Econ603:Advanced

Macroeconomics I
Worku Gebeyehu (PhD)
Department of Economics
Addis Ababa University

Email:
1workugebeyehu@aau.edu.et.
 2

Course Content and Assessment

1. Course Content
 Econ 603: Advanced Macroeconomics –a standard graduate
level that is given in most universities.

 Aim of the Couse: Enable students to have a sound

understanding of contemporary macroeconomic theories and
concepts and understand journal articles and other researches
with regards to:

 What they are trying to establish?

 What assumptions they made?
 What models they used?
 What steps they followed in the in the derivations of
results?
 What conclusions have they made?
 What lessons have they learnt?
 How do we apply the theory and research outputs to the
context of Ethiopia?
 3

Course Content
The course contains the following contents:
1. A Review of Schools of Macroeconomic Thoughts
(Classical, Keynesian, Monetarist, Neo-classical,
New Classical, New Keynesian, Real Business
Theory);
2. Aggregate Demand and Aggregate Supply;
3. Aggregate Consumption & Savings;
4. Investment;
5. Money Demand and Supply;
6. Credit and Banking;
7. Open Economy Macroeconomics –Balance of
Payment and Exchange Rates;
8. Deficits and Inflation;
9. Fix-price Models
 4

Course Assessment
Course work evaluation involves two deliverables.
1. A continuous Assessment – a combination of
assignments, exercises, tests, mid-term exams,
etc. About 40%
2. Final Examinations – About 60%
3. The passing grade for the course is to score a
minimum of B.

References
• Any Graduate Level Macroeconomics text book
can be used including the following.
• BEN J. HEIJDRA, Foundations of Modern
Macroeconomics, 2004/2009.
• David Romer, Advanced Macroeconomics.
 Chapter 1
5
Lecture 1: Major Macroeconomics School of
Thoughts

 include:

 Classical economists
 Keynesians
 Neo-classical synthesis (neo-Keynesian synthesis)
 Monetarists
 New-Classical economists
 Supply-siders
 New-Keynesians
 6

Macroeconomic Thoughts …
 Two major distinguishing issues among different
thoughts
 Can the government influence the outcome of the
economic process?
 Should the government influence the economic
process?

 Thereactions: broadly divided into two.

 Broadly defined “Keynesian economists”
generally answer “yes” to both questions.
“Broadly Classical economists” respond “yes” to
the first and “no” to the second question.
What do schools briefly say?
 7

A. Classical
 Adam Smith, David Hume, David Recardo, John
Stuart Mill, Knut Wicksell, Iriving Fisher and the 1930
Keynes.
 Ups and downs in economic activities are reflected
in ups and downs of prices;
 Prices are flexible; imbalances are short-lived;
economic agents react to prices; markets through
prices ensure equilibrium.
 Government can affect the economy; but not
effectively ensure equilibrium.

B. Keynesians
 Main Ones: Keynes (1930’s), Hicks (1937),
Modigliani (1944), Tobin (1958).
 Prices are upward sticky; wages do not adjust
rapidly.
 Private operators create dis-equilibrium because
of pessimism and animal sprit.
 8
B. Keynesians
 Market failure and involuntary unemployment exist.
 If demand declines firms may not be able to reduce
wages and sell products at lower prices; but may layoff
workers and reduce output; resulting lower employment
and lower output if left to the market.
 Government with the use of FP and MP can create
additional jobs and output. How?
 If firms maintain nominal wage but an increase in money
supply may increase prices (quantity theory money) and
this will lower real wages and enable firms to increase
their labour demand.
 Assuming money illusion, employment increases and
output increases.
 No guarantee for price flexibility and in the long-run, we
all die. Thus, A need for government intervention.
 9

C. Monetarist
• Main: Friedman, 1968.
• The use of MP may increase employment but cause
inflation (Trade-off – Stagflation-Philips curve);
• Money supply instability (because of MP) is a usual cause
for output fluctuation;
• Output deviation from natural employment level through
money illusion is temporary;
• In the long-run, there is no trade-off between output and
employment; the economy operates at natural rate of
unemployment;
• An increase in nominal wage translates into expected
rate of inflation.
• Markets are self-regulating; a need for stable money
supply; minimal government role to correct market
imbalance.
 10

D. New Classical
 Main: Lucas (1981), John Muth (1960s’).
 Economic agents form rational expectations about the future and
make optimal decisions that maximize their benefits.
 Forecasts are on average accurate; deviations are random.
 The economy is inherently stable. If there is deviation, factor and
output prices adjust to equilibrate demand and supply.
 Government interventions (FP &MP) destabilize the economy.

