Intermediate Macro

Intermediate Macroeconomics - 73240
Laurence Ales
This version: April 30, 2014
73-240 Spring 2014
Prof. Laurence Ales
Contents
I
II
Syllabus
Class Notes
13
Introduction and Methodology
14
Measurament
2.1 GDP . . . . . . . . . . . .
2.2 Forecasting . . . . . . . .
2.3 Trend and Cycles . . . .
2.4 Nominal and Real GDP
24
25
39
48
56
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
The Household
62
The Firm
77
The Government
88
Equilibrium
93
Optimality
104
7.1 Optimal Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
Growth
119
8.1 Malthus and Solow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
8.2 Endogenous Growth Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
Dynamic Model
9.1 Forecasting: Part 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
9.2 The Household . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
9.3 The Government . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
152
152
160
173
3 of 260
73-240 Spring 2014

9.4
9.5
9.6
Elastic Labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177

The Firm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180
Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185
10 Credit Imperfections
203
11 Money
11.1 Monetary model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
11.2 The Fed and Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . .
11.3 What Economists Do . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
216
221
226
236
12 The End: 7 lessons from this course
241
III
244
Problem Sets
Prof. Laurence Ales
Acknowledgements
This document has evolved over the years with contributions from:
Laurence Ales, Nicolas Petrosky-Nadeau, Chris Sleet, Sevin Yeltekin.
Invaluable feedback was also provided by students of 73-240 at Carnegie Mellons Tepper School of Business. And by the numerous teaching assistants of those classes.
These materials are subject to copyright and are being provided for the personal educational use by students enrolled in this course. Any other use, including further reproduction and distribution of the materials (whether in hard copy or electronic form) is
strictly prohibited. As an example, you may not copy any of these materials and upload
them to any other web sites without the prior permission of the applicable copyright
holder.
Some graphs and diagrams are taken from:
1. Williamson, Macroeconomics, 5th edition.
2. Hoover, Applied Intermediate Macroeconomics
3. Abel, Bernanke, Croushore, Macroeconomics.
4. Jones, Macroeconomics, 2nd edition.
5. Acemoglu, Introduction to modern economic growth.
5 of 260
Part I
Syllabus
6 of 260
73-240 Spring 2014
73-240 Intermediate Macroeconomics

Prof. Laurence Ales
Instructor : Laurence Ales

e-mail: ales@cmu.edu
Class Web: Blackboard
Office: GSIA 328
Office Hours: Th 3:30-5:30
TA 1 : Antonio Andres Bellofatto

e-mail: andresb@cmu.edu
Section A: F 1:30-2:20 POS MN AUD
Office Hours: GSIA 301 T 1:30-3:30
TA 2 : Minyoung Rho
e-mail: mrho@andrew.cmu.edu
Section B: F 1:30-2:20 WEH 5421
Office Hours: GSIA 310 Th 1:30-3:30
Class times: MW 01:30PM 02:50PM in POS MN AUD

Textbook:
Stephen D. Williamson: Macroeconomics, 5/E
ISBN-10: 0132991330
ISBN-13: 978-0132991339
Publisher: Addison-Wesley
Copyright: 2013
Learning objectives:
By the end of this course the student will be able to...
1. ...Understand and be able to use the various measures of an aggregate economys
performance and well-being;
2. ...Be able to perform simple forecast of macroeconomic variables;
This version: January 11, 2014
Prof. Laurence Ales

7 of 260
73-240 Spring 2014

3. ...Understand how aggregate macroeconomic behavior is affected by microeconomic
behavior and equilibrium restrictions;
4. ...Be able to answer simple macroeconomic policy questions by formulating a model,
finding the data and deriving an analytical and quantitative answer;
5. ...Understand the factors that cause economic growth and be able to describe the
patterns of economic development across countries and over time;
6. ...Understand how credit and labor frictions operate and how they might impact macro
economic behavior.
Course Description:
The goal of this course is to provide a rigorous framework for understanding modern macroeconomics. The study of the macroeconomy will be divided in two fronts: theory and data.
The theory part will focus in constructing and analyzing the benchmark workhorse modern
macroeconomic model. This model will be casted both in a short run and long run version.
The short run version will allow us to study policies that are often discussed in the media
and the political arena; the long run version will allows us to understand what is behind
the phenomenon of growth observed in the last three centuries. The data part of the course
will focus on studying actual macroeconomic U.S. data. The study will be both of empirical
in nature: studying past data and forecasting future behavior; and quantitative in nature
building a tight link between the macroeconomic model and the data.
Prerequisites:
Formal: (73100) and (73230) and (21120) and (21259 or 21256 or 21268 or 21269).
Informal: In the homework I will ask for extensive data work. I advice you to learn a
spreadsheet software (i.e. Excel, Google docs) as soon as possible. Also, I will require the
homework to be typed, now is a good time to brush up your typing skills! Finally I expect
you to be able to apply basic tools of mathematics, statistics and economics.
Course material:
Textbook: The textbook will be used as a guide and a reference book. I adopt the organization of the book, but do not follow it verbatim. The fourth edition of the book is also an

8 of 260
Prof. Laurence Ales
73-240 Spring 2014

acceptable version.
An additional textbook that I will occasionally cite in the slides (this book is not required)
is: Applied Intermediate Macroeconomics by Kevin Hoover.
Twitter and other News: This year I will experiment with Twitter. The class official
twitter feed is @cmu73240. In this feed I will post class announcements (that will be mirrored in the Blackboard website) and interesting macroeconomic news. Every week, as a
form of digest, I will summarize the most relevant macroeconomics news at the beginning
of class.
Slides: I will make slides available on the class Blackboard website. However, I will not
make the slides available before class. This is done to encourage discussion during class. In
particular, not posting slides before classes allows me to ask questions that might otherwise
be answered by looking at the next slide. During the semester I will also prepare the slides
in book format. The idea is for you to have a document that you might keep for years to
come.
Blackboard: I will make some additional material available on the class website: unless I
specify otherwise these are not a required reading (but most of the times are very interesting!). Check Blackboard regularly: the TAs and I will use the site to communicate additional
information to you, to post slides and update the syllabus.
Feedback and Email:
Together with the usual evaluation forms, I set up an on-line, live, anonymous feedback
system, you can access it here: http://tinyurl.com/evaluations-ales
This is a large class, in order to communicate more efficiently I will follow the following email
policy:
During the week, I will answer student emails usually within 24 hours.
Usually I will not be able to answer homework emails the night before they are due!
Any regrading request must be submitted to your TA first. If an issue persists I will
be happy to help after that.
Prof. Laurence Ales

9 of 260
73-240 Spring 2014

Requirements and Grades:
Final Grade: The final grade will be computed according to the following components:
6 assignments (30% of total grade)
2 midterms (35% of total grade). Note that no midterm will be dropped.
1 comprehensive final exam (25% of total grade).
10% for attendance and class participation. I will have random roll calls during the
semester.
Final grades will be determined on a relative basis: students with the highest total points
will receive As, those next in line will receive Bs, etc. I will not disclose cutoff values.
The class will feature instant quizzes during classes. These non-graded quizzes will be anonymous and will be used to sample your knowledge of the material we will cover in class. Instead
of using a clicker system I decided to administer quizzes via a web version that you can access
from your phone (this will save you the cost of buying a clicker). The form can be accessed
here: http://tinyurl.com/73240-ales so make sure to bookmark it!
Additional Policies:
1. Students with Disabilities: If you have a disability, let me know ass soon as possible
and contact the Office of Disability Resource to request appropriate accommodation.
2. Class room behavior: Private conversations, browsing the web and checking email will
be considered inappropriate. If you do it, you will be cold called.
3. Final score regrading: any regrading request must be submitted to the economics
program at the beginning of the fall semester.
4. Class Material: I will provide lectures slides, notes etc. These materials are subject to
copyright and are being provided for the personal educational use by students enrolled
in this course. Any other use, including further reproduction and distribution of the
materials (whether in hard copy or electronic form) is strictly prohibited. For example,
you may not copy any of these materials and upload them to any other web sites without
the prior permission of the applicable copyright holder.
Homeworks Policies:
10 of 260
Prof. Laurence Ales
73-240 Spring 2014

1. Turning in Homework: Homework must be turned in on the day it is due (usually on
a Friday) your TA will collect the homework in class. Late homework will NOT be
accepted unless you are sick and have a doctors note.
2. Homework regrading:If you believe a question has been incorrectly graded, please take
your homework to your TA within 2 weeks of it being returned.
3. Working in groups: You may work in groups of up to 4. BUT: You MUST put names
of other group members on your homework. You MUST write up your own set of
answers. Do NOT simply copy some other persons work. Copied homework will
result in receiving zero points for that homework as a minimum sanction.
4. TYPE your work. Equations may be hand written. Write your first and last name on
the title of each graph. Graphs that do not contain data may be hand drawn.
5. Buy a stapler!
Schedule
Important dates:
Midterms on Feb 24th and Apr 9th.
Final exam date: TBA
(for updates check: http://www.cmu.edu/hub/).
Grades posted by May 15th.
The following is a tentative schedule, refer to Blackboard for updates on dates and topics.
Prof. Laurence Ales

11 of 260
73-240 Spring 2014
Week
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
Monday
(Jan 13)
Introduction
(Jan 20)
No class - MLK day
(Jan 27)
Introduction to Forecasting
(Feb 3)
The Consumer
(Feb 10)
The Firm
(Feb 17)
Equilibrium and
Pareto optimality
(Feb 24)
MIDTERM 1
(Mar 3)
Growth: Malthus
(Mar 10)
Spring Break
(Mar 17)
Growth: endogenous growth
(Mar 24)
Inter-temporal model
(Mar 31)
Finance and macro
(Apr 7)
Review
(Apr 14)
Money
(Apr 21
Monetary model: Policy
(Apr 28)
Unemployment, wages

12 of 260
Wednesday
(Jan 15)
Measurement: levels and GDP
(Jan 22)
Nominal and real Quantities;
Measurement: fluctuations
(Jan 29)
The Consumer
(Feb 5)
The Firm
(Feb 12)
The Government
(Feb 19)
Taxation and spending
Friday
(Jan 17)
(Feb 26)
Growth facts
(Mar 5)
Growth: Solow
(Mar 12)
Spring Break
(Mar 19)
Saving and Investment
(Mar 26)
Inter-temporal model: Policy
(Apr 2)
Finance and macro
(Apr 9)
MIDTERM 2
(Apr 16)
Monetary model
(Apr 23)
Labor market facts
(Apr 30)
Final Review
(Feb 28)
(Jan 24)
(Jan 31)
(Feb 7)
(Feb 14)
(Feb 21)
(Mar 7)
No class
(Mar 14)
No class
(Mar 21)
(Mar 28)
(Apr 4)
(Apr 11)
No class
(Apr 18)
No class
(Apr 25)
(May 2)
Prof. Laurence Ales
Part II
Class Notes
13 of 260
Chapter 1
Introduction and Methodology
14 of 260
About Myself
My name is: Laurence Ales
Born in Italy
B.S. in Physics
Ph.d. in Economics
Joined CMU in 2008, as an Assistant Professor of Economics

My research:
How much inequality in consumption and health should there be?

How much insurance do workers have?
How should we tax people?
Slide 3 of 27
The Syllabus
Make sure to get and read the syllabus!
Slide 4 of 27
Details About the Course

The class: MW 1:30-2:50
TA and Recitation:
Antonio Andres Bellofatto

Minyoung Rho
Office Hours:
Ales: Th 3:30-5:30
Bellofatto : T 1.30-3.30
Rho: Th 1:30-3:30
The textbook:
Macroeconomics - S. Williamson 5/E
Slide 5 of 27
15 of 260
Hw, Grading and Exams

6 Homework- 30% of grade
2 Midterms (tentative: Feb 24th ; Apr 9th ) - 35% of grade
1 Final - 25% of grade (check CMU website for dates)
10% for attendance and participation
No midterm dropped
No mercy for cheating!
Grade me:
Online, live, anonymous feedback system:
http://tinyurl.com/evaluations-ales
Slide 6 of 27
Recommendations I/II
Email: for regrading email your TAs first!

Microeconomics!!
Math
Find x: log(x + 1) log(x + 2) = log

Find x: maxx f (x) s.t. g(x) = 0.
1
x
Slide 7 of 27
Recommendations II/II
Data Analysis:
We will extensively work with data, review your stats class.

Excel was released in 1985! You should be able (soon) to:
1 Manipulate data;
2 Perform simple manipulations on data;
3 Plot a (nice looking) graph!
16 of 260
Slide 8 of 27
A Bad Graph
How many bad graphical habits can you spot in this graph?
Slide 9 of 27
Twitter and News
The class official twitter feed is @cmu73240.

In this feed I will post:
1
Class announcements
(that will be mirrored in the Blackboard website).
Macroeconomic news.
Every week, as a form of digest, I will summarize the most

relevant macroeconomics news at the beginning of class.
Slide 10 of 27
Lets Start!
17 of 260
Slide 11 of 27
Upcoming...
What is this course about?
Notes on Methodology.
Slide 12 of 27
Your Questions
Every Slide From The Course
18 of 260
What Are We Going To Study?

What does Macroeconomics study?
From Semantics: large economics systems.
(Hoover) Is the study of the economy taken as a whole; whereas
Microeconomics is the study of a part of the economy, taking the

remainder as given.
What type of questions does it try to answer?

What will GDP be one year from now?
How do economic fluctuations come about?
What can we (Government, Fed) do about it?
Why is the US richer than most countries?
How does policy affect growth?
How should taxes and government debt be used?

Slide 15 of 27
What Do You Want From This Course?
Slide 16 of 27
What Will You Get From This Course?

1
...Understand and perform simple forecasts of various measures of

an aggregate economys performance;
...Understand how aggregate macroeconomic behavior is affected by

microeconomic behavior and equilibrium restrictions;
...Be able to answer simple macroeconomic policy questions by

formulating a model, finding the data and deriving an analytical
and quantitative answer;
...Understand the factors that cause economic growth and be able

to describe the patterns of economic development over time;
...Understand how credit and labor frictions operate and how they
might impact macro economic behavior.
Slide 17 of 27
19 of 260
Methodology
Slide 18 of 27
Normative vs. Positive Questions

Economics is interested in two types of fundamental questions.
These questions can be either positive or normative.
Positive questions: questions independent of any ethical or moral

consideration. Focused on what was/is/will be. These question
rely on an objective investigation of data.
Normative questions: questions that deal with the notion of
what should be. These questions rely on completely specified set

of ethical and social goals.
The hard sciences only deal with positive questions.
(just for fun try and ask a normative physics question!)
Slide 19 of 27
How Do We Get The Answers?

Economists similarly to hard scientists like to build theories.
Why? google: pitch drop experiment
20 of 260
...experiments can take a long time!

...but that is not the only reasons we build theories...
Slide 20 of 27
Friedman on the Role of Theory

Milton Friedman:2
The ultimate goal of a positive science is the development of a
theory or, hypothesis that yields valid and meaningful (i.e., not
truistic) predictions about phenomena not yet observed. Such a
theory is, in general, a complex intermixture of two elements. In
part, it is a language designed to promote systematic and
organized methods of reasoning. In part, it is a body of substantive
hypotheses designed to abstract essential features of complex reality.
A theory should:
+ be a language to help us communicate.

+ provide simplifying assumptions that help understand reality.
2
Milton Friedman The Methodology of Positive Economics In Essays In Positive
Economics (Chicago: Univ. of Chicago Press, 1966), pp. 3-16, 30-43.
How Do We Get The Answers?
A fundamental difference between an economist and a hard

scientist is what to do when a theory has been formulated.
Can economists follow closely the Scientific Method?

Karl Popper on the Scientific Method:
A theory which is not refutable by any conceivable event is
non-scientific. Irrefutability is not a virtue of a theory (as people
often think) but a vice. [...] Every genuine test of a theory is an
attempt to falsify it, or to refute it. Testability is falsifiability.3
(Karl Popper, Conjectures and Refutations, London: Routledge and Keagan

Paul, 1963, pp. 33-39; from Theodore Schick, ed., Readings in the Philosophy of
Science, Mountain View, CA: Mayfield Publishing Company, 2000, pp. 9-13. )
The Problem With the Scientific Method

Falsifiability might be impossible: people and firms are smart,
a controlled experiment might be impossible to achieve.
Socially, falsifiability may not be very desirable!
21 of 260
Source: The Onion
Slide 23 of 27
Building a Model
A theory written by an economist is simply a model.
What is a model? A simple virtual representation of a real
environment.
Some examples:
Google maps The world

F = g(m1 m2 )/d2 An apple falling from a tree
A macroeconomic model The U.S. economy
What makes a good model?
It must be simple enough so that we can learn from it!
Slide 24 of 27
The Issue of Realism

Models, by definition, are simplified representations of reality.
It is common for economic models to be criticized on the basis
of being unrealistic.
Should we be concerned about these type of critiques? If the
unrealistic assumptions made in the model drastically changes

the results: YES.
If not, the model should not be evaluated on the basis of realism

but on their predictive power.
This approach is also common in the sciences: think for example

the model that Newton considered when thinking of an apple
falling from the tree.
Slide 25 of 27
Model Ingredients
Actors:
Households
Firms
Markets
Government
Quantities:
Households: Consumption, Savings, Hours worked
Firm: Output, Vacancies
Markets: Prices, Inflation
22 of 260
Government: Taxes, Debt, Expenditures

Slide 26 of 27
Roadmap
This week Study quantities: GDP, Consumption...

Next week Study fluctuations in the data
After that... Modeling: household, firm and government
Slide 27 of 27
23 of 260
Chapter 2
Measurament
24 of 260
2.1
GDP
25 of 260
A key quantity: GDP
Slide 5 of 43
Gross Domestic Product

Important definition!
Gross domestic product (GDP):
The market value of final goods and services produced within a country
in a given period (usually a year).
Next we look at:
GDP across countries;

GDP over time for the U.S.
Slide 6 of 43
GDP Across Countries
What are potential issues in comparing GDP across countries:

1
We need a unit of measure: U.S. dollar;
If we care about relative richness,

we need to scale per capita;
Need to adjust for relative cost of living:

power purchasing parity (PPP).
26 of 260
Slide 7 of 43
The Big Mac Index

Comparing the price of a Big Mac around the world:
Country
U.S.
Switzerland
China
Euro Area
India
Norway
Price in USD
$ 4.56
$ 6.72
$ 2.61
$ 4.66
$ 1.50
$ 7.51
Data: July 2013. Source:

http://www.economist.com/content/big-mac-index
Slide 8 of 43
Appendix: Data
Where To Find Data:
National:
1
St. Louis Fed: http://research.stlouisfed.org/fred2/

(check out their mobile apps!)
Bureau of Economic Analysis (BEA): http://www.bea.gov
International:
1
Penn World Tables: http://pwt.sas.upenn.edu
International Monetary Found (IMF):

http://www.imf.org/external/research/index.aspx
GDP Per Capita Across Countries

Data taken from the IMF (2013):
http://www.imf.org/external/pubs/ft/weo/2013/01/
Country
U.S.
Canada
Italy
Mexico
Nigeria
Ethiopia
China
India
Amount (USD)
$ 49,922
$ 52,231
$ 33,115
$ 10,247
$ 1,630
$ 482
$ 6,075
$ 1,491
HUGE cross country differences: Rich/Poor > 40 !!

Slide 10 of 43
27 of 260
GDP Across Countries

World per Capita Real GDP (in 2000 dollars) 2008
Source: IMF
Slide 11 of 43
Per Capita Real GDP by State
Slide 12 of 43
How about countries over time?
28 of 260
Slide 13 of 43
U.S. GDP Over Time

In looking at GDP over time we must take care of one thing...
Prices grow, we need to rescale at a common value:

for example choose $ 1 in 2000.
Check here for what is a dollar worth calculator:

http://www.minneapolisfed.org/
Slide 14 of 43
U.S. GDP Over Time

A curiosity:
Slide 15 of 43
U.S. GDP Over Time

U.S. real GDP (in 2000 dollars) 1900 - 2013
Source: Officer, Williamson (2012).

Data Link: http://www.measuringworth.com/datasets/usgdp12/
Slide 16 of 43
29 of 260
U.S. GDP Over Time: Observations
Some observations:
1
It grows;
It fluctuates;
There are some big fluctuations, some are exogenous.
A question to think about...is it growing faster?
Slide 17 of 43
U.K. GDP Over Time

U.K. Real GDP (in 2006 GBP) 1830 - 2009:
Real GDP of England!
(Billions of 2006 Pounds)!
14000"
12000"
Real%GDP%
10000"
8000"
6000"
4000"
2000"
0"
1830"
1850"
1870"
1890"
1910"
1930"
1950"
1970"
1990"
Year%
Source: Bank of England + Data Link

Slide 18 of 43
History of GDP
Developed by Simon Kuznets and his team in 1934

(once released, data was already 2 years old!)
First estimate using IRS data and 1929 Census

(he measured the national income)
In 1940 government interested in measuring national production

(estimated with: final sales, consumption spending, shipments...)
In 1960s first value added estimates
(estimated with the aid of input-output tables)
30 of 260
Slide 19 of 43
Who Computes GDP Today?

The Bureau of economic analysis (BEA) periodically publishes the
National Income and Product Accounts (NIPA). They contain:
1
GDP and its components (more on these later)
GDP by state, metropolitan area
GDP by industry (I-O tables)
International accounts (balance of payments)
You can get all the data here: http://www.bea.gov

BEA uses data from: Census, Bureau of labor statistics (surveys),
Tax returns, Industry estimates...
BEA releases three versions of its estimates:

Advance, Preliminary, Final.
Slide 20 of 43
3 Definitions of GDP
BEA uses 3 alternative definitions/approaches to GDP:
Expenditure Approach: Total spending on newly produced final

goods and services produced within a nation during a year.
Income Approach (national income): Total Income generated by

newly produced final production goods and services, profits and
taxes paid by firms and depreciation of capital within a nation
during a year.
Product Approach (value added): Market value of final goods and

services newly produced within a nation during a year.
We will use the symbol Y to denote either total expenditure,

income or value added!
Slide 21 of 43
Taking the Pulse of the Economy: Measuring GDP

3 Definitions of GDP (2005
Data)
197
Table 1
Three Ways to Measure GDP
I. Value-added (or production) approach
2005 share
(percent)
Gross Output (gross sales less change in inventories)

Less: Intermediate inputs
183.5
83.5
Equals: Value added for each industry
100.0
II. Income (by type) approach

Sum of: Compensation
Rental income
Profits and proprietors income
Taxes on production & imports
Less: Subsidies
Interest, miscellaneous payments
Depreciation
Equals:
Total domestic incomes earned
56.6
0.3
17.6
7.4
0.5
5.5
12.9
100.0
III. Final demand (or expenditures) approach

Sum of: Consumption of final goods and services by households
Investment in plant, equipment, and software
Government expenditures on goods and services
Net exports of goods and services (exports " imports)
70.0
16.7
19.0
"5.7
Final sales of domestic product to purchasers
100.0
Equals:
Slide 22 of 43
the national accountsthe Bureau of Economic Analysis sums up C ! I ! G ! (X
31 of 260
The Components of GDP: Expenditure Approach
GDP s comprised by:
Consumption expenditures (C): consumer goods and services

Investment (I): goods produced but not consumed
Government expenditures (G)
Net exports (NX):
goods and services exported minus goods and services imported

GDP = Y = C + I + G + N X
Slide 23 of 43
The Components of Nominal GDP in 2012/2013
Table 1.1.5 from NIPA (values are Billions of $)

Slide 24 of 43
The Components of Nominal GDP in 2012/2013
Some observations:
1
Consumption is the largest component 2/3 of GDP
Government is around 15/20% of GDP
Net export is negative
Services is the largest component of consumption
Nonresidential investment is the largest component of investment
32 of 260
Slide 25 of 43
An Example: The Island Economy
Coconut Producer
Government
Restaurant
Consumer
Slide 27 of 43
The Expenditure Approach
Determine all expenditure by each agent and add government

expenditures:
Total expenditures = C + I + G + N X
Note: in this example by definition G = N X = 0

Note: in our example some coconuts are sold to the restaurant
some are sold directly.
Note: government expenditures in our example are only

for labor services, so consider wages as expenditure.
Slide 28 of 43
33 of 260

Coconut Producer
Government
Restaurant
Consumer
Expenditure approach:
GDP =
$8
|{z}
Buy coconut
Slide 29 of 43
+ $|{z}
30 +
Buy Meal
$| {z
5.5}
= $ 43.5
Government
The Income Approach
Determine all income for each agent:
For HH: wages + profits from firms + interests;

For Government: taxes payed by firms.
Slide 30 of 43

Coconut Producer
Government
Restaurant
Consumer
Income approach:
34 of 260
GDP = $| 14.5
0.5} + |{z}
$ 24 +
{z } + |$ {z
Wages
Slide 31 of 43
Interests
Profits
$| {z
4.5}
Taxes from firms
= $ 43.5
The Product Approach
Determine the final product by determining the valued added of each

firm and add government expenditures:
Note 1: the sum of value added equals the value of final products
Note 2: what is the valued added of the government?
(use value of inputs)
Slide 32 of 43
An example: The Island Economy

Coconut Producer
Government
Restaurant
Consumer
Product approach:
GDP =
$ 20
|{z}
Coconut Producer
Slide 33 of 43
+ $ (30 12) +
|
{z
}
Restaurant
$| {z
5.5}
= $ 43.5
Government
National Accounting Identities
35 of 260
Slide 34 of 43
National Accounting Identities
The 3 definitions of GDP are useful to relate production and income

(there is always income related to any value added or production!)
Another important relation is the disposable income identity:
(The idea is to relate income to its disposition by households)

Y |{z}
T + |{z}
TR =
Taxes
Transfers
C
|{z}
Consumption
+ |{z}
S
Saving
Slide 35 of 43
The Sectoral Deficit Identity

Using the definition of GDP and the disposable income identity we
can identify which sector is running a surplus or deficit
Y
| T + T{zR = C + S};
Disposable Income id.
|Y = C + I{z+ G + N X}
GDP Definition
Substitute out Y and re-arrange:

G
| T{z+ T R} +
Government Deficit
I|
{z S}
Private Sector Deficit
Not every sector can run a surplus, or deficit!
Slide 36 of 43
The Limits of GDP
36 of 260
Slide 37 of 43
N
X
|{z}
Foreign Sector Deficit
=0
Problems With GDP

What is GDP not counting in measuring the size of the economy?
1
Non-market production:
Home production (think about housework, childcare, DIY)
In developing countries: subsistence farmers
(living with 1$ a day means that most of the crops

are for own consumption, few sold for cash)
Underground economy
What does GDP mean?

1
What about environmental costs?
What about welfare?
Slide 38 of 43
Underground Economy Across Countries
Data: World Bank (1998).

Country
Nigeria
Thailand
Bolivia
Italy
U.S.
Switzerland
Fraction of GDP
77%
70%
67%
27%
10%
9%
Slide 39 of 43
Measuring the Underground Economy

Direct Approaches:
Surveys;
Tax audits.
Indirect Approaches:
National accounting statistics;

Labor force statistics;
Transactions;
Currency demand;
Electricity consumption and other inputs.
Slide 40 of 43
37 of 260
Interpreting GDP: Bads and Regrettables
A bad is a good that the more you have of it, the less happy you
are about it.
GDP measures goods, by definition bads are not included. In

comparing the state of two economies across time and space we
should also consider:
Pollution;
Depletion of natural resources.
Slide 41 of 43
Interpreting GDP: Hours

Is GDP measuring welfare ?
Leisure, health care, education...
Source: OECD.
Slide 42 of 43
Interpreting GDP: Inequality

How about inequality?
+ GDP is a sum, contains no information on distribution

of consumption/income.
Interdecile (P90/P10) ratio across countries:

Country in 2010
Denmark
France
U.K.
Italy
U.S.
Mexico
38 of 260
P90/P10
2.72
3.39
4.21
4.31
5.91
8.53
Source OECD: http://dx.doi.org/10.1787/826773162617

Slide 43 of 43
2.2
Forecasting
39 of 260
From The Previous Class:

U.S. real GDP (in 2000 dollars) 1900 - 2013
A natural question: is the U.S growing faster?

