productivity.

Endogenous growth theory (Romer-Lucas-Arrow-Uzawa) stresses that capital, labor and technology are
endogenous. Changes in taxes might have a permanent effect on the growth rate not just level as
suggested by Solow.

Most economists argue that potential GDP evolves smoothly over time. A recession or boom is a
temporary departure from potential. The Real business cycle theory argues employment is always where
supply = demand. Employment changes only when the supply or the demand curve shifts.

An oil shock could shift the demand for labor down and cause the real wage to fall.

The demand for labor is a function of the marginal product of labor. For farmers the marginal product
shifts during different times of the year. The real business cycle theory suggests that these shocks are
exogenous and cause business cycles.

The real business cycle theory states that  productivity =>  employment. Critics state that the
causality goes in reverse due to "labor hoarding" in recessions when workers are kept on because they
would be so hard to replace when the economy turns up.
13
Lecture Notes
Macro
Dr. Stokes
Supply
W/P
Demand
N*
N
Y/P
Production Function
(Y/P)*
N*
N
The Demand and Supply of Labor determine the full employment labor N* from which we get full
employment (Y/P)*
Work numerical problems 1, 2 and 3 page 95.
Problem 1. Labor supply = labor demand
a.
1000 + 12 (W/P) = 2000 - 8 (W/P)
20 (W/P) = 1000, W/P = 50,
N = 1000 + 12 * 50 = 1600
b.
Y = 100 N.5 => diminishing marginal product since
a 4 * increase in labor => output goes up 2 times
14
Lecture Notes
Macro
Dr. Stokes
Y = 100 * 1600.5 = 4000
Problem 2
Y/Y = A/A + .7N/N + .3 K/K
.05 = A/A + .7*.02 + .3 * .04
A/A = .024
If K/K rises by .01 => Y/Y rises by .003=.01*.3
If N/N rises by .01 => Y/Y rises by .007
Problem 3
Y = AN.7K.3 => lnY = lnA + .7 lnN + .3 lnK
Marginal product of capital = .3Y/K
Marginal product of labor = .7Y/N
Labor demand .7Y/L = W/P
Labor share = .7, Capital share = .3
15
Lecture Notes
Macro
Dr. Stokes
Chapter 4 Fiscal and Monetary Policy in the Growth Model

Fiscal policy => Changes in G, T and transfer payments to the private sector (F) and interest payments
on debt N'

Budget deficit = G + F + N' – T

Monetary policy => Changes in money supply. How do we measure the money supply? (M1, M2
other)? What is the effect of an increase in the amount of credit card debt? lines of credit?

In long run with flexible prices potential GDP = GDP and GDP depends on labor, capital and
technology. In order for monetary or fiscal policy to have a long run effect, one of these factors
must be affected.

If military spending goes down => no immediate effect on A, L or K. In long run private investment
might increase K.

If there was a reduction in R & D, then there may be some slowing in the growth of A.

A reduction in T rates increases worker incentives to work. For a given W/P more labor is supplied.

If prices are flexible => M/M > Y/Y => inflation. Inflation can reduce output.

Sinai-Stokes argued that real balances should be in the production function. They suggested that M/P
was a proxy for the financial sector. The effect of the financial sector was to increase economic
efficiency.

If G increases, everything else equal, the non-governmental share of GDP must decrease.

G (up) everything else = => pressure on interest rate (R) to rise. R increasing => exchange appreciation.
=> Foreign goods get cheaper, but our exports get more expensive. Trade balance worsens (X down). In
1980's this happened. As budget deficit increased trade deficit increased.

In long run, increasing the government deficit increases interest rates and crowding out of investment
and net exports occurs. In short run there is possible stimulation to the economy.

The demand for money is:
positively related to income (transactions motive),
negatively related to interest rates (speculative motive)
positively related to prices.
16
Lecture Notes
Macro
Dr. Stokes
LM Curve equation
M = (kY - hR)P
where k > 0, h > 0.

The Federal Reserve determines the money supply. Money is assumed to be currency plus balances in
checking accounts.

Given the supply of money, the equilibrium price level is
P = M /(kY* - hR*)
If M/M = 10% => P/P = 10% then money is neutral. This is called classical dichotomy. Figure
4-4 shows the effect of an increase in M on price, and in the case of a given money supply, the effect of an
increase in Y lowering P. This can be seen from the price equation.

Figure 4-5 shows effect of M/M on P/P. Since Y/Y > 0, M/M > P/P.

An implication of the classical dichotomy is that in the long run nominal variables only influence other
nominal variables.
Problem 2 page 117 and analytical problems 1, 2, 7, 9 on page 117-119.
Problem 2.
Y* = 4000. R* = .05. M =(.3Y-4000R)P, M=1000.
Problem 2a.
=> P = 1000/((.3*4000) - (4000*.05)) = 1000/1000 = 1
Problem b.
Fed increases M to 1100 => P = 1100/1000 = 1.1
Problem c.
If M = 1000, P = 1.0, k=.3 and h = 4000 =>
1000 = (.3Y - (4000*.05)). Y = (1000 + 200)/.3 = 4000.
PNEW = 1000/(.3*4000 - 4000*.1)= 1000 / 800 = 1.25
An increase in the interest rate could be caused by G up.
d. Given M = 1000, P = 1.0 if Y up from 4000 to 4500 then what happens to P?
1000 = (.3*4500 - 4000*.05)PNEW
PNEW = 1000/1150 = .87 . => given money supply, then Y up => P down. (This is what
happen in the US after the Civil War (1865-1890))
17
Lecture Notes
Macro
Dr. Stokes
Problem 1
Given I and X are negatively related to interest rate. Assume the interest rate is capped at 5% rather than the
equilibrium rate of 6%. What is the effect on the level and distribution of output? Level of output is not
changed since K, L or A not influenced initially. However, at 5% there are more claims on output than there
is output. There must be some rationing. How would the interest rate be held under 6%?
Problem 2a. Outward shift in labor supply => output up
Problem 2b Improvement in technology => output up
Problem 2c Increase in money supply => output unchanged. P up
Problem 2d Reduction in tax rate on income => Output does not
change initially BUT C crowds out I. N up since supply curve
of labor will shift outward.
_
Problem 7. Fed wants to maintain P using M.
- 7a. If potential GDP up => M up
- 7b. If t up yet potential GDP is constant => M down since N down
=> P up otherwise
- 7c. Investment function shifts right => P up. Policy is M down
- 7d. Foreign demand for US goods up => M down
Problem 9. Effects on price level
- 9a. Increase in labor supply => P down
- 9b. Decrease in sensitivity of investment to interest rate
=> P up
- 9c. Shift outward in Consumption function => P up
- 9d. Decrease on government purchases =>P down
- 9e. Increase in the average tariff rate on imports = P up.
18
Lecture Notes
Macro
Dr. Stokes
Chapter 5 Unemployment job Creation and Job Destruction

Unemployment rate measures the % of the labor force that is looking for a job but is unable to find one.
Unemployment measured in a national survey of households. In a recession, unemployment can hit
10%. In the 30’s the rate was 25%. This was quite serious since there were fewer two wage earner
families. If workers get discouraged they will stop searching and be not counted as unemployed.

Define:
b = job losing rate or the ratio of the number of people that become unemployed to the labor force
for that month.
e = job finding rate or fraction of unemployed who leave unemployment
u = unemployment rate or fraction of labor force that is unemployed
b=e*u
u = b/e or unemployment rate is ratio of job losing to job finding

In 1967 to 1993 job losing (b) was 2.7%, job finding was 43% which imply rate of unemployment u of
6.3 (.027/.43 = .062791). This suggests a natural rate of unemployment of 6.4%. Some enonomists thing
this has fallen to 5.5% in the 90’s.

Flows into unemployment due to: 1. Job destruction (in 1972-88 2% of manufacturing jobs were
destroyed), 2. Job loss without destruction (Currently 5% per month) and 3. Personal transitions
(Student changes jobs after graduation. Only 13% of unemployment rate due to this cause).

Flows out of unemployment due to 1. Successful job search (66% of cases), 2. Desire to leave labor
force (33%).

Search Theory. Workers optimally would not take first job that comes along. If all jobs are the same
worker takes first one offered. If there is a probability that a better job will come along, job seeker may
wait.

About 43% of unemployed either find jobs or leave the labor force. Natural unemployment rate = (job
losing rate)/job finding rate) = b/e. ”Efficient wage view” holds that employment relation ship works
best when workers feel their current jobs are valuable and that many are applying for their jobs and if
they leave it will be hard to get a new job. Figure 5.1 shows this is associated in equilibrium with high
unemployment.

Unions raise wages and working conditions. This implies a higher rate natural rate of unemployment.

Minimum wages raise natural rate of unemployment.
19
Lecture Notes
Macro
Dr. Stokes

Requiring those on welfare to seek jobs lowers the natural rate on unemployment.

Figure 5.2 shows pattern of unemployment since 50’s. Figure 5.3 shows job destruction (which is
positively associated with recessions).

Okun’s Law for each percentage point that unemployment is above natural rate, real GDP is 3% lower
than potential GDP.

Recessions allow firms to prune their operations. Capital is recycled. HHS found that in Chicago in
recessions there was more labor hoarding that is Detroit.

