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Unemployed: U = NF − N
Setting lnNF = nF
u nF − n
and lnN = n, it follows
Macroeconomics – Definitions and statistical regularities
The numbers of unemployment
p y 6
The behavior of the unemployment rate in Italy is
illustrated in FIGURES 5-6:
5 6:
It is much changed over the years (forty years ago it was
much lower);
It displays large fluctuations up and down (it has been
decreasing of about six percentage points over the 1998-
1998
2007; but in 2008-2009 it increased by two points);
g slowlyy ((“persistence”).
It changes p )
A comparison between the dynamics of the unemployment rate in
Europe the U.S.,
Europe, U S Japan,
Japan and Italy is also illustrated in FIGURE 6.
6
FIGURE 19 illustrates the case of Italy. But one can find a similar
relation
l i also
l ffor other
h countries.
i
W thus
We h h ̃ fu
have P i h f ′ u 0
f with
Thee intercept
te cept w
with
t the
t e vertical
ve t ca axis
a s indicates
d cates the
t e GDP
G growth
g owt
above which unemployment decreases (about 3.6%).
The slope of the straight line measures the reduction in
unemployment associated, on average , to a one-point increase
in GDP (about 0.6%).
This is an elasticity :
Δ lnU/Δ
l U/Δ lnGDP
l GDP
Macroeconomics – Definitions and statistical regularities
Output
p and unemployment
p y in Italyy 15
FIGURE 9 shows that for Italy the relationship between changes
in output and in unemployment is remarkably week
(almost not existent).
See the scatter plot in FIGURE 10, commented in the next slide.
CONCLUSION:
The short-run relationship
between output and labor-utilization dynamics
holds also in Italy (it holds in all countries)
countries).
Macroeconomics – Definitions and statistical regularities
Shocks and propagation
p p g 17
The fluctuations concern the main macroeconomic variables:
GDP (see FIGURE 4), 4) unemployment (see FIGURE 6), 6) and
inflation (see FIGURES 12 and 13). But they concern also other
variables, like exchange rates (see FIGURE 17) and
stockk market
k iindexes
d ((see FIGURE 14).
14)
The origin of fluctuations are generally related to shocks,
that hit the economy, hence altering the equilibrium.
But fluctuations also depend
p on the wayy
in which economies respond to shocks, that is, on
the so-called propagation mechanisms.
The propagation mechanisms, the laws underlying the
behavior of the economy, are different across countries, but
h
have some iimportant common features
f .
Macroeconomics – Definitions and statistical regularities
The oil p
price 18
Its dynamics (FIGURE 16) does provide several examples of shocks:
The first (1973-74)
(1973 74) is an example of permanent shock.
The second (1978-79) is an example of persistent shock.
The third (1986) is an example of negative (persistent) shock
(it is known as “counter-shock”).
There are also temporary
p y shocks ((for instance in 1991).
)
In recent years there is a rising tendency.
Compare these
C h shocks
h k to GDP ( FIGURE 4), 4) unemployment
l
(FIGURE 6) and inflation (FIGURE 12) dynamics.
FIGURE 16 plots the different dynamics for the oil price in dollars,
in euros (lire), and in “real” terms. The “real” oil price measures
the quantity of goods (GDP) that one needs to purchase it.
Macroeconomics – Definitions and statistical regularities
Whyy macroeconomics? 19
The problems illustrated in the preceding slides
( n mpl m nt infl
(unemployment, inflation,
ti n fl
fluctuations
t ti n off GDP) show
h
evident links (Phillips curve, Okun’s law).
1. Output
p ((Y ), which represents
p all g
goods and services
produced (it corresponds to the GDP). It can be consumed
(C ), or used as a mean of production (I ). The means of
production accumulated in the past are capital goods (K ).
2. Labor (N ), which is another means of production (with K ).
3 Money (M ),
3. ) which is the only means of payment.
payment
4. A fixed-income Bond (B ), purchased by those who save.
Q + ΔBS = Mr + WN + rK + π + I + δK
ΔBS = I
About investment :
I Ī
Investment is autonomous (and, for now, exogenous).
The term “autonomous” means that it does not depend on Y.