Slide 5 of 48
Logs and Growth Rates

Let yt be real GDP at time t; yt we denote growth of yt
yt+1 yt
yt
yt+1
yt+1 =
1
yt
log (1 + yt+1 ) = log(yt+1 ) log(yt )
yt+1 =
Note log(1 + x) x if x is small ... so

yt+1 log(yt+1 ) log(yt )
Plotting log of GDP is much easier to identify growth rates.

In a log GDP plot, the slope determines the growth rate.
Slide 6 of 48
U.S. GDP Over Time

Log of U.S. real GDP (in 2000 dollars) 1900 - 2013
40 of 260
Its a line!!...almost
The graph above implies a constant growth rate (approx. 2%)
Slide 7 of 48
U.S. GDP Over Time
The result holds going back to 1790.

The result holds looking in per-capita terms.
+ Check for yourself here:
http://www.measuringworth.com/datasets/usgdp12/
Can we use this robust trend of U.S GDP

to predict future values?
Slide 8 of 48
Forecasting: Introduction
Slide 9 of 48
Forecasting
This Lecture:
1
Trend forecasting;
Single time series forecasting.
Later In the Course:

1
Multiple time series forecasting.
41 of 260
Slide 10 of 48
Forecasting
A good source:
Forecasting in Business and Economics by C.W.J. Granger.

Slide 11 of 48
Forecasting: Basic Definitions
Definition (Time Series)

A time series is a sequence of values recorded at (usually) equidistant
time intervals. We denote with {xn }tn=1 a time series containing t values.
Loosely: a forecast of a time series xt is a guess about future values

of it: for example what will GDP be on Apr 30, 2014.
To formally build a forecast we need to specify:

1
What information we have available for the forecast;
What are the cost involved in a wrong forecast!
Slide 12 of 48
Forecasting: Information Sets
Definition (Information Sets)

Let It be the set of information available at time t for a forecast.
The information set It we will use can be of two types:

1
42 of 260
Slide 13 of 48
It = {xn }t1
n=1 : for the forecast we have available only past values of
the time series we want to forecast. This will be the case in this
lecture.
t1
It = {xn }t1
n=1 {cn }n=1 : for the forecast we have available past
values of the time series we want to forecast and of another time
series ct . We will talk about this later in the course.
Forecasting: Errors
Definition (Forecast Errors)
Suppose that at time t we have forecasted the future value: xt+1 . At
time t + 1 we observe the real value: x
t+1 . Our error is:
et+1 = x
t+1 xt+1 .
Not all type of errors are the same....

For example, suppose you are forecasting future demand of a
product. Over-estimating demand will imply a cost due to unsold

items. Under-estimating demand will imply an opportunity cost
for lost business.
Slide 14 of 48
Forecasting: Penalty Functions
Let C(e) be the penalty function associated with error e.

A good forecast is one that minimizes the overall penalty function.
A common approach is to use the square of the error C(e) = e2 .
In this class we will do a hands on approach. For a formal
treatment refer to your econometrics and statistics classes.
Slide 15 of 48
Fitting a Linear Trend
An idea motivated by the above: if log GDP has grown

linearly, is it natural to think it will continue to do so?
Slide 16 of 48
43 of 260
Back to the 1960s

An experiment: suppose I was teaching this class on Jan 22, 1960.
Suppose I wanted to figure out what GDP would be on Jan 22,
2014, how would I proceed?
In this experiment we only use past real GDP information from

1947 to 1960:
I1960 = {
xn }1959
n=1947 .
where yt is GDP in year t.
We will minimize the square of the error so that:

C(e2014 ) = (
x2014 x2014 )2 .
where x2014 is our forecast of GDP for 2014.
Slide 17 of 48
Fitting a Trend
Excel provides several function to add a linear trend-line.

SLOPE(known ys,known xs)
Returns the slope of the linear regression line through data points
in known ys (values) and known xs (dates).
INTERCEPT(known ys,known xs)
The intercept point is based on a best-fit regression line plotted

through the known ys (values) and known xs (dates).
+ Refer to your econometrics and regression analysis class for

precise formulas.
Slide 18 of 48
Back to the 1960s: Part 1
Algorithm used to find the linear trend forecast:

1
I use Nominal GDP from NIPA Table 1.1.5
I use quarterly data from 1947 to 1960.
I take logs (natural logarithm) of the series.
Use SLOPE and INTERCEPT to find a linear trend.
Extend the linear trend to Jan 22, 2014.
44 of 260
Slide 19 of 48

Log$of$Real$GDP$and$Trend$
31#
30#
29#
28#
27#
26#
25#
1947#
1957#
1967#
1977#
Log#Real#GDP#
1987#
1997#
2007#
Trend#Forecast#
The forecast is remarkably close to actual data!
The forecast is under-estimating actual GDP by 15%
Trend seems to increase in the 70s and decrease in the 90s.
Slide 20 of 48
Deviations from trend

Definition (Deviation From Trend)
Let x
bt the actual values of a time series. Let xt be the values of the
fitted trend line. Define the deviation from trend as dt = x
bt xt .
From our previous experiment:
Devia&ons*From*Trend*
0.6%
0.5%
0.4%
0.3%
0.2%
0.1%
0%
1947%
1957%
1967%
1977%
1987%
1997%
2007%
!0.1%
The deviations from trend dont appear completely random,

there seems to be a degree of correlation over time.
Slide 21 of 48
Forecasting: Time Series

A question. How confident are we about our forecast?
A model for dt can help provide an answer.
What model should we have for dt ? From the previous picture it
seems there is a persistence component and a shock component.

dt =
dt1
| {z }
Effect of past shocks
Effect of current shock
dt is an auto-regressive process:
1
2
Slide 22 of 48
t
|{z}
[0, 1] denotes the persistence of the process.

t is a shock process with variance 2 .
45 of 260
Appendix: Autoregressive Processes

Given an autoregressive process:
dt = dt1 + t
We have that:
cov(dt , dt1 )
.
var(dt )
The variance of t can be computed directly.

2 = var(dt dt1 ).
Q: Why do we care? Knowing 2 provides confidence intervals
around our original estimate.
Slide 23 of 48
Appendix: Autoregressive Processes

Suppose we are performing a forecast k period ahead.
Given an estimate of and 2 let
k2
(
k 2 if = 1
= 12k 2
if < 1
12
The 95% confidence intervals are given by:

xt+k 2
q
k2
where xt+k is our trend forecast k periods ahead.
The idea is that the more variable a time series is,

the least certain we can be about a forecast.
Slide 24 of 48

Algorithm used to find the confidence intervals:
46 of 260
Calculated the deviations from trend: dt .
Compute using the function CORREL in Excel.
Compute t = dt dt1 .
Compute the variance of t using function VAR in Excel.
Compute k2 .
Compute the upper bound: xt+k + 2

q
lower bound: xt+k 2 k2 .
Slide 25 of 48
q
k2 and

Ln#Real#GDP#and#Trend#
31#
30#
29#
28#
27#
26#
25#
1947#
1957#
1967#
Log#Real#GDP#
1977#
Trend#Forecast#
1987#
1997#
Lower#Bound#
Upper#Bound#
2007#
Actual data is within the 95% confidence bands.
Slide 26 of 48
47 of 260
2.3
Trend and Cycles
48 of 260
Recession and Depression

Definitions:
Recession
Two consecutive quarters of decline in real GDP.
NBER: A significant decline in economic activity spread across the
economy, lasting more than a few months, normally visible in real

GDP, real income, employment, industrial production, and
wholesale-retail sales.
Depression
Large output drop > 10% lasting several years
For more information visit here: http://www.nber.org/cycles.html
Slide 28 of 48
Trend and Cycle
In the previous experiment the fitted trend line was used to

perform forecast about the future.
The fitted trend line is also useful to study separately aspects

concerning long term growth and short term fluctuations.
Economist usually study (so will we in class) separately.
Slide 29 of 48
Trend and Cycle
Trend: captures the long term growth rate of the economy.

Cycle: captures short lived deviation from the trend.
Slide 30 of 48
49 of 260
Deviations from trend

Definition (Deviation From Trend)
Let x
bt the actual values of a time series. Let xt be the values of the
fitted trend line. Define the deviation from trend as dt = x
bt xt .
From our previous experiment:
Devia&ons*From*Trend*
0.6%
0.5%
0.4%
0.3%
0.2%
0.1%
0%
1947%
1957%
1967%
1977%
1987%
1997%
2007%
!0.1%
We observe both Large secular fluctuations: productivity

slowdowns. and Smaller fluctuations: business cycles.
Slide 31 of 48
Non-Linear Trend
The previous plot shows that a linear trend misses the fast growth
of the 70s and the slowdown in the 90s.
This is an artifice of the simple nature of the trend used: a line.

We now use a more flexible trend (also called a non-linear filter).
The once considered is the Hodrick-Prescott (HP) filter.
Slide 32 of 48
The Hodrick-Prescott filter

Let yt be GDP in year t. Suppose you have data for T years.
Suppose that:
yt =
t
|{z}
Cyclical component
xt
|{z}
Trend component
The HP filter finds the trend solving the following problem

( T
)
T
1
X
X
2
2
min
(yt xt ) +
[(xt+1 xt ) (xt xt1 )]
{gt }T
t=1
t=1
t=2
is called the smoothing parameter
50 of 260
Set = 100 if GDP is in yearly data

Set = 1600 if GDP is in quarterly data
Slide 33 of 48
HP Filter and U.S. GDP
Observe the slow moving trend line.

Slide 34 of 48
HP Filter and U.S. GDP

Given the trend line is straightforward to compute
deviations from trend.
Slide 35 of 48
The Cyclical Component
What to do when we derive the cyclical component?
We can study the frequency of the fluctuations.

We can study the amplitude of the fluctuations.
More important, the cyclical component of GDP can serve as a
benchmark for other macroeconomic quantities.
51 of 260
Slide 36 of 48
Business Cycles: Relationship To GDP
Slide 37 of 48
Two Time Variables: How to study them?
Let xt and yt be two time variables (for example: GDP, Inflation).

Natural questions you might ask:
Are the two variable related?

Is one variable predicting the other?
Does one variable move more than the other?
Slide 38 of 48
Two Time Variables: Correlation

Remember correlation does not imply causation!!!
When the trend is removed from the two variables economist usually
talk about co-movement rather than correlation
52 of 260
Q: If I have two variables that grow at the same rate and

do not remove the trend what will be the correlation?
Slide 39 of 48
Two Time Variables: Correlation
Definition
A macroeconomic variable is:
Pro-cyclical: if deviations from trend are positively correlated with

deviations from trend of real GDP.
Counter-cyclical: if deviations from trend are negatively correlated

with deviation from trend of real GDP.
A-cyclical: if deviations from trend are not correlated.
Slide 40 of 48
Two Time Variables: Lead and Lag

If xt and yt are positively correlated,
additional information on comovement
Slide 41 of 48
Two Time Variables: Amplitude
Is also important also to look at the amplitude of deviation from

trend of the two variables (who fluctuates more?)
To summarize, with two economic variables you should remember:

1
How they are correlated? pro-cyclical, countercyclical
How they are synchronized? lead-lag
How do the fluctuations compare? amplitude
53 of 260
Slide 42 of 48
Multiple Time Series: Examples
Slide 43 of 48
Deviation From Trend Consumption vs. GDP
Consumption is:
pro-cyclical, coincident and slightly less variable
Slide 44 of 48
Deviation From Trend Investment vs. GDP
54 of 260
Investment is: pro-cyclical, coincident and more variable
Slide 45 of 48
Deviation From Trend Employment Level vs. GDP
Employment level is pro-cyclical, lagging and less variable

Slide 46 of 48
Relation Between Variables: Summary
Slide 47 of 48
Relation Between Variables: Summary
Goal for the semester: construct a theory to explain these facts!

Also, can the theory guide us to better forecasts?
Slide 48 of 48
55 of 260
2.4
Nominal and Real GDP
56 of 260
Plan For This Lecture
Nominal and Real GDP.

+ http://www.youtube.com/watch?v=jTmXHvGZiSY
Study Price levels: CPI and GDP deflator.
Slide 2 of 16
Real and Nominal Quantities
Some definitions:
A nominal quantity: is a dollar denominated quantity, denoting
the market value of a quantity with prices defined at the time of

production.
A real quantity: is a dollar denominated quantity, denoting the

market value of a quantity with prices defined in a given year.
A price level: is a weighted average of prices at a given time.

A price index: is the ratio of two price levels.
Slide 3 of 16
A 2 x 2 Economy
Example economy lasts for 2 periods: 2013 - 2014; 2 goods are
produced: Apples and Oranges. The data:
Product/Time
Apples
Oranges
Prices
Apples
Oranges
Values
Apples
Oranges
Nominal GDP
2013
5
200
2014
10
250
1.2 $
0.2 $
0.6 $
0.24 $
6$
40 $
46 $
6$
60 $
66 $
Quantities and prices are changing, is nominal GDP informative?

No. Real GDP will provide a measure about real changes!
Slide 4 of 16
57 of 260
From Nominal to Real GDP

Once we define a price index we can move between the two
quantities:
Real GDP =
Nominal GDP
Price Index
To define a price index we need to determine a base year.

A year for which the price index is normalize to 1.
Price Index(t) =
Price level(t)
Price level(base year)
Slide 5 of 16
Keeping Prices Fixed

Steps to convert Nominal GDP to Real GDP:
1
Determine a base year.
Construct a price level; we have two options:

Fix weights for prices using quantities in the base year
This is called the Base-weighted or Laspeyres approach.
Every period change weights for prices using current quantities
This is called the Current-weighted or Paasche approach.
Construct the price index.
Divide the time series of Nominal GDP by the

constructed price index.
Slide 6 of 16
Laspeyres vs Paasche
Let Pit =prices, Xit =quantities of good i at time t. Nominal GDP is:
GDP (t) =
N
X
Pit Xit
i=1
Let t0 be the base year. The Laspeyres index for year time t is:
P
Laspeyres
PN
(t) = PNi=1
Pit Xit0
t0 t0
i=1 Pi Xi
Let t0 be the base year. The Paasche index for year t is:
58 of 260
P
Slide 7 of 16
Paasche
PN
(t) = PNi=1
Pit Xit
t0 t
i=1 Pi Xi
The Laspeyres Index

Product/Time
Apples
Oranges
Prices
Apples
Oranges
Values
Apples
Oranges
Laspeyres Index
2013 Base year

5
200
2014
//
10 5
250
/// 200
1.2 $
0.2 $
0.6 $
0.24 $
6$
40 $
1
3$
48 $
= 51$
46$ = 1.11
3$+48$
6$+40$
To calculate price index in 2014 use quantities of 2013.

Price Index increases by 11% between 2013 and 2014.
Slide 8 of 16
The Paasche Index

Product/Time
Apples
Oranges
Prices
Apples
Oranges
Values
Apples
Oranges
Paasche Index
2013 Base year

//
5 10
///
200 250
2014
10
250
1.2 $
0.2 $
0.6 $
0.24 $
12 $
50 $
1
6$
60 $
66$
= 62$
= 1.064
6$+60$
12$+50$
To calculate price index in 2014 use quantities of 2014.

Price Index increases by 6.4% between 2013 and 2014.
Slide 9 of 16
Nominal and Real GDP Growth

Recall:
Real GDP =
Variable ($)
Nominal GDP
Real GDP - Laspeyres
Real GDP - Paasche
Nominal GDP
Price Index
2013
46
46/1=46
46/1=46
2014
66
66/1.11
66/1.064
Growth
43.5%
29.26 %
34.86 %
Two measures of Real GDP growth differ!
In the US we use two different price indexes:

1
GDP deflator
CPI (consumption price index)
Slide 10 of 16
59 of 260
Nominal and Real GDP using GDP Deflator
Question: what happens in 2009?

Slide 11 of 16
GDP Deflator Vs. CPI: Comparing 2014 vs 2009

Deflator
Key feature 1: keep quantities fixed at the current year
Key feature 2: every good and service enters in the price index
CPI
Key feature 1: keep quantities fixed at base year (2009)
Key feature 2: only quantities purchased by consumers (C)
P
P 2014 X 2009
CPI(2014) = PiC i2009 i2009
Xi
iC Pi
Slide 12 of 16
GDP Deflator vs. CPI

The two quantities differ over time!
60 of 260
Slide 13 of 16
Inflation
Definition (Inflation)
Inflation (i): the % change in the GDP deflator between two consecutive
years. For example:
i2014 =
Def lator2014 Def lator2013

100
Def lator2013
Inflation-CPI determines changes in the cost of living

(constructed using CPI rather than GDP deflator)
Question: If you were a worker in 1970, you would like
your contract to be indexed to which value of inflation?
Slide 14 of 16
Inflation in the US
Inflation is rarely negative.

Period of high inflation in the 70s.
Slide 15 of 16
Putting Things in Perspective

Zimbabwe 2008: How about 231,000,000% Inflation?
61 of 260
Slide 16 of 16
Chapter 3
The Household
62 of 260
News of the week
How many new jobs/hires are there each month?

http://www.bls.gov/news.release/pdf/jolts.pdf
Slide 3 of 42
Plan for This Lecture
The Household
Data
The utility function
Indifference Curves
Household constraints
Househols optimization
+ Income and Substitution effects
Aggregation
Slide 4 of 42
The Household
Who are the households in the US economy?
In our model a households will be a unit working and consuming.

To whom should we model after?
From US Census: population clock as of Jan 28 2014: 317,441,572

(http://www.census.gov/main/www/popclock.html)
From BLS: Number of consumer units (2012): 124,416,000

(http://www.bls.gov/news.release/cesan.nr0.htm)
63 of 260
Slide 5 of 42
The Average Household: Working
From BLS: Civilian labor force: 154,408,000

Unemployed (Dec 2013): 9,984,000
(http://www.bls.gov/news.release/empsit.t01.htm)
Average hours worked per week (2013): 34.4

Average hourly earnings: $ 24.17 (2013)
(http://www.bls.gov/news.release/empsit.b.htm)
Slide 6 of 42
The Average Household: Not Working
What about unemployment rate (U )?

U=
labor force employment

unemployed
100 =
100
labor force
labor force
Using previous data

U=
9, 984, 000
100 6.46%
154, 408, 000
Note in this part of the course we will not model unemployment.

Instead we will focus in changes of average hours worked.
Slide 7 of 42
The Average Household: Consuming

1
Excellent source: consumer expenditure survey

http://www.bls.gov/cex/
Average annual expenditures (2012): $ 50, 631

Some spending categories:
Category
Food
Housing
Transportation
Healthcare
64 of 260
Slide 8 of 42
Expenses
$ 6,532
$ 16,940
$ 8,505
$ 3,466
The Household
The Household (a.k.a the representative consumer), cares about:

1
Consumption: c
Leisure: l
(Note, in GDP consumption is C here is c...

it is not a typo, check the end of the lecture!)
The household (HH) has a goal: be happy.
Slide 9 of 42
The Household: Assumptions
We assume that:
1
All the households have the same tastes
Households are very smart!

(understand how the world works and can solve max)
Households are not jealous, do not have regrets...
For the next month: households live one period

(we do not have to worry about savings just yet)
Slide 10 of 42
About Assumptions
Are these good or bad assumptions?

To answer this question we follow the paper by Friedman
The Methodology of Positive Economics (On blackboard)

Do not evaluate assumption by realistic appeal
(Think about Newton modeling apple falling in a vacuum)
Evaluate assumption by ability to replicate data
(Think about Newton prediction of flight-time of the apple falling)
65 of 260
Slide 11 of 42
The Decision of The Household
The household (HH) has a goal: be happy
The utility function U represents the happiness of the HH:

For every bundle (c, l), U (c, l) associates a level of utility
We say that (c1 , l1 ) is preferred to (c2 , l2 ) if and only if
U (c1 , l1 ) > U (c2 , l2 )
The objective of the HH is to maximize U (c, l) on every pair

(c, l) that it has available (feasible and affordable)
Slide 12 of 42
Some Math Notes
A function f (x) is a relation that uniquely associates members of

one set with members of another set.
A derivative of function f (x), denoted f 0 (x) is a function that at

every point x associates the slope of f .
df (x)
f (x + x) f (x)
f 0 (x) = lim
x0
dx
x
Note:
d2 f (x)
dx2
df 0 (x)
dx
Slide 13 of 42
Properties of the Utility Function

Properties of the utility function:
1
Utility is increasing (more is preferred to less)

dU (c, l)
> 0;
dc
Concavity: each additional unit of consumption and leisure adds

less utility
(eating twice as much does not make you twice as happy)
d2 U (c, l)
< 0;
dc2
66 of 260
dU (c, l)
>0
dl
d2 U (c, l)
<0
dl2
Important Implication: Households do not like risk.

Slide 14 of 42
From U to Indifference Curves
We look at 2 dimensional utility functions

(HH cares about c AND l)
How can we summarize preference? using indifference curves

Definition (indifference curve)
An Indifference curve is a curve connecting all values of consumption
and leisure among which the consumer is indifferent.
Slide 15 of 42
Indifference Curves
Utility is increasing Indifference curves are downward sloping
HH like diversity Indifference curves are convex
Question: can indifference curves cross each other?

Slide 16 of 42
Household Constraints
67 of 260
Slide 17 of 42
HH Constraints
In our economic model, HH have
Limited amount of time available: let Ns be time working

l + Ns = 24 hours = h
Slide 18 of 42
HH Constraints
In the data what else we know about usage of time?
Usage of time for American residents:

http://tinyurl.com/usage-time
Slide 19 of 42
The Budget Constraint

Limited disposable income: a budget constraint
Let:
c = consumption
h = time endowment
l = leisure time
w = hourly wage
= dividend income
T = lump sum taxes (rebates)
c = w(h l) + T
68 of 260
Question: How would you write an income tax?

Slide 20 of 42
Transfer Income in the US

If T < 0 we call it a Transfer to the household. In the US the following
are the biggest source of transfers to the Households:
Food Stamps:
http://www.fns.usda.gov/pd/snapmain.htm
Unemployment Insurance:
http://www.ows.doleta.gov/unemploy/index.asp
Disability Insurance:
http://www.ssa.gov/disability/
Temporary assistance for needy families (TANF):

http://www.acf.hhs.gov/programs/ofa/
Slide 21 of 42
Unemployment Insurance
Claims for unemployment insurance is a leading indicator:
Slide 22 of 42
Wages determines the slope of the budget constraint.

and T determine the intercept.
Slide 23 of 42
69 of 260

Suppose now T < : positive consumption even with no work
Slide 24 of 42
Consumer Maximization
Slide 25 of 42
Consumer Maximization
A consumption-leisure bundle is:
Affordable if it lies on or within the budget set.

Optimal if it is affordable and is on the highest indifference curve.
70 of 260
Slide 26 of 42
Optimal and Sub-optimal Bundles
Only H is optimal!!
Slide 27 of 42
Consumer Maximization: Math!

The household problem:
max U (c, l)
c,l
s.t. w(h l) + T = c
Write the lagrangian:
L(c, l, ) = U (c, l) + [w(h l) + T c]
where is our lagrange multiplier. First order conditions
(C) :
(l) :
Uc (c, l)
Ul (c, l) w
=0
=0
() : w(h l) + T c = 0
Slide 28 of 42
Consumer Maximization: More Math!

Lets substitute out from the two first order conditions:
Ul (c, l) w Uc (c, l) = 0
Ul (c, l)
=w
Uc (c, l)
And what is
Ul (c,l)
Uc (c,l) ?
Ul (c,l)
Uc (c,l)
= M RSl,c = w
71 of 260
Slide 29 of 42
The Marginal Rate of Substitution

Definition (Marginal Rate of Substitution)
The marginal rate of substitution is the rate at which a consumer is
willing to give up one good in exchange for another good while
maintaining the same level of utility.
A consumption-leisure bundle is optimal when:

Is on the budget line (Walras law)
Slope of indifference curve = Slope of budge line
Which implies
M RSl,c
| {z }
=w
Marginal rate of substitution
Slide 30 of 42
Choosing Unemployment
Be careful with corner solutions!!
Slide 31 of 42
Income and Substitution Effects
72 of 260
Slide 32 of 42

Effect of changing parameters of the model (comparative static)
can be decomposed in:
Definition
Income Effect:
The effect on quantities as a result of having

different income holding prices constant.
Substitution Effect:
The effect on quantities given a price change

holding utility constant.
Slide 33 of 42
Income and Substitution Effects: Example
Pure Income Effect: winning the lottery

Pure Substitution Effect: high wage only for 1 day
Income + Substitution Effect: permanent high wage
Slide 34 of 42
Income and Substitution Effects: Example
Pure Income Effect: winning the lottery more leisure.

Pure Substitution Effect: high wage only for 1 day less leisure.
Income + Substitution Effect: permanent high wage leisure ?
73 of 260
Slide 35 of 42
Income Effect: more income more leisure.

Substitution Effect: higher wage less leisure.
Note:
1
A higher wage (lower income tax) induces both

an income and substitution effect.
The overall effect is undetermined, we must proceed quantitatively.
Slide 36 of 42
Comparative Static: Changing T

Suppose increases or T decreases.
Since c and l are normal goods
the richer you are the more you want
So what happens when you give tax rebates??
Slide 37 of 42
Comparative Static: Changing Wages

Suppose your wage goes up.
74 of 260
Remember: leisure is more expensive

In general this case features both income and
substitution effects leisure changes are undetermined.
Slide 38 of 42
From One to Many Housholds
So far we have studied problem of a single household.

We need to compare aggregate quantities (GDP, C,...)
and household decision (called ci and li in this slide)
In Macro Economics the problem of going from one to many

household is referred to as an: aggregation problem.
The Issue:
1
In the data we have household with disparate income levels.
In the data we have household with different tastes.
Slide 39 of 42
The Solution: Assumptions
Definition (Homogeneous of Degree One)

Homogeneous function of degree 1: if for all n R:
n f (x) = f (n x)
Key assumptions:
1
Utility function is homogeneous of degree one.
Households have similar preferences.
Slide 40 of 42
Aggregation
We have:
N
X
i=1
max ui (ci , li ) N max u(c, l) max u(N

N l)
| {z }c, |{z}
ci ,li
c,l
c,l
C = N c: aggregate consumption;
L = N l: aggregate leisure.
75 of 260
Slide 41 of 42
The High Income Household: Consuming

Q: How good is the assumption that ci is the same for everybody?
(I.e how good is assumption about homogeneity?)
Low income households
High income households

2%
10%
12%
9%
1%
16%
4%
15%
1%
8%
6%
32%
14%
5%
41%
5%
16%
3%
Food
Alcoholic beverages
Housing
Apparel and services
Transporta7on
Healthcare
Entertainment
Personal insurance and pensions
Misc.
Food
Housing
Transporta7on
Entertainment
Misc.
Alcoholic beverages
Apparel and services
Healthcare
Personal insurance and pensions
A: Not too bad..

Check your micro lectures for the notion of homotheticity/homogeneity
76 of 260
Chapter 4
The Firm
77 of 260
Suppose 10% of U.S. capital stock gets destroyed.