Phillips Curve suggests that there is a negative tradeoff between unemployment and inflation. The
argument was that to get lower unemployment there had to be higher inflation. Friedman and others
suggested that this assumed that the workers were “fooled” into taking a job. Once they realized that the
real wage was not as high (due to the inflation) they would not take the job. The Phillips curve did not
explain “stagflation” or high inflation and high unemployment. (See section 8.2)
Discussion:
Effects of a ban on use of farm equipment:
On real wage. Since real wages track labor productivity, real wage will fall since less capital used
in farming. Less capital implies less labor productivity.
On employment. Employment will increase to satisfy the demand to
needed since less productive.
produce.
Unemployment. Unemployment will fall.
Labor productivity. Labor productivity will fall.
Discuss Analytical Problem 1 page 141
Natural unemployment rate = (job-losing rate)/(job finding rate) = (b/e).
a. No change
b. Natural rate of unemployment down due to students out of labor force e up.
c. Search costs down implies e up natural rate down.
d. Down due to e up.
e. Natural rate down since there is an incentive to take a job now rather than wait.
20
More
workers
Lecture Notes
Macro
Dr. Stokes
Chapter 6 Short-Run Fluctuations and Spending Balance

Speed of Adjustment. Why does it take so long for an economy to return to potential GDP? I. E. what
causes a recession?

Work Incentives. Figure 5.6 shows at employment level NR the employer incentive to add a worker
and the employee incentive to work more. Here the marginal product of work is greater than the forgone
cost of other activities.

Aggregate demand (AD) curve measures spending relationships that affect demand. Points on the AD
curve show the different levels of output that the spending process generates at different price levels.
See figure 6-1. Figure 6-2 shows Y down at the same price, given a leftward move of AD. Figure 6-3
shows how a price shock such as P up to P(1) => Y falls to Y(1). In short run demand sets output since
prices cannot adjust. => sticky prices.

Sticky Prices. Prices appear to be "sticky" compared with production since the adjustment of
production and employment is quicker than the adjustment in prices.

Consumption function C
=  + Yd
=  + (1-t)Y
where  = marginal propensity to consume, t = tax rate. (figure 6-4)

Exogenous variables
=> determined outside model

Endogenous variables
=> determined inside model

Spending balance determines equilibrium Y given parameters and exogenous variables.
- Basic equation
Y
=C+I+G+X
=  + (1-t)Y + I + G + X
= ( + I + G + X) /(1 - (1-t))
- Assuming G is exogenous. Income multiplier = Y/G
Y/G = 1/(1-(1-t))
1/(1-(1-t)) = 1 + (1-t) + [(1-t)]2 + [(1-t)}3 + ...
assuming 1-(1-t) < 1
-
Assuming an open economy
net export function = g – mY
21
Lecture Notes
=> Y
Macro
Dr. Stokes
=  + (1-t)Y + I + G +g -mY
= ( + I + G +g) /(1-(1-t) + m)
=> open economy multiplier = 1/(1 - (1-t) + m)
-
Numerical problem 1 page 169 and analytical problems 4, 5 and
- Problem 1.
Y
= C + 900 + 1200 + X
C
= 220 + .9 Yd
Yd
= (1-.3)Y
X
= 500 - .1Y
- 1a Y = 220 + .9(1-.3)Y + 900 + 1200 + 500 -.1Y
= 2820 + .53 Y, => Y = 2820/.47 = 6000
- 1b Yd = .7(6000) = 4200
C = 220 + .9*4200 = 4000
=> Sp = Yd - C = 4200 - 4000 = 200
T = tY = .3*6000 = 1800
Sg = T - G = 1800 - 1200 = 600
X = g - mY = 500 - .1*6000 = -100
=> Sr= - X = 100
- 1c
Since I = Sp + Sg + Sr = 900
Sp = 200/900 or 22.2% of I
Sg = 600/900 or 66.7% of I
Sr = 100/900 or 11.1% of I
- Problem 4
Y=C+I+G
C =  + Yd
Yd = Y –T
- 4a => Y =  + (Y-T) + I + G =  + Y - T + I + G
=> Y /T = -/(1-)
- 4b Y/G = 1/(1-). Y/G > Y/T since  < 1
- 4c Given G = T, Y/G + Y/T=(1/(1-))-(/(1-))= 1
- Problem 5 Given
Y=C+I+G+X
C =  + Yd
Yd = (1-t)Y
22
6 pages 171-172.
Lecture Notes
Macro
Dr. Stokes
X = g -mY
- 5a Solve for Y and sub in last equation
=> X = g - m * [( + g + G + I)/(1-(1-t)+m)]
=> g causes X  TRUE
- 5b An increase in investment => income  which in turn raises taxes and imports. TRUE
- 5c FALSE. If G = T > 0 then Y must increase because balance budget multiplier = 1.
-
Problem 6 assumes a balanced budget G = tY.
-
6a.When ever Y changes then G must change. Because Y is endogenous => G is endogenous.
-
6b. Since G = tY, then every time Y increases, G increases also making the multiplier larger.
- 6c. When t increases Y must increase. This is because an increase in government spending adds
more to aggregate demand that the reduction in spending caused by higher taxes. This is because part of the
increase in taxes comes out of savings. (Note that the above answer does not treat efficiency questions
concerning the effect of the government spending nor does it deal with what the government buys.)
23
Lecture Notes
Chapter 7
Macro
Dr. Stokes
Financial Markets and Aggregate Demand

Investment now no longer is exogenous

I = e+dR where d < 0. See figure 7-1

The R in the investment function is the real interest rate

If i = nominal interest rate then,
i  R  (Pe / P)

Net exports depend negatively on interest rate since as R increases
the exchange rate will appreciate making is less likely for foreign
countries to buy US goods. X = g - mY – nR

In short run price level can be taken as given.
24
Lecture Notes
Macro
Dr. Stokes

I
LM
Ms > Md
Ms < Md
Y/p

IS-LM analysis developed by J. R. Hicks to explain Keynes. IS-LM model is a key engine of analysis
that can be used to illustrate at least “first round” effects. To get insight into more than first round
effects a model is needed. To obtain quantitative numbers for the effects, we need to obtain estimates of
the parameters of the equations underlying the IS-LM equations.
i
I>S
I <S
IS
Y/P
IS curve shows all the combinations of interest rate R and income Y that satisfy the income identity, the
 IS curve shows all the combinations of interest rate R and income Y that satisfy the income identity, the
25
Lecture Notes
Macro
Dr. Stokes
consumption function, the investment function and the new export function. Along IS I+X = S

IS curve is downward sloping. R (up) => I (down) & X (down) hence Y must go down to cause S to go
down such that I = S. Why does X go down? R up => appreciation which make export MORE
expensive.

An increase in governmental spending shifts IS to right by amount 1/[1-(1-t) + m]. See figure 7-2.

To left (right) of IS I+X > S (I+X < S). This relationship allows us to determine how IS will move as
other things that were formerly held constant change. Assume we are on the IS. This means that I + X =
S. Now assume something changes such that people become more concerned about investment
profitability. => points formerly where I + X = S not are (I + X) < S. Thus we deduce that the IS curve
shifted to the left because the old points now MUST be to the right of the IS curve.

LM curve shows all combinations of the interest rate and income Y that satisfy the money demand
relationship for a fixed level of the money supply and for a predetermined value of the price level. LM
is upward sloping. Points to right (left) of LM are points of excess demand (supply)of money. If M
increases (decreases) => LM shifts right (left). If P increases (decreases) LM curve shifts left (right)
since old points are now excess demand (supply) for money points. This thinking will allow us to move
the LM curve as other factors change. From the intersection of the IS and LM be get the equilibrium
interest rate and income.

Equation of LM Curve
M/P = kY –hR
where k = transactions demand for money (k > 0)
h = speculative demand for money. (h<0)

k > 0 since as income increases we need more money.

h < 0 since if R increases the opportunity cost of holding money increases since the amount of interest
forgone increases.

In recent years interest bearing demand deposits have lowered cost of holding money. Many brokerage
accounts allow “sweep” arrangements whereby money is moved into interest bearing accounts as soon
as dividends etc. are paid.

Derivation of IS curve:
Y=C+I+G+X
C =  + (1-t)Y
I = e - dR
X = g - mY -nR
26
Lecture Notes
Macro
Dr. Stokes
Y =  + (1-t)Y + e - dR + G + g -mY -nR
Y =  + e + g + [(1-t) - m]Y - (d+n)R + G
=>
R = (+e+g)/(d+n) -[(1-(1-t)+m)/(d+n)]Y + (1/(d+n))G
=> G (up)=> R (up) or a shift of the IS curve upward by amount
[1-(1-t) + m] /(d+t)
=>
Derivation of LM curve:

M/P = kY-hR

R = (k/h)Y - M/hP. => (M/P) (up) => interest rate R falls for a given level of income except in the
special case of a horizontal LM curve.

Figure 7-6 shows use of IS & LM to determine R and Y. The micro solve program allows students to
simulate policy. IS/LM analysis is the key macro tool. A full understanding of the laws of motion of the
IS and LM curve is at the heart of Macro Analysis.

Analysis assumes that investment and money demand both depend on the real interest rate R not the
money interest rate i. If the LM curve is drawn as a function of the nominal interest rate, then the
intersection of IS and LM => i = R. Given a fixed nominal money supply, this can only occur if growth
= 0 or P/P = 0. If there is positive growth, then i < R and Y/Y = P/P. GG curve is drawn steeper
than the IS curve and below it except where it intersects at growth = 0. The vertical difference between
IS and GG is growth. Most IS/LM analysis ignores this “refinement” suggested by Mundell.

Figure 7-7 shows effect of monetary and fiscal policy assuming that the level of income can increase.

Think of reasons the IS curve might change, reasons the LM curve might change. For all analysis on the
IS think if formerly (I + X_) = S, what is the relationship now? Once you have solved this thought
problem, move the IS curve.

For the LM curve think if formerly Md = Ms, what is the relationship now? Once you have solved this
thought problem, move the LM curve. Finally read off the answer.

Monetary policy to increase income will be more effective the more sensitive investment and net
exports are to changes in R and the less sensitive the transactions demand is to changes in income.

Fiscal policy to increase income will be more effective the less sensitive the transactions demand is to
changes in income and or the more sensitive the speculative demand is to changes in R.