Let us set:
1
m 1−c M ltiplier
Multiplier
̄ Ī Autonomous expenditure
ĀC Y∗ m Ā
1
1−c
ΔI
Δ
c c 2 c n ΔI ∑ c i limn→
ΔY ΔI1 1−cn1
1
1−c
ΔI
i0
Macroeconomics – Income-expenditure model
Production lag
g 49
HYPOTHESIS: production requires time: it is equal to demand of
the p
previous p
period:
Yt E t−1
Y t Ā cY tt−11 Y t − cY tt−11 Ā
Et Ct It
̄ cY t
Ct C “Finite-difference” (first-order, linear)
equation; it describes the dynamics,
dynamics resulting
It Ī
from the model, of Y over (“discrete”) time.
EQUILIBRIUM: when one has Y t Y t−1 Y ∗. It follows Y ∗ 1
1−c
Ā
DYNAMICS: it is described by the general solution of the finite-
diff r n equation,
difference q ti n given
i nb by
Y t Y ∗ Y 0 − Y ∗ c t
Since c < 1,
1 the second term tends to 0 (there is convergence).
convergence)
Macroeconomics – Income-expenditure model
Saving
g (S
( ) 50
DEFINITION: in general, S = Yd − C . In this model
((without the State)) we have Yd = Y . It thus follows S = Y − C.
SAVING FUNCTION. It _ is derived from
_ the consumption
_ function:
S = Yd − C = Yd − C − cYd = − C + ((1 − c)Yd = − C + sYd
s = 1 − c is the marginal propensity to save (0 < s < 1).
In this model (without the State):
S _
S = − C + sY
S
The graph of the function
i an iincreasing
is i liline with
ith
0
Y negative intercept and
̄
−C
C 1 c
1−c less than one derivative.
Macroeconomics – Income-expenditure model
Saving
g and investment 51
In equilibrium : Y = C + I Y−C=I S=I
It is an equivalent way to write the equilibrium condition Y = E
Recall that S = ΔBD and that I = ΔBS .
Thus S = I ΔBD = ΔBS (equilibrium in the bonds market).
market)
Consistently with the “Walras law”, the goods market leads to
equilibrium also the bonds market (see the GRAPH).
To the right of Y* one has S > I, so
S, I ΔBD > ΔBS , and so Y > E . It then
S follows Δ Y < 0, and so Δ BD < 0.
̄ − cT̄ cTr Ī G
C ̄ Autonomous expenditure
Macroeconomics – Income-expenditure with the State
Budgetary
g y policies
p 57
When there is the State, the equilibrium value Y* depends upon
the values of the “budgetary
g y variables” : G, Tr, T̄ and t.
∂Y ∗
∂G
m0
∂Y ∗
∂Tr
cm 0
One easily obtains: ∂Y ∗
∂T̄
−cm 0
∂Y ∗
∂t
−cm 2 Ā −cmY ∗ 0
ΔG has an expansionary
p y effect on Y ((measured byy the multiplier
p m));
ΔTr and ΔT̄ have an opposite effect (but of equal size);
In general, the increase in the expenditure components of the
government
rnm nt budget
b d t isi expansionary
p n i n r , while
hil th
the in
increase
r in th
the
revenue components is contractionary.
The State is enabled to use the budget to influence the level of Y
in the desired direction (example of “economic policy”).
Macroeconomics – Income-expenditure with the State
Two uses of macroeconomic models 58
A macroeconomic model can be read in two ways:
11. As a description 2 As an instrument to
2.
of what happens: decide “what to do”:
Ri (i = 1,
1 22, …, T ) are the expected future net revenues
Macroeconomics – Investment
The net p
present value criterion 66
Net present value (NPV): it is the difference PV0 − K0.
g R0 = − K0, one has
Setting
T
npv 0 ∑ Ri
1r i
i0
The IRR is
Th i a generalization h concept off profit
li i off the fi rate. Setting
S i T
= 1 we soon obtain, in fact,
R1 −K
K0
K0
IRR criterion:
it i th
the project
j t will
ill be
b undertaken
d t k if ρ ≥ r.
ρ represents the return of one euro invested in the project.
r represents the return of one euro employed in the market.
Macroeconomics – Investment
From the micro level to the macro level 68
Assume that there are N projects available for the aggregate
operator “firms” .
Each investment project Kn ( n = 1,1 22, …, N) has its own ρn .
We can rank the Kn projects in a decreasing order with respect to
the p y, measured byy its own ρn (K1 is the most p
profitability, profitable,,
it follows K2, and so on.)