How much will GDP decrease by?
Your answer here: http://tinyurl.com/73240-ales
Slide 2 of 31
Plan for this Lecture
The Firm
Data: firms in the US
The representative firm
The production function
Firm maximization
Calibrating the capital share:
Note: with this lecture we finish Ch.4 - Review it!!
Slide 3 of 31
U.S. Firms: Data

How many businesses?
Non-employers (firms with no payroll): 21,708,021

(census data 2008)
Employers (firms with payroll): (census data 2008)

Firms
Establishments
Employment
6,022,127
7,601,160
119,917,165
Source: http://www.census.gov/epcd/www/smallbus.html
78 of 260
Slide 4 of 31
where s0 is the minimum size and ! is a parameter. This distribution is a
U.S.classical
Firms:
SizeofDistribution
example
a power or scaling law. The empirical data for 1997
!
are shown binned as a PDF in figure 1 below, with size measured by
along with aof

line
having
! = 1.059.2
Whatemployees,
is the distribution
firm
size?
Figure 1: PDF of U.S. firm sizes, 1997 Economic Census data
Thee Zipfian character

of thisRobert
distribution
is robust to alternative
(source:
Axtell)
definitions of firm size (e.g., firm receipts).
Look Data
on the
web for Zipf law!
of such vast regularity are highly unusual in the social
A
firm
over
time:
sciences. Only at theLINK
extremes of the support do the data depart in any
Slide 5 of 31
systematic way from the distribution. Indeed, there are relatively too few
small and very large firms in the data. Such deviations are often
U.S.very
Firms:
Data
1
The Zipf distribution is usually considered a discrete distribution; more on this below.
The origin of these data are tax filings and, for reasons of confidentiality, only binned
data are available. The kinds of statistical procedures used on these data are therefore
not generally commensurate with other papers in this volume that analyze raw data.
2
Source: http://www.bea.gov/industry/
Look at behavior of Professional vs Manufacturing.
The Representative Firm

And
The Production Function
79 of 260
Slide 7 of 31
The Firm
A firm converts inputs (factors of productions)
into output (consumption goods)
Goal of the firm: maximize profits

Assumptions:
1
Firms are very smart
They all have similar technology exists a representative firm
They use only two factors of productions: capital and labor
Live 1 period (relaxed later in the course)
No financing issues (relaxed later in the course)
Slide 8 of 31

Let:
Capital: K
Labor employed: N d
Total Factor Productivity (TFP): z
Output: Y
Ability of a firm to transform factors of production into output is

summarized by the production function F
Y = zF (K, N d )
Slide 9 of 31
Properties of the Production Function

1
F is increasing
dF (K, N )
>0
dK
dF (K, N )
>0
dN
F exhibits constant return to scale

Double the size double the output
zF (xK, xN d ) = xzF (K, N d )
Note: This as for the consumer is key to study a representative firm

Note: decreasing (increasing) returns to scale
zF (xK, xN d ) < (>) xzF (K, N d )
80 of 260
Slide 10 of 31
Marginal Products
Marginal product of capital (labor) M PK (M PN ) is the additional
output produced by increasing capital (labor) by one unit,
keeping fixed the other input.
Slide 11 of 31
Properties of the Production Function

dF
dF
Note: M PK = z dK
and M PN = z dN
3
F is concave:
M PN decreases as N increases (alternatively
d2 F
dN 2
< 0)
M PK decreases as K increases (alternatively
d2 F
dL2
< 0)
(Example: double the size of a study group)

4
M PN increases as capital increases:

(Example: buy a laptop for a student)
Slide 12 of 31
Example: TFP Shock

Consider two economies 1 and 2 with z2 > z1
81 of 260
Why do we care? Think how wages change with technology
Slide 13 of 31

Very popular production function is the Cobb-Douglas
Y = zK (N d )(1)
With 0 < < 1 ( =capital share). Examples:
Kenya vs. U.S.
zkenya < zU.S.
U.S. (1776) vs. U.S. (2014)

z1776 < z2014
K1776 < K2014
??
Question: what are and z for the U.S. today?
Slide 14 of 31
Firm Maximization
Slide 15 of 31
The Problem of the Firm
Some additional assumption:

1
The objective of a firm is to maximize profits.
A firm owns the capital

(later we will introduce the investment decision.)
Firms takes the wage as given from the market.
No taxes in the baseline environment.
The firm sets the demand for labor: N d .
82 of 260
Slide 16 of 31
Profits
Let:
Revenue: zF (K, N d )
Variable cost: wN d
Profits = = zF (K, N d ) wN d
The firm solves:

max zF (K, N d ) wN d
Nd
Question: Why doesnt the firm choose N d VERY large?
Slide 17 of 31
Optimal Labor Choice
Choose N d so that: M PN = w
Slide 18 of 31
Solution: Intuition
Suppose M PN > w
Then raise N d very little: revenue raise faster than the costs
Suppose M PN < w
Then lower N d very little: revenue decrease slower than the costs
In both cases we reach a contradiction so that the only alternative is:
M PN = w
83 of 260
Slide 19 of 31
What is ?
Slide 20 of 31
Solution: Example
Useful property of a Cobb-Douglas production function:
M PN
= z(1 )K N 1 N 1
= (1 )zK N 1 N 1
M PN = (1 )
Y
N
+ We can relate M PN to output per worker N/Y .

Slide 21 of 31
The Labor Share of Income

We now calculate from the data . Start from previous equation:
M PN = w = (1 )
Solve for 1 :
1=
wN
Y
Where:
84 of 260
wN is the compensation of employees
Y is GDP
+ Both can be obtained from the data!

Slide 22 of 31
Y
N
In the NIPAs, GDP is defined as the market value of the final goods and services
and property located in the United States. Conceptually, this measure

Calculatingproduced
Theby labor
Labor
Share From Data
can be arrived at by three separate means: as the sum of goods and services sold to final
users, as the sum of income payments and other costs incurred in the production of goods
and services, and as the sum of the value added at each stage of production (chart 2.1).
Although these three ways of measuring GDP are conceptually the same, their calculation
may not result in identical estimates of GDP because of differences in data sources,
timing, and estimation techniques.
Remember the three ways to calculate Y ?
Chart 2.1Three Ways to Measure GDP

Gross output
Less: Intermediate purchases
Personal consumption
expenditures
Compensation of employees
Equals: Gross value added
Gross private domestic fixed

investment
Taxes on production and

imports less subsidies
Change in private inventories
Net operating surplus
Government consumption
expenditures and gross investment
Consumption of fixed capital
Net exports
GDP
The sum of final
expenditures
GDI
The sum of income payments
and costs incurred in
production
Gross Value Added

The sum of gross value
addedgross output less
intermediate purchases
across all private industries
and government
As the sumthe
of goods
and services
sold to final
users. This
measure, known as the
Lets compute expenditures
1.from
BEA
data:
Table
2.1
approach is used to identify the final goods and services purchased by
Slide 23 of 31
persons, businesses, governments, and foreigners. It is arrived at by summing the

following final expenditures components.
2-7
Changes in Capital Stock and
At the beginning of class I asked you about the effect of a 10%

decrease in the U.S. capital stock. The number provided is
connected with .
From Lecture 3 we have that:

Growth Rate of Yt = log(Yt+1 ) log(Yt )
In our example:
log(Yt ) = zt + log(Kt ) + (1 ) log Nt
So that (if Nt and zt do not change)
Growth Rate of Yt = log(Yt+1 ) log(Yt ) = Growth Rate of Kt
|
{z
}
10%
Labor Demand
85 of 260
Slide 25 of 31
U.S. Firm Data: Employment
Source: http://www.bls.gov/web/cewbd/
Slide 26 of 31
Who Affects Un-Employment?
Source: http://www.bls.gov/web/cewbd/
Note how the recession unemployment due to
contractions rather than failures.
Slide 27 of 31
Solution of the Firm Problem

Consider F (K, N ) = K N 1 (notice: I removed the superscript
The firm solves:
max (N ) = max zK N 1 wN
N
To solve, take first order condition:

d
= z(1 )K N w = 0
dN
Our optimality condition:

86 of 260
z(1 )
|
{z
M PN
Slide 28 of 31
K
N
=w
D)
Labor Demand
The firm problem provides the key equation that determines the
demand for labor:
z(1 )K
N=
w
1
Comparative statics:
1
z increases N increases
K increases N increases
w increases N decreases
Slide 29 of 31
Labor Demand: Exercise

Labor Demand:
N=
z(1 )K
w
1
Suppose K changes by 1%.

1
By how much should we expect N to change?
What key assumption are we making?
Proceeding as before:
log Nt =
i
1h
log zt log wt + log(1 ) + log Kt
Assume wt does not change.
The growth rate of N depends 1:1 with growth rate of K.

Slide 30 of 31
Firm Problem: Other Examples
We can now study what happens if:

1
Government taxes revenues.
Government subsidizes employment.
.
Firm have a minimum firm size N
Note these are partial equilibrium examples. What are we missing?
87 of 260
Slide 31 of 31
Chapter 5
The Government
88 of 260
The Government
Slide 3 of 41
The Government: Size

Employed (2012) Federal + State and Local : 21,973,000
http://research.stlouisfed.org/fred2/series/USGOVT
Government expenditures:
Slide 4 of 41
Governments Size Across Countries
89 of 260
Source: OECD
Slide 5 of 41
The Government
In our model the government is benevolent:
maximizes welfare of its citizen
Question: why do we need a government?
It provides public goods:
Schools, Police, Fire, Military

Infrastructures
It corrects market failures:
SEC, FTC, Retirement (?), CO2

Slide 6 of 41
The Government: Budget Constraint

Let G be the dollar value of the public goods. In a static world the
budget constraint is:
G=T
When we will look at dynamics we will have
G = T + debt
Slide 7 of 41
Governments in Europe: Debt size

In 2012:
90 of 260
Slide 8 of 41
The Government: Data

Policy Revenues by Source
2011
2011
Security Discretionary
Excise Taxes
Net Interest
Other Mandatory
Programs and
Disaster Costs
Non-Security
Discretionary
Social Security
Medicare
Other Receipts
Unemployment
Insurance
Medicare
Payroll
Taxes
Medicaid
Borrowing and
Other Net
Financing
Social
Security
Payroll Taxes
Individual
Income Taxes
THE BUDGET FOR FISCAL YEAR 2011
Policy Outlays by Category
Corporation
Income Taxes
2015
Source: U.S budget 2011
2015
Current Budget: LINK

Historical data: LINK
Non-Security
Discretionary
Excise Taxes
Net Interest
Other Mandatory
Programs and
Disaster Costs
Social
Security
Slide 9 of 41
Medicare
Other Receipts
Borrowing and Other Net

Financing
Unemployment
Insurance
Medicare Payroll
Taxes
Social
Security
Payroll Taxes
Individual
Income Taxes
Medicaid
153
Corporation
Income Taxes
Static government budget constraint is:

G=T
Taxes T also appear in the household budget constraint:

C = wN + T
In the data from where does the government draws revenue?
Slide 10 of 41
The Government: Data
Policy Revenues by Source
2011
2011
Excise Taxes
Net Interest
Other Mandatory
Programs and
Disaster Costs
Non-Security
Discretionary
Social Security
Medicare
Other Receipts
Unemployment
Insurance
Medicare
Payroll
Taxes
Medicaid
Borrowing and
Other Net
Financing
Social
Security
Payroll Taxes
Individual
Income Taxes
THE BUDGET FOR FISCAL YEAR 2011
Policy Outlays by Category
Corporation
Income Taxes
2015
2015
Source: U.S budget 2011

Non-Security
Discretionary
Excise Taxes
Net Interest
Other Receipts
Unemployment
Insurance
Other Mandatory
Slide 11 of 41 Programs and

Disaster Costs
Medicare Payroll
Taxes
Social
Borrowing and Other Net

Financing
91 of 260

The impact of Government policy on HH and Firm:
y : income tax (appears in HH budget constraint)

C = (1 y )wN s + T
c : tax on consumption (appears in HH budget constraint)

(1 + c )C = wN s + T
r : tax on revenues (appears in firm profits)

Y = (1 r )zF (k, N d ) wN d
Slide 12 of 41
Who Pays Income Tax?
Source:
http://www.cbo.gov/publications/collections/tax/2010/graphics.cfm
Slide 13 of 41
92 of 260
Chapter 6
Equilibrium
93 of 260
Competitive Equilibrium
Slide 14 of 41
Why do we Need an Equilibrium Concept
Example of equilibrium fallacy:

Here is a great way to warm up the house: On Dec 1st turn the heating
up to 70. Once the house gets to 70. Turn them off for the rest of the
winter, thats it the house will remain at 70. We might need to turn AC
ON on May 1st...
Slide 15 of 41
Why do we Need an Equilibrium Concept
Some potential fallacies:
Suppose government consumption (G) Increases by 20%

what happens to C and I?
Suppose government subsidizes employment?

what happens to wages?
94 of 260
Slide 16 of 41
A Note on Aggregation
Remember:
Our consumer is a representative consumer: it represents ALL

of the consumers in the US
Our firm is a representative firm: it represents ALL

of the firms in the US
Slide 17 of 41
Equilibrium
The idea:
1
Set some external conditions

(exogenous variables)
Determine what happens to all of the other variables of interests

(endogenous variables)
In our static model:

1
Exogenous variables: (K, G, z)
Endogenous variables: (C, N s , N d , T, Y, w)
Notation: N d = labor demanded; N s = labor supplied

Slide 18 of 41
Equilibrium
How do we know what is going to happen?

1
Must be optimal:
everybody (household and firm) must like the decision
it has taken.
Must be feasible:
cannot have more consumption than goods produced.
95 of 260
Slide 19 of 41
Competitive Equilibrium: Static
Definition (Competitie Equilibrium)

For a set of exogenous variables (K, G, z) A competitive equilibrium is a
set of endogenous variables (C, N s , N d , T, Y, w), so that:
1
The consumer chooses C (consumption) and N S (labor supply)

optimally, taking as given w (wage), T (taxes), (dividends)
The firm chooses N d (labor demand) to maximize profits, taking as

given w (wage), K (capital stock), z (productivity)
+ Turn to next page...
Slide 20 of 41
Competitive Equilibrium: Static

Definition (Competitie Equilibrium (continued))
[...] continued:
3
Government balances the budget: G = T
Labor market clears: N d = N s
Goods market clears: Y = C + G
Question: nice definition, but does it exist?

Answer: YES! (take my word, or better take theirs nobelprize.org)
Slide 21 of 41
Working With the Model
Next step is to characterize the equilibrium:
Our first approach: find a graphical summary representation

The production possibility frontier (PPF)
Then: characterize equilibrium by solving system of nonlinear

equations.
96 of 260
Slide 22 of 41
Working With the Model

Derive a relation (production possibility frontier - PPF) so that given
(K, G, z) we can determine all the feasible (C, l) pairs
Y = zF (K, N d )
since market clear N d = N s :
Y = zF (K, N s )
substitute feasibility of hours of household: N s = h l
Y = zF (K, h l)
substitute the goods market clearing: Y = C + G
C = zF (K, h l) G
Slide 23 of 41
The Production Possibilities Frontier
Some properties of the PPF:

C(l) = zF (K, h l) G
1
Equilibrium consumption decreasing in leisure:
Decreasing returns - PPF is concave:
d2 C(l)
dl2
dC(l)
dl
()
= z dF
dN < 0
<0
Slide 24 of 41
The Production Possibilities Frontier
97 of 260
Slide 25 of 41
The Marginal Rate of Transformation

Minus the slope of the PPF is the marginal rate of transformation
C(l) = zF (K, h l) G
this implies
M RTl,C =
dC(l)
dF (k, h l)
=z
= M PN
dl
dN
or in words:
Marginal rate of transformation = marginal product of labor
for any (C, l) on the PPF we can find the wage!
Slide 26 of 41
Moving Towards the Competitive Equilibrium
To the production possibilities frontier we need to add:

1
Add the households budget constraint C = w(h l) + T

Find the slope: done
Find the intercept: in appendix
Add indifference curves.
Slide 27 of 41
The Competitive Equilibrium
D'
98 of 260
Slide 28 of 41
The Competitive Equilibrium

Algorithm to find a Competitive Equilibrium:
1
Find the values of capital (K), government expenditures (G) and

productivity (z): these are the exogenous variables.
Given exogenous variables determine PPF,
Find point of tangency between PPF and preferences,
Recover endogenous variables (C, N s , N d , T, Y, w).
Use the constructed equilibrium to determine relationship between

exogenous and endogenous variables: comparative statics.
Slide 29 of 41
APPENDIX: Adding The Consumer

We show that the segments ADB constitute the budget constraint
Step 1: segment AD has slope w
Step 2: Need to show that segment DB is of length T
To see this note that
Segment D0 D has length h l = N

So that segment JD0 has length wN
Since J is at hight equal to C it follows that
DB = J JD0
DB = C wN = T
Slide 30 of 41
Online Survey!
Q: Suppose the government increases expenditures by G.

What happens to GDP
A: Your answer here: http://tinyurl.com/73240-ales
1
Increases by more than G
Increases by G
Increases by less than G
99 of 260
Slide 31 of 41
Examples
Slide 32 of 41
Examples
We are going to consider the following two exogenous changes:

1
Changes in government expenditures: G.
Changes in productivity: z.
Slide 33 of 41
Government Spending
Suppose the government increases its expenditure : G > 0
100 of 260
Slide 34 of 41
Government Spending
Suppose the government increases its expenditure : G = G2 G1 > 0
1
Balanced budget if G2 > G1 then T2 > T1 ;
Reduces households disposable income C2 < C1 and l2 < l1 ;
Increase in equilibrium hours worked: N2 > N1 implies Y2 > Y1 .
Question 1: C vs. G?
Question 2: what has happened to the real wage?
Question 3: does GDP increase?
Question 4: does the household prefer the increase in G?
Slide 35 of 41
The effects of government spending: DATA

Suppose the government increases its expenditure : G > 0
Slide 36 of 41
Testing the prediction of the model: G
Look at the relation between G and C

(we expect a negative correlation)
Look at the relation between G and N

(we expect a positive correlation)
For G and C we use NIPA table 1.1.6:

http://www.bea.gov/
For N we use FRED:
http://research.stlouisfed.org/fred2/series/CE16OV?cid=12
101 of 260
Slide 37 of 41
Changes in TFP
Suppose there is an increase in TFP: z > 0
Slide 38 of 41
Changes in TFP
Summarizing:
1
z1 z2 with z2 > z1
Wage increases w2 > w1
Consumption increases C1 C2
Hours worked? depends on Income and Substitution effects
Slide 39 of 41
Separating Income and Substitution Effects

P P F3 is P P F2 adjusting the income of the HH so that its indifferent
between new and old equilibrium
102 of 260
Slide 40 of 41
Testing the prediction of the model: z

Look at the relation between z and C
Look at the relation between z and N

For G and C we use NIPA table 1.1.6:

http://www.bea.gov/
For N we use FRED:
http://research.stlouisfed.org/fred2/series/CE16OV?cid=12
For K use Private nonresidential fixed assets:
line 1 of Table 4.1 of the NIPA fixed asset tables:
http://www.bea.gov/national/FA2004SelectTable.asp
Slide 41 of 41
103 of 260
Chapter 7
Optimality
104 of 260
Efficiency: Pareto Optimality
Slide 4 of 39
Efficiency
Idea:
Up to now we showed what is going to happen in equilibrium.

Now we determine what should happen in equilibrium.
Why do we care? Think about a role for the government.
Slide 5 of 39
Definition
Pareto Optimality
An equilibrium is Pareto optimal if there is no rearrangement of
production or consumption that makes the consumer better off.
The Pareto optimum is chosen by a social planner that:
1
Allocates factors to production, consumption and leisure

to maximize the utility of the household.
Does not use markets.
Is only subject to feasibility.
105 of 260
Slide 6 of 39
The Planner Problem
The planner solves

max U (C, l)
C,l
subject to
C = zF (k, h l) G
Optimality implies:
UL (C, l)
UC (C, l)
C = zF (k, h l) G
zFN (k, h l) =
Those equations also characterize a competitive equilibrium, so...
Slide 7 of 39
Pareto Optimality
Theorem
First Welfare Theorem First welfare theorem: a competitive equilibrium
is Pareto optimal.
Slide 8 of 39
The First Welfare Theorem

A.k.a: why do we like markets so much
Competitive markets achieves the optimal allocation

It seems that government are at best useless.
However, how many assumptions did we use to get here?

Government might have a role after all.
When do we fail to have Pareto optimality?
106 of 260
Externalities (pollution)
Missing markets (financing frictions, moral hazard)
Non competitive firms
Slide 9 of 39
Pareto Optimality
Theorem (Second Welfare Theorem)

Second welfare theorem: a Pareto optimum is a competitive equilibrium
This last theorem would not be so obvious if you had two types
of consumers.
Slide 10 of 39
107 of 260
7.1
Optimal Taxation
108 of 260
Optimal Taxation
Slide 11 of 39
Optimal Taxation
General Principles
Distortionary effects of taxation
Optimal taxes at the top
The Laffer Curve
Great Source for Data:

http://www.taxpolicycenter.org/taxfacts/
Lets begin with an example:
http://users.nber.org/ taxsim/taxsim-calc9/index.html
Slide 12 of 39
Federal Taxes
What is the profile of taxes in the data?
2. Federal Average Tax Rates by Income Groups
(individual+corporate+payroll+estate taxes)
80%
70%
1970
60%
2000
50%
40%
2005
30%
20%
10%
Source: Piketty and Saez (2007)
Source: Piketty and Saez JEP'07
Note: Missing State and Local and FICA.

Slide 13 of 39
P99.99-100
P99.9-99.99
P99.5-99.9
P99-99.5
P95-99
P90-95
P80-90
P60-80
P40-60
P20-40
P0-20
0%
109 of 260
Optimal Taxation
In the rest of the lecture we will study marginal taxes on income.
Lets be concrete:
c = (1 |{z}
(z))
tax rate
w (h l)
| {z }
pretax income = z
The tax rate (z) depends on labor income z.
Some definitions:
1
Tax liability (z) z.
Marginal Tax Rate (MTR). The idea: MTR tells me what fraction
of one more dollar earned do I take home.
M T R = 0 (z).
Slide 14 of 39
Optimal Taxation
Definition (Progressive/Regressive Tax System)

A Tax system is progressive (regressive) if the Marginal Tax Rate is
increasing (decreasing) in income: 0 (z) increasing (decreasing) in z.
+ A Progressive tax system reduces after tax income inequality.
Slide 15 of 39
Marginal Rates
7-Feb-14
2014 Individual Income Tax Rates, Standard Deductions,
Is The U.S Federal Tax
Code
Progressive of Regressive ?
Personal Exemptions, and Filing Thresholds
If your filing status is Single

Taxable Income
But not
Over --over --$0
$9,075
$36,900
$89,350
$186,350
$405,100
$406,750
$9,075
$36,900
$89,350
$186,350
$405,100
$406,750
and over
Marginal Rate
10%
15%
25%
28%
33%
35%
39.6%
If your filing status is Married filing jointly

Taxable Income
But not
Over --over --Marginal Rate
$0
$18,150
$73,800
$148,850
$226,850
$405,100
$457,600
$18,150
$73,800
$148,850
$226,850
$405,100
$457,600
and over
10%
15%
25%
28%
33%
35%
39.6%
If your filing status is Married filing

Source: IRS (2014)
separately
110 of 260
If your filing status is Head of Household

Taxable Income
But not
Over --over --Marginal Rate
Slide 16 of 39
$0
$12,950
$49,400
$127,550
$12,950
$49,400
$127,550
$206,600
10%
15%
25%
28%
Taxable Income
But not
over ---
Over ---
$0
$9,075
$36,900
$74,425
$9,075
$36,900
$74,425
$113,425
Marginal Rate
10%
15%
25%
28%
Optimal Taxation
Why does the government use proportional taxes?
Easy to administer.
Allows for redistribution of resources (progressive vs. regressive)
A major downside:
Are taxes efficient? Do the welfare theorems hold?
Slide 17 of 39
The Distortionary Effects of Taxation
Government expenditure is to be financed through tax

Does the first welfare theorem hold?
The Households maximization problem is now:
max u(c, l) + [(1 )w(h l) + c]
|
{z
}
c,l
Budget Constraint
Slide 18 of 39
The Distortionary Effects of Taxation

Optimality conditions for the household:
(C) :
(l) :
() :
So that
Uc (c, l) = 0
Ul (c, l) (1 )w = 0
(1 )w(h l) + c = 0
Ul (c, l)
= (1 )w
Uc (v, l)
Substituting
M RSl,c = (1 )M PN M RSl,c < M PN
The competitive equilibrium is not Pareto optimal!
Slide 19 of 39
111 of 260
Optimal Taxation
Why does the government use proportional taxes?
Easy to administer.
Allows for redistribution of resources (progressive vs. regressive)
A major downside:
Are taxes efficient? Do the welfare theorems hold?

+ The answer to both questions is NO! Proportional taxes should
then be used in moderation.
Slide 20 of 39
What Should Taxes Be?
Slide 21 of 39
An Utopian Goal
Suppose there are N individuals with incomes z1 < z2 < . . . < zN
Suppose the government cares equally about all of them.
Social welfare is:
W =
N
X
u(ci ),
i=1
s.t. ci = (1 (zi ))zi .
and subject to government budget constraint:

N
X
(zi )zi = G.
i=1
Where ci is consumption and () are taxes on zi .
112 of 260
What should taxes be?
Slide 22 of 39
An Utopian Goal: Optimal Taxation

Planning Problem choose taxes to maximize welfare :
max
(zi )
N
X
i=1
u((1 (zi ))zi ),
s.t.
N
X
(zi )zi = G
i=1
What should taxes be?

From first order conditions ( multiplier on budget constraint)
u0 ((1 (zi ))zi ) =
The above implies that for all i and j:
(1 (zi ))zi = (1 (zj ))zj
+ Full redistribution. What is the problem with this?
Slide 23 of 39
General Principles
What are the tradeoffs for choosing taxes?

1
Equity Considerations.
+ For example the relative welfare weights of top earners v.s. the
rest.
Efficiency Considerations.
+ Behavioral responses from high taxes.
Slide 24 of 39
Behavioral Effects
In Data do we observe behavioral responses from taxation?
113 of 260
Source: Prescott (2004)
Slide 25 of 39
Ok...but what Should Taxes Be?
Slide 26 of 39
Taking Stock
Some lessons learned from optimal taxation:

1
In the U.S. and most countries taxes on income are proportional.

(sometimes referred as marginal taxes)
The U.S. tax system is in most part progressive.
Proportional taxes make the equilibrium inefficient.
If we ignore individual responses, then optimal taxes should be

completely redistributive.
Slide 27 of 39
Tax Reform
The goal is to now derive a simple formula for optimal taxes.
A Tax Reform: suppose the government increases taxes
by on individual earning more than z .
What happens to revenues? how do tax payer respond?

Definition (e)
Elasticity of reported income with respect to the net-of-tax rate 1 .
e=
114 of 260
1
dz
z d(1 )
Online Survey!
Q: In your opinion what is a reasonable value for e.

That is, if taxes go up by 1% by how much would your
income go down by?
Slide 29 of 39
Tax Reform
Any individual with income z > z changes taxes paid by:
(z z ).
Benefit +
Due to behavioral responses income changes by:

Cost +
z = e z
.
1
Combining the two effects so that cost and benefit are zero:

(z z ) e z
=0
Slide 30 of 39
Tax Reform
Disposable
Income
c=z-T(z)
Top bracket: slope 1- above z*

Reform: slope 1above z*
Mechanical tax increase:
[z-z*]
z*-T(z*)
Behavioral response tax loss:
z=-
z*
e z /(1- )
Pre-tax income z
Source: Diamond, Saez (2011)
Figure 1
Optimal Top Tax Rate Derivation
Slide 31 of 39
Note. The figure depicts the derivation of the optimal top tax rate *=1/(1+a e) by
115 of 260
Tax Reform
Combining the two effects so that cost and benefit are zero

(z z ) e z
1
Algebra...
=0
ez
1
=
z z
Let a = z/z z , more algebra...

=
1
1+ae
Slide 32 of 39
Tax Reform: A formula

Definition (e)
Elasticity of reported income with respect to the net-of-tax rate 1 .
e=
1
dz
z d(1 )
Balancing the tax increase and behavioral response we get:

=
1
1+ae
The value of a = 1.5 is not controversial
(connected with the Pareto distribution of income).
The values of e is controversial (estimates range from 0.25 to 2).

Taxes ranges from ?? to ??
Back To a Simple Case
116 of 260
Slide 34 of 39
Optimal Taxation: Maximizing Revenue

We now simplify the analysis assuming everybody is the same and
government wishes to maximize revenue.
Household preferences: U (c, l) = log(v) + log(l)

Household budget constraint: c = (1 ) w (h l) +
Assume F (K, N ) = zN wages are fixed!
Government revenues are
R( ) = w (h l)
Suppose the government has the goal of maximizing revenues.
Slide 35 of 39
From first order conditions of households we get

c = (1 ) w l
Substituting the above in the budget constraint

wl =
wh
+
2
2(1 )
Substituting the above in the expression for revenues R( ) we get

R( ) = wh wl
hw

2
1 2
Slide 36 of 39

Revenues:
R( ) =
hw

2
1 2
The objective of the government can be written as

Set so that R( ) = G
Note that R(0) = R(1) = 0... must be curved!

R( ) is also called in a different way:
+ http://www.youtube.com/watch?v=dxPVyieptwA
Slide 37 of 39
117 of 260
The Laffer Curve

R( ) =
hw

2
1 2
KEY: besides the maximum revenue there are always

two tax rates that provide the same revenue.
Since tax are distortionary is always
better to choose a small .
Slide 38 of 39
Taking Stock
Some lessons learned from optimal taxation:
118 of 260
In the U.S. and most countries taxes on income are proportional.