3 Main arguments:
 Policy ineffectiveness: Random/arbitrary MP can have SR real
effect as it is not anticipated by rational economic agents
(Sargent & Wallace, 1975, 1976); but if anticipated no effect.
 Keynesian macroeconomic models do not provide accurate
prediction on the effect of policy changes on macro variables.
 Economic performance improves if government does not have
discretionary/flexible power.
 11
E. New Keynesian
 Main: Oliver Blanchard, Gregory Mankiw, Edmund
Phelps, David Romer and Joseph Stiglitz
 They consider
 (a) Rational expectation hypothesis;
 (b) Markets fail to clear because of price and wage
stickiness and
 (c) The Friedman Natural Rate of Unemployment
Hypothesis: No trade-off between unemployment
and inflation.
 Demand and supply shock cause inefficient
fluctuation in output and employment.
 Stagflation arises because of mostly supply shocks
(cost push inflation);
E. New Keynesian
12

 Markets may not clear though agents are

rational/optimizing; why?

 Information problems and transaction costs for

change make prices to be rigid.

 If actual rate of unemployment remains above

the natural rate for a longer period, the natural
rate may also increase.

 Government improves macroeconomic

performance and the economy.
 13

G. Supply Siders or Real Business Cycle Theories

 Main: Kydland and Prescott (1982), Long and Plosser

(1983).
 Economic fluctuations, from natural rate of output, are
caused mainly by real or supply side shocks–such as
technology; not necessarily from unanticipated demand
side shocks;
 Stabilization policy are less effective to control
fluctuation.
 Attempting to reduce instability (ensure equilibrium)
reduces welfare (against both Keynesian and Classical) .
 Both Classical and Keynes: Departure from full-
employment is disequilibrium and affect social welfare,
but for
 Real Business Cycle: Each stage of business cycle (boom
or slump) is an equilibrium.
 Markets are efficient to achieve best outcomes.
 14

Building blocks Macroeconomic Models

For further discussion of macroeconomic thoughts,
let as derive AD & AS.
(i) IS-LM-AD model in Closed Economy
Product Market Y = C + I + G,

C = c(Y− T ), 0 < c < 1, MPC

I = I (R), IR < 0,

T = T (Y ), 0 < TY < 1,
where
I is investment (in capital goods, e.g. machines, buildings,
change in inventories, etc).
G is government consumption.
T is taxes; (Y − T ) is after tax income or disposable income).
T (Y ) is the tax function and TY is the marginal tax rate.
 15

Building blocks Macroeconomic Models

Slope of IS curve:

Y  c(Y  T (Y ))  I ( R)  G  dY  c(dY  TY dY )  I R (dR)  dG

dY  c(1  TY )dY  I R dR  dG
I R dR  dG
dY  .....(1) or
1  c(1  Ty )

1  c(1  Ty )dY  dG
 dR
IR
dR 1  c(1  Ty )  (dG / dY )

dY IR
 16

Building Blocks…
The money market: Two main motives for holding
money:
 transaction which depends on income (Y)
 Speculative which depends on interest rate (R).
 Nominal money supply (M) is exogenously
determined.
 Real money supply equals real demand for money
at equilibrium.
Money Market RMS=RMD
M/P = L(Y, R), LY > 0, LR ≤ 0
 17
Building Blocks…
 Given the implicit function, the slope of the LM is given as:
M M 
 L ( R, Y )  d    kY dY  l R dR
P  P 
Solving for dR to get:

 M    M  
d  P 
 Y 
k dY d  P  / dY  kY

dR      ......( 2) or dR     
lR dY lR
dR ky
  0, becuase l R  0
dY lR
 Given exogenous M/P , the LM curve summarizes the locus
of interest rate and income that makes the money market
equilibrium (Figure 1.1).