Figure 7-8 shows cases were monetary and fiscal policy are strong and weak. Try to work out the cases
in your head, then check graph. Finally think back into what variables change in the model as the LM
and IS curve change.
27
Lecture Notes
Macro
LM
Dr. Stokes
LM*
i
b
a
d
c
IS IS*
Y/P
Start at a. If M  => LM to LM* and a movement to c.
Start at a. If T  or G  => IS to IS* and a movement to b.
Which point is better for banks? For you?
If both M  and G  or T  => movement to d.
Rational expectation
 Rational expectations. The IS-LM analysis must be modified to take into account expectations. If the
economy believes that in the future inflation will fall => long term interest will fall today.

Figure 7-10 and 7-11 shows the aggregate demand curve. The aggregate demand curve shifts right if M
up (or government spending increases). If the LM shifts due to a price change, then we move along the
aggregate demand curve. See graphical lineup of the curves in figure 7.11.
- Work numerical problem 6 on page 201 and analytical problems 3,
5 and 6 on page 202.
Problem 6
Y=C+I
C = 90 + .9Y
I = 900 - 900R
M = (.9Y - 900R)P
M=900
P = 1.0
Problem 6a.
28
Lecture Notes
Macro
Dr. Stokes
LM curve: (M/P) = .9Y - 900R
Y = (M/P)*(1/.9) + 900R/.9 = (M/P)*(1/.9) + 1000R or
R = -(1/900)*(M/P) + .001Y
IS curve: Y = C + I
= 90 + .9Y + 900 - 900R
Y = 9900 - 9000R or
R = 1.1 - (1/9000)*Y
Solve for Y and R
9900 - 9000R = (M/P)*(1/.9) + 1000R
9900 - 9000R = (900/1)*(1.9) + 1000R
9900 - 9000R = 1000 + 1000R
10000R = 8900 => R = .89
=> Y = 9900 - 9000*.89 = 1890.0
Problem 6b.
To get AD curve equate IS and LM and solve for Y.
-(1/900)*(M/P) + .001Y = 1.1 - (1/9000)*Y.
=> Y = 990 +(M/P). Given M=900 => AD Y = 990 + 900/P. If M were to
decrease, then AD shifts left.
Problem 6c.
Solving for P P = 900 / (Y - 990)
Problem 6d.
If M = 900 => Y = 1890 and R = .89 see 6a.
Problem 3a.
If investment demand is insensitive to the interest rate, then as interest rates
fall, investment will increase only a small amount. Thus only a small increase in
output will be necessary in order to keep output equal to aggregate demand.
Problem 3b.
An increase in interest rates decreases the demand for money. If money demand is
insensitive to income, then for a given rise in interest rates, it will require a
larger increase in income to restore balance between money supply and money
demand.
29
Lecture Notes
Macro
Dr. Stokes
Problem 3c.
If the LM is flat, a given rise in interest rates causes a larger decrease in money
demand, and requires a larger increase in income to equilibrate money demand
with fixed money supply.
Problem 3d.
When interest rates fall, investment and new exports increase. In order to restore
the balance between output and demand, output must increase. The
increase in output increases demand by less than the increase in output.
Thus an increase in output eventually restores the equilibrium between
output and demand. However the larger the marginal propensity to
consume the faster demand will rise as output rises and so it will take a
larger total increase in output to catch up with demand. M up => LM
moves right. G up (or T down) => IS moves right. R remains fixed.
Problem 6.
Democratic administration raises taxes more than Republican administration. => IS
is lower. Republican administration has a tighter monetary policy than
democratic administration. => LM is above democratic administration. At
the same level of income, the Republican administration will have a higher
interest rate, less investment, more consumption , less net exports, less
government savings and more private savings.
30
Lecture Notes
Chapter 8
Macro
Dr. Stokes
The Adjustment Process

In the short run the price level is predetermined. The AD curve shifts due to T, G or
M. If the resulting income level is above (below) the level of potential income price
will increase (decrease) in subsequent periods. This analysis abstracts from
expectations effects. Figures 8-1 & 8-2 shows these situations.

Okun's law states that for each percentage point by which the unemployment rate is
above the natural rate, real GDP is 3 percent below potential GDP.

Figure 8-4 illustrates that if GDP is < potential GDP it is possible to determine the unemployment rate
using Okun's law.

(Yt-1 - Y*)/Y* measures the pressure on prices to adjust. Inflationary momentum is an added effect.

Phillips curve. Define  = inflation = (Pt - Pt-1)/Pt-1, e = expected inflation.

 = e + f((Yt-1 - Y*)/Y*) see figure 8-5 and 8-6

Natural rate property. Since actual GDP can only exceed potential GDP if actual inflation exceeds
expected inflation, this implies that there is no way for GDP to be above its natural rate without
inflation (not just prices) increasing. This was first discovered by Phelps and independently by
Friedman. The implication of this analysis is that the government cannot fool the people in the long run.
This analysis was developed during the stagflation period when the US economy had high inflation and
high unemployment.

If we assume that e = .6t-1 the Phillips curve becomes
 = .6t-1 + f(Yt-1 -Y*)/Y*.
This implies that under conditions of expected inflation the price adjustment relation is shifted
upward by the amount of the expected inflation. Hence only in the short run when inflation
expectations are catching up can output be above potential output. The mechanism is that in this
situation workers are fooled into working longer since they see their real wages as higher than
they actually are.

Figure 8-7 and 8-8 illustrate the overshooting. The economy is first at potential GDP.
Next M up causes Y > Y*. Initially  > e. Then as price expectations increase Y falls
to a value below Y*. => In the long run an increase in M does not lead to an increase in
Y.
31
Lecture Notes
Macro
Dr. Stokes
- Work numerical problem 2 page 223 and analytical problems 5 and 9 page 224-225.
Problem 2 Given
Yt = 3401 + 2.887 M/P
t = .6t-1 + 1.2[(Yt-1 - 6000)/6000]
P =1
Problem 2a
6000 = 3401 + 2.887M
M = (6000-3401)/2.887 = 900.24
Model used:
C = 220 + .63Y
R = ((M/P)-.1583Y)/-1000
I = 1000 - 2000R
X = 525 - .1Y - 500R
Speakeasy setup to solve problem 8-2a and b
:_LIST P8D2
LISTING OF PROGRAM P8D2
1 PROGRAM
2 $ PROBLEM 8-2
3 Y=ARRAY(6:)
4 INF=ARRAY(6:)
5 P =ARRAY(6:)
6 R =ARRAY(6:)
7 C =ARRAY(6:)
8 INV=ARRAY(6:)
9 X =ARRAY(6:)
10 TEST=ARRAY(:6)
11 I=1
12 P(I)=1.0
13 Y(I)=3401 + 2.887*850/P(I)
14 R(I)=((850/P(I))-.1583*Y(I))/(-1000.)
15 C(I)=220+.63*Y(I)
16 INV(I)=1000 - 2000*R(I)
17 X(I)=525 - .1*Y(I) - 500*R(I)
18 INF(1)=0.0
19 TEST(I)=C(I)+INV(I)+X(I)
20 MAX=30
21 FOR I=2,MAX
22 INF(I)=.6*INF(I-1) + 1.2*((Y(I-1)-6000)/6000)
23 P(I)=P(I-1)*(1.0+INF(I))
24 Y(I)=3401 + 2.887*850/P(I)
25 R(I)=((850/P(I))-.1583*Y(I))/(-1000.)
26 C(I)=220+.63*Y(I)
27 INV(I)=1000 - 2000*R(I)
28 X(I)=525 - .1*Y(I) - 500*R(I)
29 TEST(I)=C(I)+INV(I)+X(I)
30 NEXT I
31 YEAR=INTEGERS(MAX)-1
32 TABULATE YEAR Y INF P R C INV X TEST
33 END
32
Lecture Notes
:_P8D2
EXECUTION STARTED
YEAR
Y
INF
**** ****** **********
0
5855
0
1
5928.3
-.02901
2
6011.1
-.031753
3
6055.8
-.016823
4
6053
.0010677
5
6023.5
.011236
6
5993.8
.011443
7
5979.3
.0056337
8
5981.3 -7.5707E-4
9
5992.2
-.0042009
10
6002.8
-.0040901
11
6007.7
-.0018953
12
6006.7
4.0965E-4
13
6002.6
.0015792
14
5998.8
.0014592
15
5997.1
6.2911E-4
16
5997.6 -1.9561E-4
17
5999.2 -5.8885E-4
18
6000.5 -5.1881E-4
19
6001.1 -2.0705E-4
20
6000.8
8.7671E-5
21
6000.3
2.1892E-4
22
5999.8
1.8386E-4
23
5999.6
6.7265E-5
24
5999.7 -3.7653E-5
25
5999.9 -8.1034E-5
26
6000.1 -6.4942E-5
27
6000.1 -2.1529E-5
28
6000.1
1.571E-5
29
6000
2.9887E-5
MANUAL MODE
:_JOURNAL OFF
Macro
P
*******
1
.97099
.94016
.92434
.92533
.93573
.94643
.95177
.95105
.94705
.94318
.94139
.94177
.94326
.94464
.94523
.94505
.94449
.944
.94381
.94389
.94409
.94427
.94433
.9443
.94422
.94416
.94414
.94415
.94418
Dr. Stokes
R
*******
.076839
.063049
.047461
.039061
.039594
.045136
.050716
.053448
.053081
.051034
.049032
.048103
.048304
.049076
.049789
.050096
.050001
.049713
.04946
.049358
.049401
.049508
.049598
.049631
.049612
.049573
.049541
.049531
.049538
.049553
C
******
3908.6
3954.8
4007
4035.2
4033.4
4014.8
3996.1
3987
3988.2
3995.1
4001.8
4004.9
4004.2
4001.6
3999.2
3998.2
3998.5
3999.5
4000.3
4000.7
4000.5
4000.2
3999.9
3999.8
3999.8
3999.9
4000.1
4000.1
4000.1
4000
INV
******
846.32
873.9
905.08
921.88
920.81
909.73
898.57
893.1
893.84
897.93
901.94
903.79
903.39
901.85
900.42
899.81
900
900.57
901.08
901.28
901.2
900.98
900.8
900.74
900.78
900.85
900.92
900.94
900.92
900.89
X
********
-98.914
-99.351
-99.845
-100.11
-100.09
-99.919
-99.742
-99.655
-99.667
-99.732
-99.795
-99.825
-99.819
-99.794
-99.771
-99.762
-99.765
-99.774
-99.782
-99.785
-99.784
-99.78
-99.777
-99.776
-99.777
-99.778
-99.779
-99.78
-99.779
-99.779
TEST
******
4656
4729.4
4812.3
4856.9
4854.1
4824.6
4794.9
4780.4
4782.4
4793.3
4803.9
4808.8
4807.8
4803.7
4799.9
4798.2
4798.7
4800.3
4801.6
4802.2
4801.9
4801.4
4800.9
4800.7
4800.8
4801
4801.2
4801.2
4801.2
4801.1
In long run Y = 6000,  = 0.0, P = .94418, R = .049553, C = 4000,
I= 900.89, X=-99.779, and G = 4801.
Problem 2c.
Since C depends on only Y, when Y overshoots, C will overshoot. I depends only on R. I will
overshoot when R is low. I overshooting will push up Y. X depends on both Y and R and does not have this
pattern.
33
Lecture Notes
Macro
Dr. Stokes
A SPEAKEASY program to graph answers is given next.
:_LIST DISP
LISTING OF PROGRAM DISP
1 PROGRAM
2 $ PROBLEM 8-2 DISPLAY
3 GRAPHICS VGA
4 GRAPH Y :YEAR ; PAUSE
5 GRAPH INF:YEAR ; PAUSE
6 GRAPH P :YEAR ; PAUSE
7 GRAPH R :YEAR ; PAUSE
8 GRAPH C :YEAR ; PAUSE
9 GRAPH INV:YEAR ; PAUSE
10 GRAPH X :YEAR ; PAUSE
11 END
Problem 5.
If there is a sudden and permanent decline in potential GDP then
initially there is no effect. Since Y > potential Y => P up.
As prices rise, R will increase while investment and
consumption fall. The effect on net exports is unclear
since Y up => X down (due to increased imports and
possibly a fall in exports at the exchange rate appreciates)
yet R up => X up due to capital being attracted. The
economy might proceed to a new equilibrium or cycle as
it proceeds to the new equilibrium depending on inflation
expectations.
Problem 9.
Y = Y0 + 2.887 * M /P
 = e + f((Yt-1 - Y*)/Y*)
Problem 9a. Real money supply = 1080/1.2 = 900
nominal money supply
= 1080
Problem 9b. In either case the Fed needs to keep the real money stock fixed at 900
billion. Thus it must increase the money stock by the rate
of inflation. If et = t-1 the Fed must increase the money
stock by 5% each year. If et = .6t-1 then inflation and
money growth will be 3%, 1.8%, 1.08% and .65% in each
year.
34
Lecture Notes
Chapter 9
Macro
Dr. Stokes
Macroeconomic Policy