K1 K2 Ks KN
1 ≥ 2 ≥ ≥ s ≥ ≥ N
The number of the projects undertaken depends on the level of r :
if r > ρ1, then no project is convenient; if r ≤ ρN, all projects will
be undertaken; if r ≤ ρs, the first s p
projects will be undertaken,
and the aggregate level of investment will be
s
I ∑ Kn
n1
Macroeconomics – Investment
The investment function 69
s
If r rises, the summation I ∑ n1 Kn looses terms, and I
decreases;; if r falls,, the summation ggains terms,, and I increases.
We thus have:
I = I(r) with I′ < 0.
Assume a linear specification:
r
I(r)
I Ī − br
The parameter Ī represents the
state of expectations.
The expectations explain the
observed fluctuations of I. 0 Ī I
One could obtain the same result using the NPV criterion instead
of the IRR criterion.
Macroeconomics – Investment
The IS schedule 70
In the income-expenditure model, we had I = Ī . Let us replace it
with the function I = I(r)
( ) . We obtain the solution
Y 1 ̄ − cT̄ cTr Ir G
C ̄
1−c1−t
That is:
Y mĀ − br
where we used the linear specification Ir Ī − br,
and now Ā represents the exogenous component (independent
of r) of the autonomous expenditure
p :
ĀC ̄ − cT̄ cTr Ī G ̄
The multiplier m, instead, did not change.
We no longer have a single equilibrium Y*. We have a “locus” of
equilibrium points, one for each level of r.
Thi “locus”
This “l ” off equilibrium
ilib i points
i iis called
ll d IS schedule.
h d l
Macroeconomics – The IS schedule
The characteristics of the IS schedule 71
The IS identifies all the combinations of Y and r such that Y = E
((such that there is equilibrium
q in the g
goods market).
)
The IS is a decreasing curve (straight line): dY
dr
−bm 0
Economic reason: the increase in r decreases I (since dI −b ),
dr
and the fall in I decreases Y by an amount measured by m.
The intercept on the Y axis is
obviously mĀ . r
bm
So ΔA > 0 moves the IS to the right;
the shift is measured byy the
multiplier (why?);
Δb > 0 makes it rotate downwards
(what is the economic reason?);
Δm > 0 makes it rotate upwards
(what is the economic reason?).
reason?) 0
mĀ Y
Macroeconomics – The IS schedule
“Outside” the IS schedule 72
The points on the IS identify equilibrium combinations (of Y
goods market. On the IS we have Y = E.
and r ) in the g
What happens outside the IS? Obviously there is no equilibrium.
To the right of the IS we have Y > E.
In fact, we have Y mĀ − br E .
According to the effective demand principle,
r
Ẏ Y E − Y
If the system is to the right of the IS,
Y>E o tp t tends to decrease.
output decrease
To the left of the IS we have Y < E.
According to the effective
Y<E demand principle, if the system
p
is to the left of the IS, output
0
Y tends to increase.
Macroeconomics – The IS schedule
The IS with g
generic functions 73
To obtain the IS, we have assumed that the consumption and
investment functions were linear.
Its main properties hold also with generic functions.
Assume C = C(Y) with 0 < C ′ < 1, and I = I(r) with I ′ < 0.
The IS equation then will be Y = C(Y) + I(r) + G ,
and thus also, taking variations, dY = dC +dI + dG .
To find dY, compute the total differential:
dY C ′ dY I ′dr dG
S i dG = 0,
Setting 0 one easily
il obtains
b i the h slope
l off the
h IS
IS:
dY I′
(1)
dr
1−C ′
0
Setting dr = 0, one easily obtains the effect of dG:
dY 1
(2) dG
1−C ′
1
Note the correspondence of (1) and (2) with the results in slide 71.
Macroeconomics – The IS schedule
The bonds p
price and the interest rate 74
What is the relationship between Pb and r?
EXAMPLE 1 ((“zero-coupon”
p bond):) the bond ggives the right
g to a
certain payment Rb after one year; how much is one willing to pay
it today? Not more nor less than its present value:
P b 1Rbr
Two questions :
1. What is the link between monetary base and money supply?
2 Who does make the monetary base circulate? And how?
2.
Macroeconomics – Money supply
Monetaryy base and moneyy supply
pp y 85
Let us indicate by γ the currency-deposit ratio:
Cu
De
Let us indicate by δ the reserve-deposit ratio :
Re
De
We thus have:
H C u Re De D
e
D
e
And also:
M Cu De De De 1 De
Deriving De from H and substituting into M, one obtains:
1
M
H H
W h
We have α > 1.
1 Hence
H i a multiple
M is l i l off H.