 The slope of the LM curve is the source of disagreement

among the different schools of macroeconomic thoughts.
 18

Building Blocks…
Figure 1.1: LM curve
Panel B
Panel A

Panel C
Panel D
 19
Building Blocks…
 Slope of IS curve:

I R dR  dG
dY  .....(1)
1  c(1  Ty )

 Slope of LM curve:

 M  
d  P   kY dY 
dR     
lR …. (2)
 20

Building Blocks…

 Combing IS and LM gives AD curve.

 To find the slope of the AD curve we substitute (2)
or the value of dR into (1):
 I R [( d M P)  kY dY ] 
   dG
dY   lR  ...(3)
1  c(1  TY )
 To solve for dY
I R [( d ( M P )  kY dY ]
[1  c(1  TY )]dY   dG...( 4)
lR

I R kY I R d ( M / P)
[1  c(1  TY )  ]dY   dG...(5)
lR lR
Building Blocks… 21

 Manipulation of Equation 5 gives the equation of AD

curve as:
 IR   dM dP 
dG   ( M / P )  
 lR  M P 
dY  ...( 6)
1  c(1  TY )  I R kY
 Note that: lR
P(dM )  M (dP) P(dM ) M (dP)
d ( M / P)  2
 2

P P P2
dM M dP M
  ; if we bring out
P P P P
M  dM dP 
  
P M P 
 AD is expressed as combinations of Y and P (given
M and G being exogenous) that ensures both the
product and the money market to be at equilibrium
given exogenous G and M.
Building Blocks… 22

(ii) Aggregate supply

 Technology: assume the economy operates with a
production function of the form:
Y  F ( N , K )...(7)
 Assume the production function satisfies the
following properties:
 Constant returns to scale
 Positive marginal products: FN  0; FK  0
 Diminishing returns ; FNN  0,FKK  0
Building Blocks… … 23

 Assuming a competitive market, with fixed K, the

objective function of the representative firm is to
maximize profit subject to employment:
max   PY  WN
N …. 8
 
 PF N;K  WN
where Y  F ( N , K )
 P denotes the price level;
 W denotes nominal wages and WN is the total
reward for labour;
 Nominal profit ( П ) is a reward that accrues to
owners of capital stock;

 FOCs: d dF ( N , K )
 0; P  W  0...(9)
dN dN
Building Blocks… 24

 FOCS imply that the representative firm keeps on

increasing employment (N) up to the point where
MRPL equals the wage rate and at the breakeven
point
dF ( N , K )
W / P
dN
 This can be shown using graph 1.2.

 Maximum profit occurs at point A, where the slope

of the production function (MPL) times its price
equals the slope of the wage bill line, which is the
wage rate.
 At point B, no profit; where the slope of PF declines
while the slope of the wage bill remains the same.
 25
Building Blocks…
Figure 1.2: profit maximization
Building Blocks… 26

(iii) Labour Demand Function

 FOC is simply an “implicit function” relating labour
demand (ND) to the real wage(W/P) and the capital
stock(K):

 
PFN ND;K  W  FN ND;K    W
… (10)
p
 Equation (10) shows the relationship between ND,
W/P and K.
 Totally differentiating both sides of (10) to get:

dFN ND;K  d  
 W … (11) gives

 p 

W  W 
FNN dN  FNK dK  d    d    FNK dK  FNN dN D ...(11a)
D

P P
 27
Building Blocks…
 In short, the demand for labour can be expressed as:
D 1  W  … (12)
dN  d    FNKdK 
FNN   p  
W 
N D  N D  , K , with
 or P 
dN D 1
  0;
 (W / P) FNN
 (dN D ) F
  NK  0; FNK  0...(13)
 (dK ) FNN

 Equation (13) indicates labour demand decreases with

an increase in real wages and increases with K [as K
increases MPL increases and thus increases ND].
 Effects of changes in real wages and capital stock on
labour demand can be shown by Figure 1.3.
 28
Building Blocks…
Figure 1.3: Demand for labour and capital stock
 29

(iv) Supply of labour by households

 Assuming total endowment of a representative
households is normalized to unity, a utility
function of a representative household is given
by

U  U C,1  Ns 
…(14)
Where:
 C: consumption
 N s: The supply of labour-spent for working by the
household
 U: Household utility
 1- N s: Leisure of the household.
 30