(sometimes referred as marginal taxes)
The U.S. tax system is in most part progressive.
Proportional taxes make the equilibrium inefficient.
If we ignore individual responses, then optimal taxes should be

completely redistributive.
Quantitatively taxes at the top should be fairly high!
But not so high as being on the wrong side of the Laffer Curve.
Chapter 8
Growth
119 of 260
Income Per Capita Across Countries

In 2008:
Slide 4 of 32
Income Per Capita Over Time

As a histogram:
Density of countries
1960
1980
2000
8
Log GDP per capita
10
12
FIGURE 1.2 Estimates of the distribution of countries according to log GDP per capita (PPP adjusted)
in 1960, 1980, and 2000.
Density of countries (weighted by population)
Source: Acemoglu (2008).

Slide 5 of 32

1980
2000
1960
How did we get there:
1.4 Todays Income Differences and World Economic Growth
11
Log GDP per capita

11
10
8
Log GDP per capita
United States
10
12
FIGURE 1.3 Estimates of the population-weighted distribution of countries according

to Korea
log GDP per
South
capita (PPP adjusted) in 1960,
Spain 1980, and 2000.
United
9 Kingdom
Brazil
Singapore
Guatemala
8
Botswana
India
Nigeria
7
1960
1970
1980
1990
2000
FIGURE 1.8 The evolution of income per capita in the United States, the United Kingdom, Spain,
Singapore, Brazil, Guatemala, South Korea, Botswana, Nigeria, and India, 19602000.
120 of 260
40 years? Why did Spain grow relatively rapidly for about 20 years but then slow down? Why
Source: Acemoglu
did Brazil(2008).
and Guatemala stagnate during the 1980s? What is responsible for the disastrous
growth performance of Nigeria?
Slide 6 of 32
Growth In the Last 35 Years
Existence of large and sustained growth:

(recall the 2% per year for the US)
Existence of growth miracles:
(South Korea, Singapore, Japan)
Existence of growth disasters:
(Venezuela, Norh Korea, Most of South Saharan Africa)
Slide 7 of 32
Modern Growth Rates

Chapter 1 Economic
and Economic
Development: The Questions
The 10distribution
of Growth
growth
rates:
.
Density of countries
1980
1960
2000
0.1
0.0
0.1
Average growth rate of GDP per worker
0.2
FIGURE 1.7 Estimates of the distribution of countries according to the growth rate of GDP per worker
(PPP adjusted) in 1960, 1980, and 2000.
grows rapidly, and by the mid-1990s it has become richer than both. South Korea has a similar
Source: Acemoglu
(2008).
trajectory, though it starts out poorer than Singapore and grows slightly less rapidly, so that by
Slide 8 of 32
the end of the sample it is still a little poorer than Spain. The other country that has grown very
rapidly is the African success story Botswana, which was extremely poor at the beginning
of the sample. Its rapid growth, especially after 1970, has taken Botswana to the ranks of the
middle-income countries by 2000.
The two Latin American countries in this picture, Brazil and Guatemala, illustrate the oftendiscussed Latin American economic malaise of the postwar era. Brazil starts out richer than
South Korea and Botswana and has a relatively rapid growth rate between 1960 and 1980.
But it experiences stagnation from 1980 on, so that by the end of the sample South Korea and
Botswana have become richer than Brazil. Guatemalas experience is similar but even more
bleak. Contrary to Brazil, there is little growth in Guatemala between 1960 and 1980 and no
growth between 1980 and 2000.
Finally, Nigeria and India start out at similar levels of income per capita as Botswana but
experience little growth until the 1980s. Starting in 1980, the Indian economy experiences
relatively rapid growth, though this has not been sufficient
tfor its income per capita to catch
up with the other nations in the figure. Finally,
t Nigeria,
0 in a pattern that is unfortunately all
too familiar in sub-Saharan Africa, experiences a contraction of its GDP per capita, so that in
2000 it is in fact poorer than it was in 1960.
The patterns shown in Figure 1.8 are what we would like to understand and explain. Why is
the United States richer in 1960 than other nations and able to grow at a steady pace thereafter?
How did Singapore, South Korea, and Botswana manage to grow at a relatively rapid pace for
A Useful Formula
How to visualize growth rates more directly?
Lets determine the time to double in size. Recall:

x =x e
where is the growth rate (not in %).

Let T the time required to go from x0 2x0
2x0 = x0 eT T =
Also know as rule of 70:

T =
ln 2
.7
70
Where % is now in percentage terms

Slide 9 of 32
ln 2
121 of 260
Modern Growth Rates

The distribution of growth rates:
Slide 10 of 32
Historical Growth
Slide 11 of 32

14 did
Chapter
Economic
Growth and Economic Development: The Questions
How
we1 get
there:
.
Log GDP per capita

10
Western offshoots
Western Europe
Latin
America
Asia
Africa
6
1000
1200
1400
1600
1800
2000
FIGURE 1.11 The evolution of average GDP per capita in Western offshoots, Western Europe, Latin
America, Asia, and Africa, 10002000.
122 of 260
Source: Acemoglu
(2008).
terms takeoff or industrial revolution. This debate is again secondary to our purposes.
Slide 12 of 32
Growth Before 1800

What happened before 1800?
Growth Was Slow! World GDP growth was:

1
Between 1700-1820: 0.07%
Between 1500-1700: 0.04%
Long-term cycles.
Huge changes in relative rankings (Rome, China, Incas, Haiti).
Little difference between countries:
(Rich to poor ratio 2)
Slide 13 of 32
Taking Stock
So far the following questions have emerged:
1
How can some countries sustain stable growth?
Why do some country go much faster than others?
Why are some countries not growing?
Why was the world not growing before the 19th century?
Question for review:
Is the World accelerating?

Is there a Widening gap between rich and poor?
Slide 14 of 32
What Determines Growth?
123 of 260
Slide 15 of 32
First step find the data!

Great sources:
1
Penn World Tables:

https://pwt.sas.upenn.edu/php site/pwt71/pwt71 form.php
IMF World Economic Outlook Database:

http://www.imf.org/external/pubs/ft/weo/2013/02/weodata/index.aspx
Slide 16 of 32

We need a model, but what matters? what should we model?
18
1.6
Chapter 1 Economic Growth and Economic Development: The Questions
Correlates of Economic Growth

The previous section emphasized the importance of certain country characteristics that might
be related to the process of economic growth. What types of countries grow more rapidly?
Ideally, this question should be answered at a causal level. In other words, we would like to
know which specific characteristics of countries (including their policies and institutions) have
a causal effect on growth. Causal effect refers to the answer to the following counterfactual
thought experiment: if, all else being equal, a particular characteristic of the country were
changed exogenously (i.e., not as part of equilibrium dynamics or in response to a change in
other observable or unobservable variables), what would be the effect on equilibrium growth?
Answering such causal questions is quite challenging, precisely because it is difficult to isolate
changes in endogenous variables that are not driven by equilibrium dynamics or by omitted
factors.
For this reason, let us start with the more modest question of what factors correlate with
postwar economic growth. With an eye to the theories to come in the next two chapters, the
two obvious candidates to look at are investments in physical and human capital (education).
Figure 1.15 shows a positive association between the average investment to GDP ratio and
economic growth between 1960 and 2000. Figure 1.16 shows a positive correlation between
average years of schooling and economic growth. These figures therefore suggest that the
countries that have grown faster are typically those that have invested more in physical and
human capital. It has to be stressed that these figures do not imply that physical or human capital
investment are the causes of economic growth (even though we expect from basic economic
theory that they should contribute to growth). So far these are simply correlations, and they
Investment is positively correlated with GDP levels.

Slide 17 of 32

More on investment:
Average growth rate of GDP per capita, 19602000

0.08
TWN
0.06
KOR
CHN
THA
MYS
JPN
0.04
PRT
IRL
LKA
ESP
EGYDOM
IND
GHA
PAN
MUS
PAK
MAR
BRA
USA
TTO
GBR
CHL
MEX
TUR
COL
0.02
CRI
PRY
MWI
ZAF
ETH
UGA
0.00
NGA
ZWE
BEN
BFA BOLKENHND
GIN
ARG
NOR
FIN
NLD
DNK
CAN
SW E AUS
ECU
NZL
URYPHL
GTM
SLV
LUX
AUT
ISR
ITA GRC
BEL
ISL
FRA
IRN
CHE
PER
JAM
ZMB
VEN
JOR
NIC
0.0
0.1
0.2
Average investment rate, 19602000
0.3
0.4
FIGURE 1.15 The relationship between average growth of GDP per capita and average growth of
investments to GDP ratio, 19602000.
124 of 260
Source: Acemoglu (2008)

Slide 18 of 32

Population growth?
Population growth is negatively correlated with GDP levels.

Slide 19 of 32

Levels of GDP?
Levels of GDP are not correlated with GDP growth rates.

Slide 20 of 32

Schooling
1.7 From Correlates to Fundamental Causes
19

TWN
0.06
CHN
KOR
HKG
THA
MYS
SGP
0.04
PRT
LSO
PAK GHA
IND
EGY IDN
MUS
TUR
TUN
LKA
IRL
ESP
ITA
NPL
BEN
MLI
MOZ
GMB
BDI
0.00
MWI
DOM
BRA
IRN
CMR
GTM
COG
UGA
DZA
KEN
RWATGO
SEN
ZWE
GRC
FRA
PAN
SYR
0.02
BEL
ISR
FIN
NOR
GBR
ISL
PRY
COL MEXECU
ZAF
CRI
HND
SLV
BOL
ZMBJAM
JPN
AUT
NLD
CHL
TTO
PHL
URY
BRB
DNK
AUS
SW E
CAN
CHE
USA
ARG
NZL
PER
VEN
JOR
NER
NIC
0.02
0
4
6
8
Average years of schooling, 19602000
10
12
FIGURE 1.16 The relationship between average growth of GDP per capita and average years of
schooling, 19602000.
are likely driven, at least in part, by omitted factors affecting both investment and schooling
on the one hand and economic growth on the other.
We investigate the role of physical and human capital in economic growth further in
Chapter 3. One of the major points that emerges from the analysis in Chapter 3 is that focusing
only on physical and human capital is not sufficient. Both to understand the process of sustained
Schooling levels are positively correlated with GDP growth rates.

Slide 21 of 32
125 of 260
This is why we need a model!!! Latitude is positively correlated

with GDP levels and growth rates!
Slide 22 of 32
Welfare And Inequality
Slide 23 of 32
Growth and Welfare
Does growth Increase Welfare?

Economists define welfare as the expected lifetime utility for all
individuals in a country.
To make things simple suppose that welfare depends on:

(i) life expectancy (H) and (ii) income (y). We have:
W = H E[u(y)]
where W is average welfare. E[] is an expectation.
126 of 260
Slide 24 of 32
Growth and Welfare
Let y be the average income in a country.

We can approximate E[u(y)] taking second order Taylor expansions
around y. We have:
E[u(y)] = u(y) + u0 (y) E[(y y)] +
u00 (y)
E[(y y)2 ]
2
Slide 25 of 32
Growth and Welfare

Simplifying
E[u(y)] = u(y) + u0 (y) E[(y y)] +
| {z }
u00 (y)
2
=0 by definition
So that welfare is
W = H [u(y) +
E[(y y)2 ]
|
{z
}
=Variance of income
u00 (y)
V ar[y]]
2 1.2 Income and Welfare
1.2 Income and Welfare

Should we care
aboutWelfare:
cross-country income differences? The answer is definitely yes. High
This implies
that
income levels reflect high standards of living. Economic growth sometimes increases pollution
or may raise individual aspirations, so that the same bundle of consumption may no longer
satisfy an individual.
at the
end of the day, when one compares an advanced, rich country
Is increasing
inButlife
expectancy
living, and health. in income per capita

Is increasing
Figures 1.5 and 1.6 give a glimpse of these differences and depict the relationship between
00
Is decreasing
variance
of World
income
(recall
is negative!)
year. Consumption in
data the
also come
from the Penn
tables, while
data onulife expectancy
Slide 26 of 32
with a less-developed one, there are striking differences in the quality of life, standards of
income per capita in 2000 and consumption per capita and life expectancy at birth in the same
at birth are available from the World Bank Development Indicators.

These figures document that income per capita differences are strongly associated with
differences in consumption and in health as measured by life expectancy. Recall also that
these numbers refer to PPP-adjusted quantities; thus differences in consumption do not (at
least in principle) reflect the differences in costs for the same bundle of consumption goods in
different countries. The PPP adjustment corrects for these differences and attempts to measure
the variation in real consumption. Thus the richest countries are not only producing more than
30 times as much as the poorest countries, but are also consuming 30 times as much. Similarly,
cross-country differences in health are quite remarkable; while life expectancy at birth is as
Welfare: Consumption
Relationship with consumption:

Log consumption per capita, 2000
15
USA
LUX
HKG
CHEBMU
GBR
AUTARE
AUS
ISL
GER
CAN
BRB CYP
ITA
NLD
FRA
BEL
DNKNOR
JPN
BHS
IRL
TWN
SWE
KWT
PRI
NZL
ESP
MUS MLT
ISR
FIN SGP
GRC PRT
BHR MAC
SVN
TTO
OMN
ANT
KOR
ARG KNA
SW Z URY
QAT
CHLCZESAU
LBN
EST
CRI
HUN
LTU
BLR
SYC
POL
SVK
MEX
LVA
HRV
ZAF
TUN
LBY
GAB
PAN
DOM
BGR
PLW MYS
BRA
CPV
LCA
VEN
SLV
MKD
DJI
CUB
PRY
RUS
ROM
GRD
TUR
EGY
BRN
KAZ DMA
COL
ATG
THAVCT
BLZ
IRN
TON
GTMJAMNAM
ARM
GEO
FJI
BWA
TKM
PNG
MAR
NIC
WSM
PER
DZA
LKA
BIH
JOR
ECUUKR
ZWEPHL
GINBOL IDN
GNQ
ALB
UZB
GUY
MDA
HTI
FSM MDV
SUR
CMR
IRQ
PAK VUT
KGZ
AZE
HND
CIV
CHN
SCG
LSO
VNM
BGD
IND
SEN
SYR
SLB
GHA
MNG
STP
BEN
COM
MRT
PRK
KEN
MLI
RWA
MOZ
NPLTJK
CAF
GMB
SDN LAO
BFA
MWI
MDG
ZMB UGA KIR
TCD
AGO
TGO
NER
ETH
SLE
BDI
TZA NGACOG
ERI SOM BTN
AFG
KHM
YEM
GNB
14
13
12
11
ZAR
LBR
10
6
8
9
Log GDP per capita, 2000
10
11
FIGURE 1.5 The association between income per capita and consumption per capita in 2000. For a
definition of the abbreviations used in this and similar figures in the book, see http://unstats.un.org/unsd
/methods/m49/m49alpha.htm.
Source: Acemoglu (2008).

Slide 27 of 32
127 of 260
Welfare: Life Expectancy

8
Chapter 1 Economic Growth and Economic Development: The Questions
Relationship
with life expectancy:
.
Life expectancy, 2000 (years)

80
HKG
JPN
ISL
SWE
MAC
CHE
ISR
CAN
ITAAUS
CYP
GRC MLT
SGPNOR
NLD
NZL
ESP
BEL
GBR
FRA
KWT
AUTARE
GER
IRL
FIN
BRN
DNK USA
CHL ANT
PRT
BHR
PAN
MEX
OMN
SVN
KOR
CZE
BRB
URY
BIHTON
BLZTUN
LKA MKD
PRI
LBY
SYR
QAT
SCG
ALB
LCA
ECU
JAM
ARG
MYS
VEN HRV
SAU
SVK
POL
JOR
LBN
TTO
CHN PRYDZA
VCT
COLBGR
IRN
ARM
VNM
PHL
SLV
FSM
GEO
HUN MUS
ROM
PER
NIC
MAR
TUR
EGY
CPV
WSM
THA
SUR
VUT
BRA LTU EST
MDV
FJI
HND
BHS
DOM LVA
UZB
IDN
AZE
BLR
MDA
STP
KGZ
GTM UKR
TJK SLB PAK
PRK
IND
BOL
RUS
MNG
NPL BGD
TKM
COM
BTN
KAZ
IRQ
GUY
GAB
YEM GHA
NAM
ZAF
SDN
SEN
PNG
TGO
MDG
KHM
GMB BEN
LAO
GIN
DJI
KEN
ERI
COGMRT
BWA
HTI
CMR
TZA MLI
CIV
ETH
AFG
BFA
LSO
GNQ
NGA
TCD
SOM
NER
GNB
UGA
ZWE
MOZ
SW Z
BDI MWI
CAF
LBR
CUB
70
60
50
40
CRI
LUX
AGO
SLE ZMB
RWA
30
6
FIGURE 1.6
8
9
Log GDP per capita, 2000
10
11
The association between income per capita and life expectancy at birth in 2000.
high as 80 in(2008).
the richest countries, it is only between 40 and 50 in many sub-Saharan African
Source: Acemoglu
Slide 28 of 32
nations. These gaps represent huge welfare differences.

Understanding why some countries are so rich while some others are so poor is one of the
most important, perhaps the most important, challenges facing social science. It is important
both because these income differences have major welfare consequences and because a study
of these striking differences will shed light on how the economies of different nations function
and how they sometimes fail to function.
The emphasis on income differences across countries implies neither that income per
2 nor that
capita can be used as a sufficient statistic for the welfare of the average citizen
it is the only feature that we should care about. As discussed in detail later, the efficiency
properties of the market economy (such as the celebrated First Welfare Theorem or Adam
Smiths invisible hand) do not imply that there is no conflict among individuals or groups in
society. Economic growth is generally good for welfare but it often creates winners and losers.
Joseph Schumpeters famous notion of creative destruction emphasizes precisely this aspect
of economic growth; productive relationships, firms, and sometimes individual livelihoods
will be destroyed by the process of economic growth, because growth is brought about by
the introduction of new technologies and creation of new firms, replacing existing firms and
technologies. This process creates a natural social tension, even in a growing society. Another
source of social tension related to growth (and development) is that, as emphasized by Simon
Kuznets and discussed in detail in Part VII, growth and development are often accompanied by
sweeping structural transformations, which can also destroy certain established relationships
and create yet other winners and losers in the process. One of the important questions of
Inequality Over Time
Decomposing inequality between and within countries:
Inequality between countries in increasing

Inequality within countries is decreasing
2
See appendix for formal definition of inequality
Wealth Share at the Top

What about inequality the US?
128 of 260
Source: Piketty and Saez (2009)
Slide 30 of 32
8.1
Malthus and Solow
129 of 260
Two Models of Growth

Two model main difference is in the production function:
Malthus
Y = zF (|{z}
L , N)
land
Solow
Y = zF ( |{z}
K , N)
capital
N = labor
L = land
K = capital
z = productivity (TFP)
Note: new ingredient land
Slide 5 of 1
Two Models of Growth
Key difference:
L = land is in fixed supply
K = can be accumulated over time
We will use two models to describe growth facts both ancient

(Malthus) and modern (Solow).
Hansen-Prescott in the paper entitled Malthus to Solow describe

how society switched from one regime to the other.
Slide 6 of 1
Malthusian Model
Technology: Y = zF (L, N )
assume constant return to scale
Preferences: fixed labor supply (we normalize to 1 unit)
Population = number of workers

Use N to denote number of workers today;
Use N 0 to denote number of workers tomorrow;
Question: what determines population growth?
130 of 260
Slide 7 of 1
Malthusian Model: Population Growth

Key assumption:
Growth rate of population depends on living standards.
Living standard are related to consumption per capita:

living standards =
We have:
N0
=g
N
C
N
C
N
g() increasing and concave function;
Slide 8 of 1
Equilibrium in the Malthusian Model

Equilibrium is standard: Agents and firm optimize, market clearing...
plus: steady state in the population N 0 = N = N
Equilibrium is determined by:
1
Market Clearing for goods market:

C = Y = zF (L, N )
Steady State condition:

N0 = N
Population growth equation:

N0
=g
N
C
N
(A)
Slide 9 of 1
Substitute C in population growth equation:

N0
=g
N
zF (L, N )
N
Using our constant return to scale assumption:

N0
L
= g zF
,1
N
N
(B)
where L/N = land per capita
131 of 260
Slide 10 of 1
We now have two equilibrium conditions:

N0 = N

N0
L
= g zF
,1
N
N
(A)
(B)
Combining (A) and (B):
g zF
L
,1
N

=1
Slide 11 of 1
Equilibrium: Example
Let F (L, N ) = zL N 1 and g() = () , then
N 0 = z L N 1
recall < 1 and < 1.
Equilibrium exist: N
(intersection of 45 degree line and concave curve)
Note: is there another equilibrium?
Slide 12 of 1
Malthusian Model: Analysis and Policy
132 of 260
Slide 13 of 1
Malthusian Model: Policy
We have large technology developments prior to industrial

revolution
If z has always been increasing, why have standard of living been

stagnating for centuries?
Slide 14 of 1
Malthusian Model: Analysis

What happens if z increases at a time T = 1?
Recall that in steady state :
g
C1
N1
=1
(B)
C1 = z1 F (L, N1 )
If z1 z2 (with z1 < z2 ) then :
1
2
3
C1 < z2 F (L, N1 ), so C1 must increase to C2

C
From equation (B): g N2 > 1 so N1 must increase to N2
1
Converge to new steady state with C2 = z2 F (L, N2 )
Slide 15 of 1
Malthusian Model: Analysis
133 of 260
Slide 16 of 1
How can we increase standard of living? Population Control

+ Cut population growth by factor < 1
New equilibrium conditions become:

g
C
N
=1
(C)
C = zF (L, N )
Compare equation (B) with equation (C).
Slide 17 of 1

Cutting population growth rates:
Slide 18 of 1
Malthusian Model: Taking Stock
The Malthusian model achieve stagnation in growth.
Any technological development gets absorbed by larger populations.
Land seems to play a key role in depressing growth.
134 of 260
Slide 19 of 1
The Solow Growth Model
Slide 20 of 1
The Solow Growth Model: Introduction
Key difference with Malthus: the use of capital

New Ingredients:
Exogenous population growth.
Saving (S).
Slide 21 of 1
The Household
Exogenous population growth:
N 0 = (1 + n)N
n is the growth rate and n > 1
Households care about consumption, leisure and the future

the budget constraint is:
C + |{z}
S = |{z}
Y
Saving
Income
For now: rule of thumb for saving

S = sY
C = (1 s)Y
household save a constant fraction of their income

Slide 22 of 1
135 of 260
Saving Rate in the US

Fraction of disposable income saved:
Slide 23 of 1
Saving Rate in the US

Historical:
Slide 24 of 1
Capital and the Firm

Production function:
Y = zF (K, N )
Note for now z is exogenous.
New ingredient: law for capital accumulation

K0
|{z}
Capital tomorrow
136 of 260
= (1 d)
K
|{z}
+I
Capital today
where I is investment and d is the depreciation rate: 0 < d < 1
Slide 25 of 1
Depreciation Rates in the US
What is the value of d for the US?

Data: http://www.bea.gov/scb/pdf/national/niparel/1997/0797fr.pdf
Type of asset
Computing equipment
Aircrafts 1960 and later
General industrial equipment
Agricultural machinery
Industrial buildings
Submarines
Depreciation rate
.3119
.0660
.1072
.1179
.0314
.0825
Service life
7
25
16
14
31
20
Slide 26 of 1
The Firm
Maximizes profits:
Subject to
(K) = max Y wn I +
I,N
(K 0 )
| {z }
Profits Tomorrow
Y = zF (K, N )
And
K 0 = (1 d)K + I
Slide 27 of 1
Equilibrium and Steady State
Firm and Household optimize.
Market clearing for goods:

Y =C +S
Market clearing for assets (NEW!):

S=I
This implies that all investments comes from saving.
137 of 260
Slide 28 of 1
Steady State
In Malthus steady state was N = N 0 = N
In Solow population always grows,
use notion of per capita steady state

K0
K
=
= k
0
N
N
Y0
Y
=
= y
0
N
N
k0 = k = k
y0 = y = y
From now on lower case letters denote per-capita quantities, also

F (K, N )
=F
N

K
, 1 = f (k)
N
Slide 29 of 1
Kaldor Facts
Facts about economic growth proposed by Kaldor in 1961

Y
1 N
increases at a constant rate over time
K
N
increases at a constant rate over time
K
Y
remains constant
Steady state assumption seems justified...

+ Can one of the above help me figure out K?
Slide 30 of 1
Solving For the Steady State
Our goal is now to derive a condition for equilibrium value of k.

This is important to understand questions like:
1
How to foster growth?
Why is the saving rate important?
Is a capital tax good or bad?
Algebra ahead: take a deep breath!!
138 of 260
Slide 31 of 1
Solving For the Steady State

Start:
K 0 = (1 d)K + I
Substitute I from market clearing for goods and assets:

Y = C + K 0 (1 d)K
Substitute rule of thumb for saving and production function:

Y = (1 s)Y + K 0 (1 d)K
Divide by N
K 0 = szF (K, N ) + (1 d)K
K0 N 0
szF (K, N ) (1 d)K
=
+
N N0
N
N
Recall that N 0 = (1 + n)N
k 0 (1 + n) = szf (k) + (1 d)k
since in steady state k = k 0
szf (k) = (n + d)k

Slide 32 of 1
Analysis of the Steady State

Key equilibrium condition:
szf (k ) = (n + d)k
To understand it, graph both sides of the equation:
What happens if s, n, d, z changes?

Slide 33 of 1
Changing the Saving Rate

Suppose s changes: s1 to s2 (s2 > s1 )
k1 increases to k2
Question: what happens to y1 ?
Slide 34 of 1
139 of 260
From Data Lecture

Recall that in equilibrium saving = investment.
Investment is positively correlated with GDP levels.

Slide 35 of 1
Changing the Population Growth Rate

Suppose n changes: n1 to n2 (n2 > n1 )
k1 decreases to k2
Slide 36 of 1
From Data Lecture
140 of 260
Population growth is negatively correlated with

GDP levels.
Slide 37 of 1
Growth
Slide 38 of 1
Growth Rates
In Malthus consumption per capita is constant over time.

Question 1: how is consumption, output and
capital growing over time?

capital per capita growing over time?
Slide 39 of 1
Growth Rates
What is the growth rate of K, C, Y in steady state?
k0 = k
K0
K
=
0
N
N
so that
N0
K = (1 + n)K
N
growth rate is the population growth rate!
K0 =
(Same for Y and C)

Question: how do you show it for Y ?
(hint you will need CRS assumption for F)
Slide 40 of 1
141 of 260
Growth Rates
capital growing over time?
Answer 1:
Y, C, K grow at rate n, the population growth rate.

capital per capita growing over time?
Answer 2:
The above implies that K/N is constant over time...as Malthus?
Something is now very different than Malthus...
Slide 41 of 1
Sustaining Growth
To sustain growth over time we need something other than s and n: z!
Increasing z1 z2 z3 generates long term growth!

Slide 42 of 1
The Solow Residual

We have identified z as a key source for growth.
z is sometimes called the Solow Residual
Key question, what is z in the data, how do we calculate it?

From equilibrium condition:
Y = zF (K, N ) = zK N 1
hence
z=
142 of 260
Y
Y
= 1
F (K, N )
K N
We need information on: GDP (Y )...easy, Workers (N )...easy,

not easy but done, K hard.
Slide 43 of 1
Measuring K
Starting point to determine Kt+1 (at time t + 1) is:
Kt+1 = (1 d)Kt + It
We have information on It since 1947 but we do not know K1947

Idea from Kaldor: set K1947 so that over time Kt /Yt is roughly
constant
If K1947 is set too high then Kt /Yt will decrease over time.
If K1947 is set too low then Kt /Yt will grow over time.
As a rule of thumb it is ok to set K1947 so that K1947 /Y1947 = 3.