Macroeconomics – Money supply
The deposit
p multiplier
p 86
1
The coefficient is called deposit multiplier.
The reason for this denomination becomes clear if one examines
how a variation ΔH generates a multiple variation ΔM.
Suppose that private agents come into possession of a given
amount off cashh ΔH. They
Th will ill di
distribute
ib iit b
between currency andd
deposits according to the parameter γ: ΔH = γΔDe + ΔDe = (γ +
1))ΔDe. We thus have a first creation of banks’ deposits
p equal
q to
1
ΔDe 1 ΔH . Banks will create a reserve ΔRi 1 ΔH
and lend to the rest of private agents, who in turn, as before, will
hold a share γ in terms of currency,
currency depositing the remaining
amount. It can easily be shown that the deposit propagation
process is described by the geometric series
j
ΔDe ΔH
1
∑ j0
1−
1
ΔH
ECONOMIC TRANSACTIONS:
• transactions
i off goods
d and d services;
i
• transactions of financial assets (bonds);
• transfers
transfers.
Macroeconomics – “Open” economies
The balance of payments
p y 108
It records all economic transactions between
“residents” and the “rest of the world”.
world”
Residents’ revenues are recorded with the sign plus; payments are
recorded with the sign minus.
We will indicate by Bp the balance of payments.
The current account balance (Bc) is the difference between
revenues and payments associated to the transactions of goods
and services.
The capital account
acco nt balance (Bk) is the difference between
bet een
revenues and payments associated to the transactions of bonds.
The following g identityy holds:
Bp = Bc + Bk
Y − T Tr C ΔBDH ΔL
FIRMS:
ΔB SF I
STATE:
T ΔB SG G Tr
TWO OBSERVATIONS:
• The State does not issue moneyy (the
( central bank does it);
);
• The purchases of goods by agents (C, I, G) can concern both
domestic products (Y ) and foreign products, i.e., imports (Z ).
D(e) = S(e)
This equation determines the equilibrium exchange rate e*.
Graphically, it is identified by the intersection point between the
demand curve and the supply curve.
If the
h exchange
h rate iis hi
higher
h e
that the equilibrium one (e > e*), $D $S
the demand for currency is lower
than the supply ($D < $S), so that
the exchangeg rate tends to fall e*
( de
dt
0 ). The opposite occurs
when e < e* .
Th this
Thus, hi equilibrium
ilib i is bl . 0
i stable $* $
Macroeconomics – “Open” economies
Fixed exchange
g rates 118
We have a fixed exchange rate when the central bank intervenes
in the currency market with the rule Δ$BC = $S − $D (see slide 115).
Three main cases:
• EXCHANGE RATE AGREEMENT. The central bank of a countryy
draws up a treaty with the central banks of other countries in
which it commits itself to keep the exchange rates fixed;
• UNILATERAL “PEGGING”. The Th centrall bank
b k off a country
commits explicitly itself to keep its own exchange rate linked to
the currency of another country;
• EXCHANGE RATE MANAGEMENT. The central bank of a
countryy systematically
y y intervenes to keepp stable the exchange
g
rate also in the absence of an explicit commitment.
Fixed exchange rates require availability of currency reserves to
finance interventions implying currency sales.
Macroeconomics – “Open” economies
Open
p economyy and macro-equilibrium
q 119
In relation to the exchange market, one must distinguish between
the very short run (the single day), the short run (the year), and
the long run.
With respect to the very short run, see slide 116.
In h short
I the di i $D = $S, determining
h run, condition d i i theh equilibrium
ilib i
exchange rate, coincides (see slide 112) with condition
Bp = 0
According to the Walras law (see slide 113), a balance of payment
equal to zero is linked to what occurs in the goods, bonds, and
money markets, i.e., to the macroeconomic equilibrium.
This issue should thus be studied in the context of the IS-LM
model. Such a framework must, however, be modified to take into
account that the economy is “open”. This extension is called
“Mundell-Fleming” model
Macroeconomics – Open economy and macroeconomic equilibrium
The three fundamental equations
q 120
There are several versions of the Mundell-Fleming model. We will
see four. In all these versions, we will work under the assumption
of “small country” (see slide 110). So what happens within our
economy does not affect the economy in the rest of the world.
All versions are based on three equations :
E=Y equilibrium in the goods market (the IS);
L=M equilibrium in the money market (the LM);
Bp = 0 balance of payment equal to zero (the BB).