Building Blocks…
 Properties

(i) UC  0,U1 Ns  0

(ii) UCC  0,U1 Ns ,1 Ns  0

 Budget constraint
PeC  WNs …. (15)
 (15) Says expected consumption expenditure =
Labour income
 Pe is expected price level.
 Labour income (WNs) is the only source of income
 Utility maximization subject to budget constraint:

max U  U C,1  Ns s.t. PeC  WNs … (16)
 31
Building Blocks
Alternative formulation:
 W  
max U  U  e  Ns,1  Ns 
 P  
WN
C
Given (15), we have = Pe
FOCs: dU
0
W
U U 0
s  e C 1 Ns
dN P 

 Two elements:  W 
 e  UC
 MU of consumption = P 
 Marginal benefit of supplying one extra unit of labour
 By working more , the HH obtains more income and
increase consumption
 Marginal utility of leisure = U1Ns
 Measures the (opportunity) cost of supplying an extra
unit of labour for work; leisure decreases with the
amount of labour supplied.
 32

Building Blocks …
Private cost-benefit analysis determines the optimal
values of C and Ns.
Figure 1.4 plots consumption (C)on the vertical line
and leisure (1-NS)on the horizontal line as real wage
varies.

Initial expected real wage rate is (W/Pe )0

W
The budget goes through C0   e 
 P 0
on the C-axis and 1
on the 1-Ns axis.

Optimal consumption choice occurs at E0 where

MB=MC at consumption C0 and leisure
S
1 N 0
 33

Building Blocks …
Figure 1.4: The consumption-leisure choice
 34

Building Blocks …
Now suppose expected real wage has increased to
(W/Pe)1.
The budget rotates to the right or clockwise. The
new tangency on the C-axis is C  W .N S
1 1
P1e

The new optimum choice occurs at E1, with

consumption = C1 , leisure = N1 and utility U1.
S

Plotting the implied values, we obtain labour supply

schedule = Ns (W/Pe).

The slope of the labour supply curve depends on

net effect of two different effects as real wage
increases.
 35
Building Blocks…
Figure 1.5: Labour supply
 36
Building Blocks …
(a) Substitution effect
To remain in the initial utility level, what combination
of consumption and leisure would a household
choose when expected real wages rise?
The HH would choose point E’ where consumption is
Cc and labour supply is Ncs , c  Compensated
A move from the E0 to E’ reflects the pure substitution
effect (SE).
A rise in expected real wage means that the price of
leisure goes up.
HHs buy less of anything for which a price has risen;
thus leisure declines and consumption increases.
This indicates that the compensated labour supply
curve is always upward slopping!
 37

Building Blocks …
(b) Income effect (IE):
 Given the initial level of labour supply, higher
expected real wage means higher expected real
income.
W s W s
 e  N0   e  N0
 P 0  P 1

 Ifleisure is a normal good, a household would

buy more leisure as income increases.
 The income effect works in the opposite direction.
 IE effect is a move from E’ to E1 (Figure 1.4).
 38
Building Blocks …
Conclusion: Two effects of higher real wage rate on
the labour supply:

 It makes leisure expensive which induces households

to have less of it, and encourages households to work
more hours (SE)
 It raises household income and induces households
to work less hours (IE).

The slope of the labor supply curve depends on the

relative magnitude of SE and IE.

It may or may not have a positive slope depending

on the test and preference of the household. +++++
 39

Building Blocks
 To summarize, the implicit labour supply equation equals:
W
Pe
 
 g Ns , gN


0

 Alternatively, divide both sides by actual price

W  Pe 
P
  g Ns
 P 
 
 
 Actual real wage rate is a affected by expected price
relative to actual price and the supply of labour on the on-
going price.
 If HHs overestimate the expected price level, they will
demand a higher real wage for a given level of labour
supply than had they estimated the price level correctly.

Supply side of the model consists of two elements:

 Labour market
 Production function-linked to the goods market.
 40

Building Blocks …. (v) Expectations

 Price expectations influence the supply side of the
model.
Two hypotheses
(i) Adaptive Expectation Hypothesis (AEH)
 
Pte1  Pt  1    Pte  Pt , 0    1 (…17)

 (17) says HHs expect the price in the future period (t+1)
to be equal Pt e1 toPt the actual price in the current period (
) if their expectation is correct in the current period.
If Pt  Pt , there is expectation error given by
e


Pt e1   (Pt e  Pt )   (Pt  Pt e ) … (18)