Two types of shocks can hit the economy.

An aggregate demand shocks is some event other than a policy change that shifts the aggregate
demand curve. Examples include changes in foreign demand changing net exports, or a new type of
credit card that impacts money demand.

A price disturbance is some event that shifts the price adjustment relationship.

Disturbances can be temporary or permanent.

Figure 9-1 show examples of a shift in the net export market and a shift in the money demand equation.
Note what variables are on the axis of the graph.

Since monetary and fiscal policy also shift the aggregate demand curve, in order to determine the effect
of a shock we have to know what will be the change in monetary and fiscal policy.

Figure 9-2 illustrates the two situations shown in figure 9-1. In case one on the left: initially foreign
demand fell causing Y to fall at the old price level. As prices fell, Y increases. In case two on the right:
A reduction in money demand causes R down => I up => Y up as the aggregate demand curve moves
out. The effect will be to raise prices as Y falls to potential Y.

Price level shocks. Oil cartel; Firms make a mistake on expectations and increase prices; Union gets an
excessive settlement.

Economic Shocks. Investment function intercept changes. Change in money demand for a given level
of income or interest rate.

Figure 9-3 shows that a price level shock temporary moves economy up AD curve.

Figure 9-4 shows that an increase in money demand shifts AD left until the Fed increases M. => counter
cyclical stabilization policy.

Figure 9-5. If a stimulus arrives too late => economy can overheat.

While most economists agree on the desirability of maintaining aggregate demand, there is
disagreement on the means by which this is done. Disagreements center on:
The effectiveness of a governmental policy especially in a world of changing expectations, the
difficulty at predicting when a policy is needed (recognition lag) and problems in implementing the
policy in a timely manner (implementation lag).

Monetarists agree that monetary policy has an effect on real variables in the short run. In the long run
35
Lecture Notes
Macro
Dr. Stokes
prices adjust and the effect wears off. The problem is the monetary policy occurs with a long and
variable lag.

Politics. Monetary policy can lead to inflation, especially when monetary policy decisions are made in a
political setting.

Assume an upward price shock. Policies that increase the money supply in response to a price shock are
called accommodative policies. These put less pressure on prices to fall than nonaccommodative
policies that hold the money supply fixed and put maximum pressure on prices to fall.

Figure 9-7 highlights the dynamic pattern of GDP and prices in these two situations.

While treating policy variables as exogenous has long been the tradition, another view would treat them
as endogenous or the function of some policy rule.

There is a controversy over how much cost is incurred by not smoothing out the cycle. Tobin & Okun
stress that the costs are larger than Lucas and others. A recession may have the benefit of making firms
leaner.

By the selecting the policy mix the Fed can control the position and the slope of the AD curve.

Recent research has stressed that for a policy to be effective it must be consistent and credible. The
Budget Enforcement act of 1990 provides that every increase is entitlement spending must be matched
by either decreased in other entitlement spending or increased taxes. Explicit dollar limits were placed
on discretionary spending for 5 years.

In recent years have concentrated on policy rules not exogenous changes in the policy instruments.
Reasons include:

1. The recognition that expectations of policy can influence how policy works

2. The desire that policy not be time inconsistent, i. e. over time policy makers will do
what they said they would.

If Phillips relationship was  = e + f((Yt-1 - Y*)/Y*), then the only way that a policy maker could obtain
disinflation would be to have Y fall below potential output. If this is case, then the Fed must first
determine the target level of Y below Y*. The appropriate amount of money supply needed to achieve
this goal can be obtained from the LM equation. The more Y is less than Y* the faster the price level
falls. See figure 9-11A.

Sargent studied hyperinflation and concluded that it did not require Y to be substantially less than Y* for
a long period to curtail inflation. The key was the perception that a policy change had occurred.
Work numerical problem 1 page 248. Work analytical problems 5, 6, 9 page 292.
36
Lecture Notes
Macro
Dr. Stokes
Problem 1
Y=C+I+G+X
C = 220 + .63Y
I = 1000 - 2000R
X = 525 - .1Y - 500R
M = (.1583Y - 1000R)P
 = 1.2((Yt-1 - 6000)/6000)
M = 900, G = 1200, Y = 6000, P = 1
Problem 1a.
In year of shock new money demand function is
M = (.1583Y - 2000R)P. Price initially will not change.
Real money stays at 900/1 = 900. We derive the IS
Y
=C+I+G+X
= 220 + .63Y + 1000 - 2000R + G + 525 -.1Y - 500R
= 1745 - 2500R + .53Y + G
R
= (1745 - .47Y + G)/2500 = .6980 - .000188Y + .0004G
From new LM
R
= (.1583Y - (M/P))/2000 = .00007915Y -.0005M/P
Equate to form equation for AD curve
.6980 - .000188Y + .0004G = .00007915Y - .0005M/P
.6980 - .00026715Y + .0004G =-.0005M/P
Y = (-.0004G - .0005M/P -.6980)/(-.00026715)
Y = 2612.764365 + 1.497286169G + 1.871607711M/P
When M=900, P= 1, G=1200 =>
Y = 2612.764365 + 1796.743403 + 1684.446940 = 6093.954708
R = .00007915*6093.954708 - .0005*900 = .03203
=> Monetary shock raised Y and R
Problem 1b.
In subsequent years Y will fall back to 6000 and P will rise to solve the new AD curve.
6000=2612.764365 + 1.497286169*1200 + 1.87160771*900/P
6000 - 2612.764365 - 1796.743403 = 1684.446930/P
P = 1684.446930/1590.492232 = 1.059072717
Problem 1c.
R for long run Y=6000 calculated from new LM equation
R = .00007915*6000 - .0005*900/1.059072717 = .04999999
Problem 1d.
37
Lecture Notes
Macro
Dr. Stokes
The Fed could have reduced the money supply at once to maintain
money supply. The correct money supply would be (900/1.05072717) = 856.54
the same real
Problem 5a.
If there is a positive (negative) spending shock the Fed will increase (decrease) M and
prices will rise (fall) without limit.
Problem 5b. See 5a.
Problem 5c.
Fiscal policy can be used to stabilize interest rates. Using fiscal policy to offset fiscal
shocks and monetary policy to offset monetary shocks allows policy makers to stabilize the interest rate and
prices.
Problem 6.
"Stagflation." After a price shock, output falls. Prices, however, can continue to rise in
subsequent periods due to the effect of past inflation on inflationary expectations. This leads to further
reductions in output.
Problem 9a.
Reagan wanted to reduce inflation, lower taxes and increase defense spending. Lowering
taxes and increasing defense both moved the aggregate demand curve right. This would drive output above
potential and cause inflation unless a very tight monetary policy was used
Problem 9b.
Other policies could be used. If defense was lower, then a less restrictive monetary policy
would be needed. However Reagan felt that lowering taxes would have long run effect of increasing
potential output.
38
Lecture Notes
II.
Macro
Dr. Stokes
The Micro Foundations of Aggregate Demand
Chapter 10 The Consumption Demand

Figure 10-1 illustrates that over the long run real GDP and real C grow at about the same rate but over
short-run business cycles, consumption expenditures fluctuate less than GDP.