Slide 44 of 1
The Solow Residual

Plotting z (the Solow residual) for the US
Slide 45 of 1
Cross Country Convergence
143 of 260
Slide 46 of 1

Q: If the world was described by a Solow model, what would
happen eventually to identical countries with different level of GDP

per capita ypoor and yrich today?
ypoor = zf (kpoor )
yrich = zf (krich )
If today ypoor < yrich it implies kpoor < krich ...

what happens in steady state?
Key equation:
szf (k) = (n + d)k
Slide 47 of 1

A: In the long run, they will have the same level of gdp per capita
Is this happening?
Slide 48 of 1
Cross Country Convergence: Eastern Europe

Source: http://www.voxeu.org/index.php?q=node/7740
144 of 260
Here is an example of countries converging.
However looking across all countries...

...not quite
Levels of GDP are not correlated with GDP growth rates.

Slide 50 of 1
Convergence: An Explanation
What is wrong with the model?

1
Maybe all the countries are not the same
Barriers to technology adoption
Barriers to investment
Non optimizing firms?
If interested, see also Parente, Prescott (2000).

If really Interested take my class in the Fall: Emerging Markets.
Slide 51 of 1
145 of 260
8.2
Endogenous Growth Model
146 of 260
Education and Growth
Slide 2 of 14
Endogenous Growth
Solow explains why we have growth: its either z or n

Does not tell us what to do to improve long run growth:
i.e how does z go up?
we need to go further and introduce: human capital
Slide 3 of 14
Schooling Years
Source: World Bank

What can we learn from the above?
Slide 4 of 14
147 of 260
Education and growth
19

TWN
0.06
CHN
KOR
HKG
THA
MYS
SGP
0.04
LKA
PRT
LSO
PAK GHA
IND
EGY IDN
TUR
TUN
IRL
ESP
ITA
MUS
0.02
NPL
BEN
MLI
MOZ
GMB
BDI
0.00
MWI
DOM
BRA
IRN
ZWE
CMR
GTM
COG
UGA
DZA
KEN
RWATGO
SEN
GRC
FRA
PAN
SYR
AUT
BEL
ISR
FIN
NOR
GBR
ISL
PRY
COL MEXECU
ZAF
CRI
HND
SLV
BOL
ZMBJAM
JPN
NLD
CHL
TTO
PHL
URY
BRB
DNK
AUS
SW E
CAN
CHE
USA
ARG
NZL
PER
VEN
JOR
NER
NIC
0.02
0
4
6
8
Average years of schooling, 19602000
10
12
FIGURE 1.16 The relationship between average growth of GDP per capita and average years of
schooling, 19602000.
Slide 5 of 14
are likely driven, at least in part, by omitted factors affecting both investment and schooling
on the one hand and economic growth on the other.
We investigate the role of physical and human capital in economic growth further in
Chapter 3. One of the major points that emerges from the analysis in Chapter 3 is that focusing
only on physical and human capital is not sufficient. Both to understand the process of sustained
economic growth and to account for large cross-country differences in income, we also need
to understand why societies differ in the efficiency with which they use their physical and
human capital. Economists normally use the shorthand expression technology to capture
factors other than physical and human capital that affect economic growth and performance. It
is therefore important to remember that variations in technology across countries include not
only differences in production techniques and in the quality of machines used in production
but also disparities in productive efficiency (see in particular Chapter 21 on differences in
productive efficiency resulting from the organization of markets and from market failures).
A detailed study of technology (broadly construed) is necessary for understanding both the
worldwide process of economic growth and cross-country differences. The role of technology
in economic growth is investigated in Chapter 3 and later chapters.
Schooling: Spending
Country
% of GDP
Yemen
9.5%
Mongolia
9%
Kenya
7%
Switzerland (U.S) 5.8% (5.7%)
Italy
4.7%
The correlates of economic growth, such as physical capital, human capital, and technology, is
Zambia
our first topic of study. But these are only proximate causes of2%
economic growth and economic
success (even if we convince
ourselves that there is an element
of causality in the correlations
Ecuador
1%
Source: United Nations
What can we learn from the above?
Slide 6 of 14
Endogenous Growth:
The relation between z and education
148 of 260
Slide 7 of 14
Endogenous Growth: Human Capital
Human Capital:
The stock of skills and education that workers have at a point in time
Properties:
1
It grows
It does not depreciate
Technologies using it do not exhibit decreasing returns
Is non-rivalrous
Slide 8 of 14
A Simple Model: The Consumer

Suppose :
1
There is no leisure:
Workers divide their time between work
and human capital accumulation.
Let N denote time at work. (1 N ) time at school.
Human capital H s increase effective time at work: more human

capital = more output for the same amount of hours.
There is no capital.
Slide 9 of 14
A Simple Model: The Consumer
Budget constraint:
C = |{z}
w
Wage
N
H}
| {z
Effective labor
Note that effective amount of labor is now N H not N .
Human capital accumulation

0
H = b(1 N )H
b is efficiency of human capital accumulation (quality of schools)
149 of 260
Slide 10 of 14
A Simple Model: The Firm
Firm maximize profits choosing effective labor N H

max zN
H wN H
N H | {z }
technology
Note: we assumed linear firm technology
Since problem of the firm is linear:

1
Equilibrium wage is z.
Firm is indifferent in choice of N H.
Slide 11 of 14
A Simple Model: The Equilibrium

Lets determine the consumption growth rate
From budget constraint and firm maximization problem:
C = zN H
(note w = z) and
H 0 = b(1 N )H
H0
1 = b(1 N ) 1
H
Computing growth rates of consumption:
C0
zN H 0
H0
1=
1=
1=
C
zN H
H
= |{z}
b (1 N ) 1
| {z }
efficiency
Slide 12 of 14
intensity
A Simple Model: Summary
Economy grows indefinitely because of human capital

accumulation.
Rate of growth determined by intensity and efficiency

of human capital accumulation.
150 of 260
Slide 13 of 14
A Simple Model: Policy
What are good policies?

1
Increase schooling
Increase efficiency of schooling
+ http://www.worldbank.org/education
Slide 14 of 14
151 of 260
Chapter 9
Dynamic Model
9.1
Forecasting: Part 2
152 of 260
Forecasting Part II: Leading Indicators
Slide 2 of 22
This Lecture
Leading Indicators
Application to Employment Forecasting:
1
ADP employment Survey
Vacancies
Application to GDP Forecasting:

1
Heavy truck sales
Slide 3 of 22
Forecasting: Information Sets
Definition (Information Sets)

Let It be the set of information available at time t for a forecast.
In previous lecture we used past information on the variable of

interest (xt ) to forecast its feature.
In particular we used all of the available past information to

forecast via a linear trend. Formally It = {xn }t1
n=1
In this lecture we will use other variables to help us forecast xt so

that: It = {zn }t1
n=1
153 of 260
Slide 4 of 22
Leading Indicators
Setting It = {zn }t1
n=1 is particularly useful if zt1 predicts xt .
In this case we will call zt a leading indicator of xt .
Recall that a leading indicator (zt in our case) is a variable that
over the cycle anticipates the changes of another variable (xt ).
Examples:
1
Earnings Dividends;
Monetary base Inflation;
?? Employment;
?? GDP.
Slide 5 of 22
A Simple Model
Suppose we knew that:

xt = b0 + b1 zt1 + t
|{z}
error
Suppose today we observe zt ; Then today we can forecast the

future value of xt+1 by:
xt+1 = b0 + b1 zt
+ Goal: find b0 and b1 .
Slide 6 of 22
A General Model
The previous model only consider 1 explanatory variable z.
We can generalize:
xt = b0 + b1 zt1 + b2 xt1 + b3 wt1 + . . . + t .
We now also consider:

1
Past realization of the variable xt1 ;

(for example if x is GDP is natural to include past values)
Additional explanatory variables wt1 .
The generalization to include additional explanatory variables is

conceptually easy. Is harder to implement quantitatively.
154 of 260
+ Refer to your econometrics class
Slide 7 of 22
(1)
Appendix: Which Model to Choose?
The previous and this lecture point to a variety of modeling

approaches. Including different leading indicators or lagged
variables.
Natural question, which is the best model?

Many formal ways to answer this.
A simple approach is to look at t the error term.
In particular we are interested to see if the series t has patterns.
Slide 8 of 22
Appendix: Durbin-Watson
The Durbin-Watson Statistic (d) is given by

(assuming is of length T ):
d=
PT
t=2 (t t1 )
PT 2
t=1 t
d determines how correlated are the error over time. If errors are
correlated then one could used past errors to reduce future errors.
Rule of thumb: the closer d is to 2 the better the model.
Slide 9 of 22
A Word of Caution: Lucas 1976

Consider a simple econometric model of the household:
ct = b0 + b1
yt +b2 Tt
|{z}
|{z}
Income
Transfers
parameters b0 , b1 and b2 can be estimated looking at past data.
Suppose a policy maker is considering changing Tt or Tt+1 .
What mistake he would be making relying on the above model?

The mistake would be considering (b0 , b1 , b2 ) as fixed rather than
dependent on policy itself. Households are smart and have
expectations about future policies!
Lucas (1976) Econometric Policy Evaluation: A Critique makes

this points with multiple examples. Since this critiques has be
referred to as: The Lucas Critique
155 of 260
Application to Employment Forecasting
Slide 11 of 22
BLS Employment Survey

Policy maker and market pay close attention to the behavior of the
labor market as a good indicator of the state of the economy.
From the BLS:
Each month the Current Employment Statistics (CES) program

surveys approximately 144,000 businesses and government agencies,
representing approximately 554,000 individual worksites, in order to
provide detailed industry data on employment, hours, and earnings
of workers on nonfarm payrolls.
Note: The CES is an estimate on the number of salary jobs: an

individual with two jobs is counted twice by the payroll survey.
The CES releases monthly, next releases are April 4th and May 2nd .
ADP Employment Report
ADP (Automatic Data Processing) is a private firm that offers

payroll services to other companies.
ADP process approximately 411,00 US firms (20% of the private
sector). This puts ADP on similar footing to the BLS in terms of

data owned.
Every month shortly (few days) before the CES report, ADP
releases the National Employment Report.
Next release dates are April 2nd and April 30th .
156 of 260
Slide 13 of 22
ADP vs. CES
Legend payems (BLS); nppttl (ADP).

The two series track each other very closely.
Slide 14 of 22
Leading Indicator: Job Openings
The ADP series is released only few days the CES series.
Other leading indicators are available. A popular one: job openings
The idea is simple to fill a job, a job must first become available.
Job openings are published in the JOLTS
(Job openings and labor turnover survey)
The next release date is April 8th .
Slide 15 of 22
Vacancies vs. CES
157 of 260
Job opening anticipates the behavior of payroll employment.
Slide 16 of 22
Results
The previous two graphs are displayed as:
differences from a year ago.
This is done to remove possible seasonality effects.

We compute b0 and b1 in (1) using Excel.
As before we can use Slope to compute b1 and
Intercept to compute b0 .
We find:
b0 = 75.11;
b1 = 0.186;
d = 0.5
If we use 1 lag of CES as explanatory variable then d = 2.7.

Slide 17 of 22
Application to GDP Forecasting
Slide 18 of 22
Truck Sales
We now look at GDP more closely.

The idea is to look at the behavior of firms. Firm, as a whole can
internalize the current conditions. of the economy
In the next class we will see that investment is an important

forward looking variable.
Today we look at one particular investment heavy trucks.2
158 of 260
2
Heavy trucks are trucks with more than 14,000 pounds gross vehicle weight.
Slide 19 of 22
Historical Truck Sales
There appears to be a negative relationship between

shaded areas and truck sales.
Slide 20 of 22
GDP vs. Truck Sales
Truck Sales is a good leading Indicator for GDP

for the current recession...
Slide 21 of 22
Historical Relationship
...the relationship seem to be also present in historical data.

Slide 22 of 22
159 of 260
9.2
The Household
160 of 260
News of the Week
The Federal Open Market Committee (FOMC) meets 8 times a

year to set monetary policy for the US.
On March 19th the FOMC released a statement concerning the

latest meeting.
This Meeting was important as it marks the first one chaired by

Janet Yellen.
The statement can be found here:
http://www.federalreserve.gov/newsevents/press/monetary/20140319a.htm
Slide 2 of 44
Reading FOMC Statements

FOMC statement have a precise structure:
1
Start with an overview of the current economic conditions
Relate conditions with the FED mandate
Describe the policy taken and how they might impact
Key information that economist look for in FOMC statement is

Forward guidance:
Through forward guidance, the Federal Open Market Committee

provides an indication to households, businesses, and investors
about the stance of monetary policy expected to prevail in the future.
Source: http://www.federalreserve.gov/faqs/money 19277.htm
Slide 3 of 44
Forward Guidance?
In January:
Committee today reaffirmed its view that a highly accommodative stance of

monetary policy will remain appropriate for a considerable time after the asset
purchase program ends and the economic recovery strengthens. The Committee
also reaffirmed its expectation that the current exceptionally low target range for
the federal funds rate of 0 to 1/4 percent will be appropriate at least as long as
the unemployment rate remains above 6-1/2 percent
In March:
Committee currently anticipates that, even after employment and inflation are
near mandate-consistent levels, economic conditions may, for some time,
warrant keeping the target federal funds rate below levels the Committee views as
normal in the longer run.
161 of 260
Online Survey!
Q: Suppose this year the economy is in a recession.

When should the government levy more taxes?
1
This year
Next year
At the end of the recession
Slide 5 of 44
The two period model: the consumer

Inter-temporal budget constraints
Household savings data
The two period model: comparative statics

Changes in wealth
Changes in interest rates
The two period model: the government

Ricardian Equivalence
Slide 6 of 44
Two Period Model
162 of 260
Slide 7 of 44
Two Period Model: Consumer

Consumers live two periods
New trade-off: consumption today vs consumption tomorrow
(add this to the consumption leisure trade-off studied in part I)
New instrument: bonds s

1
All bonds are identical
All bonds are safe
No intermediaries
New price: interest rate r (1 bond today, pays 1 + r tomorrow)

4
Borrowers and lenders face the same r
Slide 8 of 44
Two Period Model: Budget Constraints

Budget constraint today:
c+s=yt
Budget constraint tomorrow: (recall 0 denotes tomorrows variable)

c0 = y 0 t0 + (1 + r)s
Define lifetime wealth (today) as:

we = y +
y0
t0
t
1+r
1+r
then c0 = (1 + r)c + we(1 + r)
Slide 9 of 44
Two Period Model: Budget Constraints

Plotting the budget constraint
E = (y t, y 0 t0 ) used to determine how income is

distributed during the lifetime
Slide 10 of 44
163 of 260
Two Period Model: Optimality

Households enjoy consumption today and tomorrow
Households enjoy more the present
Preferences :
u(c) + u(c0 )
0 < < 1: time discount factor; u(): standard utility function
Problem of the household:

max
u(c) + u(c0 )
0
c,c
(1 + r)c + c0 = we(1 + r)
Subject to
Slide 11 of 44

From first order conditions:
uc (c) = (1 + r)uc (c0 )
Optimality:
uc (c)
uc0 (c0 )
+
= (1 + r)
M RSc,c0
= 1+r
Intuition:
Give up one consumption today (valued at uc0 (c0 )) for (1 + r) units
of consumption tomorrow (valued at uc0 (c0 ) and discounted by )
Slide 12 of 44

The case of borrowers and lenders
(a) Lender
164 of 260
Note slope of indifference curves = 1 + r

Note the different position relative to E!
Slide 13 of 44
(b) Borrower
Two Period Model: Saving

What are the implication for saving?
1
2
3
flat income profile (y t = y 0 t0 ) : optimal saving is 0.

increasing income (y t < y 0 t0 ) : optimal saving is < 0.
decreasing income (y t > y 0 t0 ) : optimal saving is > 0 .
Slide 14 of 44
(c) Positive saving
(d) Negative saving
Two Period Model: Consumption Smoothing
Question: what are the implications for consumption?
A simple case: let =
1
1+r .
Optimal solution is given by:
uc (c) = uc0 (c0 ) c = c0
(1)
Household seeks to equalize his marginal utility over both periods.

This property is called consumption smoothing
Slide 15 of 44
165 of 260
Negative Saving Rate: Panic?
Is there a problem with a negative national saving rate?
This aggregate measure leaves out realized earning in other assets

This is important especially thinking about retirement
(if your stock portfolio goes well, you save less)
Is this impacting the business sector?

A nice article:
http://www.clevelandfed.org/research/trends/2010/0410/01ecoact.cfm
Slide 23 of 44
Two Period Model: The Government
Slide 24 of 44
The Dynamic Government

Government spends and taxes in two periods
NEW: now it can borrow and save!
Budget constraint today
G=T +B
Budget constraint tomorrow

G0 + (1 + r)B = T 0
Life-time budget
166 of 260
Slide 25 of 44
G+
T0
G0
=T+
1+r
1+r
Slide 26 of 44
Punchline: the timing of taxes is irrelevant
Key equation: lifetime budget constraint (in todays $)

c0
c+
1 + r}
| {z
present value of consumption

y0
t0
=y+
t+
1 + r}
1+r
| {z
|
{z
}
...of income
...of taxes
Let T = t (assuming size of population equal 1, otherwise let T = N t)

G0
t0
=G+
1+r
1+r
substituting in consumer lifetime budget

c0
y0
G0
c+
=y+
G+
1+r
1+r
1+r
t+
Note: if r is constant changes in t and t0 dont matter
Slide 27 of 44
Ricardian Equivalence: In words
Suppose the government today lowers T by 100$ and raises B by 100$
If r = 3%, tomorrow the government owes 103$

taxes tomorrow go up by 103$.
Household has two course of actions:

1
Keep same spending on C, today save 100$,

tomorrow earn 103$ and use to pay increased taxes.
Spend today the extra 100$, today save 0$,

tomorrow lower consumption by 103$ to pay for taxes.
What would the household do?
167 of 260
Slide 28 of 44
Ricardian Equivalence: Credit Markets

Does r change?
No: since demand and supply of assets cancels out
Think about the previous example
Note: S P is private demand for saving

Slide 29 of 44
Ricardian Equivalence: Assumptions
Taxes are equal for all populations (no redistribution)
Debt repaid while you are alive
Lump sum taxes
Credit markets without frictions
Slide 30 of 44
Data on Interest Rates
168 of 260
Slide 31 of 44
Household Savings: Interest Rates

The closest parallel in data of the bond in our model is the:
3 month T-bill
Source: St. Louis Fed http://research.stlouisfed.org/fred2/series/WTB3MS

Slide 32 of 44
Bonds: Model vs Data
The bond in the model has two special features:

1
It cannot be defaulted on
Is available in one maturity
In data...
Slide 33 of 44
Bonds: Maturity
In data we have different maturities:
*#"'1/#0)2+"34)5/#6")7-#).'#$8)9:;)9<=9)
'#$"
'"
!"#$"%&'(")
&#$"
&"
%#$"
%"
!#$"
!"
%"()"
'"()"
*"()"
%"+,"
&"+,"
'"+,"
$"+,"
-"+,"
%!"+,"
&!"+,"
'!"+,"
*+,")&-).'&/#+&0))
Source: http://www.treasury.gov/resource-center/data-chart-center/interestrates/Pages/TextView.aspx?data=yield
Slide 34 of 44
169 of 260
Bonds: Maturity
Question: how would the model price different maturities?

Answer: lets assume that by the time the bonds matures, the
return is the same even if you had rolled over bonds of shorter
maturities
Let rm = return of bond of maturity m
(1 + rm )m = (1 + r) (1 + r)
{z
}
|
m times
Yield curve should be flat... what is missing?
Slide 35 of 44
Bonds: Default
In data we have bonds with different default risk:
Source: http://markets.ft.com/RESEARCH/Markets/Government-Bond-Spreads
Bonds: Default
Question: how would the model price different default risks?

Answer: lets assume that the return on each bond is the same
(In finance you will study the efficient market hypothesis)
Let pi =probability that country i defaults
(1 pi )
170 of 260
Slide 37 of 44
ri
|{z}
return on bonds of i
r
|{z}
return on US bonds
Two period model:

Comparative statics
Slide 38 of 44
Comparative Statics
We look at the following cases:

1
Temporary changes in income: either today or tomorrow.
Permanent changes in income.
Changes in interest rate.
Slide 39 of 44
Comparative Statics: Change in Income

Increase in todays income: y1 y2 with y2 > y1
Recall wei = yi +
y0
1+r
t0
1+r
Change in wealth: we = (we2 we1 ) = y2 y1 > 0

So that: outward shift in budget constraint
Consumption increases today and tomorrow!

(remember income effects)
Slide 40 of 44
171 of 260

Dont forget consumption smoothing!
Our model of C does not include durables,

how would you model them?

Suppose permanent increase in income y1 y2 and y10 y20
In the picture optimal choice moves from H K
Difference with respect to temporary changes?
Larger effect on consumption since savings may

not increase
Slide 42 of 44
172 of 260
9.3
The Government
173 of 260
Deviation From Trend Consumption vs. GDP

From Lecture 3:
Consumption is: slightly less variable
Slide 16 of 44
Two Period Model: Saving

Question: how much does a household save?
Recall saving equals
s=ytc
Using equation (1) the budget constraint is

c(2 + r) = y(1 + r) + y 0 + t(1 + r) + t0
So that
s=
(y t)(2 + r) [y(1 + r) + y 0 + t(1 + r) + t0 ]

2+r
s=
(y t) (y 0 t0 )
2+r
Slide 17 of 44
Data on Saving
174 of 260
Slide 18 of 44
Household Balance-sheet: Flow of Funds

Federal Reserve provides all information on who saves where...
104
Z.1, September 17, 2009
B.100 Balance Sheet of Households and Nonprofit Organizations (1)

Billions of dollars; amounts outstanding end of period, not seasonally adjusted
2003
1
2
3
4
5
6
7
8
Tangible assets
Real estate
Households (2,3)
Nonprofit organizations
Equipment and software owned by
nonprofit organizations (4)
Consumer durable goods (4)
2006
2007
2008
2009
Q1
Q2
Q3
Q4
Q1
Q2
56744.9
63506.2
70987.5
76749.0
78228.8
75868.6
74945.9
72339.4
67134.0
65244.0
67207.9
21437.7
24270.7
27719.1
28724.2
27525.6
26863.9
26541.9
26051.2
25177.0
24660.1
24847.1
17599.0
16170.3
1428.7
20214.4
18629.4
1585.0
23458.4
21427.7
2030.7
24259.6
21948.2
2311.4
22880.2
20477.4
2402.8
22154.7
19803.5
2351.2
21785.0
19538.7
2246.2
21261.5
19036.3
2225.3
20397.7
18317.1
2080.5
19869.0
17948.6
1920.4
20025.9
18272.0
1753.9
3
4
5
160.7
3678.0
173.2
3883.1
183.7
4077.0
196.5
4268.1
207.9
4437.5
210.4
4498.9
214.0
4542.9
218.1
4571.5
220.9
4558.5
221.0
4570.1
220.5
4600.8
6
7
35307.2
39235.5
43268.4
48024.8
50703.1
49004.7
48404.0
46288.2
41957.0
40583.8
42360.8
Deposits
Foreign deposits
Checkable deposits and currency
Time and savings deposits
Money market fund shares
5350.4
52.1
399.1
3939.0
960.2
5742.5
57.5
370.3
4410.6
904.1
6153.6
59.9
256.8
4887.6
949.2
6779.0
65.2
236.4
5363.0
1114.5
7381.3
81.0
156.9
5796.7
1346.8
7579.1
74.5
87.8
5958.9
1457.9
7420.3
68.3
98.5
5859.8
1393.7
7566.4
63.9
64.7
5991.7
1446.1
7827.4
59.8
236.7
5949.2
1581.7
7848.9
55.7
241.7
5988.8
1562.7
7760.2
50.6
300.1
5913.8
1495.7
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
Credit market instruments

Open market paper
Treasury securities
Savings bonds
Other Treasury
Agency- and GSE-backed securities
Municipal securities
Corporate and foreign bonds
Other loans and advances (5)
Mortgages
2755.2
105.9
438.6
203.8
234.8
421.2
703.8
964.2
3.1
118.5
3075.8
136.1
532.2
204.4
327.8
390.0
742.4
1135.6
5.9
133.6
3426.8
164.2
507.5
205.1
302.4
488.3
821.0
1294.1
8.7
143.0
3553.5
187.7
433.1
202.4
230.7
412.6
871.8
1517.7
8.3
122.4
4113.4
149.7
252.3
196.4
55.9
689.8
895.9
2001.7
17.4
106.5
4077.9
117.5
322.1
195.3
126.8
657.0
883.3
1971.0
20.1
107.0
4138.8
82.7
368.1
194.9
173.2
675.5
894.5
1979.9
22.3
115.8
4218.5
39.1
386.8
194.2
192.6
820.1
910.1
1919.2
27.5
115.7
4054.5
10.4
240.0
194.0
46.0
711.3
938.0
2010.9
27.9
116.0
4536.2
7.3
576.4
193.9
382.5
439.6
954.5
2415.4
28.5
114.5
4326.6
8.9
605.9
193.5
412.4
129.5
996.8
2443.6
29.2
112.7
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
Corporate equities (2)

Mutual fund shares (6)
Security credit
Life insurance reserves
Pension fund reserves
Equity in noncorporate business (7)
Miscellaneous assets
6749.9
2904.3
475.4
1013.2
9718.9
5838.7
501.3
7491.0
3417.4
578.3
1060.4
10635.5
6680.9
553.8
7999.5
3839.3
575.3
1082.6
11373.7
8208.9
608.7
9488.0
4387.6
655.7
1163.7
12696.2
8655.0
646.1
9453.0
4832.0
866.4
1201.5
13375.9
8767.3
712.2
8759.6
4575.2
984.5
1187.2
12566.7
8548.5
725.9
8449.1
4662.8
992.1
1196.4
12476.1
8335.1
733.5
7442.0
4111.1
998.6
1197.7
11832.5
8170.3
751.3
5878.7
3444.7
742.7
1179.8
10442.6
7618.4
768.2
5150.3
3254.7
667.0
1181.1
9913.8
7266.7
765.1
6266.3
3740.5
649.2
1197.6
10656.3
6995.7
768.4
24
25
26
27
28
29
30
9842.8
11012.1
12164.2
13414.0
14318.1
14416.4
14368.2
14514.8
14216.9
14102.5
14068.0
31
9482.6
6871.9
2102.5
178.3
49.8
118.7
161.4
10552.4
7819.3
2219.5
188.6
26.7
119.0
179.2
11723.1
8855.3
2319.8
205.1
36.4
119.0
187.4
12899.2
9832.8
2415.0
226.9
86.4
123.8
214.3
13754.2
10485.2
2551.9
249.5
99.7
127.0
240.8
13807.5
10547.9
2529.6
252.3
104.9
128.0
244.9
13828.9
10544.3
2555.6
261.6
89.2
129.7
248.4
13860.9
10503.5
2588.0
265.2
121.4
130.7
252.1
13794.8
10430.7
2592.1
269.6
117.7
133.2
251.5
13709.6
10431.0
2517.0
273.0
104.0
133.5
251.0
13661.8
10401.7
2475.5
281.9
118.5
134.0
250.1
32
33
34
35
36
37
38
32
33
34
35
36
37
38
Financial assets
2005
9
10
11
12
13
31
Slide 19 of 44
Assets
2004
Liabilities
Credit market instruments
Home mortgages (8)
Consumer credit
Municipal securities (9)
Bank loans n.e.c.
Other loans and advances
Commercial mortgages (9)
Household Savings: Rates

39
40
41
Security credit
Trade payables (9)
Deferred and unpaid
life insurance premiums
182.5
156.8
264.0
173.3
232.4
186.3
292.1
199.9
325.5
214.5
365.3
218.4
291.5
222.2
402.3
226.2
164.8
230.2
134.6
231.8
147.6
233.8
39
40
20.9
22.5
22.4
22.8
23.9
25.2
25.5
25.3
27.0
26.5
24.8
41
42
Net worth
46902.1
52494.0
58823.3
63334.9
63910.6
61452.2
60577.8
57824.7
52917.1
51141.5
53139.9
42
43
44
45
46
Memo:
Replacement-cost value of structures:
Residential
Households
Nonprofit organizations
Nonresidential (nonprofits)
10679.9
10513.7
166.1
955.5
12030.3
11848.9
181.4
1058.3
13475.1
13275.9
199.3
1174.8
14440.6
14229.3
211.3
1279.5
14643.0
14430.3
212.7
1352.6
14587.2
14375.4
211.7
1356.9
14523.6
14313.0
210.6
1368.9
14359.8
14151.6
208.2
1394.2
13981.2
13778.7
202.5
1424.0
13776.4
13577.1
199.4
1412.1
13831.2
13631.3
199.9
1379.2
43
44
45
46
8377.8
8889.4
9277.3
9915.7
10403.1
10610.4
10966.7
10849.3
10799.1
10765.4
10902.9
47
559.8
590.5
634.1
638.7
614.3
579.2
552.4
533.0
490.0
475.1
487.4
48
9298.4
10810.1
12572.5
12115.4
9992.2
9255.6
8994.4
8532.8
7886.4
7517.7
7870.4
49
57.5
58.0
58.7
55.2
48.8
46.7
46.0
44.8
43.1
41.9
43.1
50
47
48
49
50
Disposable personal income

Household net worth as percentage of
disposable personal income
Owners equity in household real
estate (10)
Owners equity as percentage of
household real estate (11)
(1) Sector includes farm households and domestic hedge funds.