 Equation (18) indicates that HHs slowly adjust over time
to correct past expectation errors at a rate of  .
 41

Building Blocks…

(b) Perfect foresight hypothesis (PFH)

Pte  Pt
 Households expect the price level that actually
holds.
 PFH is the deterministic counterpart to Rational
Expectation Hypothesis (REH); which will be dealt
latter.
 WE use labour market description and the
assumption of AEH or PEH to determine the AS
curve.
 Note that the shape of AS curve depends on the
assumptions of expectations: AEH or PFH
 42

Expectations…
AS and AEH
Suppose that
e
P
There is no expectation error 0 0 P
 Households supply the correct quantity of labour.
 Market determines employment and wages
Output is at its potential level
The labour supply function is: Y*  F N*;K  s

W / P e  g ( N s )  W / P  ( P e / P) g ( N ) 
The labour demand function is: W  P0FN ND,K 
Equilibrium is at Eo in Figure 1.6.
Consider a higher actual price level, P1
e
The expected price level is unchanged = P0
- Labour supply curve also remains unchanged.
 43

AS and expectations…
 The demand curve shift upward to

W  P1FN ND,K 
 Labourmarket equilibrium becomes at A, with
nominal wage rate W1, employment N1 and output
Y1.
 Employment and output are larger because real
wages are low.
 Because HHs have underestimated price level and
overestimated real wages.
 Firms employ more labour.
 If
the opposite holds (lower actual price level, P2)
new equilibrium at point B with lower actual price
level and lower output.
 HHs overestimated price level (actually low) and
underestimated the real wage rate (but actually high).
 44

Figure 1.6: AS curve and expectations

 45
AS and Expectations…
AS and PFH
 Expected and actual prices are the same
 Households make no expectation error or
 Actual and expected price levels always coincide

 Labour supply is based on correct information

 Households supply the ‘right’ quantity of labour.
 Labour market equilibrium determines employment
level and wage rate.
 Employment is N* and output is Y* for P0, P1and P2
 AS curve is vertical at Eo regardless of actual price
variation.
Nominal wage rigidity 46

 However, Modigliani (1944) indicated that upward

sloping AS curve can be obtained even under PFH
 Assume that nominal wages are inflexible
downwards but perfectly flexible upwards.
 Workers often hate wage cuts but love pay rise.
 Assume full employment occurs at wage W0 and
price P0 ( Figure 1.7)
 If price exceeds P0, nominal wages must increase
to keep real wages constant and maintain full
employment.
 What if price is lower than the initial level?
 47

Nominal…
 Suppose P= P2; where P2<P0.
 The demand for labour is: W  P2FN ND,K 
 Effective labour supply is given by the horizontal
segment: W0C
 Since nominal wages are not allowed to fall,
employment equals N2   N *
 Unemployment: N2  N2
s

 Unemployment occurs due to wages do not fall.

 Households pay the price since they do not allow
their nominal wages to fall.
 48

Figure 1.8: AS and downward nominal wage rigidity

 49
Labour market and AS: Little algebra
W
Labour supply function :  g(N S )
 P e

Totally defferentiating, we have

W  1 dN s dN s 1 W 
d e   gN   d
 P  N S
Ns Ns gN N s P 
e

W e
dN s P  dW dP e 
 s
   e 
becuase of the quotient rule
N gN N s  W P 
W
 Given e
 g(N s )
P
dN s g ( N s )  dW dPe 
   
Ns gN N s  W Pe 
dN s  dW dPe 
  s   
Ns  W Pe 
g(N s )
where  s 
gN N s
So wage elasticityof labour supply is given as :
dN s  dW dPe  g(N s )
s    e 

Ns  W P  gN N s
 50
Labour market and AS: Little algebra
 FN ND ,K 
W
 Implicit labour demand function: P
… (1)
Using the implicit function approach, totally
differentiate (1):

…. (2)
 Rearranging (2)

 …(3)
 51
Labour market and AS: Little algebra
 Explicit labour demand function:

N D  N D (W / P, K );
i. Given (3), inverse relationship exists between labour
demand and real wage rate, where is a partial
derivative of ND with respect to real wage rate given
capital stock or

ii. The partial derivative of labour demand to capital stock is

positive: dN D  FNK
 0
dK FNN
 Because an increase in capital stock increases labour
demand as complimentary inputs;
 52

Labour market and AS: Little algebra

Diggression : Assume a linear homogenous
production function of degree on (CRS),
Y  F ( N , K ), then
(1) FN N  FK K  Y [Euler Theorem,
Simon and Blume,1994)
(2) FN and FK are homogeneous of degree 0 in N and K,
NFNN  KFNK  0 and
KFKK  NFKN = 0;
(3) FNK  FKN [Young’ s Theorem]

Based on these properties; we can rewrite the equation.