Figure 10-2 illustrates that expenditures on services and nondurables grow smoothly while expenditures
on durables are the most volatile component of C.

Consumption expenditures => when you buy the car.

Consumption => takes place over the life of the car.

Consumption is a function of real disposable income not real GDP.

Due to automatic stabilizers, (progressive tax system, unemployment benefits)real disposable income
fluctuates less than real GDP. (See figure 10-3).

Figure 10-4 illustrates as a first cut C = .93Yd.

Figure 10-5 plots the errors of the simple model. Big positive errors in 1960-1967 and 1987-1995. Big
negative errors in 1973-1975.

On average consumption is smoothed out compared with disposable income. => Long run MPC =/
Short run MPC.

MPC
Total Consumption
long run
.93
short run
.72

Long run MPC's based on least squares fit on levels.

Short run MPC's based on least squares fit on year-to-year changes.

Friedman's permanent income theory stresses that consumption is a function of permanent income not
transitory income. (Income = permanent income + transitory income). Modigliani's life cycle theory
stresses that families look ahead over their whole life times in forming their consumption decisions.

Simple treatment using models that can be estimated easily:
Nondurables & Services,
.78
.41
39
Durables
.15
.31
Lecture Notes
Macro
Keynesian
Ct     Yt
Friedman
Ct  cYt p
Dr. Stokes
k
Yt p   iYt i 1
i 1
k
Ct  c  iYt i 1
=>
i 1
assume i   i 1
k
Ct  c   i 1Yt i 1  et
=>
i 1
if we lag and multiply by 

Ct 1  c   iYt i  et 1
i 1
subtracting gives
[Ct  Ct 1 ]  cYt  [et  et 1 ]
Ct
 cYt  Ct 1  [et  et 1 ]
Note added term Ct 1

Life cycle suggests Ct = f(Y, W) where W is wealth and Y is

Ct =  + 1Yt + 2Wt-1

Problem, how do we get wealth?
Wt - Wt-1 = Yt - Ct
Since Ct-1 =  + 1Yt-1 + 2Wt-2
=> [Ct - Ct-1]
= 1[Yt - Yt-1] + 2[Wt-1 - Wt-2]
40
disposable income.
Lecture Notes
Macro
Dr. Stokes
= 1[Yt - Yt-1] + 2[Yt-1 - Ct-1]
= 1Yt + [2 - 1]Yt-1 + [1-2]Ct-1
=> Ct

This formulation nests Keynesian and Friedman as special cases of this form of the life cycle model
which can be easily tested with data. Extensions include better measures of wealth.

More advanced treatment of wealth: Family faces intertemporal budget constraint. Define
At
Rt
Et
Tt
Ct
=>
= assets at beginning of year of year t
= interest rate on assets during year t
= income from work during year t
= taxes during year t
= consumption during year t
At+1
= At + RtAt + Et - Tt - Ct

Figure 10-7 shows steady consumption pattern compared with income growth and decline over lifetime.

Implications of forward looking model:

Households choose current consumption as a part of lifetime consumption pattern.

MPC of permanent income close to one.

Since will not spend transitory income that is added to family assets, in long run consumption will
increase by  transitory income times the after tax rate of interest.

Theory assumes household prefer smooth consumption profiles.

In 1968 LBJ passed the temporary tax surcharge to curb inflation. The economy figured this was
temporary and did not reduce their consumption as much as expected. Short run fiscal stimulus, such as
tried in 1974-75, did not work as expected since economy figured out what was going on. The
implications is that short term activist economic policy does not work as well as expected.

Why is Japanese savings rate > US savings rate? If an economy is growing, younger people who
disproportionately save, will have higher incomes than the older people had when they were young. =>
savings rate of fast growing country will be > savings rate of slow growing country. Other reasons are
tax system in Japan favors savings, not as extensive a social security system and high cost of Japanese
housing.

Rational expectations approach uses forecasted income in consumption function.

The current level of consumption is the best predictor of future consumption. There is some evidence
that consumption is a random walk.
41
Lecture Notes
Macro
Dr. Stokes

The evidence from temporary changes in taxes in the 60's and 70's is that consumption changes are
small. => fiscal policy that involves T may be weaker that the Keynesian theory predicts.

The interest rate affects the price of future consumption relative to current consumption. Assuming a
positive real rate of interest => an incentive to defer spending.

If the real rate of interest is higher than the rate of time preference, then people will shift the
consumption a bit toward the next year.
Work numerical problem 2 page 291 and numerical problem 5 page 292.
Problem 2.
Assume
C
Yp
Y
= 220 + .9Yp
= .5(Yt +Yt-1)
= disposable income
Problem 2a.
Yp = .5(4000 + 4000) = 4000. => C2 = 220 + .9*4000 = 3820.
Problem 2b.
C3 = 220 + .9*.5*(5000 + 4000) = 4270
C4 = 220 + .9*.5*(5000 + 5000) = 4720
Problem 2c. Short run MPC = .45
Long run MPC = .90
Problem 2d.
People seek to smooth out their consumption expenditures over time. Therefore they base
their consumption expenditure plans on a long-run average of income, or permanent income, rather than on
the more variable annual income.
Problem 5a.
In response to the higher spending by the government, it may take a while for consumers to realize
that there has been a permanent increase in their income. As consumers come to regard more and more of
their increased income as permanent, they will increase their consumption and shift out the IS curve.
Problem 5b.
The higher the weight on this period's income, the faster the IS curve moves out.
42
Lecture Notes
Macro
Dr. Stokes
Chapter 11 Investment Demand

Investment the most volatile component of aggregate demand.

Figures 11-1 and 11-2 plot investment components

Capital has diminishing marginal product. The marginal benefit of capital schedule is the firms demand
for rented capital schedule.

The demand for capital schedule move out if Y increases since Y up => N up which in raises the
marginal product of capital.

Determination of rental price of capital:
Pk
R
d
RK
= price of new machine
= real interest rate
= rate of depreciation (at end of year have to spend d times original price
to make up for wear and tear)
= rental price of the equipment

RK = (R + d)PK

Demand for capital declines if RK up.

Demand for capital rises if planned output rises.

Demand for capital rises in W down. (substitution effect).

Define K = PK /PK, then RK = (R-K + d)PK . In words, if the rental price of capital depends positively
on real interest rate, negatively on the expected change in the price of capital and positively on
depreciation.

K* = desired capital stock.

K* = .5(W/RK)Y

If firm wants capital stock to equal desired capital stock.

I = K*t - Kt-1 = .5(W/RK)Yt - Kt-1

Investment depends positively on W, negatively on rental price of capital and positively on output.
Effect of output on investment is accelerator.

If v = .5(W/RK), then It = vYt - vYt-1 = vY. In words the level of investment depends on the change in
output.
43
Lecture Notes
Macro
Dr. Stokes

The above model assumes complete adjustment in each period.

Assuming lags I = s(K*t - Kt-1) = s(.5(W/RK)Yt - Kt-1)

Taxation of capital tends to discourage investment by reducing the earnings the firm receives from its
investment.

Define:
u = tax rate on rental income
z = investment incentive
(1-u)RK = (R+d)(1-z)PK
We equate after tax rental income to after tax cost of renting.

RK = [(R+d)(1-z)PK]/(1-u)

Anticipated changes in tax incentives further complicate decision.

Residential housing equations are similar.

Housing is most sensitive to real interest rates since d is small relative to R since most houses last a long
time.

Inventories provide a buffer stock to accommodate unexpected changes in demand. If inventories are a
fix percentage of expected sales, and this percentage changes, this can imply a shock to aggregate
demand due to inventory adjustment.