(2) At market value.
(3) All types of owner-occupied housing including farm houses and mobile homes, as well as second homes that are not rented, vacant homes for sale, and vacant land.
(4) At replacement (current) cost.
(5) Syndicated loans to nonfinancial corporate business by nonprofits and domestic hedge funds.
(6) Value based on the market values of equities held and the book value of other assets held by mutual funds.
(7) Net worth of noncorporate business (table B.103, line 31) and owners equity in farm business and unincorporated security brokers and dealers.
(8) Includes loans made under home equity lines of credit and home equity loans secured by junior liens, shown on table L.218, line 22.
(9) Liabilities of nonprofit organizations.
(10) Line 4 less line 33.
(11) Line 49 divided by line 4.
Source: St. Louis Fed

http://research.stlouisfed.org/fred2/series/PSAVERT/
Slide 20 of 44
International Rates
Guidolin and La Jeunesse
Figure 12
International Household Saving Ratios (quarterly)
Percent
20
15
10
Australia
Canada
United Kingdom
Japan
United States
France
Germany
5
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006
SOURCE: Organisation for Economic Co-operation and Development.
175 of 260
consumption boom that has at the same time
characterized the behavior of U.S. households.
A third argument refers mainly to FoF estiSlide 21 of 44
recent decline in the U.S. personal saving rate

would simply hide a shift from savings in the
form of accumulation of traditional assets (stocks,
Source: St. Louis Fed: Guidolin, La Jeunesse (2007)
National Savings
At a national level:
S
|{z}
updated through
03/05/14
Sp
|{z}
Private Saving
National Saving
Sg
|{z}
Government
NationalSaving
Economic Trends
Gross Saving Rates and Balance on Current Account (NIPA)

Percent of GDP
25
Gross Private Saving
20
15
10
Gross Govt. Saving
5
0
BOCA
-5
-10
88
88
89
89
90
90
91
91
92
92
93
93
94
94
95
95
96
96
97
97
98
98
99
99
00
00
01
01
02
02
03
03
04
04
05
05
06
06
07
07
08
08
09
09
10
10
11
11
Real Private Fixed Investment
Nondefense Capital Goods Orders
20
30
12
12
13
13
14
Compounded
annual rates of change
Percent change from year ago, excluding aircraft
Source:
http://research.stlouisfed.org/publications/net/page15.pdf
Equipment
Investment
20
15
10
Slide 2210 of 44
Orders
-10
-20
0
-30
-5
-40
18628
2011
18993
2012
19359
2013
19724
2009
18263
2010
18628
2011
18993
2012
19359
2013
19724
Real Equipment Investment
Real Nonresidential Fixed Investment
Compounded annual rates of change
25
25
20
20
15
15
10
10
-5
-5
-10
2014
20089
-10
18628
2011
18993
2012
19359
2013
19724
Real Residential Fixed Investment
18628
2011
18993
2012
19359
2013
Millions, annual rate
25
1.2
20
1.1
15
1.0
10
0.9
0.8
0.7
-5
0.6
-10
0.5
Millions, annual rate

0.60
New Home Sales

(right scale)
0.55
0.50
0.45
0.40
0.35
Housing Starts
(left scale)
0.30
0.25
0.4
18628
2011
18993
Research Division
Federal Reserve Bank of St. Louis
2012
19359
19724
Housing Starts and New Home Sales
-15
176 of 260
17898
2013
19724
18993
0.20
2012
19359
2013
19724
2014
20089
15
9.4
Elastic Labor
177 of 260
Extending the two period model
Slide 2 of 18
What is the two periods model missing so far?

1
Labor supply and wages
Firms
Investment decision
Slide 3 of 18
Consumption Today
Let consumption depend on wealth and interest rate: C(we, r)
Q: What happens when we change wealth and interest rates?
Effects on the consumption of goods:
Demand of current consumption increases when
lifetime wealth increases (consumption is a normal good)

dC(we, r)
>0
dwe
Current consumption decreases with interest rate increases

(we assume substitution effect dominates)
dC(we, r)
<0
dr
178 of 260
Slide 4 of 18
The Elastic Consumer

Up to now y was exogenous now introduce elastic labor:
Today budget constraint:

c + s = w(h l) + T
Tomorrow budget constraint:

c0 = w0 (h l0 ) + 0 T + (1 + r)s
Lifetime budget constraint:

c+
c0
w0 (h l0 ) + 0 T
= w(h l) + T +
1+r
1+r
Slide 5 of 18
Optimality and Labor Supply
Optimality conditions:
First period consumption-leisure trade-off: M RSl,c = w

Second period consumption-leisure trade-off: M RSl0 ,c0 = w0
Optimal consumption saving: M RSc,c0 = 1 + r
Slide 6 of 18
Interest Rates and Labor Supply

Let labor supply be N (we, r, w). Effects on the supply of labor:
Current labor supply is increasing in real wage
(from now on assume substitution larger than income effect)

dN (we, r, w)
>0
dw
Current labor supply decreases if lifetime wealth increases

dN (we, r, w)
<0
dwe
Current labor supply increases when the interest rate increases

dN (we, r, w)
>0
dr
Slide 7 of 18
179 of 260
9.5
The Firm
180 of 260
The Firm
Slide 8 of 18
US Firms: Data
Adding Investment decision:

Table 784. Capital Expenditures: 2000 to 2009
[In billions of dollars (1,161 represents $1,161,000,000,000). Based on a sample survey and subject to sampling error; see source
for details]
Item
Capital expenditures, total . . .
Structures . . . . . . . . . . . . . . . . . . .
New . . . . . . . . . . . . . . . . . . . . . . .
Used . . . . . . . . . . . . . . . . . . . . . .
Equipment and software . . . . . . . .
New . . . . . . . . . . . . . . . . . . . . . . .
Used . . . . . . . . . . . . . . . . . . . . . .
Capital leases . . . . . . . . . . . . . . . .
2000
1,161
364
329
35
797
751
46
20
All companies
2005 2008
1,145 1,374
402
562
366
523
36
39
743
812
701
765
42
47
18
20
Companies with employees Companies without employees

2000 2005 2008 2009 2000 2005 2008 2009
1,090 1,063 1,294 1,015
71
82
80
75
338
369
529
413
26
33
33
35
309
341
500
393
20
25
23
28
29
28
29
19
6
8
10
8
752
694
765
602
45
49
47
40
718
665
728
577
32
37
37
30
34
29
37
25
12
13
10
10
19
18
19
17
(Z)
(Z)
1
1
2009
1,090
448
421
27
642
607
35
17
Z Less than $500 million.

Source: U.S. Census Bureau, 2009 Annual Capital Expenditures Survey, February 2011, <http://www.census.gov/econ
/aces/>, and earlier reports.
Source US Census: LINK

Table 785. Capital Expenditures by Industry: 2000 and 2009
[In billions of dollars (1,090 represents $1,090,000,000,000). Covers only companies with employees. Data for 2000 based on
the North American Industry Classification System (NAICS), 1997; 2009 based on NAICS, 2007; see text this section. Based on
a sample survey and subject to sampling error; see source for details]
NAICS
code
Industry
Total
. . . . . . . . . . . . (X)
Slide
9 expenditures
of 18
Forestry, fishing, and agricultural
services . . . . . . . . . . . . . . . . . . . . . .
Mining . . . . . . . . . . . . . . . . . . . . . . . .
Utilities . . . . . . . . . . . . . . . . . . . . . . . .
Construction . . . . . . . . . . . . . . . . . . .
Manufacturing . . . . . . . . . . . . . . . . . .
Durable goods . . . . . . . . . . . . . . . . .
Nondurable goods . . . . . . . . . . . . . .
Wholesale trade. . . . . . . . . . . . . . . . .
Retail trade . . . . . . . . . . . . . . . . . . . .
Transportation and warehousing . . . .
Information. . . . . . . . . . . . . . . . . . . . .
Finance and insurance . . . . . . . . . . .
Real estate and rental and leasing . .
2000 2009
1,090 1,015
113115
21
22
23
3133
321, 327, 33
31, 322326
42
4445
4849
51
52
53
1
43
61
25
215
134
81
34
70
60
160
134
92
Online Survey!
2
101
102
20
156
77
79
25
58
56
88
100
73
NAICS
code
Industry
Professional, scientific, and technical
services . . . . . . . . . . . . . . . . . . . . . . . .
Management of companies and
enterprises. . . . . . . . . . . . . . . . . . . . . .
Admin/support waste mgt/remediation
services . . . . . . . . . . . . . . . . . . . . . . . .
Educational services . . . . . . . . . . . . . . .
Health care and social assistance . . . . .
Arts, entertainment, and recreation . . . .
Accommodation and food services . . . .
Other services (except public
administration) . . . . . . . . . . . . . . . . . . .
Structure and equipment expenditures
serving multiple industry categories . .
2000 2009
54
34
55
56
61
62
71
72
18
18
52
19
26
19
28
79
16
26
81
21
29
(X)
2
Q: which industry does the bulk of investment?
27
X Not applicable.

Mining
1 786. Business Cycle Expansions and ContractionsMonths of Duration:

Table
1945 to 2009
[A trough is the low point of a business cycle; a peak is the high point. Contraction, or recession, is the period from peak to
subsequent trough; expansion is the period from trough to subsequent peak. Business cycle reference dates are determined by
the National Bureau of Economic Research, Inc.]
Forestry and agricultural services
Peak
Manufacturing
Business cycle reference date
Month
February . . . . . . . . . . . . . . . . .
November . . . . . . . . . . . . . . . .
July . . . . . . . . . . . . . . . . . . . . .
August . . . . . . . . . . . . . . . . . . .
April . . . . . . . . . . . . . . . . . . . . .
December . . . . . . . . . . . . . . . .
November . . . . . . . . . . . . . . . .
January . . . . . . . . . . . . . . . . . .
July . . . . . . . . . . . . . . . . . . . . .
July . . . . . . . . . . . . . . . . . . . . .
March. . . . . . . . . . . . . . . . . . . .
December . . . . . . . . . . . . . . . .
Year
1945
1948
1953
1957
1960
1969
1973
1980
1981
1990
2001
2007
Trough
Month
October . . . . . .
October . . . . . .
May . . . . . . . . .
April . . . . . . . . .
February . . . . .
November . . . .
March. . . . . . . .
July . . . . . . . . .
November . . . .
March. . . . . . . .
November . . . .
June . . . . . . . . .
Year
1945
1949
Finance and Insurance
1954
Health Care
Average, all cycles:

1945 to 2009 (11 cycles) . . . .
Slide1 Previous
10 of 18
trough: June 1938. 2 Previous peak: May 1937.
1958
1961
1970
1975
1980
1982
1991
2001
2009
Contraction
(Peak to
trough)
8
11
10
8
10
11
16
6
16
8
8
18
Expansion
(Previous
trough to
peak)
1
80
37
45
39
24
106
36
58
12
92
120
73
11
59
Length of cycle
Trough from
Peak from
previous
previous
trough
peak
1
2
88
93
48
45
55
56
47
49
34
32
117
116
52
47
64
74
28
18
100
108
128
128
91
81
73
66
181 of 260
Equipment and software . . . . . . . .

New . . . . . . . . . . . . . . . . . . . . . . .
Used . . . . . . . . . . . . . . . . . . . . . .
Capital leases . . . . . . . . . . . . . . . .
797
751
46
20
US Firms: Data
743
701
42
18
812
765
47
20
642
607
35
17
752
718
34
19
694
665
29
18
765
728
37
19
602
577
25
17
45
32
12
(Z)
49
37
13
(Z)
47
37
10
1
40
30
10
1
Z Less than $500 million.

Q: who does the bulk of investment?

Table 785. Capital Expenditures by Industry: 2000 and 2009
[In billions of dollars (1,090 represents $1,090,000,000,000). Covers only companies with employees. Data for 2000 based on
the North American Industry Classification System (NAICS), 1997; 2009 based on NAICS, 2007; see text this section. Based on
a sample survey and subject to sampling error; see source for details]
NAICS
code
Industry
Total expenditures . . . . . . . . . . . .
Forestry, fishing, and agricultural
services . . . . . . . . . . . . . . . . . . . . . .
Mining . . . . . . . . . . . . . . . . . . . . . . . .
Utilities . . . . . . . . . . . . . . . . . . . . . . . .
Construction . . . . . . . . . . . . . . . . . . .
Manufacturing . . . . . . . . . . . . . . . . . .
Durable goods . . . . . . . . . . . . . . . . .
Nondurable goods . . . . . . . . . . . . . .
Wholesale trade. . . . . . . . . . . . . . . . .
Retail trade . . . . . . . . . . . . . . . . . . . .
Transportation and warehousing . . . .
Information. . . . . . . . . . . . . . . . . . . . .
Finance and insurance . . . . . . . . . . .
Real estate and rental and leasing . .
2000 2009
1,090 1,015
(X)
113115
21
22
23
3133
321, 327, 33
31, 322326
42
4445
4849
51
52
53
1
43
61
25
215
134
81
34
70
60
160
134
92
2
101
102
20
156
77
79
25
58
56
88
100
73
NAICS
code
Industry
Professional, scientific, and technical
services . . . . . . . . . . . . . . . . . . . . . . . .
Management of companies and
enterprises. . . . . . . . . . . . . . . . . . . . . .
Admin/support waste mgt/remediation
services . . . . . . . . . . . . . . . . . . . . . . . .
Educational services . . . . . . . . . . . . . . .
Health care and social assistance . . . . .
Arts, entertainment, and recreation . . . .
Accommodation and food services . . . .
Other services (except public
administration) . . . . . . . . . . . . . . . . . . .
Structure and equipment expenditures
serving multiple industry categories . .
2000 2009
54
34
55
27
5
56
61
62
71
72
18
18
52
19
26
19
28
79
16
26
81
21
29
(X)
X Not applicable.
Source US Census: LINK

Table 786. Business Cycle Expansions and ContractionsMonths of Duration:
1945
Slide
11 to
of 2009
18
[A trough is the low point of a business cycle; a peak is the high point. Contraction, or recession, is the period from peak to
subsequent trough; expansion is the period from trough to subsequent peak. Business cycle reference dates are determined by
the National Bureau of Economic Research, Inc.]
The Firm
Business cycle reference date

Peak
Month
February . . . . . . . . . . . . . . . . .
November . . . . . . . . . . . . . . . .
July . . . . . . . . . . . . . . . . . . . . .
August . . . . . . . . . . . . . . . . . . .
April . . . . . . . . . . . . . . . . . . . . .
December . . . . . . . . . . . . . . . .
November . . . . . . . . . . . . . . . .
January . . . . . . . . . . . . . . . . . .
July . . . . . . . . . . . . . . . . . . . . .
July . . . . . . . . . . . . . . . . . . . . .
March. . . . . . . . . . . . . . . . . . . .
December . . . . . . . . . . . . . . . .
Year
1945
1948
1953
1957
1960
1969
1973
1980
1981
1990
2001
2007
Trough
Month
October . . . . . .
October . . . . . .
May . . . . . . . . .
April . . . . . . . . .
February . . . . .
November . . . .
March. . . . . . . .
July . . . . . . . . .
November . . . .
March. . . . . . . .
November . . . .
June . . . . . . . . .
Year
1945
1949
1954
1958
1961
1970
1975
1980
1982
1991
2001
2009
Contraction
(Peak to
trough)
8
11
10
8
10
11
16
6
16
8
8
18
Expansion
(Previous
trough to
peak)
1
80
37
45
39
24
106
36
58
12
92
120
73
11
59
Length of cycle
Trough from
Peak from
previous
previous
trough
peak
1
2
88
93
48
45
55
56
47
49
34
32
117
116
52
47
64
74
28
18
100
108
128
128
91
81
Introduce non linear technology and investment decision

Output today:
Average, all cycles:

1945 to 2009 (11 cycles) . . . .
Y = zF (K, N )
73
Output tomorrow: Y 0 = z 0 F (K 0 , N 0 )
66
Previous trough: June 1938. 2 Previous peak: May 1937.

Source: National Bureau of Economic Research, Inc., Cambridge, MA, Business Cycle Expansions and Contractions,
<http://www.nber.org/cycles.html>, accessed May 2011.
1
Firm invests I so that
Business Enterprise 515
U.S. Census Bureau, Statistical Abstract of the United States: 2012
K 0 = (1 d)K + I
Note: we are modeling K as in Solow.
Slide 12 of 18
The Firm
Firm maximize present discounted value of the firm

V =+
0
1+r
Profits today: = Y wN I
Profits tomorrow: 0 = Y 0 w0 N 0 +
(1 d)K 0
| {z }
Liquidation Value
Note that now the firm owns the capital and

liquidates it in the last period
182 of 260
Slide 13 of 18
The Firm and Labor Demand

Optimality M PN = w (wage goes up labor demand goes down)
If z or K increase labor demand increases. Why?
Slide 14 of 18
The Firm and Investment Decision

We now calculate the optimal investment decision.
The problem of the Firm is:
max
zF (K, N ) wN I +
0
N,N ,I
z 0 F (K 0 , N 0 ) w0 N 0 + (1 d)K 0
1+r
Optimality with respect to I gives

K0
z
}|
{
z 0 FK ((1 d)K + I, N ) + (1 d)
1 +
=0
1+r
so that
z 0 F (K 0 , N 0 ) d = r
| K {z
}
0
M PK
(net marginal product of capital tomorrow = interest rate)

Slide 15 of 18

Suppose r1 r2 , since
z 0 FK ((1 d)K + I1 ) d = r1
then investment increases I1 I2

(marginal benefit goes down)
183 of 260
Slide 16 of 18

If z 0 tomorrow increases or if K decreases, investment curve shifts
0 increases)
to the right (marginal benefit increases since M PK
Slide 17 of 18
The Firm and Investment Decision: Formal

Suppose that the production function is Cobb-Douglas:
zF (K, N ) = zK N 1
Then optimality implies
z0
K0
N0
1
=r+d
substituting K 0 = (1 d)K + I we get

z0
I=
r+d
1
1
N 0 (1 d)K
Note that I is increasing in z 0 and decreasing in r and K.

Slide 18 of 18
184 of 260
9.6
Equilibrium
185 of 260
Equilibrium in the complete two period model

The output supply curve
The output demand curve
Experiments/ Policy
1
Change in government expenditures
Production shocks:
Change in productivity
Change in capital stock
Slide 3 of 52
Equilibrium in the complete two period model
Slide 4 of 52
Competitive Equilibrium: Dynamic

Definition of equilibrium expands what we have done in Lecture 5.
Definition (Competitie Equilibrium)
For a set of exogenous variables (K, G, G0 , z, z 0 ) A competitive
equilibrium is a set of endogenous variables (C, N s , S, I, N d , B, T, Y, r, w)
for both today (without prime) and tomorrow (with prime), so that:
186 of 260
The consumer chooses consumption, savings and labor supply

optimally, taking as given wages, interest rate, taxes and dividends.
The firm chooses labor demand and investment to maximize profits,

taking as given wages, interest rate and current/future
productivity.
+ Turn to next page...
Competitive Equilibrium: Dynamic

Definition (Competitive Equilibrium (continued))
[...] continued:
3
Government balances the budget (B is borrowing):

G = T + B;
G0 + (1 + r)B = T 0
0d
Labor market clears: N d = N s ;
Goods market clears: Y = C + I + G
Financial market clears: B = S
=N
0s
Y 0 = C 0 + I 0 + G0
Equilibrium: 2 Markets
Analytical or graphical characterization of equilibrium is hard.

We focus on the equilibrium of two markets:
1
Todays labor market (relating wages and employment)
Todays goods market (relating interest rate and output)
Which markets are we NOT focusing on?
Slide 7 of 52
Equilibrium in the Labor Market

We equate demand for labor (firm) and supply of labor (household):
We determine employment level: N

We determine wage rate: w
!! supply of labor depends on r
Slide 8 of 52
187 of 260
Equilibrium in the Goods Market
We equate demand of goods (Y d ) and supply of goods (Y s ), where:

Y s = zF (K, N s )
Y d = C(we, r) + I(r) + G
+ Goal: determine the relationship between Y s , Y d and r
Slide 9 of 52
The Output Supply Curve
Y s as a function of r is called output supply curve.

How does Y s vary with respect to r? Recall that N s (we, r, w)
dY s
d
dN s
= zF (K, N s ) = zFN (K, N s )
>0
dr
dr
| dr
{z }
>0
Y s is an increasing (and concave) function of r
Slide 10 of 52
The Output Demand Curve
Y d as a function of r is called output demand curve.

Y d (r) = C(we, r) + I(r) + G
Changing r:
dY d
dC(we, r) dI(r)
=
+
<0
dr
| dr
{z } | dr
{z }
<0
<0
Y is a decreasing (and concave) function of r
188 of 260
Slide 11 of 52
Output Supply Output Demand

Graphing together demand and supply:
We determine output level: Y

We determine interest rate: r
Slide 12 of 52
Graphical Equilibrium
Combining with the labor market equilibrium graph:
Slide 13 of 52
2 Questions
On March 11, 2011, Japan was hit by a massive

earthquake.
What do you forecast will happen to GDP, wages, employment,
investment, interest rates?
On February 17, 2009 the US passed the

American Recovery and Reinvestment Act.
What do you forecast will happen to GDP, wages, employment,
investment, interest rates?
189 of 260
Slide 14 of 52
Online Survey!
Q: Suppose the government increases spending (G) by a

dollar by how much does GDP (Y) change?
1
Between 0 and $0.5
Between $0.5 and $1
Between $1 and $2
More than $2
Slide 15 of 52
Shifting Output Curves
Slide 16 of 52
Shifting the Output Supply Curve

Questions:
How does output supply change following a change in G?

1
2
3
If G then T so we
If we then N s
So zF (K, N s ) , Supply curve shifts to the right!
How does output supply change following a change in z?

1
2
3
190 of 260
If z then zF (K, N )
If zF (K, N ) then N d
Supply curve shifts to the right!
Note: these are exogenous changes,

not changes due to r or w
Slide 17 of 52
Shifting the Output Supply Curve: Graphically

Suppose TFP increases z1 z2
Slide 18 of 52
Shifting the Demand Curve
A change in output demand is due to a change in one of its

components:
Y d C + I + G
G is exogenous but C and I are endogenous

We need to look closer at what exogenous change impacts C and I
Slide 19 of 52
Shifting the Output Demand Curve
Impacting C and I:
1
decrease in present value of taxes:
increase in future income: C
increase in future T F P :
decrease in the capital stock:
I
I
Each of these either affects C, or I. Also:

these are exogenous changes, not changes due to r or w
191 of 260
Slide 20 of 52
Shifting the Demand Curve: Quantitative
Quantitatively, how much does Y d change due to a change in

environment?
Key difficulty changes in Y affect income which affects the wealth

of the worker.
So what happens if the household become wealthier?

(for example with higher labor income)
more demand for C more demand for output

more labor income even more demand for C . . .
Slide 21 of 52
MPC (Marginal Propensity to Consume) defined as:

The rate at which consumption increases when (disposable) income
is increased by a small amount
Formally:
dC
= MPC we
dwe
Note that in general 0 < MPC < 1
Slide 22 of 52
Average Propensity to Consume

Average propensity to Consume is AM P C =
It can be shown that AM P C > M P C
consumption
disposable income
!"#$%&#'($)*#+,-./'.)'0)+,12#'
!"('$
!"(&$
!"(%$
!"($
!"##$
!"#'$
!"#&$
!"#%$
!"#$
)(&#$
192 of 260
)(*#$
)('#$
Taken from: Hoover (2011)

Slide 23 of 52
)(+#$
)(##$
)((#$
%!!#$

The additional wealth effect of an increase in Y is:
dC
= MPC
dwe
d
Y
| {z }
change in wealth
Introduce the indirect increase in C following a increase in Y

Wealth effect
Y d
change
z
}|
{ Additional
z}|{
d
Y +{z
C
= MPC
|
} +I + G =
Total consumption change
1
(C + I + G)
1
MPC
| {z }
The Multiplier
The multiplier since multiplies changes in demand, captures the

overall income effect. Note that the multiplier is greater than 1.
Experiments
Slide 25 of 52
Experiments
We next go over the following examples studying equilibrium changes:

1
Temporary Increase in G
Increase in TFP today
Decrease In Capital Stock
Increase in TFP tomorrow
Permanent Increase In G
193 of 260
Slide 26 of 52
Algorithm
To solve these exercises follow these steps:
1) Identify effect of change on consumer, government, firm
(these are exogenous changes, not changes due to r or w)
2) Identify first tentative equilibrium in labor market
3) Identify effect on output supply curve
4) Identify effect on output demand curve
5) Determine changes in Y and r in the goods market.
6) Using result in 2) and change in r determine change in N and w
7) In 5) and 6), specify which result are determinate and
which are indeterminate
Slide 27 of 52
Government Expenditure in Equilibrium

Suppose government increases expenditures G > 0:
1) N s > 0, why?
2) Output supply shifts to the right
3) Output demand (start from key formula):
Y d =
1
(C + G + I)
1 MPC
G > 0, I = 0 also C =
dC
dwe
|{z}
= MPC (G)
Effect of taxes
4) So that:
Y d =
Slide 28 of 52
(MPC G + G)
= G > 0
1 MPC
Increase in G: graphical summary

Note that if Y s shift a little r increases
194 of 260
Note that if Y s shifts less than Y d

Slide 29 of 52
Increase in G: summary
The effect of a stimulus:
C goes down (government is crowding out private consumption)

N and Y go up
w goes down
r goes up
Important: Y < G
(Government multiplier < 1,
for every dollar spent GDP goes up by less than a dollar)
Slide 30 of 52
Government Spending and GDP
Question: what is the relation between G and Y in the data?

Answer: no consensus among economist
Our theory predicts a government multiplier < 1
Keynesian analysis is based on a government multiplier > 1
+ For a quick summary look at this discussion between Boldrin DeLong starting at 42:20
http://tinyurl.com/BoldrinDelong
Slide 31 of 52
Question: what is the relation between G and Y in the data?