Labour market and AS: Little
53
algebra

dFN ( ND, K )  FNN dN  FNK dK  d (W / P)

D

W  dW dP 
 FNN dN   FNK dK  
D
 
PW P
FNK 1 W  dW dP 
dN  
D
dK    
FNN FNN P  W P

dN  
D FNK
dK 
1 D

FN N , K 
 dW dP 
W  P
FNN FNN  

 
 dW dP 
D
dN FNK dK 1
  D D
FN N , K W  P
 
D D
N FNN N N FNN
 54

Labour market and AS: Little algebra

ButNFNN  KFNK

N
D
D
KFNK D
N FNN N  
dN   FNK dK  1 F ND, K dW dP
 W P 
dN  dK  dW dP
D

N K  W P 
D d

Where d  
FN
NFNN
Similarly, given implicit labour supply function

W  
 g ( N ); g N 0  SE IE
s

P e
 
Labour supply equation 55

We have
W  dW dPe 
dN g N ( N )  e 
s s
 
P W Pe 
W
But e  g ( N s ), thus,
P
s  dW dPe 
dN g N ( N )  g ( N ) 
s s
 
W Pe 
g ( N s )  dW dPe 
dN 
s
s   e 
,
gN (N )  W P 
divide both sides by N s
dN s g ( N s )  dW dPe 
   
Ns N s gN (N s )  W Pe 
dN s  dW dPe 
 s   e 
, where
Ns  W P 
g(N s )
s  s ; assume SE  IE ;  s  0.
N gN (N s )
 56
At labour market equilibrium
N  ND  NS
dN D dN s
D
 S
N N
dK  dW dP   dW dPe 
 D    s   e 
K W P W P 
dP
Both sides add -  s
P
dK dP  dW dP  dP  dW dPe 
 s  D    s  s   e 
K P W P P W P 
dPe  dW dP 
  s e   D   s 
dK dP
s 
K P P W P 
Solving for real wages
dW dP 1  dK  dP dPe  
   s   e 
W P  D   s   K P P 
At labour market equilibrium57
We have differentiated production function
dY FN F
 dN  K dK
Y Y Y
Given FN  W / P,
dY W dN FK
 N  dK
Y PY N Y
WN F K
Let wN  ; (1  wN )  K
PY Y
dY dN dK
 wN  (1  wN )
Y N K

where wN is the share of wages in national income.

If we insert the value of the equilibrium real wage

into the labour demand equation, we get
 58

Derivation of Aggregate Supply

dN dK  dW dP 
  d   
N K W P
 d  dK  dP dPe  dK
    s    
d  s K  P P  K
 d  s  dP dPe  ( d   s )dK   d dK
    
d  s  P P  ( d   s ) K
 d  s  dP dPe   s dK
    
d  s  P P  ( d   s ) K

Substitute the above into the differentiated production

function
 59

Derivation of the Relative Change of AS

dY   d  s  dP dPe   s dK  dK
 wN    e     (1  wN ).
Y   d   s  P P  ( d   s ) K  K
wN  d  s  dP dPe   wN  s  dK
   e     (1  wN )
 d   s  P P   ( d   s )  K
dY wN  d  s  dP dPe   (1  wN ) d   s  dK
   e    
Y  d   s  P P   ( d   s )  K
 60

Derivation of the Relative Change of AS

Note: The above equation implies
 An increase in capital stock increases marginal
productivity of labour, increases equilibrium
labour input and aggregate supply.
 Anticipated price change or dPe/Pe =dP/P do not
affect real wages, employment or the aggregate
supply of goods.
 Under Adaptive Expectation Hypothesis (AEH),
expected price is fixed in the SR so that AS curve
slopes upwards.
 AS curve shifts if capital stock changes.
 In the LR, if P rises above Pe; subsequently Pe rises;
expected real wage declines and labour supply
declines; implying in the LR arise in expected
price level shifts AS curve to the left.
 61