One can show, after some algebra, that this derivative is positive
(i e the increase in the exchange rate improves the current
(i.e.,
account) if the “Marshall-Lerner condition” holds, that is, if:
X Z 1
Macroeconomics – Open economy and macroeconomic equilibrium
The Marshall-Lerner condition 123
We have just seen that its formula is
ηX + ηZ > 1
where ηX and ηZ are, respectively, the elasticities of exports and
imports with respect to the (real) exchange rate:
dX
X X
/ dvv dX v
d X
dv
Z − dZ
d
dv
v
Z
Instead monetary
Instead, monetar policy
polic
(the shift in the LM) rF BB
is p
possible andd effective.
TRANSMISSION MECHANISM: the
increase in v stimulates the
current account and moves the IS. 0 Y* YN Y
Macroeconomics – Capital mobility and flexible exchange rates
Another development
p of the IS-LM model 142
In the foregoing slides we have studied both “closed” and “open”
versions of the IS-LM model.
Role for economic policy :
“CLOSED” VERSION. Policy y is “omnipotent”:
p it can always
y
bring Y* (and also r* ) to the desired level, managing
appropriately budget variables and money supply.
“OPEN” VERSIONS. Things, for economic policy, become less
simple, but (with certain exceptions) still possible.
In the next slides we will study another development of the
model: what happens when the price level P becomes and
endogenous
d variable
i bl ?
FIRST STEP: what is the effect on macroeconomic equilibrium
(described by the IS LM model) of a variation (exogenous) in P ?
IS-LM
Macroeconomics – Aggregate demand
Nominal variables and real variables 143
Let relax the hypothesis that P P̄ 1 . The distinction
between nominal variables and real variables becomes relevant.
NOMINAL VARIABLES: are those expressed in units of account.
REAL VARIABLES: are those expressed in units of domestic
product. They are derived dividing the corresponding
nominal variables by P.
W are more concerned
We i h reall output (which
d with ( hi h affects
ff
employment) than nominal output.
ABSENCE OF MONEY ILLUSION: consistently with the hypothesis
of rationality , economic choices depend on real variables
and relative p
prices ((that are p
prices in units of account
divided by P).
The symbols
y of the foregoing
g g models indicate, unless explicitly
p y
noticed, real variables: Y is real output, C real consumption,…
Macroeconomics – Aggregate demand
The IS-LM model with P variable 144
If the hypothesis of absence of money illusion holds, in the IS
nothingg changes,
g , exceptp that now all variables are real:
Y mĀ − br
Also money demand is expressed in real terms:
L kY − hr
̄ ).
But the central bank controls the nominal money supply (M
Thus, the LM must be written as follows:
̄
M
P
kY − hr
that is, the real money supply equals the real money demand.
Solving the model with the usual procedure yields
̄
M
Y m1Ā m2 P
T
This result shows that P has real effects
ff : ΔP > 0 → ΔY < 0.
Macroeconomics – Aggregate demand
The aggregate
gg g demand curve 145
The graph of the function Y m 1 Ā m 2 MP̄ (with Y in abscissa
and P in ordinate)) is a decreasing g curve, asymptotic
y p with respect
p
to the abscissa axis. It is called aggregate demand curve (AD).
The AD curve gives, for each value of P, the quantity of output
that firms can sell (recall that the AD has been derived by the IS-
LM model, so that one has, indeed, Y = E).
Th position
The i i off the
h AD d dependsd P
on A and M: we have ∂Y ∂A
m1 0
(A controls the vertical
asymptote) and ∂M ∂Y
mP2 0 . So
ΔA > 0 and/or ΔM > 0 move the
AD curve to the right.
Therefore, economic policy AD
controlsl the
h AD position.
ii 0 Y
Macroeconomics – Aggregate demand
Variations in P and “Keynes’
y effect” 146
̄
From the AD it follows that − m 22M 0. What is the
dY
dP P
transmission mechanism from P to Y ? Recall that P appears in
the LM. A decrease in P implies an increase in real money supply;
thus, it shifts the LM downwards and, as consequence, generates
an expansionary effect on output Y.
In the graph, the LMO position depends on M ̄ /P O . We have Y = YO .
If we move ffrom PN < PO , we r LMO
have an increase in real money IS
̄ /P O M/P
supply ( M/P
M ̄ /P N ), and
M LMN
the LM shifts downwards.
Output increases (YN > YO ).
