Aufbau der Zusammenfassung:

Transcription

1 Aufbau der Zusammenfassung: ro Kapitel ist erst die Zusammenfassung aus dem Buch Macroeconomics von Roger E. Farmer angegeben und danach eine eigene Zusammenfassung.

2 2 Chapter 1 Conclusion from book Three main issues are addressed in this book: What determines economic growth? What are the causes of business cycles? What determines inflation? Economic growth is a sustained increase in a nation s standard of living. Business cycles are irregular, persistent fluctuations of real G around its trend growth rate, accompanied by highly correlated co-movements in many other economic variables. Inflation is the rate of change of the average level of prices. Economic growth is important because small differences in the growth rate can have very big differences in the standard of living when growth is compounded over several years. Business cycles are important because during recessions unemployment increases, and there are associated increases in a variety of social problems, such as homicides and poverty. It is important to avoid inflation because high inflation is associated with loss of output and related social problems. In practice, central banks usually act to remove inflation before it reaches this stage, but the policies required to do this may generate a recession. My own conclusion Business cycles is the study of what causes booms and recessions. The theory of growth focuses on why economies produce more each year on average, whereas the theory of business cycles explains why real G an employment fluctuate from year to year. Economic growth: tandard of living: It is measured by the average rate of change of the real gross domestic product per person. real G G per erson number of eople G measured using current prices is called nominal G. G measured using base-year prices is called real G. Nominal G can go up because of two reasons: 1. A country produces more goods and services (increase growth) 2. Goods and services cost more money on average (increase inflation) G per person can be used to make comparisons across time and also it can be used to compare living standards across countries. Rule of seventy: g growth rate t time until a quantity is doubled 70 t g

3 3 The business cycle is an irregular persistent fluctuation of real G around its trend growth rate, which is accompanied by highly coherent co-movements of many other economic variables. Business cycles are irregular, persistent movements in many different economic time series. G is the most important measure of economic activity. When G is below trend for a number of time periods in a row, we say the economy is in a contraction or a recession. When G is above trend for a number of time periods in a row, we say the economy is in a boom or an expansion. The process of separating the observations on a single time series into two components (a trend and a cycle) is called detrending a series. NBER the National Bureau of Economic Research Recession (NBER definition): The NBER Business Cycle ating committee defines a recession as a recurring period of decline in total output, income, employment, and trade, usually lasting from six month to a year, and marked by widespread contractions in many sectors of the economy. Many economic variables move very closely in tandem. This co-movement is called coherence. Variables which move in the same direction as G over the cycle are said to be procyclical because they move with the cycle (e.g. consumption). Variables that move in the opposite direction to G over the cycle are said to be countercyclical, because they move against the cycle (e.g. unemployment). Inflation is a sustained increase in the average price level, measured by the percentage rate of change of one of several commonly used price indices. rice indices differ according to the bundle of goods and services that they include: 1. The consumer price index (CI) Measures the average cost of a standard bundle of consumer goods in a given year. The price of each good in the bundle is multiplied by a fraction, called its weight, and the weighted prices are added up to generate a single number called the consumer price index. 2. The producer price index (I) Is a weighted average. The bundle of goods is selected from an earlier stage in the manufacturing process. 3. The G deflator It includes all of the goods and services produced in a country weighted by their relative values as a fraction of G. 4. The G-price index It includes all of the goods and services produced in a country, but it differs from the G deflator in the way it weights different commodities. 5. The CE price index (personal consumer expenditure) It contains only consumer goods an not producer goods.

4 4 The problem of high volatile prices is worse for high rates of inflation than for low rates. As inflation increases prices also begin to fluctuate more, and the price system begins to function less accurately. rices convey less information.

5 5 Chapter 2 Conclusion from book The world economy is a collection of national economies, each of which can be analysed as open or closed. The domestic economy can be further divided into a public sector; and the private sector can, in turn, be divided into households and firms. The most important measure of the productive capacity of an economy is G, which can be measured in three ways: the income method the expenditure method the value-added method. The G of a closed economy is equal to consumption plus investment. In an open economy it equals consumption plus investment plus net exports. G, consumption, investment and net exports are examples of flows that is, variables that are measured per unit of time. U.. G in 1999 was $ per person, of which 82 % was consumed and 22 % invested. The extra 4 % came from abroad as foreigners chose to invest in the U.. economy rather than in their own countries. The wealth of an economy is a stock, a variable measured at a point in time. Wealth consists of real assets and financial assets. A real asset is a tangible commodity, such as land or a machine; a financial asset is a promise by someone to deliver commodities in the future. U.. national wealth in 1998 was equal to $ per person. There are two kinds of investment: gross and net. Gross investment is net investment (additions to capital) plus depreciation (replacement of worn-out capital). Wealth and net investment are related to each other because net investment is an addition to wealth. My own conclusion Closed economy When a domestic economy is studied in isolation from the rest of the world it is called a closed economy. Open economy When we consider interactions with other countries it s called an open economy. There are two big sectors of a domestic economy: 1. the public sector (government) 2. the private sector which can be divided into households and firms Measuring gross domestic product 3 Methods are used to arrive the G 1. the income method (adding up all of the income earned by the factors) 2. the expenditure method (adding up all of the expenditure on final goods and services) 3. the product (or value-added) method (this method computes the difference between the value of the firm s output and the cost of its expenditure on intermediate inputs) The value added is the difference between the value of the output that a firm sells and the value of the intermediate goods used to manufacture that output.