Back to Schools of thoughts

 IR   dM dP 
 Recall AD curve: dG   ( M / P)   
 lR  M P
dY 
1  c(1  TY )  I R kY
lR
Classical Economists
 Fiscal policy useless. Given flexibility of prices, an
increase in G, raises interest rate and fully crowds -
out investment (see Figure 1.8).
 Money demand being completely interest inelastic,
LM curve is vertical, and AS is at full employment
level.
dY
 The fiscal policy effect is zero: 0
dG
 Note: Complete crowding out of private investment.
 62

Classical…
 Money demand does not depend on interest rate
or fully interest inelastic. It is given by
1M
M  kPY  Y 
k P
 Where 1/k is velocity of money circulation. Thus,
lR=0 & kY = k=constant. At LM curve is vertical.
 Output is at full employment level, vertical AS.
 Hence a change in money supply translates into a
change in prices as k is constant (determined by
institutional factors), monetary policy does not
have real effect.
 There is perfect foresight, flexible wages and
prices;
Classical… 63

 Monetary policy useless. It raises prices and does

not affect real variables (see Figure 1.8).

dY  0  dM  dP
 Classical
dichotomy: money is a veil which
determines nominal prices but does not affect
real quantities and relative prices
 Monetary neutrality.

 Conclusion: No need for macroeconomic policy.

“Laissez-faire” economics.
 64

Figure 1.8: Monetary and Fiscal policy in the classical

model
Keynesians 65

Two basic assumptions or Keynesian Innovations

 Liquidity preference schedule (Modigliani 1944) &
Nominal wage rigidity.
 Interest rate is so low (R min); and economy is at the
horizontal segment of the LM curve.
 AD curve independent of nominal money supply M.
 Liquidity preference (Figure 1.9):
 Households hold no cash if the rate of interest is very
high (Rmax)
 Bond prices are low and capital gains are expected
 At high interest rate, bonds will not be attractive-
demand falls
 However,if the interest rate is very low (Rmin),
households are indifferent between money and
bond.
 66

Figure 1.9: Liquidity preference function

Keynesians…
67

 The level of spending at the minimum interest rate

is too low.
 The classical assumption of prices and wages are
flexible; self-correcting nature of the market does not
work. No amount of price or wage reductions will bring
equilibrium.
 At this interest rate, output is Y0 < Y* ; the classical
model is inconsistent!
 Monetary policy in the Keynesian is ineffective; an
increase in money supply does not further reduce
interest rate and boost private investment. Investors
absorb the additional money.
 Fiscal policy is very useful. It just raises AD thus moves
the economy towards full employment; no interest
rate change and thus no crowding out of private
investment(see Figure1.10).
 68

Figure 1.10:MP & FP in the Keynesian model

 69

Neoclassical(Neo-Keynesian) Synthesizers
 Names: Paul Samuelson(1915-2009),James Tobin-
(1918-2002), Franco Modigliani(1918-2003),Robert
Solow (1924-)plus virtually all economists in1950s
and 1960s except Milton Friedman(1912-2006).

 Pick elements of Classical and Keynesian

approaches: Economy is “Keynesian” in the short-
run but “ Classical” in the long-run.
Neo-Keynesian… 70

 Two versions of neo-Keynsian synthesis depending

on the assumption of the labour market.
1. The first version: Nominal wages are rigid
downwards & upward slopping AS curve with
unemployment.
Add Phillips equation to allow adjustment over
time.
.
 NS  N 
W  U    S
,   0.
 N 

 Change in nominal wages depend on amount of

unemployment.
 Full employment will restore over time.
Neo-Keynesian… 71

2. Second version of Neo-Keynesian

 Nominal wages are flexible and
 Expected price level is sticky in the SR (AEH).
 Full employment will be eventually restored depending
on the speed at which agents adapt to expectational
errors.
 Suppose G increases; both IS and AD curve shift upward.
 Output rises above Y* despite some crowding out of
private investment.
 In this case, the multiplier is smaller than the Keynesian
(seen in AD equation) due to:
 A rise in AD induces an increase in price level (from P0
to P1);
 Real money supply contracts due to high price level;
 Leads to a rise in interest rate and a fall in AD
(backward shift of LM curve);
 In the SR a rise in G is small on employment and output
and large on P if AD curve is steep and AS curve is flat.
 72
Neo-Keynesian…
 In subsequent periods, HHs revise their price level
upwards.
 This lowers the expected real wage and supply of
labour
 AS curve shifts backwards until equilibrium is
restored.
 Employment and output back to their original levels
 The LR effects of fiscal expansion is to increase P
with no effect on employment and output levels.
 Consider expansion of nominal money supply from
m0 to m1 under AEH.
 Outward shift of LM curve lowers interest rate and
stimulates AD & AD curve shifts outward
 Prices rises, which boosts output.
 73