The mechanism is the same of
the Keynes effect (see slide 105),
but is triggered by ΔP. 0 YO YN Y
Macroeconomics – Aggregate demand
Wealth effect 147
The Keynes effect meets a limit in the interest rate decline (the
liquidity
q y trap). g about dY
p) But there is another effect that brings dP
0
along the AD: the wealth effect (or Pigou effect).
Households’ WEALTH is ggiven byy the overall goods,
g , bonds and
money that they have: PK + M + B.
REAL WEALTH: is derived dividing wealth by P:
MB
K P
P2
P MR P1
0 Y 0 Y1 Y2 Y
Y*
Macroeconomics – Aggregate supply
pp y curves to the AS schedule 151
From supply
It is easy to move from the supply curves of the single firms, in
which the single quantity produced depends on the single price,
price
to the aggregate supply curve (the AS schedule),
in which domestic product Y depends on the price level P.
It is sufficient to aggregate the single productions (like one does,
precisely,
p y for domestic product)
p ) and observe that each of these
productions increases (hence making Y increase)
when the corresponding price rises. But when the single price
i
increases, also
l their i h d) average,
h i ((weighted)
that is, the general price level P increases.
As a result, there is an aggregate relation between Y and P. Such a
relation (i.e., the AS schedule) is increasing if the individual supply
curves are increasing,
increasing that is,
is if marginal costs are increasing.
increasing
Macroeconomics – Aggregate supply
The marginal
g cost function 152
To derive the supply curve, it is enough to derive
thee marginal
g cost function:
cos u c o : MC dTC
dY
Let consider total cost: TC = WN + (r + δ)PK.
Let assume that the wage is fixed in the short run : W W ̄.
Let set (r + δ)PK = Cf (it is the fixed cost). Thus TC = W
̄ N + Cf .
It follows that marginal cost is MC dTC ̄ dN .
W
dY dY
It is convenient to rewrite it as:
̄
W
MC dY/dN
Marginal cost is equal to the ratio of wage to the marginal
productivity of labor. This
T has a clear economic meaning.
Marginal cost is increasing if dY/dN is decreasing.
In perfect
f competition,
ii dY/dN must be
b d decreasing.
i
Macroeconomics – Aggregate supply
Marginal
g productivity
p y 153
Let us suppose that the technology to produce Y, with the
employment
p y of N and K, is described byy a Cobb-Douglas
g
production function with constant return to scale: Y N K1− .
In the short run, K is given. For simplicity, we set K = 1.
Th aggregate production
The d i ffunction i bbecomes ((see theh GRAPH):
)
Y = Nα
dY
We have dN N −1 0
(positive marginal productivity) Y Nα
2
and d Y2 − 1N −2 0
dN
(decreasing marginal productivity).
Y N* N U = NF − N*
Macroeconomics – The AD-AS model
Labor and leisure 159
Not all unemployed are equal. To clarify this point, we need to
introduce labor supply
pp y in the ggraph.
p
Let us start with the budget constraint of a consumer:
PC = WN + R
Disposable income (all consumed, for simplicity) is given by the
sum of labor income WN and other incomes R.
There is a second constraint : T = TL + N.
Disposable time (T, which is exogenous)
must be distributed between leisure (TL) and labor N.
Substituting
g the second constraint in the first and rearranging,
g g,
one obtains:
WTL + PC = WT + R
which
hi h h
has the
h characteristics
h i i off a standard
d db budget
d constraint.
i
Macroeconomics – The AD-AS model
The budget
g constraint and the choice 160
The consumer must decide how to distribute her given resources
of time (WT) and income (R) between leisure (TL) and
consumption (C), given the two prices W and P. The wage is the
price of time, since it is an opportunity cost: one unit of TL
implies that the individual forgoes income obtainable with one
unit of labor, that is exactly W.
GRAPH: the budgetg constraint C
starts from point E; the
consumer can choose of not
rkin (TL = T) and
working nd
consuming C RP . Or she can R E
P
choose, working, along all NS
points of the colored segment, 0 T ∗L T TL
whose slope is given by the real wage W/P.
The choice is identified by the highest indifference curve.
Macroeconomics – The AD-AS model
Labor supply
pp y 161
As long as the real wage increases, the budget line becomes
steeper
p ((alwaysy hinging
g g on point
p E)). The choice shifts to a higher
g
indifference curve. Does labor supply increase?