Tobin's q. Since investment takes place with a lag for substantial periods of time a firm may be out of
adjustment. Let J = marginal benefit of capital and RK = rental price of capital. J/RK > 1 => firm will
invest in capital. In the stock market J/MV should equal RK where MV is the market value of
outstanding stock. Tobin defined q = MV / PK = j/RK. Investment is positively related to q.
Work numerical problems 1-3 page 325.
Problem 1.
Assume I = s(K*t - Kt-1), K*t = .1Yt/Rt
Problem 1a
44
Lecture Notes
Macro
Dr. Stokes
K* = .1*200/.05 = 400
I = .25(400-400)=0
Problem 1b
K* = .1*250/.05 = 500
year
Kt-1
2
400
3
425
4
443.75
It
Kt
25
425
18.75
443.75
14.0625 457.8125
Long run K* = 500, I = 0
Problem 1c
year
2
3
4
Kt-1
400
500
500
It
100
0.0
0.0
Kt
500
500
500
=> immediate adjustment of capital stock
Problem 2a
K* = .1*200/.05 = 400
I = .25(400-400) + .1*400 = 40
Problem 2b
K* = .1*250/.05 = 500
year
Kt-1
It
Kt
2
400
65
425
3
425
61.25 443.75
4
443.75 58.4380 457.8125
Long run K* = 500, I = 0
Problem 2c
year
2
3
4
Kt-1
400
500
500
50
It
140
50
500
=> immediate adjustment of capital stock
=> Investment is .1 * Kt-1 + old values
45
Kt
500
500
Lecture Notes
Macro
Dr. Stokes
Problem 3.
Y=C+I+G+X
I = 400 - 2000R + .1Y
C = 220 + .63Y
X = 525 - .1Y - 500R
M = (.1583Y - 1000R)P
G = 1200, P=1.0, M=900
Problem 3a
Y = 220 + .63Y + 400 - 2000R + .1Y + G + 525 -.1Y - 500R
= 1145 + .63Y - 2500R + G
=> R = (-.37/2500)Y + .0004G + .458
= -.000148Y + .0004G + .458
Coefficient on old IS was -.00188. New IS is flatter because as Y up => I up along with C
up thus a larger increase in Y is required to restore balance.
Problem 3b
The old LM was R = .0001583Y - .001M/P
AD => .0001583Y - .001*M/P = -.000148Y + .0004G + .458
.0003063Y
= .001M/P + .0004G + .458
Y
= 3.264773098M/P + 1.305909239G + 1495.266079
The coefficients of G and M/P in the old AD were 1.15 and
2.89 respectively.
Problem
3c
dY/dG = 1.3059 which is larger than old value of 1.15
Problem 3d
dY/dM = 3.26477309 which is larger than the old value of
2.89. M up => interest rates lower and I up => Y up which in turn drives I up more due
to .1Y in investment function.
46
Lecture Notes
Macro
Dr. Stokes
Chapter 12 Foreign Trade and the Exchange Rate

Figure 12-1 shows historical data on imports and exports.

When imports > exports US must finance difference plus any other expenditures abroad with
borrowing.

Terms of trade = price of exports / price of imports.

Exchange rate = $ price of one unit of foreign currency is usual definition. Book uses foreign currency
price of one US dollar. Using book definition appreciation means exchange rate rises.

Figure 12-2 shows the trade weighted exchange rate for US vs Canada, France, Germany, Japan and
UK.

Real exchange rate is an exchange rate adjusted for differences in price levels between US and rest of
world. (ROW)= foreign price of US goods/foreign price of ROW goods.

Nominal exchange rate = number of units of the foreign exchange rate per 1 US dollar.

When real exchange rate is high foreigners have to pay more for goods produced in the US.

Purchasing power parity => exchange rates move in step with prices of traded goods in different
countries. Does not work in the short run but underlies long run adjustment dynamics.

Net Export function:
X = g - mY - n*RE
RE = real exchange rate

Figure 12-4 show negative relationship between real exchange rate and net exports.

The real exchange rate (RE) is positively related to the US interest rate. High US interest rates attract
capital into the US and appreciates the exchange rate.

Open economy IS curve:
Y
=>R
=C + I + G + X
= a + b(1-t)Y + e-dR + G + g - mY - n*RE
=[(a+e+g)/d] -[(1-b(1-t)+m)/d]Y -[n*RE/d] +[G/d]
47
Lecture Notes
Macro
Dr. Stokes

Shows that the interest rate is negatively related to the real exchange rate. Appreciation of the dollar
shifts the IS curve downward; depreciation raises the curve.

M up => interest down=> I up => depreciate exchange rate => net exports rise. However the increase in
GDP tends to decrease net exports because imports rise.

Government runs a deficit due to tax cut => IS shifts outward, interest rates rise, and the dollar
appreciates and net exports decline. This happened in the 80's.

Fixed exchange rates and perfect capital mobility => monetary policy can inflate the world but have no
effect on the domestic interest rate.

Flexible exchange rates allow the monetary authorities to establish an interest rate different from the
rest of the world.

Price level adjust quickly to events outside the country, especially if the home country is small.

Movements in the exchange rate implicitly change prices in the home country.

Recently there has been a trend toward trade liberalization (NAFTA and GATT).
Work numerical problem 1 page 358
48
Lecture Notes
Macro
Dr. Stokes
Problem 1:
Y=C+I+G+X
C = 220 + .63Y
I = 400 - 2000R + .1Y
M = (.1583Y - 1000R)P
X = 600 -.1Y -100 EP/Pw
EP/Pw = .75 + 5R
Problem 1a.
Endogenous Y, C, I, X, R, E
Exogenous G, M, P, Pw
Problem 1b.
Y
=>
R
=220+.63Y+400-2000R+.1Y+G+[600-.1Y-(100(.75+5R)]
= 1145 + .63Y - 2500R + G
= .458 - .000148Y + .0004G
From LM M/P - .1583Y = -1000R
=>
R
= .0001583Y - .001M/P
Equate R from the two equations
AD
.458 - .000148Y + .0004G = .0001583Y - .001M/P
=> Y = 1495.266079 + 1.305909239G + 3.264773098M/P
Given G = 1200, M=900 and P = 1
Y = 1495.266079 + 1567.091087 + 2938.295788 =6000.65295
C = 220 + .63*6000.65295 = 4000.41136
R = .458 - .000148*6000.65295 + .0004*1200 = .049903363
I = 400 - 2000*.049903363 + .1*6000.65295 = 909.2585690
X = 600 - .1*6000.65295- 100(.75+5*.049903363)= -100.16978
E = .75 + 5*.049903363 = .999516815
49
Lecture Notes
Macro
Dr. Stokes
Chapter 13 Spending, Taxes, and the Budget Deficit

In past have assumed that G is exogenous. Actually level of government expenditure adjusts to changes
in economic activity following a reaction function.

In Reagan & Bush years, Federal Government pushed responsibility down to state level of many
functions formerly done at the Federal level.

Figure 13-1 indicates that Real Federal Government Expenditures have not responded to changes in
unemployment rate.

Government transfers (food stamps, welfare, Medicaid and Social security) have moved in step with
unemployment. See Figure 13-2.

Figure 13-3 shows how taxes as a % of GDP move in opposite direction of unemployment rate.

Figure 13-4 tracks the unemployment rate and the budget deficit as a percentage of GDP. The deficit is
strongly cyclical.

The full-employment deficit measures the deficit that occurs at full employment. If at full employment
there is a surplus is called fiscal drag.

The structural deficit is a nether term for full employment deficit.

The cyclical deficit = difference between actual deficit and structural deficit.

Figure 13-5 shows relationship between the budget deficit and the real interest rate. Economic theory
suggests that an increase in the deficit should move the IS to the right and put pressure on the real
interest rate to rise. For the most part this is not seen in the data.

Figure 13-6 shows the cumulative government debt. The important relation is the debt to GDP ratio.

Eisner and Pieper have questioned the way the deficit is measured since all government expenditures
are treated as consumption and there is no adjustment for increases in the stock of physical or human
capital. In 1988 the OMB classified 207 billion of the deficit as investment which would have made the
deficit zero.

The massive run up of the deficit in the 80's in the US also occurred in Canada and Belgium. The three
major US areas of expenditure were military spending, income maintenance and interest payments on
the debt.

In 1980's people felt better because their income was greater, future generations of tax payers will have
to pay the interest on the debt. Reagan wanted less government. He created a deficit situation in which
cutting the budget was an option that was placed on the table.
50
Lecture Notes
Macro
Dr. Stokes

Barro suggested that Ricardian equivalence indicates that there is no effect of a deficit. The business
press accepts the burden of the debt as an absolute truth although this has been hard to quantify.

Government policies can shift the IS curve and also alter its slope.
Work analytical problems 3, 4 and 5 page 383.
Problem 3.
When there is a rise in income, say due to an exogenous increase in government spending, a portion
of the income is spent abroad. This flow out of the domestic economy tends to reduce the increase in
income. The reverse holds in a recession. Where imports consist primarily of luxury goods, imports will be
especially sensitive to income and their role as an automatic stabilizer increased.
Problem 4a.
The government has pledged not to change fiscal policy. It must stimulate the economy by
monetary policy. The immediate effect of increasing M is to lower the interest rate which will stimulate
investment and output and increase tax revenues. The effect on trade deficit is unclear. Income increasing
will increase imports but lowering the interest rate will increase exports as the exchange rate depreciates.
Problem 4b.
In the long run prices will rise and shift the LM curve to the left and there will be no effect.
Problem 4c.
The real value of the government debt outstanding will be reduced in the short run (over what it
would have been) due to the smaller deficits; in the long run, the reduction will be even greater as the rise
in prices reduces the real value of the nominal debt.
Problem 4d.
If investors anticipate that the government will inflate its way out of its debt, they will require
compensation in the form of higher nominal interest rates.
Problem 5.
Suppose that government spending is increased when the economy is below potential GDP. Why
doesn't the decrease in government saving lead to an equal decline in total saving and investment?
Government saving decreases, but output increases, so private saving is increased due to higher output and
higher interest rates. Investment may be lower, though, due to higher interest rates.
51
Lecture Notes
Macro
Dr. Stokes
Chapter 14 The Monetary System and the Fed’s Policy Rule

Elements of a Monetary system.

Money is used as Means of payment, standard of differed payment, and unit of account.

What is money?

M1 = currency (c) + checking deposits (D)

M2 = M1 + savings deposits + small time deposits + money market mutual funds + money market
deposits at banks

M3 = M2 + time deposits > 100,000

Far more transactions made with credit cards than currency.

Reserve requirements => reserves (RE) = rD where r is reserve ratio.

Currency to deposit ratio (c) = CU/D

Monetary base = high powered money = MB
M
= CU + D = cD + D = (1 + C)D
MB
= CD + RE = cD + rD = (c + r)D

Monetary base multiplier = M/MB = (1+c)/(r+c)

Required reserves = rD.

Excess reserves = total reserves - required reserves

Banks can borrow reserves at the discount rate

Total reserves - borrowed reserves = nonborrowed reserves

Monetary base - borrowings = net base

Federal Open Market Committee makes decisions about monetary policy.