TABLE 2
PRESENT VALUE MULTIPLIERS OF THE POLICY SHOCKS
DEFICIT FINANCED TAX CUT

DEFICIT SPENDING
1 qrt
4qrts
8 qrts
12 qrts
20 qrts
0.20
0.44
0.53
0.31
2.08
0.37
6.19
0.29
3.80
0.33
Maximum
9.59 (qrt 14)
0.44 (qrt 1)
This table shows the present value multipliers for a deficit financed tax cut policy shock and for a deficit
spending fiscal policy shock. The multipliers given are the median multipliers in both cases.
4.3
A Deficit Financed Tax Cut Fiscal Policy Shock
The impulse
for a deficit
tax(2005)
cut fiscal policy shock are shown in
Taken
from:responses
Mountford
andfinanced
Uhlig
Figure 8. The shock is designed so that tax revenues fall by 1% and government spending
remains unchanged for four quarters following the shock. The responses look very similar
to a mirror image of the responses to the basic government revenue shock in Figure 3.
Thus the tax cut stimulates output, consumption and investment significantly with the
eect peaking after about three years. The eect on prices is initially negative but
Slide 32 of 52
subsequently positive following the rise in output.
195 of 260

When does government spending have an effect?
TABLE 5
MAXIMUM AND MINIMUM IMPACT MULTIPLIERS OF FISCAL POLICY SHOCKS
Fiscal Shock
Maximum Multiplier
Minimum Multiplier
Median
Multiplier
Confidence Interval
16th,84th Quantiles
Median
Multiplier
Confidence Interval
16th,84th Quantiles
Deficit Spending
1.36
lag 9
0.75, 1.59
lag 1, lag 24
-0.73
at lag 24
-2.73, -0.22
lag 24, lag 5
Balanced Budget
0.45
lag 3
0.18, 1.59
lag 1, lag 24
-3.64
at lag 11
-6.39, -2.26
lag 23, lag 8
Tax Cut
3.45
lag 13
3.11, 4.65
lag 9, lag 14
-0.11
at lag 1
-0.40, 0.28
lag 1, lag 1
Deficit Spending
In first year
0.71
lag 4
0.56, 0.89
lag 4, lag 4
0.03
at lag 3
-0.25, 0.17
lag 4, lag 1
Balanced Budget
In first year
0.31
at lag 1
0.05, 0.71
lag 4, lag 1
-0.83
at lag 1
-1.39, -0.60
lag 4, lag 2
These statistics relate to the distribution of the maximum and minimum impact multiplier effects of each fiscal shock. For each draw the maximum and minimum fiscal multiplier is calculated and the 16th, 50th and 84th percentiles of these results are displayed. The multiplier
statistic is calculated in terms of the initial, lag 0, fiscal shock as follows: multiplier for GDP
GDP response
=
/(Average Fiscal variable share of GDP).
Fiscal shock at Lag 0
Taken from: Mountford and Uhlig (2005)

Slide 33 of 52
and minimum multipliers of the two spending shocks in the first year after the shock.
In this case we now get the result that the deficit spending shocks minimum multiplier
is insignificantly dierent from zero but that for the balanced budget spending shock is
still significantly negative.
4.8
Policy Conclusions
An important lesson one can draw from the results is that while a deficit-financed expenditure stimulus is possible, the eventual costs are likely to be much higher than the
immediate benefits. For suppose that government spending is increased by two percent,
financed by increasing the deficit: this results, using the median values from Table 5,
19
Shocks to the Production Function
Slide 34 of 52
Change in Productivity
Suppose TFP today increases: z > 0

1) N d > 0, why? marginal product of labor increases
2) Output supply shifts to the right (higher z and N )
3) Output demand: C = 0, I = 0, G = 0. So that
Y d =
No shift!
196 of 260
Slide 35 of 52
1
(C + G + I) = 0
1 MPC
Dont forget affect of r2 on labor supply

Slide 36 of 52
Summarizing:
Output supply shift to the right lowers r

This causes labor supply to shift to the left
In equilibrium:
Effect on N ambiguous (most likely increasing); w increases

Y increases and r decreases
Slide 37 of 52
RBC Model and the US

Changes in z can be used to model US economy Cycles
Taken from: Kydland and Prescott (1982)

Slide 38 of 52
197 of 260
Change in Capital Stock: Japan 2011
Suppose capital stock today decreases: K

1) Labor demand shifts to the left (why?)
2) Output supply shifts to the left
3) Output demand: I > 0. Output demand shift to the right.
(Firm increases investment since K decreased)
Slide 39 of 52
Change in Capital Stock
4) Increase in r makes labor supply shift to the right
Slide 40 of 52
Change in Capital Stock
Summarizing in equilibrium:
I increases
Y ambiguous, r goes up
w decreases; N ambiguous (most likely down)
198 of 260
Slide 41 of 52
Japan: Data
Slide 42 of 52
Changing Future Income
Slide 43 of 52
Changing Future Income
The peculiarity of the next two examples is that GDP tomorrow

will change.
In solving for equilibrium it will be important to understand how

the household will anticipate future income changes.
199 of 260
Slide 44 of 52
Increase in Future TFP
Suppose that z 0 goes up

No change (for now) in current labor market or labor supply
Recall:
1
(C + G + I)
1 MPC
I > 0 firm anticipate higher return to capital tomorrow
C = M P C Y 0 > 0
Y d =
Interest rate go up
Labor supply shifts to the right
Slide 45 of 52
Slide 46 of 52
Punchline:
C might go up if income effects due to future income increase

dominate substitution effect due to higher r
I goes up
N and Y go up
r goes up
w goes down
200 of 260
Slide 47 of 52
Permanent Increase in G
We model permanent changes as changes to G and G0

(suppose both go up by G)
When G and G0 increase it implies T or T 0 prime go up.

Change in NPV of taxes
(taxes) = G +
G
1+r
Labor Supply and Output Supply shift to the right
Slide 48 of 52
Recall:
1
(C + G + I)
1 MPC
Y d =
and C = M P C (income)
The tricky shift is on the output demand curve;

two effects on income
1) increase in NPV taxes: G +
G
1+r
2) changes in income: Y 0 /(1 + r)
Slide 49 of 52
Y d =
MPC
Y 0
1+r
G
1+r
1 MPC
+ G + I
Permanent changes imply same changes today and tomorrow

no changes in saving of the household
If r does not change no changes in investment, so that:

I = 0 and Y 0 = G
Y d = G
201 of 260
Slide 50 of 52
Q: Does r change?
A: NO
Slide 51 of 52
Punchline:
C unchanged
I unchanged
N and Y go up
r unchanged
w goes down
Important: Y = G
(Government multiplier = 1)
Slide 52 of 52
202 of 260
Chapter 10
Credit Imperfections
203 of 260
Online Survey!
Q: In your opinion what is the biggest shortcoming in our
modeling of credit markets?
1
Lack of collateral for loans
Lack of default and bankruptcy
Lack of financial panics
Lack of bid/ask spreads
Lack of bank failures
Slide 3 of 38
Plan for This lecture
Financial Imperfections: Asymmetric information

Effect on Spreads
Effect on Ricardian Equivalence
Financial Imperfections: Limited Commitment

Collateral
Panics and Bank Runs
Slide 4 of 38
Credit Market Imperfections
204 of 260
Slide 5 of 38
Credit Market Imperfections

How do real credit markets compare to what we have studied?
Borrowing and lending at different rates

Different rates for different borrowers
Limits on the quantity borrowed
Collateral requirements for loans
Definition
Credit Imperfection: Any type of obstacle, either technological or
institutional that prevents an optimal level of trade in the credit market.
We will look into two types of credit market imperfections:
Asymmetric information
Limited commitment
Slide 6 of 38
Asymmetric Information
We have asymmetric information when some market participants

know more about own characteristics than other participants.
In the credit market: a borrower knows more about his or her own
credit worthiness than do potential borrowers.
Why does it matter?

A lender cannot differentiate between good and bad borrowers.
Slide 7 of 38
Asymmetric Information: Implications
If lender cannot distinguish between good and bad borrowers:

Lending is more risky (some borrowers will default)
Different rates at which consumers can borrow and lend
Suppose that: good borrowers, repay; bad, do not.

0 < a < 1: fraction of good borrowers
1 a: fraction of bad borrowers
Suppose that a measure 1 of savers saves (deposits) amount L
205 of 260
Slide 8 of 38
Banks, Lenders, Borrowers

Banks:
Issues loans at interest rate rL

Pays interest rD on deposit
Diversify by lending to a large number of borrowers

a fraction of borrowers a will not default, 1 a will default
Good borrowers:
Choose the same loan quantity L

Bad borrowers:
Mimic good borrowers and choose loan quantity L

Slide 9 of 38
Banks: Default Premium

Profit of banks:
= aL(1 + rL ) + (1 a)L 0 L(1 + rD )
In equilibrium each bank makes 0 profits = 0. So that
aL(1 + rL ) = L(1 + rD )
Equilibrium interest rate on a loan:
rL =
1 + rD
1
a
Each borrower pays a default premium on a loan
Premium is equal to the difference rL rD

It grows as the fraction of bad borrowers increases
Slide 10 of 38
Interest rate spreads during the Financial crisis

A credit spread is the difference in interest rate between
two different loans.
206 of 260
Source: St. Louis Fed
http://research.stlouisfed.org/fred2/categories/119
Slide 11 of 38
Asymmetric Information and Ricardian Equivalence
Slide 12 of 38
Asymmetric Information and Ricardian Equivalence

To prove Ricardian Equivalence we require perfect credit markets.
Ricardian equivalence fails in the presence of
asymmetric information
Use our basic inter-temporal model
consumer has income y and y 0 in periods 0 and 1

consumption of c and c0 in periods 0 and 1
saving denoted by s = y c
Consumer lends at the interest rate r1 and borrows at rate r2 , with

r1 < r2
Slide 13 of 38
The Inter-temporal Budget Constraint

Budget constraint: AEF .
Households that picks to the right of E are credit constrained:

they would like to borrow more if rate was r1 .
Slide 14 of 38
207 of 260
Credit Market Imperfections and Ricardian Equivalence
Suppose that:
Key assumption:
the interest rate on government debt is the lending rate r1
There is a tax cut in the current period t < 0

A tax increase in the second period t(1 + r1 )
Slide 15 of 38
Credit Market Imperfections and Ricardian Equivalence
Change in timing of taxes
shifts the endowment point
In the figure consumes new

endowment point E2
Consumption today increase by

the amount of the tax cut
Ricardian equivalence fails!
Slide 16 of 38
Credit markets and Limited Commitment
208 of 260
Slide 17 of 38
Credit markets and Limited Commitment

A loan is a promise to pay in the future.
In the future, the borrower may decide to not keep his promise.
Whenever a borrower cannot commit to repay we have a credit
imperfection: Limited Commitment.
With limited commitment, lender needs to set up contracts such

that borrower has the incentive to pay.
One possible incentive device: require collateral
Definition
Collateral: An asset owned by the borrower that the lender has a
right to seize if the borrower defaults on the loan.
Housing as collateral
Suppose household owns a house of value H:
Value of the house is p H. Where p is the housing price level
House are illiquid assets. Cannot be sold quickly to finance current
consumption
Consumers lifetime wealth:

we = y t +
y 0 t0 + p H
1+r
Note: wealth depends on p

Suppose household uses H as a collateral
Slide 19 of 38
Banks and Housing

Let: c + s = y t
Using H as collateral, banks offer loan s so that: the amount
borrowed s by the consumer must satisfy:
s(1 + r)
| {z }
Repayment
p H
| {z }
Value of collateral
this inequality is called the collateral constraint
Since c = y t s, we have
cyt+
pH
1+r
consumption depends on value of collateral!

Slide 20 of 38
209 of 260
Consumption and Collateral Constraints

The budget constraint with a collateral constraint:
Consumption today and tomorrow is impacted by p

Slide 21 of 38
Consumption and Collateral Constraints

What happened to the valued of housing from 2007 onwards?
Source:
http://research.stlouisfed.org/fred2/series/SPCS20RSA?rid=199
Slide 22 of 38
Financial Intemidiation
210 of 260
Slide 23 of 38
Intermediation and Growth

Definition
Share of Private Credit: Value of credit by financial
intermediations to the private sector devided by GDP.
48
R. Levine et al. / Journal of Monetary Economics 46 (2000) 31}77
Fig. 3. Partial scatter plot of growth vs. private credit.
seven additional countries with residuals more than two-standard deviations

away from zero (Belgium, El Salvador, Guyana, Jamaica, Mauritius, Niger,
and Senegal.) This did not change the conclusions either.!" We followed the
same procedures in checking for the e!ect of outliers for COMMERCIALCENTRAL BANK and LIQUID LIABILITIES. In no case did removing
outliers alter the results.!# The strong positive connection between the
Source: Levine, Loayza, Beck (2000)

Slide 24 of 38
What is Happening?
!" Speci"cally, when we remove South Africa and Switzerland the coe$cient on Private Credit
rises to 4.72 and the t-statistics equals 3.65 while the GMM estimate satis"es the litany of diagnostic
tests. Similarly, when the seven additional countries are removed, the Private Credit enters with
a value of 4.53 and a t-statistic of 3.91, while passing the diagnostic tests.
!# For the COMMERCIAL-CENTRAL BANK regressions, Haiti's level of "nancial develop-
is much less than predicted by its country characteristics. Nonetheless, removing Haiti
Septemberment
2007:
increases the estimated coe$cient on COMMERCIAL-CENTRAL BANK to 13.4 (with a t-statistic
of 3.35). Moreover, when removing other potential outliers such as Korea, Niger, and Peru, the
results are unchanged (coe$cient estimate of 9.6 on Commercial-Central Bank and a t-statistic of
2.44). When examining the GMM residuals, Niger, Honduras, Jamaica, Korea, Mauritius, Pakistan,
Senegal, and Taiwan are more than two-standard deviations from zero. Removing these countries
produces an estimated coe$cient of 7.71 on COMMERCIAL-CENTRAL BANK, with a t-statistic
of 2.92, and the regression passes the battery of diagnostic tests discussed in the text. In terms of
LIQUID LIABILITIES, the robustness checks produce similar results. The partial scatter plots
point to Niger and Korea as potential outliers. Removing these countries does not a!ect the results
(The estimated coe$cient becomes 2.24 with a t-statistic of 2.71). Similarly, when using the GMM
residual criteria, Korea, Jamaica, Switzerland, Taiwan, and Zaire fall more than two-standard
deviations away from zero. Removing these countries produces a coe$cient estimate of 2.63 on
LIQUID LIABILITIES, with a t-statistic of 4.24, and a regression that passes the various diagnostic
tests used in this paper.
Slide 25 of 38
What is Happening?
March 2014:
Source:
http://www.reuters.com/article/slideshow/idUSBREA2P02H20140326#a=2
Slide 26 of 38
211 of 260
Financial Intermediation
Up to this point in the course we have abstracted from

financial intermediation.
The previous models of private information and limited
commitment introduce the concept of an intermediary: a bank.
There is substantial evidence linking growth to the maturity of

the financial sector.
+ Given this lets have a close look at the benefits and costs of bank
as financial intermediary.
Slide 27 of 38
Banks as Intermediaries
What do Bank-like intermediaries do:

1
They borrow from one group of agents and lend to another

group of agents.
The borrowing and lending groups are large, suggesting

diversification on each side of the balance sheet.
The structure of the bank loans does not mirror the banks
obligations in the form of deposits.
Source: Gorton, Winton

http://fic.wharton.upenn.edu/fic/papers/02/0228.pdf
Slide 28 of 38
Banks as Intermediaries
Why do banks exists?

1
They are delegated monitors:

Banks monitor borrowers; given comparative advantage is natural
to have one agent specializing in it.
They generate information:

By searching and allocating loans banks provide signals to other
investors.
They provide insurance to consumers:

Providing loans helps consumer smooth consumption over time.
212 of 260
Slide 29 of 38
Intermediation: Diamond - Dybvig
Model of banking studied by Diamond and Dybvig

Written to explain bank runs
(could also be applied to financial panics)
Basic idea: depositors/investors play a coordination game:

1
With good coordination no problem for the bank;
With bad coordination bank fails.
Note: failure can occur without fundamental problems

with the bank.
Slide 30 of 38

The model
Bank offer deposits:
Short term return Rs

Long term return Rl (Rl > Rs )
Investors/Depositors have need for liquidity either:

In the short term (1/2 of the population)
In the long term (1/2 of the population)
Bank is aware of the need for liquidity and invests accordingly:

Bank has half its asset in short securities half in long securities
The problem:
Depositors can withdraw at any time

(even if they do not need liquidity)
Banks has half of its asset in short securities.
If every agent withdraws at the same time the bank FAILS!
213 of 260
Slide 32 of 38
Decision to withdraw for long term investors depends

on their beliefs of what others do:
If they believe other investors are not withdrawing the best decision
is to wait for the long run and cash higher return Rl
If they believe other investors are withdrawing the is best to
run to the bank and withdraw now!
Why run? they believe (and are correct) that the bank will fail.
Slide 33 of 38

Model as a 2 person game between myself and others:
Table : Payoffs from a Diamond Dybvig game
Me - Others
Run
Dont Run
Run
1
2 Rs
0
Dont Run
Rs
Rl
The game has two Nash equilibria:

1
No panic: Dont run / Dont run
Panic: Run/ Run
Slide 34 of 38
Suspension of Convertibility
The foundamental issue is that:

1
Liquidity needs are non-observable/non-contractable.
Consumers reach the bank 1 by 1: a sequential service constraint.
A solution to the problem of runs can be simple: the bank can

simply close. This is usually referred to suspending convertibility.
Suspending convertibility is costly for consumers who need liquidity.
Is there a better solution? YES
214 of 260
Slide 35 of 38
The FDIC
Federal Deposit Insurance Corporation signed into law in the
Banking Act of 1933.
Simply: It provided a Federal guarantee to bank deposits.

Nine banks failed in 1934, compared to more than 9,000 in the
preceding four years.
Today: FDIC insurance covers all deposit accounts, including
checking and savings accounts, money market deposit accounts and

certificates of deposit. The standard insurance amount is $250,000
per depositor, per insured bank, for each account.
Source http://www.fdic.gov/bank/historical/brief/brhist.pdf
Slide 36 of 38
How does the FDIC work in the DD framework?

Table : Payoffs from a DD game with FDIC
Me - Others
Run
Dont Run
Run
Rs
Rl
Dont Run
Rs
Rl
Q: In the model described, how much does the FDIC pay out?
Slide 37 of 38
Deposit Insurance Across Countries
215 of 260
Source: Kunt, Karacaovali, Laeven (2005).
Slide 38 of 38
Chapter 11
Money
216 of 260
Outline
1
Money
Money aggregates
Real and nominal interest rates
Monetary model
The consumers, firms and government using money
Money Demand, effects of money
The Federal Reserve

History and Structure
Changing money supply
Simple monetary policy

Inflation Targeting
Interest Rate Targeting
Slide 3 of 47
Money
Slide 4 of 47
Money
Three questions:
1
What is money?
A medium of exchange
A store of value
A unit of account
Why does money matter?
Why do people hold money?
217 of 260
Slide 5 of 47
Measuring the money supply

Federal Reserve issues 3 measure of monetary aggregates:
M0: Liabilities of the Federal Reserve: currency
M1: M0 + travelers checks + demand deposits
M2: M1 + savings deposits + money market mutual funds
Table : Billions of Dollars. Data April 7, 2014
M1
Currency
Travelers checks
Demand deposits
Other checkable deposits
2,754.2
1,196.9
3.3
1,079.3
474.6
M2
Savings deposits
Time deposits
Money market mutual funds
11,194.0
7,269.9
528.6
641.3
Source: http://www.federalreserve.gov/releases/h6/Current/h6.pdf
Slide 6 of 47
Who Holds The Cash?
In 2012, U.S. currency averaged about $2800 per person

Surveys show U.S. HH only hold about $100
Some is held by businesses and the underground economy
(another $200/300)
The rest is held abroad!
Slide 7 of 47
Changes in Money Supply

Federal Reserve controls the money supply
218 of 260
Source: http://research.stlouisfed.org/fred2/categories/29
Slide 8 of 47
Changes in Money Supply

What does it effect?
Strong relation between Money Supply and Prices.

This Introduces a relation between Money Supply and
return on a bond.
Slide 9 of 47
The Return on a Bond

We focus on risk-less bonds:
A nominal Bond is an asset that sells for one unit of dollars today
and returns 1 + R dollars tomorrow.
The nominal return is R, what is the real return?

P 0 P
P
P 0 tomorrow)
Recall the inflation rate i =

(P is the price level today,
The real return r is given by the Fisher equation:

1+r =
1+R
1+i
For small inflation rates, approximate to r R i

Slide 10 of 47
Appendix: Deriving The Fisher Equation
Real cost today:
1
P
Real return tomorrow:

Real return:
1+R
P0
1+r =
1+R
P0
1
P
1+R
P0
P
1+R
1+i
219 of 260
Slide 11 of 47
Nominal Returns and Inflation

Comparing the nominal returns on a 1 Year T-bill and inflation:
Slide 12 of 47
220 of 260
11.1
Monetary model
221 of 260
A Monetary Model
We want to build a model where Household and Firms use money.

Lets look at real return on money (rm ):
1 + rm =
1+0
1
=
1+i
1+i
so rm < r, money always has lower real returns than

other safe assets.
A Puzzle: Why do households use money?
Slide 14 of 47
Models of Money
There are several way to introduce money in a model:

1
Money in the utility function

(people hold money because they like too)
Money search
(people need money to ease transactions)
Cash in advance model

(people need money to finance consumption and investment)
Slide 15 of 47
A Monetary Model : Cash in Advance
Some new ingredients for our model:

1
Nominal prices of goods today (price level): P
Household:
needs cash to buy goods
uses bonds to save
Firms: need cash to pay for Investments
Government controls the quantity of money: M
222 of 260
Slide 16 of 47
The Government
In the model Government is in charge of the Federal Reserve.
Changes the money supply:
M = M 0 M
Budget constraint is:

P G + (1 + R) B = P T + B 0 +
| {z }
Old debts
0
M
M}
| {z
Change in money supply
Question:
Is there a problem if the government controls
both B and M ?
Slide 17 of 47
Changing The Money Supply
Slide 18 of 47
Changing The Money Supply: Model/ Real Life

In the Model from the government budget constraint:
0
M
M}
| {z
Change in money supply
= P G P T + (1 + R)B B 0
Can change money supply with:

1
2
Changes in T : rebates
Changes in B 0 : open market operations
(exchange of cash for debt)
In the US and most economies money supply is controlled by

a central bank (the Federal Reserve System in the US)
Changes in the money supply are achieved with:
1
2
3
Slide 19 of 47
Reserve Requirements (rare)

Open Market operations
Discount loans
223 of 260
The Federal Reserve System - History I

1775-1791: US Currency in the Beginning
Continental Congress prints paper money (Continentals) to

finance the American Revolution.
Over printing lead to high inflation and loss of faith in notes.

1791-1811: First Attempt at Central Banking
Treasury Secretary Alexander Hamilton pushes Congress to

establish the First Central Bank of the United States,
headquartered in Philadelphia, in 1791.
1811 when the banks 20-year charter expired, Congress refused,

by one vote, to renew it.
Slide 20 of 47
The Federal Reserve System - History II

1836-1865: The Free Banking Era
State-chartered banks and unchartered free banks took hold
during this period, issuing their own notes, redeemable in gold.
Beginning of modern banking: demand deposits, check

transactions, clearinghouses...
1863: National Banking Act
Nationally chartered banks, whose circulating notes had to be

backed by US government securities.
Amendment required taxation on state bank notes but not national

bank notes, creating a uniform currency for the nation.
Slide 21 of 47
The Federal Reserve System - History III
1873-1907: Financial Panics Prevail
Regular bank runs and financial panics.

1893 a banking panic triggered the worst depression the United
States had ever seen.
1913: The Federal Reserve System is Born
Federal Reserve Act signed into law by President

Wilson on December 23, 1913.
224 of 260
Slide 22 of 47
The Structure of the Federal Reserve System
Slide 23 of 47
225 of 260
11.2
The Fed and Monetary Policy
226 of 260
Board of Governors:
Seven members appointed by the President and confirmed by the

Senate to 14-year terms of office.
President designates, and the Congress confirms, two members of

the Board to be Chairman and Vice Chairman for 4-year terms.
The President by law selects a fair representation of the financial,
agricultural, industrial, and commercial interests and geographical

divisions of the country.
Slide 24 of 47
Federal Open Market Committee (FOMC):
12 membersthe seven members of the Board of Governors of the
Federal Reserve System; the president of the Federal Reserve Bank

of New York; and four of the remaining eleven Reserve Bank
presidents, who serve one-year terms on a rotating basis.
Holds eight meetings per year. At these meetings, the Committee
reviews economic and financial conditions, determines the

appropriate stance of monetary policy, and assesses the risks to its
long-run goals of price stability and sustainable economic growth.
http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm
Slide 25 of 47
FED and Banks Balance Sheet

The Banks:
Balance sheet of the Banking System
Assets
Liabilities
US securities
Checkable Deposits
Reserves
Discount loans
Loans and Mortgages
Definition:
Reserves = Required Reserves + Excess Reserves
227 of 260
Slide 26 of 47
FED and Banks Balance Sheet
The Fed:
Balance sheet of the FED
Assets
Liabilities
US securities
Currency in Circulation
Discount loans to banks
Reserves
Definition:
Monetary Base = Currency in Circulation + Reserves
Slide 27 of 47
FED Balance Sheet
Taken from: http://www.clevelandfed.org/research/

Slide 28 of 47
Open Market Operations

For example the Fed buys 1$ in US securities from banks:
Assets
Liabilities
US securities +1$
Discount loans to banks
Reserves +1$

Assets
Liabilities
US securities 1$
Checkable Deposits
Reserves +1$
Discount loans
228 of 260
Monetary base increase by 1$

Question: what if the T-bill is purchased from
the Household?
Slide 29 of 47
Discount Loans
For example: the Fed loans 1$ to banking system:
http://tiny.cc/8RDgD

Assets
Liabilities
US securities
Discount loans to banks +1$
Reserves +1$

Assets
Liabilities
US securities
Checkable Deposits
Reserves +1$
Discount loans +1$
Monetary base increase by 1$

Slide 30 of 47
Money Demand and Equilibrium
Slide 31 of 47
Equilibrium in the Monetary Model
Four markets must be in equilibrium:

1
Goods Market: Y = C + I + G
Labor Market: Ns = Nd
Credit Market: B = S
NEW! Money Market:

Md
|{z}
Money Demand
Slide 32 of 47
Ms
|{z}
Money Supply
229 of 260
The Money Demand Equation
Money Supply is set by the Government/FED

We need a money demand equation
How is it derived?
Lots of algebra...for this course lets take it as given
Slide 33 of 47
230 of 260
Equilibrium in the Money Market

Since government supplies M s inelastically:
Slide 35 of 47
Targeting Rules
Slide 36 of 47
Targeting rules
Central Banks use one of the following rules for monetary policy:
1
Inflation Targeting:
Set i = i
Nominal Interest Rate Targeting:

Set R = R ;
Where R = r + i
231 of 260
Slide 37 of 47
Inflation Targeting: Data

Recent FED behavior seems to target i = 2% or 3%
Other central banks:
Slide 38 of 47
Interest Rate Targeting: Data
Taken from: http://www.newyorkfed.org/charts/ff/

Slide 39 of 47
Targeting rules: Example
Recall M d = P L(Y, r)
Function L is increasing in Y
Function L is decreasing in r
Suppose Y increases and r decreases.

This implies that money demand shifts outwards.
How should policy respond?
232 of 260
Slide 40 of 47
Targeting rules: Example

Suppose the central bank targets i = 0, so that P1 = P2 .
Money supply must shift outward

Interest rate targeting is similar in spirit but more
complicated since both r and i are changing.
Slide 41 of 47
The effects of inflation
Slide 42 of 47
Changes in M and Real Variables

Question: what is the long run effect on C, Y, N of changes in
money supply?
233 of 260
Slide 43 of 47
Changes in M and Real Variables: Long Run
To answer this lets (for example) look at the budget constraint:

P C + (1 + R) B + M 0 = P Y + B 0 + M
Given long run focus i = 0 so that R = r
Changes in level of M and M 0 are ofset by changes in P
The answer: is none!

This result is called long run money neutrality.
Slide 44 of 47
Changes in M and Real Variables: Short Run
Question: what is the effect on Y and N of changes in money

supply in the short run?
The answer depends on weather inflation is expected or not:

If inflation is expected
output decreases
If inflation is unexpected output increases
Slide 45 of 47
Expected Inflation
Suppose workers get paid today and can use wages only for next
period consumption.
From optimality of the household:

M RSl,C 0 =
P w
w
=
0
P
i1
Intuition:
Higher wages
higher incentive to work
Higher inflation lower purchasing power next period =
less incentive to work!
234 of 260
Note: this case assumes the agent expects inflation (i).