Neo-Keynesian…
 Overtime, prices further revised upwards, and shifts
the AS curve backward until the original equilibrium
is restored.

 Inthe SR, monetary policy improves output and

employment (Money is not neutral.)

 In the long-run, it has no effect on output and

employment; prices rise in exact proportion to the
increase in the money supply (Money is neutral.)

 Overall,both monetary and fiscal policies can

affect the economy in the short-run (see Figure
1.11).
 74

Fig1.11:MP & FP in the neo-Keynesian synthesis model

Monetarists 75

 Milton Friedman(1912-2006) and his “Chicago firiends”.

 Interest sensitivity of investment (IR) is large and IS curve is flat.
 Strong crowding out of private investment by government.
Thus, FP is ineffective or impotent.
 Quantity theory of money (lR ≈ 0 ; near vertical LM curve) is
assumed.
 Unlike Classicals, Friedman assumes AEH.
 Monetary policy is potent but fiscal policy can’t influence
employment and output.
 Monetary policy has a real effect
1 on the economy
M  kPY, dM  0 and dPY  dM  0
k
 Distribution of the total effect (dPY) on real variables (dY) and
nominal variables (dP) depends on assumptions with respect
to the labour market and expectation formation.
 Under AEH, there are temporary effect of monetary
expansion on output.
 Policy makers can use monetary policy in the SR to combat
unemployment and increase real output.
 76
Monetarists…
 Quantity theory of money (lR ≈ 0; near vertical LM curve)
and AEH.
 MP is potent to influence employment and output in SR.
1
M  kPY, dM  0 and dPY  dM  0
k
 Distribution of total effect (dPY) between real (dY) and
nominal (dP) depends on assumptions with respect to the
labour market and expectation formation.
 Under AEH, there is a temporary effect of monetary
expansion on output and unemployment.
 However, policy makers commit timing errors(“long and
variable lags”)before:
 A macroeconomic problem is recognized;
 Appropriate macroeconomic policy is identified; and
 A macroeconomic policy has the required effect

 Thus, MP may exacerbate the cycle; thus a need for a

constant money growth rule.
Supply siders 77

 Names: Arthur Laffer, Robert Mundell (1932-).

 They are radical conservatives.
 They have strong distrust on “the government”.
 They emphasis on the distorting aspects of taxation.
 Policy advice too good to be true: you can cut the
tax rate without reducing government spending.
The tax cut pays for itself–see the so-called Laffer
curve (named after Arthur Laffer)(see Figure1.12).
 Whenever tax rate is zero, there is no tax revenue.
 Whenever tax rate is 100%, then no tax base and tax
revenue will be zero.
 Rise in tax rate increases tax revenue up to a certain
pint.
 But further higher tax rates discourage business and
result in a small tax base thus reducing tax revenue.
 78
Fig1.12:The Laffer curve
 79

New Classical Economists

 Names: Robert Lucas(1937-),Thomas Sargent (1943-

), Edward Prescott(1940-),Robert Barro (1944-).
 Natural successors to the classical economists.
 Flexible prices/wages, REH (or PFH),full employment,
efficient markets.
 Micro-foundations of macro-relations(e.g.
investment demand, consumption demand, money
demand, labour demand and supply).
 PIH as gimmick early on
 80

New Keynesian economists

 Names: Edmund Phelps(1933-), Stanley Fischer(1943-),
 John B.Taylor (1946-),Olivier-Jean Blanchard(1948-,Greg
Mankiw (1958-).
 Derive their inspiration from John Maynard Keynes.
 Markets are prone to fail or to be incomplete.
 After initial hesitation acceptance of the REH (or PFH).
 Government can and should intervene in the macro-
economy.
 Keen attention to micro foundations.