Less than 2% of government expenditures were financed by printing money in 1990.
52
Lecture Notes
Macro
Dr. Stokes

Between 1776-1778 prices rose 300%

Between 1778-1780 prices rose 1000% gave rise to "Not worth a continental"

Motives to hold money: Transactions motive, Precautionary motive, Speculative motive
Given
R0 = opportunity interest
Opportunity cost = interest foregone = R0M
Given
k = cost of each transfer
W = total planned consumption per month
M = .5 * transfer.
# of transfers = W/2M
Want to minimize
(kW/2M) + R0M
Setting derivative with respect to M = 0 and solving for M gives
M=
(kW / 2 R 0

Family will hold less money the larger R0 and the smaller k.

Figure 14-2 tracks Currency/GDP. Trend has been downward.

Figure 14-3 tracks checking/GDP. Trend has been downward.

Fed can target a money supply or a money supply growth rate.

Difficult for the Fed to target an interest rate. Will push up booms and down recessions.

Policy rule selected by Fed determines position of the LM curve.

An interest rate target tend to stabilize real GDP if most disturbances originate with money demand.

A money supply target will tend to stabilize real GDP if most disturbances originate with spending
demand.

Monetary policy acts with a 1-2 year lag. Due to uncertainty this suggests a cautious monetary policy.
53
Lecture Notes
Macro
Dr. Stokes
Work numerical problem 1 page 417 and analytical problem 4 page 418.
Problem 1a
R0 = q1R - q0 = 1 *.08 - .06 = .02
Md = (kY/2R0).5 = (2*2500/2*.02).5 = 353.5533906
When Y = 1000
Ms = Md => 353.55 = (2*1000/2*R0).5
R0 = 1000/(353.55**2) = .008
.008 = R -.06, R = .068
When Y = 4000
Ms = Md => 353.55 = (2*4000/2*R0).5
R0 = 4000/(353.55**2) = .032
.008 = R -.06, R = .092
Problem 1b
R0 = q1R - q0 = .25*.08 =0 = .02
Md = (kY/2R0).5 = (2*2500/2*.02).5 = 353.5533906
If M = 353.55 and Y = 1000
=> 353.55 = (2*1000/2R0).5, R0 =1000/(353.55**2) = .008
.008 = .25*R, => R = .032
When Y = 4000, R0 = .032, = > R = .128
Problem 1c.
The LM curve is steeper for part b since money demand is less sensitive to the interest rate.
It is so because the opportunity cost of holding money varies less with the interest rate and it is this channel
through which interest rates affect money demand in the inventory model.
Note: Recently checking accounts have begun to earn interest which is very close to market rates of interest.
The opportunity cost of such accounts, then, varies very little with the market rate of interest. This came
about as high interest rates in the 1970s led to the removal of restrictions on how much interest could be
paid on such accounts. With a steeper LM curve, spending shocks become less destabilizing.
Problem 4.
Suppose competition in the credit card market drives down the cost of using credit cards. How does
this affect money demand? Clearly money demand will fall and at some time in the future the LM curve will
move to the right. If the Federal Reserve is not sure whan this will happen it should keep an eye on the
interest rate and when it falls (as the LM curve moves right) the Federal Reserve can reduce the stock of
Money and move the LM curve back left.
54
Lecture Notes
Macro
Dr. Stokes
Chapter 15 The Micro Foundations of Price Rigidity

We incorporate informational problems into a flexible price model.

In the short run the labor supply curve is more elastic than in the long run. This would suggest that in
the long run employment is not sensitive to real wages.

Real business cycle economists stress that labor supply curve is flat in the short run. This suggests that
if (W/P) goes then the # of hours supplied will fall a great deal as workers do other things. =>
voluntary unemployment. This argument does not make too much sense for long periods of
unemployment. Two wage earner families might have a flatter supply schedule than one wage earned
families.

Rogerson suggests that with a fixed cost of going to work each day, added work days can be induced by
small changes in the real wage.

If the labor demand curve is flat => changes in the labor supply curve => large changes in employment.

Are firms in positions of diminishing marginal product? If firms have unused capacity => can add more
workers and combine these workers with capital and not face a declining MPP for labor. For example if
firm has Unused shifts it can add workers and increase production without declining MPP of labor.

Complementarities (such as higher levels of activity => a rise in productivity) could be an argument for
labor not having a declining MPP as more workers are added.

A shock to the labor demand curve (say left) in a model with an almost flat supply curve of labor => a
large change in employment without much of a change in the real wage.

The flatter the labor demand curve, the more effect on employment, with little effect on W/P of a shift
in the labor supply curve.

If the real interest rate were to increase then the labor supply function will move right since an hour of
work is work today is worth more next year. This hypotheses is open to question.

The misperceptions model was developed by Lucas to explain what would happen if the workers were
"fooled" into thinking the real interest rate was higher than it was. This could occur if the expected
level of inflation was less than what actually happened. In his model monetary expansion raises both
output and the price level along an upward-sloping curve called the Lucas supply curve.
Yt = h(Pt - Pet) + Y* which can be written as
Pt = (1/h)(Yt – Y*) + Pet . Subtracting Pt-1 from each side
55
Lecture Notes
Macro
Dr. Stokes
Pt - Pt-1 = (1/h)(Yt – Y*) + Pet - Pt-1
Given t = (Pt - Pt-1), then
t = (1/h)(Yt - Y*) + et
5th edition uses another approach. Suggests that for each firm production Yi will be above
normal production Yi* if the firm’s price Pi is above the aggregate price P.
Yi = h(Pi – P) + Yi*
Assume estimated price is Pe
Yi = h(Pi – Pe) + Yi*
In words, a firm will produce a level of production greater than its potential output if the
firm’s relative price increases.
Can transform the aggregate Lucas supply curve to have P on the right
P = Pet + (1/h)(Y - Y*)
For further detail see figure 15.2. Key idea. If aggregate demand curve moves up due to an
increase in the money supply with a vertical supply curve, then price will increase more than it would in the
short run if there is an increase in supply due to firms being “fooled” into producing more. The smaller h the
larger 1/h and the more vertical the Lucas supply curve.

Sargent & Wallace suggest that while at full-employment in the flexible price model monetary policy
can do nothing. In the misperceptions model monetary policy can do nothing if it is a systematic
countercyclical policy since the market will realize what is going on and there will be no misperception.

Monetary policy ineffectiveness theorem. Even in short run an effective counter cyclical monetary
policy will not help stabilize the economy. The goes beyond even what Friedman argued. Sargent &
Wallace suggested that any information used by the Fed to form expectations and hence policy, would
be used by the market. Fed can only surprise market. A surprise policy is not a systematic policy. =>
Policy rules based on the same information available to workers cannot have an influence on output
fluctuations.

Critique of Misperceptions model. Given the monetary information in the Wall Street Journal, hard to
fool market.

Barro assumed that "misperceptions" about money was the the same thing as "surprises" about money.
It is not the same thing to be "unaware" of something as to be "surprised" about something. It now
appears that Barro's evidence was that monetary changes (not surprises) preceded changes in output and
employment.
56
Lecture Notes
Macro
Dr. Stokes

Recent evidence casts doubt on importance of monetary shocks vs other types of shocks.

Labor Theory

Jury is still out whether flexible price models or sticky price models are most appropriate.

With a flat labor demand curve and a rigid and horizontal labor supply curve assume a reduction in
employment, => there is only a little divergence between the real wage and the marginal product of
labor which suggests little incentive for employers to add workers.

A horizontal real wage line understates the value of workers time in booms and overstates the value of
workers time in recessions.

The real wage fixed hypothesis suggests that firms decide on the numbers of workers not the wage that
they pay workers. It remains to be seen whether in a period of declining union influence, whether this
continues.

Labor contract theory suggests that in booms workers work over time at premium pay. In recessions
workers work less hours at the old wage. In a sense they are partially laid off but keep their jobs. Hence
the real wage is fixed but the # of hours worked in not fixed.

By keeping real wage fixed, workers do not let employers push down the real wage under the argument
that demand has fallen.

Demand for electric power works the same way. The rate is fixed yet the consumer can change the
amount of power demanded.

From micro theory. Given  = Demand elasticity and a firm operates where MC = MR. Note that
MR = p(1-(1/)) = ((-1)/)P.

Can show that ((-1)/)P = MC or P = (/(-1))MC.
(/(-1)) = markup ratio.

With flat demand the markup ratio is small suggesting profits will not change much if employment
changes. => profit is insensitive to changes in the level of employment.

There are institutional reasons why nominal prices of goods may be sticky. These include menu costs.
But not all prices are sticky. Agricultural good prices change often.

Sticky nominal wages can occur due to union contracts. This in turn can tend to make prices sticky.
20% of the US market is union.
57
Lecture Notes
Macro
Dr. Stokes

If there are rigidities in setting nominal wages or there is a built in escalator clause, then Federal
Reserve policy can change real output even in case of rational expectations. Assume that wages in all
sectors are set by union contract and will be increased by 11% each year for three years. If the Federal
Reserve were to reduce the growth on the money supply this would drive up the real wage and
substantially reduce employment.