It depends. It increases if the W NS
substitution effect (leisure P
becomes relatively more costly)
pr il on
prevails the income
n th in m effect
ff t (the
(th
higher wage makes the consumer
richer and induces her to work
less). We will suppose that this is
the case. 0 NF N
Then, let assume, at aggregate level, that the labor supply function
dN S
increases along with real wage ( dW/P 0 ). We shall suppose that
the
h growth h will
ill slow
l d down when
h approaching b fforces NF.
hi llabor
Macroeconomics – The AD-AS model
Involuntaryy unemployment
p y 162
Let incorporate labor supply in the SECOND GRAPH. The real wage
̄ /P ∗ determines
W
P AS W/P ND NS NF labor supply.
Two types of
̄ /P ∗
W unemployment emerge:
P* involuntary
AD U unemployment
l iis given
i
by N S − N* (are those
Y* Y N* S
N NF N
Y Y who want work at wage
45° Nα
W̄ /P ∗);
Y* voluntary unemployment
is given by NF − NS (are
those who want more).
Y N* N
Macroeconomics – The AD-AS model
Nominal wage
g and the “long
g run” 163
The distinction between short and long run has several meanings.
In relation to the labor market, it means what follows:
ASL
B
PB (W/P)B B
L
PL
(W/P)L L
AD
0 YB YL Y 0 NB NL NF N
NL is full employment; YL is potential output.
Macroeconomics – AD-AS and the long run
Economic p
policyy and “full employment”
p y 165
One can arrive at NL and YL without waiting the decrease in W.
Economic p policyy is able to move the AD to the right,
g ,
with ΔA > 0 and/or ΔM > 0 (demand management).
GRAPH ON THE LEFT: in this case W is fixed, but P increases.
GRAPH ON THE RIGHT: theh arrival
i l point
i ddoes not change
h (h
(however
the time of adjustment is shorter).
P AS W/P ND NS
L
P1
B B
P0 (W/P)B
AD1 L
(W/P)L
AD0
0 YB YL Y 0 NB NL NF N
(W/P)L is the same of the previous slide.
Macroeconomics – AD-AS and the long run
Imperfect
p competition
p 166
The version of the AD-AS model so far shown is Keynesian.
Usually,
y, however,, in the Keynesian
y versions one assumes
imperfect competition in the goods markets.
W respect
With p to the AD,, nothing g changes
g ((it remains as before).
)
With respect to the AS, something changes:
(i) firms are price maker;
(ii) firms face a decreasing demand curve.
dY
So one has dP
0 . Then, it follows:
d dP
dY
0 → P Y dY
MC
where the left-hand-side expression is marginal revenue (MR);
note that (as expected) one has MR < P. One also has
1
MR P Y dPdY
P 1 Y dP
P dY
P1 −
where η (eta) is firm’s demand elasticity.
Macroeconomics – AD-AS and imperfect competition
Mark-up
p and constant p
productivityy 167
From the maximum profit condition MR = MC, that is
̄
P1 − 1 dY W
d /dN
d
we derive the relationship between P and Y (i.e., the AS schedule):
̄
W
P dY/dN −1
MC1 z
Since η > 1 (why?) we have P > MC. We indicate by z 1−1 the
mark-up over marginal cost.
We will assume that the mark-up z is an exogenous parameter.
With h production
Wi h respect to the d i ffunction i , we make
k the
h hhypothesis
h i
that Y = XN
where X is an exogenous parameter representing the average
productivity (Y/N = X ) and the marginal productivity (dY/dN = X ).
h assume a constant marginal
We thus i l productivity
d i i .
Macroeconomics – AD-AS and imperfect competition
The AD-AS with imperfect
p competition
p 168
With the hypotheses of the former slide, the AS schedule becomes:
W
P X
1 z
P W/P NS
W X
X
1 z
1z and is horizontal: (on the
right-hand-side
i h h d id thereh are
P0 ND
AS only constant terms).
AD Th production
The d ti
Y* Y N* NS N function Y = XN is
Y
45°
Y an increasing line.
XN Also labor demand is
Y* horizontal.
We obtain it from the AS:
W X
P
1z
Y N
Macroeconomics – AD-AS and imperfect competition
Mark-up
p variations 169
Effect of an increase in z on the macroeconomic equilibrium.
It can soon be verified that P increases and Y decreases:
dP
W
0 and hence dY dY dP
−m 2
M W
0
dz X dz dP dz P2 X
Let draw the graph: Δz > 0 moves the AS schedules upwards,...
upwards
What does the level of z depend on?