Slide 46 of 47
Unexpected Inflation
What if inflation is unexpected? Friedman-Lucas model
Suppose wage is payed next period, so that nominal wage is P 0 w.
Suppse also that P 0 w (nominal wages) increases.
Summary:
1
Workers do not expect inflation.
Nominal changes in wage are perceived as real changes in wage

(P = P 0 and w )
Wages goes up so workers work more output increases.
Question: how many times will workers be surprised by inflation?
235 of 260
11.3
What Economists Do
236 of 260
What Economists Do
Robert E. Lucas, Jr.
December 9, 1988
Economists have an image of practicality and worldliness not shared by physicists
and poets. Some economists have earned this image. Othersmyself and many Of my
colleagues here at Chicagohave not. Im not sure whether you will take this as a confession or a boast, but we are basically story-tellers, creators of make-believe economic
systems. Rather than try to explain what this story-telling activity is about and why I
think it is a usefuleven an essentialactivity, I thought I would just tell you a story and
let you make of it what you like.
My story has a point: I want to understand the connection between changes in the
money supply and economic depressions. One way to demonstrate that I understand
this connectionI think the only really convincing waywould be for me to engineer a
depression in the United States by manipulating the U.S. money supply. I think I know
how to do this, though Im not absolutely sure, but a real virtue of the democratic system
is that we do not look kindly on people who want to use our lives as a laboratory. So I
will try to make my depression somewhere else.
The location I have in mind is an old-fashioned amusement parkroller coasters, fun
house, hot dogs, the works. I am thinking of Kennywood Park in Pittsburgh, where I
lived when my children were at the optimal age as amusement park companions - a
beautiful, turn-of-the-century place on a bluff overlooking the Monongahela River. If
you have not seen this particular park, substitute one with which you are familiar, as I
want you to try to visualize how the experiment I am going to describe would actually
work in practice.
Kennywood Park is a useful location for my purposes because it is an entirely independent monetary system. One cannot spend U.S. dollars inside the park. At the
gate, visitors use U.S. dollars to purchase tickets and than enter the park and spend the
tickets. Rides inside are priced at so many tickets per ride. Ride operators collect these
tickets, and at the end of each day they are cashed in for dollars, like chips in a casino.
237 of 260
For obvious reasons, business in park fluctuates: Sundays are big days, July 4 is
even bigger. On most concessionsI imagine each ride in the park to be independently
operatedthere is soma flexibility: an extra person can be called in to help take tickets
or to speed people getting on and off the ride, on short-notice if the day is unexpectedly
big or with advanced notice if it is predictable. If business is disappointingly slow, an
operator will let some of his help leave early. So GNP in the park (total tickets spent)
and employment (the number of man hours worked) will fluctuate from one day to the
next due to fluctuations in demand. Do we want to call a slow daya Monday or a
Tuesday, saya depression? Surely not. By an economic depression we mean something
that ought not to happen, something pathological, not normal seasonal or daily ups and
downs.
This, I imagine, is how the park works. (I say imagine because I as just making
most of this up as I go along.) Technically, Kennywood Park is a fixed exchange rate
system, since its central bankthe cashiers office at the gatestands ready to exchange
local currencyticketsfor foreign currencyUS dollarsat a fixed rate.
In this economy, there is an obvious sense in which the number of tickets in circulation is economically irrelevant. No-onecustomer or concessioner really cares about
the number of tickets per ride except insofar as these prices reflect U.S. dollars per ride.
If the number of tickets per U.S. dollar were doubled from 10 to 20, and if the prices
of all rides were doubled in terms of tickets6 tickets per roller coaster ride instead of
3and if everyone understood that these changes had occurred, it just would not make
any important difference. Such a doubling of the money supply and of prices would
amount to a 100 percent inflation in terms of local currency, but so what?
Yet I want to show you that changes in the quantity of moneyin the number of
tickets in circulationhave the capacity to induce depressions or booms in this economy
(just as I think they do in reality). To do so, I want to imagine subjecting Kennywood
Park to an entirely operational experiment. Think of renting the park from its owners
for one Sunday, for suitable compensation, and taking over the functions of the cashiers
office. Neither the operators of concessions nor the customers are to be informed of this.
Then, with no advance warning to anyone inside the park, and no communication to
them as to what is going on, the cashiers are instructed for this one day to give 8 tickets
per dollar instead of 10. What will happen?
We can imagine a variety of reactions. Some customers, discouraged or angry, will
turn around and go home. Others, coming to the park with a dollar budget fixed by
Mom, will just buy 80 percent of the tickets they would have bought otherwise. Still
others will shell out 20 percent more dollars and behave as they would have in the
238 of 260
absence of this change in exchange rates. I would have to know much more than I
do about Kennywood Park patrons to judge how many would fall into each of these
categories, but it is pretty clear that no-one will be induced to take more tickets than if
the experiment had not taken place, many will buy fewer, and thus that the total number
of tickets in circulationthe money supply of this amusement park economywill take
a drop below what it otherwise would have been on this Sunday.
Now hear does all of this look from the point of view of the operator of a ride
or the guy selling hot dogs? Again, there will be a variety of reactions. In general,
most operators will notice that the park seems kind of empty, for a Sunday, and that
customers dont seam to be spending like they usually do. More time is being spent
on freebies, the river view or a walk through the gardens. Many operators take this
personally. Those who were worried that their ride was becoming passe get additional
confirmation. Those who thought they were just starting to become popular, and had
had thoughts of adding some capacity, begin to wonder if they had perhaps become overoptimistic. On many concessions, the extra employees hired to deal with the expected
Sunday crowd are sent home early. A gloomy, depressed mood settles in.
What I have done, in short, is to engineer a depression in the park. The reduction
in the quantity of money has led to a reduction in real output and employment. And
this depression is indeed a kind of pathology. Customers are arriving at the park, eager
to spend and enjoy themselves, Concessioners are ready and waiting to serve them. By
introducing a glitch into the parks monetary system, we have prevented (not physically,
but just as effectively) buyers and sellers from getting together to consummate mutually
advantageous trades.
That is the end of my story. Rather than offer you some of my opinions about the
nature and causes of depressions in the United States, I simply made a depression and
let you watch it unfold. I hope you found it convincing on its own termsthat what I said
would happen in the park as the result of my manipulations would in fact happen. If so,
then you will agree that by increasing the number of tickets per dollar we could as easily
have engineered a boom in the park. But we could not, clearly, engineer a boom Sunday
after Sunday by this method. Our experiment worked only because our manipulations
caught everyone by surprise. We could have avoided the depression by leaving things
alone, but we could not use monetary manipulation to engineer a permanently higher
level of prosperity in the park. The clarity with which these affects can be seen is the
key advantage of operating in simplified, fictional worlds.
The disadvantage, it must be conceded, is that we are not really interested in understanding and preventing depressions in hypothetical amusement parks. We are in239 of 260
terested in our own, vastly more complicated society. To apply the knowledge we have
gained about depressions in Kennywood Park, we must be willing to argue by analogy
from what we know about one situation to what we would like to know about another,
quite different situation. And, as we all know, the analogy that one person finds persuasive, his neighbor may well, find ridiculous.
Well, that is why honest people can disagree. I dont know what one can do about
it, except keep trying to tell better and better stories, to provide the raw material for
better and more instructive analogies. How else can we free ourselves from the limits
of historical experience so as to discover ways in which our society can operate better
than it has in the past? In any case, that is what economists do. We are storytellers,
operating much of the time in worlds of make believe. We do not find that the realm
of imagination and ideas is an alternative to, or a retreat from, practical reality. On the
contrary, it is the only way we have found to think seriously about reality.
In a way, there is nothing more to this method than maintaining the conviction (which
I know you have after four years at Chicago) that imagination and ideas matter. I hope
you can do this in the years that follow. It is fun and interesting and, really, there is no
practical alternative.
240 of 260
Chapter 12
The End: 7 lessons from this course
241 of 260
Tools you have learned

Four fronts:
1
Theory: You know how to build equilibrium macro models:

Micro-foundations
Empirics: You know where to look for any type of Macro data:
Proficient in using aggregate datasets
Graphical analysis and basic statistics
Filtering: linear and Hodrick-Prescott
Forecasting: Do you know what unemployment will be on Friday?
Quantitative: You know how to map models to data:

Calibration: factor shares, TFP, disutility from labor, capital stock
Effect of taxes on hours; Optimal Taxation
7 Lessons to remember
Slide 6 of 8
In data households and firms display dynamic

and forward looking behaviour.
Government expenditures reduce wealth and hence

consumption. Government multiplier is less than 1.
Taxes discourage work, optimal taxes should take the

response of workers into account.
Without credit frictions the timing of taxes

and stimuli are irrelevant.
242 of 260
Slide 7 of 8
Without capital accumulation technology cannot lead

to sustained growth of standard of living.
Borrowing short and lending long makes the banking

system prone to panics. Policy can prevent panics at
no cost.
Money creation has no long run real effect.

Unexpected inflation can have short term real effects.
Slide 8 of 8
243 of 260
Part III
Problem Sets
244 of 260
73-240 Spring 2014
73-240 Problem set 1

Due Friday Feb. 7th
From the Syllabus:

1. Homework must be turned in on the day it is due. Late homework will NOT be
2. You may work in groups of up to 4. BUT: You MUST put names of other group
members on your homework. You MUST write up your own set of answers.
3. TYPE your work. Long equations may be hand written. Buy a stapler!
4. Write your first and last name on the title of each graph. Graphs may be hand drawn.
5. Carefully explain your work.
Problem 1 (20 points)

Consider the following data:
Quantities/Time 2013
Red Widgets
32
Blue Widgets
32
Prices
Red Widgets
$1.75
Blue Widgets
$2
2014
15
9
$1.6
$2.2
1. Compute the Laspeyres and Paasche indices for each year taking as base year 2013.
2. Compute Nominal GDP and its growth rate.
3. Compute Real GDP using both the Laspeyres and Paasche indices. Compute growth
rates of real GDP using both indices.
4. Compute inflation in 2014 using both the Laspeyres and Paasche indices.
Prof. Laurence Ales

245 of 260
73-240 Spring 2014
Problem 2 (15 points) A first glance at NIPA

1. Write the formula for GDP following the expenditure approach.
2. Refer to table 1.1.6 (Real Gross Domestic Product) of the NIPA tables. You can
find them here http://www.bea.gov/iTable/index nipa.cfm, click on Begin Using the
Data then click on Section 1. Map each of they item in the formula of GDP in terms
of expenditure approach to one of the line of table 1.1.6.
3. For each item in the formula of GDP compute the fraction of total GDP. You can pick
the last quarter of 2012.
Problem 3 (15 points)

Problem 3 of Chapter 2 (page 65) In Williamson 5th edition.
(The wheat and bread economy.)
Problem 4 (30 points) Working with data: Forecasting

This question will introduce you to some data work, also refer to Lecture 3 for details.
Using data from http://research.stlouisfed.org/fred2/:
1. Use series (UNRATE): Civilian unemployment rate.
(Hint: type UNRATE in the search box)
2. Compute the average (in percent) unemployment rate from 1950 to 2008.
3. Using a linear forecast (careful in deciding the data to use) predict when unemployment
will hit the average unemployment rate from 1950 to 2008. Make sure to carefully
explain all the steps you do.
Problem 5 (20 points) Working with data: Filtering

This question will introduce you to some data work, also refer to Lecture 3 for details.
Using data from http://research.stlouisfed.org/fred2/:

246 of 260
Prof. Laurence Ales
73-240 Spring 2014

1. Use series (GDPCA): Real gross domestic product. Take data from 1980 to 2012
included. Compute the Hodrick-Prescot filter of the time series. This will be the trend
of GDP.
2. Plot the trend over time.
3. Compute the deviation from trend of GDP. This will be the cyclical components.
4. Plot the cyclical component of GDP.
Prof. Laurence Ales

247 of 260
73-240 Spring 2014

Due Monday Feb. 24th
From the Syllabus:

Problem 1 (30 points): The U.S. firm

Consider the Cobb-Douglas production function:
Y = zK N 1
(1)
where is the share of capital in the production function

1. Write down the problem of the firm and determine the labor demand function.
2. Suppose wages (w) change by 1%, by how much does labor demand change?
3. Using the optimality condition of the firm, write down a formula to compute from
the data.
4. Using data on Compensation of employees (BEA, NIPA Table 2.1 line 2) and GDP,
compute . Use yearly data from 1970 onwards and report the average value of alpha
for this time period.
5. In a graph plot the time of changes by year. On the same graph plot the HP filtered
version of the time series (see also Hw 1).
This version: February 19, 2014
248 of 260
Prof. Laurence Ales
73-240 Spring 2014
Problem 2 (30 points): The U.S. household

In this problem you will study the representative household. Suppose that the utility function
is given by
1
U (C, l) = log(C) + log(l)
Where C is consumption, l is leisure, and 1/ is a parameter that determines how much

the representative household values consumption versus leisure. Let h be the total time
endowment, w the wage and the dividend payments.
1. Write the problem of the household making sure to include the budget constraint (dont
forget taxes and dividends in the budget constraint)
2. Solve the household problem. This implies deriving two equations one providing a
value of C and one for the value of l. These two equation must only depend on h, ,
w and T .
3. Suppose T = 0. Derive the optimality condition for the household using first order
conditions. Using the optimality condition write a formula for leisure. How does leisure
change when wages change? Explain in terms of income and substitution effect.
4. Lets calibrate the model to the US household. Keep T = 0. In US data we observe
that households enjoy 2/3 of their time endowment in leisure. Given this fact derive a
realistic value for the parameter .
5. Lets simulate a recession. Suppose the wages decrease by 10% how do hours worked
change? What happens to consumption? Explain in terms of income and substitution
effect. For this question set w = 1 (initially) also set h = 1, T = 0.1 and use the
value of calculated in the previous step.
Hint: Be careful not to mix leisure with hours worked.
Also T is now different than zero!
Problem 3 (40 points): Health and the Macroeconomy

In this question you are asked to analyze the behavior of U.S. health spending at an aggregate
level. The aggregate behavior of health spending in the U.S. is potentially worrying; in the
next question you are asked to show that it might not be the case.
1. Use Information reported by the BEA in NIPA table 1.5.5. Compute the share of GDP
due to health spending from 1970. Plot this time series. Explain which data series you
will use.
Prof. Laurence Ales

249 of 260
73-240 Spring 2014

2. Using the above data, compute a linear trend from 1970. Use this trend to forecast the
share of health spending up to 2030. Plot the overall time series from 1970 to 2030.
3. A model for health care. Suppose a household has income equal to Y . Suppose
income can be spent on either consumption C or health goods H. Suppose that
consumption and health goods have prices equal to 1. Write the budget constraint for
the household
Hint: note that there is not leisure decision, income is fixed and equal to Y .
4. Suppose that health goods increase the enjoyment of consumption goods (think about
being healthy and enjoying more consumption). Formally let the utility from H and
C be given by
U (C, H) = H (b + log(C))
where b is a parameter that describes the value of being alive and is a given
parameter. Write the problem of the household.
5. Using Excel solve the problem of the household. Set b = 15, = 0.2 and consider
three distinct income levels Y = 10, 15, 35. Plot the share of income devoted to health
care for this household. How does it change as income increases?
This is a hard step. In recitation the TA will help you with this step!
6. Look for a definition of luxury good. Using this definition and the results in the
prior question, comment on the behavior of health care in the US. Provide a possible
explanation for its behavior.

250 of 260
Prof. Laurence Ales
73-240 Spring 2014

Due Friday Mar. 28th
From the Syllabus:

Problem 1 (25 points): Optimal Taxation

Refer to Lecture 8. Write a formula for the optimal top tax rate ( ) that contains the
elasticity of reported income with respect to tax rate (e).
1. Plot the optimal top tax rate over a range of e going from 0.1 to 5. Assume that
a = 1.5.
2. Find the top labor income tax rate in the US today (make sure to correctly cite your
source). Call this value U S . For what value of e roughly we have = U S ?
Problem 2 (25 points): Solow

Consider the Solow growth model. Derive an equation that determines the steady state level
of capital per capita. Analyze the long-run effects on the steady state of the following
changes to the environment:
1. Tax rates on savings are decreased, hence saving rates increase.
2. A fraction of the country capital stock gets destroyed. For this last case also explain
in detail what happens in the short run (i.e. the transition to the new steady state)
This version: March 21, 2014
Prof. Laurence Ales

251 of 260
73-240 Spring 2014
Problem 3 (25 points): Malthus

Consider the Malthusian model of growth. Analyze the long-run effects on the steady state
of the following changes to the environment:
1. Increase in the hygiene in medical practice increases the survival rates of newborns.
2. Following a war, the country looses land.
Note that you are required to support your argument with either graphs or equations!
Problem 4 (25 points): Solow and the US

In this question you will calculate the capital stock in the US. Your starting point will be
the following equation (refer to lecture 10):
Kt+1 = Kt (1 d) + It ,
(1)
where Kt+1 is the capital stock in year t + 1, Kt in year t, It investment in year t. Set the
depreciation rate d = 0.05. Use data from table 1.1.6 of the NIPA accounts. For GDP (line
1) and Investment (line 7). Use annual data from 1960 to 2013.
1. Calculate the level of capital in 1960 assuming that the capital output ratio for that
year is equal to 2: K1960 /Y1960 = 2.
2. Using equation (1) and the value of K1960 , calculate Kt+1 for all years 1961 to 2013.
3. Plot the capital output ratio between 1960 to 2013.
This version: March 21, 2014

252 of 260
Prof. Laurence Ales
73-240 Spring 2014

Due Wednesday April 9th
From the Syllabus:

1. Homework must be turned in on the day it is due.
2. You may work in groups of up to 4. But: You must put names of other group members
on your homework. You must write up your own set of answers.
3. Type your work. Long equations may be hand written. Buy a stapler!
Problem 1 (30 points): Taxes and Household Behavior

Consider the household in the two period model studied in Lecture 12. Study the impact
on consumption today (c) and consumption tomorrow (c0 ) of the following changes in taxes
(assume taxes are lump sum):
1. It is announced that this year every household in the US will receive a 10% reduction
in this years taxes.
2. For this year you receive (and only you) a larger than expected tax refund.
Problem 2 (40 points): The Dynamic Household

Consider the problem of the household studied in Lecture 13 (with endogenous labor supply).
Describe every symbol you use. Suppose the utility function in every period is U (c, l).
1. Write down the problem of the household. Make sure to write the objective function
and all of the constraints. (Hint use the lifetime budget constraint)
2. Write down the four first order conditions for consumption today (c) consumption
tomorrow (c0 ), labor today (l0 ) and labor tomorrow (l0 ).
Prof. Laurence Ales

253 of 260
73-240 Spring 2014

3. Show that two first order conditions can be combined so that M RSc,c0 = 1 + r.
4. Consider a graph plotting c versus c0 show how a change in r might affect the optimal
choice of c and c0 .
Problem 4 (30 points): The Dynamic Firm

Consider the problem of the firm studied in Lecture 13.
1. Write the two period problem of the firm labeling every symbol.
2. Compute the first order condition for investment (I).
3. Show how changes in the interest rate (r) impact I.
4. Show how changes in tomorrow (z 0 ) impact I.

254 of 260
Prof. Laurence Ales
73-240 Spring 2014

Due Wednesday April 30th
From the Syllabus:

1. Homework must be turned in on the day it is due.
2. You may work in groups of up to 4. But: You must put names of other group members
on your homework. You must write up your own set of answers.
3. Type your work. Long equations may be hand written. Buy a stapler!
Problem 1 (20 points): Asymmetric Information

Williamson 5th edition: Problem 1 (page 372) of Chapter 10.
Problem 2 (30 points): The Effects of TFP Growth

For this question you will need to refer to Lecture 14. Suppose that both productivity today
(z) and productivity tomorrow (z 0 ) grow. Use the equilibrium diagrams (for current labor and
goods market) to determine the effects this will have on current aggregate output, current
employment, the current real wage, the real interest rate, consumption and investment.
Explain your results.
Problem 3 (20 points): Limited Commitment

Williamson 5th edition: Problem 2 (page 372) of Chapter 10.
Prof. Laurence Ales

255 of 260
73-240 Spring 2014
Problem 4 (20 points): Hyper-Inflations

In this question you are asked to work with data on money, prices indices and output. The
data has been collected by Warren Weber (CMU Ph.D 69) economist at the Minneapolis
Federal Reserve Bank. I have attached the data in a separate file (hw-prices-money.xlsx)
on Blackboard. In the tab Prices looking across countries, what is the biggest episode
of inflation you observe over time? How large was inflation during this hyper-inflation
period? In the tab Money locate in line 1 the series for M0 and M2. For the country you
have identified experiencing a hyper-inflation episode, plot the behavior of the natural log
of M0 and M2. Describe what you observe.
Problem 5 (10 points): The End

Write down one topic, result or fact you have learned from this class and would like to
remember beyond the final examination.

256 of 260
Prof. Laurence Ales
73-240 Spring 2014

Due Thursday May 1st and Friday May 2nd
Rules:
1. This homework is optional.
2. The grade of this homework will be averaged with your previous 5 problem sets if it
will increase the average score. This way there is no risk in submitting the homework.
3. You may work in groups. Each group member must submit an answer independently.
Question 1
On Friday May 2nd at 8:30AM (EST) the Bureau of Labor Statistics will release the Employment Situation for April 2014. In this homework you are asked to forecast some of the
key metrics in this release. In particular answer the following:
1. Forecast 1: By what amount will Total Nonfarm Payroll Employment grow by.
2. Forecast 2: The Unemployment Rate.
Here are important guidelines and tips for the homework:
1. The numerical values of the forecast must be submitted here: http://tinyurl.com/73240hw6 by Thursday May1st at 11:59PM Pittsburgh time.
2. To homework will be graded not by the precision of the forecast but by the methodology
used. A detailed description of the methodology used must be submitted in class on
Friday May 2nd .
3. Any official data including ADP data might be used to generate the forecast.
4. Any of the procedures studied in Lecture 3 or Lecture 856 will be acceptable (more
advanced procedures are also welcomed).
5. A sample of the same release for March 2014 can be found here:
http://www.bls.gov/news.release/empsit.nr0.htm
Prof. Laurence Ales

257 of 260
Index
ADP, 160, 257
Aggregation, 62
Asymmetric Information, 203, 255
Durbin Watson, 160

Dynamic budget, 160
Dynamic equilibrium, 185
Bank Runs, 203

Banks, 203
Behavioral Responses, 108
BLS, 160
Bonds, 160
Budget Constraint, 62
Education across countries, 146

Endogenous growth, 146
Equilibrium in goods market, 185
Equilibrium in labor market, 185
Expenditure Approach, 25
Caldor Facts, 129

Calibration Exercise, 248
Capital Shares Across Countries, 251
Cash in Advance model, 221
Competitive Equilibrium, 93
Confidence interval, 39
Consumption smoothing, 160
Convergenze, 129
Counter-cyclical, 48
CPI, 56
Credit Imperfection, 203
Data on money, prices and output, 255
Default Premium, 203
Deficits, 173
Depression, 48
Determinants of Growth, 119
Deviation from trend, 39
Diamond-Dybvig model, 203
Discount loans, 231
Distortionary Taxation, 108
258 of 260
Failures of GDP, 25
FDIC, 203
Feasibility, 93
Fed balance sheet, 226
Federal Reserve System, 226
Filtering, 245
Financial Panics, 203
Firm investment, 180
First Welfare Theorem, 104
Fiscal stimulus, 185
Fiscal Stimulus: static, 93
Fisher Equation, 216
Flow of funds, 160
FOMC, 226
Forecasting, 245
Forecasting: definition, 39
Friedman on Methodology, 14
Friedman-Lucas Model, 231
Full Redistribution, 108
GDP deflator, 56
Government Budget Constraint, 88
Government multiplier, 185

Growth and deficits, 245
Growth Miracles and Disasters, 119
Health Spending, 248
Heavy Truck Sales, 160
Historical Growth Data, 119
History of the Fed, 226
Hodrick-Prescott filter, 48
Homogeneity, 62
Household saving, 160
Human Capital, 146
Hyperinflation, 255
Income Approach, 25
Income Effect, 62
Indifference Curves, 62
Inequality, 25
Inflation, 56
Inflation targeting, 231, 255
Information set, 39
Interest rate targeting, 231
Interest rates and the consumer, 177
Interest rates and the firm, 180
International Interest Rates, 160
Job Openings, 160
Laffer Curve, 108
Land in the Production Function, 129
Laspeyres Index, 56
Leading Indicators, 160
Limited Commitment, 203, 255
Liquidation value, 180
Loan Defaults, 203
log-scales, 39
Lucas Critique, 160
Lump Sum Taxes, 88
M0,M1,M2, 216
Macroeconomics, 14
Maddison Data, 251

Malthus Model, 129
Malthus to Solow: Hansen-Prescott 1999,
129
Malthusian Trap, 129
Marginal Product, 77
Marginal propensity to consume, 185
Marginal Rate of Substitution, 62
Marginal Taxes, 108
Mean Logarithmic Deviation, 119
Methodology, 14
Modern Growth Data, 119
Money, 216
Money and Prices, 216
Money demand, 221
Multiplier, 185
National Income Identities, 25
National saving rate, 160
NIPA Tables, 25
Nominal Bonds, 216
Open Market Operations, 221
Open market operations, 231
Optimal Saving, 160
Output demand, 185
Output supply, 185
Paasche Index, 56
Pareto Optimum, 104
Penalty function, 39
Penn World Tables, 251
Phillips curve, 231
Popper on Methodology, 14
Price Index, 56
Pro-cyclical, 48
Product Approach, 25
Production Function, 77
Production Possibility Frontier, 93
Productivity shock, 185
Progressive Taxes, 108
259 of 260
Real and Nominal Variables, 56

Recession, 48
Regressive Taxes, 108
Return on Money, 221
Ricardian Equivalence, 253
Ricardian equivalence, 173
Saving Rate, 129
School efficiency, 146
Scientific Method, 14
Sectoral Deficit Identity, 25
Share of Capital: , 77, 248
Solow Accounting, 251
Solow Model, 129
Sovereign Default, 160
Structure of the Fed, 226
Substitution Effect, 62
Summary behavior, consumer, 177
Summary behavior, firm, 180
Tax Elasticity of Income, 108
Taxes in the Data, 88
Technology shocks, 93
TFP, 77
Timing of taxes, 173
Total Nonfarm Payroll Employment, 257
Trend, linear, 39
Trend, nonlinear, 48
Underground Economy, 25
Utility Function, 62
Wealth Shares, 119
Working with NIPA tables, 245
World Inequality, 119
Yield Curve, 160
260 of 260

Intermediate Macro

Încărcat de

Informații document

Drepturi de autor

Formate disponibile

Partajați acest document

Partajați sau inserați document

Opțiuni de partajare

Vi se pare util acest document?

Este necorespunzător acest conținut?

Drepturi de autor:

Formate disponibile

Intermediate Macro

Încărcat de

Drepturi de autor:

Formate disponibile

Intermediate Macroeconomics - 73240

This version: April 30, 2014

73-240 Spring 2014

This version: April 30, 2014

Prof. Laurence Ales

Introduction and Methodology

73-240 Spring 2014

Elastic Labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177

12 The End: 7 lessons from this course

This version: April 30, 2014

Prof. Laurence Ales

73-240 Spring 2014

73-240 Intermediate Macroeconomics

Instructor : Laurence Ales

TA 1 : Antonio Andres Bellofatto

Class times: MW 01:30PM 02:50PM in POS MN AUD

Prof. Laurence Ales

73-240 Spring 2014

This version: January 11, 2014

Prof. Laurence Ales

73-240 Spring 2014

This version: January 11, 2014

Prof. Laurence Ales

73-240 Spring 2014

Prof. Laurence Ales

73-240 Spring 2014

This version: January 11, 2014

Prof. Laurence Ales

73-240 Spring 2014

This version: January 11, 2014

Prof. Laurence Ales

Joined CMU in 2008, as an Assistant Professor of Economics

How much inequality in consumption and health should there be?

Make sure to get and read the syllabus!

Details About the Course

Antonio Andres Bellofatto

Macroeconomics - S. Williamson 5/E

Hw, Grading and Exams

Online, live, anonymous feedback system:

Email: for regrading email your TAs first!

Find x: log(x + 1) log(x + 2) = log

We will extensively work with data, review your stats class.

Twitter and News

The class official twitter feed is @cmu73240.

Every week, as a form of digest, I will summarize the most

What is this course about?

Every Slide From The Course

What Are We Going To Study?

From Semantics: large economics systems.

(Hoover) Is the study of the economy taken as a whole; whereas

Microeconomics is the study of a part of the economy, taking the

What type of questions does it try to answer?

How do economic fluctuations come about?

What can we (Government, Fed) do about it?

Why is the US richer than most countries?

How does policy affect growth?

How should taxes and government debt be used?

What Do You Want From This Course?

What Will You Get From This Course?

...Understand and perform simple forecasts of various measures of

...Understand how aggregate macroeconomic behavior is affected by

...Be able to answer simple macroeconomic policy questions by

...Understand the factors that cause economic growth and be able

Normative vs. Positive Questions