Economists are divided on how much nominal wage and price stickiness there is. What is clear is that
the greater the degree of wage and price rigidity, the more powerful monetary policy.
Work numerical problem 1 page 443.
Problem 1.
Assume Lucas supply curve
Y = nh(1-b)(P - pe) + Y*, nh(1-b)=20000, Y* = 4000
Aggregate demand curve
Y = 101 + 1.288 G + 3.221M/P
Problem 3a.
If Y=Y* and P = Pe => Y = 4000. Substituting in AD curve curve for P where M = 600 and G =
750 gives
4000 = 1101 + 1.288 * 750 + 3.221*600/P
P = (3.221 * 600)/(4000 - 1101- 1.288*750) =
1932.6/1933. = .999793068 = 1.0
Problem 3b.
Since the monetary increase is anticipated, P=Pe =>
Y = Y* = 4000. M/P stays the same.
600/.999793069 = 620/P.
P = 620* .999793069/600 = 1.033119503
Problem 3c.
People expect M to rise to 620. Actually it rises to 670.
=> Pe = 1.03311. New supply is
Ys = 20000(P - 1.033119503) + 4000
Yd = 1101 + 1.288 * 750 + 3.221*670/P
58
Lecture Notes
Macro
Dr. Stokes
20000P - 20662.3266 + 4000 = 1101 + 966 +(2158.07/P)
20000P -16662.326 = 2067 + (2158.07/P)
=> 20000P2 - 18729.3266P - 2158.07=0
Use SPEAKEASY® to get factors. Could use MATLAB® or TI-85 etc.
:_list p15d1
LISTING OF PROGRAM P15D1
1 PROGRAM
2 $ SOLVES EQUATION 20000P**2 - 18729.3266P - 2158.07
3 X=-2158.07,-18729.3266,20000
4 POLYROOT(X)
5 END
:_p15d3
EXECUTION STARTED
POLYROOT(X) (A 2 Component Array)
-.10373344
1.04019977
MANUAL MODE
:_journal off
=> P = 1.0401997
Substituting in AS or AD =>
Ys = 20000(1.0401997 - 1.033119503) + 4000 = 4141.60394
Work analytical problem 6 page 445.
Problem 6.
If prices are flexible and if expectations are rational, then in the Lucas model anticipated monetary policy as
no effect on output, and disinflation, when credibly announced by the monetary authorities will have no
effect on output. However when wages and prices are sticky, then by definition P need not and may not
adjust to keep Y = Y*. Therefore monetary policy can affect output. This can occur in the contract wage
model.
59
Lecture Notes
Macro
Dr. Stokes
Chapter 16 Inflation and Output Fluctuations

Expectations-augmented Phillips Curve
 = f((Yt-1 -Y*)/Y*) + e + Z
where Z = price shocks. Equation indicates that there is no long run trade off between inflation and the level
of GDP. Called natural rate property since unemployment will go to the natural rate no matter what the
inflation rate.

Reasons why this equation might work.
Prices are set as a markup over the costs of production. Hence as wage costs go up, so do prices.
Wages respond with a lag to unemployment.
Wages respond to expected inflation.
If indexing of wages to prices is less than 100%, then a price shock sets off a damped wage price
spiral. Wages that are 100% indexed causes an explosive situation. However the above analysis assumes
velocity is increasing or the monetary authorities print money.

Quantity theory of money MV = PT.

How do we calculate  te ?

Can use  te 
k
 
i 1
i
t i
but no mechanical system is perfect. Simple case is  te   t 1

Modifications to IS curve to take into account real interest rate

Define R = nominal interest rate.  is actual inflation rate.

R -  = s0 - s1Y + s2G

R* = equilibrium real interest rate

R* = s0 - s1Y* + s2G

Subtracting gives

R -  - R* = s0 - s1(Y - Y*)
60
Lecture Notes
Macro
Dr. Stokes

Fiscal policy affects the real interest rate R* but not the difference rate between the actual real interest
rate and the equilibrium real interest rate.

Equation can be transformed to

R -  - R* = - s1(Y*)[(Y - Y*)/Y*]

There is a simple relation (negative) between the gap between the actual and equilibrium real interest
rates and the gap between actual and potential output.

Define Y** =[(Y - Y*)/Y*]

(3) R -  - R* = -s1 Y*Y**

Assert the Fed’s Monetary policy rule is

(4) R =  + bY** + d( - t) + a
where t = Fed’s target interest rate.

To derive the aggregate demand-inflation curve put equation (4) in equation (3). Note from (4) we get

(4’) R -  -a = bY** + d( - t)

Substitute (4’) in equation (3) to get

(5) -s1Y*Y** = bY** + d( - t) + (a - R*)
Final transformation gives

(6) Y** = - [d/(b+s1)] ( - t) - [(a-R*)/(b+s1)]

Equation (6) indicates that there is a negative relation between the output gap (Y**) and the amount of
inflation above target ( - t). The aggregate demand-inflation curve shifts up then the fed raises the
target rate of inflation (t).
Work analytical problem 1 page 467.
Problem 1.
Describe the behavior of investment and interest rates during the boom described in example 3 of
section 16.3?
61
Lecture Notes
Macro
Dr. Stokes
The investment boom corresponds to a shift out of the IS curve and initially investment and interest rates
rise. As prices start to rise, the LM curve shifts inward and further raises interest rates and reduces
investment. In the long run, interest rate increase; investment will have increased if higher interest rates
crowd out net exports. If however net exports are insensitive to the interest rate, the rise in the interest rates
would cause investment to return to, its original level.
62
Lecture Notes
Macro
Dr. Stokes
Chapter 17 Designing and Maintaining a Good Macro Policy

General Principles of Policy analysis

When making decisions, people think about the future and their expectations of the future can be
modeled by assuming that they have a sense of economic fluctuations and use the information to make
unbiased (but not error-free) forecasts. => people use all information to make forecasts.

Macro economic policy can be usefully described and evaluated as a policy rule, rather than by treating
the instruments as exogenous and looking only at one-time changes in these instruments.

Lucas Critique => policy changes will change the parameters of the underlying model. How relevant is
this? Build expectations formation into the model. Sims suggests that there are rarely big policy
changes. This suggests that the Lucas critique not all that important.

In order for a particular policy to work well it is necessary to establish a commitment to that rule.

Activist policy rules involve feedback.

Discretionary policy involves case by case situations.

Passive policy rules involves no feedback.

The economy is basically stable; after a shock the economy will eventually return to its normal trend
paths of output and employment. However, because of rigidities in the economy, this return could be
slow.

The objective of macroeconomic policy is to reduce the size (or the duration) of fluctuations in output,
employment, and inflation from normal levels after shocks hit the economy. The objective is to be
achieved over a long period of time, which will in general include a larger number of business cycle
experiences. Future business cycle fluctuations are not viewed as less important than the current one.

To analyze policy need social welfare function.

Need # policy instruments = # of targets.

Inflation is undesirable

"Shoe-Leather" costs of holding money ( German case)

Tax distortions (depreciation does not cover replacement) capital gains tax is on nominal returns not
real returns.

Unfair gains and losses (unexpected inflation helps debtors hurts creditors)
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Lecture Notes
Macro
Dr. Stokes

Nonadapting economic institutions (Retirement arrangements are negatively impacted by unexpected
inflation.)

People see inflation as a breakdown of basic government responsibilities.

People see rising prices and a reduction in real income.

Unemployment and Y < Y* cause direct costs.

Possible improvements in Economy

Streamline labor market

Better job matching

More appropriate education

Eliminate Government price and wage fixing. (Davis-Bacon Act prevents contractors from cutting
construction costs in a slack market. Governments regulate taxi rates.

Improve indexation (Note discussion by Clinton of CPI)

Avoid Government price shocks

Government promote trade
Work analytical problem 4 page 501.
Problem 4 "Compare a policy of fixing the money stock to a policy of fixing the interest rate. Prepare a brief
argument in favor of each type of targeting. List advantages and disadvantages."
Monetary aggregate targeting is easier to achieve and provides a stable, predictable monetary policy
allowing for a reasonable long-run average inflation rate. The disadvantage is that it makes no attempt to
insulate the economy from price shocks, and so it is in principle far below the optimal policy in terms of
social welfare. Interest rate targeting is very difficult since if an error is made on the target serous problems
can occur. Assume that the interest rate target is above the market value. Here the Fed will be taking money
out of the system to raise the rate. This may drag the economy into recession. If the target interest rate is
below the market rate, the Federal Reserve will increase the money supply in an attempt to lower the
interest rate. This will cause inflation. The real problem is that appropriate interest rate will differ in
different points in the cycle. Targeting the interest ate has the same problem at the free reserves doctrine
that proved disastrous in the 30’s.
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Lecture Notes
Macro
Dr. Stokes
Chapter 18 The World Economy

As a policy goal, it is desirable to increase trade so that countries can exploit their comparative
advantage.

NAFTA is showing gains for Canada and Mexico.

GATT provides a mechanism by which tariffs can be reduced.

International Foreign Exchange unit must deal with:
- Liquidity problem
- Adjustment problem
- Confidence problem
- Seignorage problem

Flexible exchange rates in Europe give rise to "snake in the tunnel" Note that (A:B)=(A:C)*(C:B).
($:L) = ($:M)*(M:L)

With high capital mobility and no expected change in the exchange rate, the domestic interest rate will
be the same as the world interest rate.

Under fixed exchange rate and capital mobility the central bank must keep the interest rate equal to the
world interest rate.

SDR (Special drawing right. Bears interest. No country required to accept more that 2 times its quota.)

Figure 18-1 World inflation rates

Given E = exchange rate (# of foreign units per $1.00) PE = Pw or domestic price time exchange rate =
world price in the long run.
=>
E = Pw/P
=>  + E/E = w or w -  = E/E

If world inflation is greater than US inflation exchange rate will appreciate.

Under flexible exchange rate each country can have its own level of inflation. This is not possible under
fixed exchange rates.
Work analytical problem 6 page 628.
65
Lecture Notes
Macro
Dr. Stokes
Problem 6.
"Explain why a depreciation of the exchange rate could have an inflationary impact in one country
and a deflationary impact in other countries?"
If E falls foreign goods cost more; this contributes to price increases experienced by consumers at
home. Also, lower E raises X and this demand stimulation leads to higher prices for domestic output. Other
countries experience opposite effects, so that the decline in E is deflationary for them.
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