1 COMPETITION DEFICIT. It is measured by the degree of
1.
monopoly Cm1z −Cm
g m P−Cm
P
Cm1z
z
1z
dg m 1
which is a direct function of z: dz
0
1z 2
In p
perfect competition,
p , we have P = MC and hence z = 0.
2. COSTS DIFFERENT FROM LABOR. For instance, the costs of raw
materials and energy (the effect of an increase in the oil price
can be seen as Δz > 0).
Macroeconomics – AD-AS and imperfect competition
Distributive shares 170
The mark-up, quantifying the firms’ market power by firms, also
affects distributive shares:
s W WN
PY
wage share of workers
s PY−WN
PY
1 − sW profit share of firms
PERFECT COMPETITION. From the AS schedule one obtains:
P W−1 Y/N
W
→ WN
PY
N
Thus we have s W and s 1 −
IMPERFECT COMPETITION ((we use the
h same production
d i ffunction i to
facilitate the comparison):
W
P Y/N 1 z → s W 1z and
d also
l s 1 − 1z
We soon see that: 0 and dsdz 0
ds W
dz
The mark-up enlarges the profit share and reduces the wage share.
Macroeconomics – AD-AS and imperfect competition
Pareto-efficiencyy 171
DEFINITION. An allocation is Pareto efficient when it is not
possible improving the position of an agent without worsening
the position of another agent. Pareto-efficiency is equivalent
absence of wastes (all resources are employed at best).
If there is no full employment, there is
inefficiency
(not all resources are utilized).
If full employment occurs, is there efficiency? Not always.
There is efficiency if the market is perfectly competitive
(the first theorem of welfare economics).
If there is imperfect competition,
even in the long-run equilibrium (with full employment) the
allocation is Pareto-inefficient
Pareto inefficient.
Macroeconomics – AD-AS and imperfect competition
Imperfect
p competition
p and inefficiencyy 172
Under imperfect competition (monopoly), the market chooses
point M. It is inefficient since there are buyers willing to pay an
additional unit of the good by more than the cost needed to
produce it: in the monopolist’s chosen point we have SMB > SMC.
Social marginal benefit (SMB): is what society is willing to spend
to have one more unit of y. Social marginal cost (SMC): is how
much it costs society to produce one more unit of y.
p The optimal point is C (what we would have in perfect
competition); but is a point that the monopolist will never
choose spontaneously, since she would not get profits.
pm M Are point C and point M
comparable? No, it would seem
pc C (i C the
(in h monopolistli iis worse);
)
MC = SMC
but the comparison is possible
MR D = SMB ((buyersy could indemnifyy the firm). )
0 ym yc y
Macroeconomics – AD-AS and imperfect competition
The AD-AS model and Pareto-efficiencyy 173
Condition such that there is Pareto-efficiency: P = Cm.
Equivalent condition: WP dN dY
.
In imperfect competition, we have: P = MC(1+ z) > MC. Thus, the
equilibrium (also the long
long-run
run one) is Pareto-inefficient.
Pareto inefficient
We also have W X X dY (confirming the inefficiency).
P 1z dN
The equilibrium employment is NL;
W/P NS The efficient one is NP, that would
X
P occur if the real wage
g was equal
q to
the marginal productivity of labor
X L
1z
ND (X).
Spontaneously, the market will
never reach NP. Can economic
0 policy do it?
N L N P N
Macroeconomics – AD-AS and imperfect competition
The AD-AS model with logarithms
g 174
Before answering the question in slide 173, it is convenient to
rewrite the model using logarithms.
logarithms Two advantages:
(1) simpler equations; (2) possibility of studying inflation.
The model:
(AD) y = μ1a + μ2(m − p)
(AS) p = w − x + z
The AD is not the same equation we have written in levels, but it
has a very similar meaning: output (y) depends positively on
autonomous expenditure (a) and real money supply (m − p). The
two coefficients μ1 and μ2 are not multipliers
p but elasticities.
st
s.t. P̃ u L − u
Macroeconomics – The Phillips Curve
The choice: “optimal”
p inflation 191
The solution can be found graphically: the point of the Phillips
curve corresponding
p g to the lowest indifference curve ((the tangent
g
one). We find u* and P̃ *. P̃
Or u* and P̃ * can be computed
solving the system
P̃ *
MRS
P̃ u L − u
u* uL u
The marginal rate of substitution is:
∂L/∂u 1− u
MRS
∂L/∂P̃ P̃