6 6 G is the value of all final goods and services produced within a country in a year. Final goods are those that are sold directly to end users. Intermediate goods (or inputs) are produced by one firm and used as an input by another. Consumption goods are commodities which meet our immediate needs. Capital goods are commodities which help us to produce more goods in the future. aving is the act of abstaining from consumption. Investment is the result of purchasing a new capital good. aving and investment in a closed economy Y G C private consumption I private investment G government purchases of goods and services Y C + I + G G I NAT NAT I Gov Y C + C Y C NAT + C Gov NAT Gov + I + I "G accounting identity" Gov C NAT + I NAT National saving aving and investment in a open economy The trade deficit is equal to imports minus exports. A budget surplus can be seen as government saving. Because the trade surplus is equal to the difference in exports over imports, we also call this net exports. NAT I Y C NAT NAT NX + I NAT + NX Government and the private sector Y Y + TR T Y C ( I) + ( T TR G) NX

7 7 Income earned by the factors of production consist of the following components 1. compensation to employees (wages and other employees benefits) 2. net interest 3. rent 4. corporate profit 5. proprietor s income Measuring wealth A stock is a variable measured at a point in time. A flow is a variable measured per unit of time. A flow is often the rate of change of a stock.

8 8 Chapter 3 Conclusion from book Economic data are recorded using time series. To analyze time series, we split them into a low-frequency component (the trend) and a high-frequency component (the cycle). The three principal ways of decomposing a time series are: linear detrending flexible detrending differencing. The business cycle is an irregular, persistent fluctuation of real G around its trend growth rate that is accompanied by highly coherent co-movements in many other economic variables. To measure business cycles, we first need to separate the high- and low-frequency components of economic time series by detrending the raw series. The low-frequency component is the trend, and the high-frequency component is the cycle. etrending allows us to uncover relationships between time series that hold at one frequency but not at another. We measure the strength of the statistical relationship between two series with the correlation coefficient. A time series that has a high correlation coefficient with its history is persistent; two series that have a high correlation coefficient with each other are coherent. Coherence can be positive (both series go up and down together) or negative (one series moves up as the other moves down). If a series is positively correlated with G, it is procyclical; if its is negatively correlated with G, it is countercyclical. Unemployment and employment are two different measures of economic activity. The employment rate is the percentage of the population that are employed; the unemployment rate is the percentage of the labor force that are unemployed. Because the labor force increased in the United tates after World War II, the employment rate and the unemployment rate both increased at the same time. The unemployment rate is countercyclical and highly coherent with G. Output is measured by real G. Until recently real G was measured by computing the values of all goods and services produced in a given year, valued using prices from a single base year. More recently, G has been measured by the chain weighted method. Inflation is the rate of change of a price index. There are five principal price indices. Recently, there has been a controversy over the best way to measure inflation because some prices are increasing faster than others. Inflation was procyclical before World War II but has been countercyclical since then. My own conclusion There are two kinds of regularities in economic data 1. relationships between the growth components in different variables and 2. relationships between the cycles ifferentiating growth from cycles removing the trend from a variable There are 3 Methods of detrending linear detrending (lineare Regression) flexible detrending (H-Filter) differencing

9 9 Relationship between variables 1. persistence this records how closely a variable is related to its own past history. 2. coherence measures how closely two variables are related to each other Transforming economic data The trend in a time series is the low-frequency component of the series. The deviation of the series from its trend (the part of the series that moves up and down over the business cycle) is called the high-frequency component. ifferencing This method defines the cycle in a variable as the percentage change in the original series. e.g. G 1987 G1987 G G etrending reveals relationships between time series that exist at one frequency but not at another. The business cycle is an irregular, persistent fluctuation of real G around its trend growth rate that is accompanied by highly coherent co-movements in many other economic variables. Coherence is measured by the correlation coefficient. The degree of coherence is measured by the absolute value of a single number, the correlation coefficient. Measuring unemployment Labor force participation rate ercentage of the civilian population over the age of 16 employment rate people employed population unemployment rate people not working labor force Employment rate and unemployment rate can move independently of each other because of the two explanations above.

10 10 Measuring inflation Inflation is the average rate of change of the price level. There are 5 measures of price levels 1. consumer price index 2. producer price index 3. G deflator 4. G price index 5. CE price index There are 3 alternative kinds of price indices 1. Laspeyres (CI, I, G deflator) 2. aasche 3. uperlative (G price index, CE price index) Because a Laspeyres index uses historical weights, it tends to overstate the importance of inflation. (Because spending habits change more rapidly than the weights of the index). The CI is the index most commonly used to measure inflation. b base year t time t aasche price index: p p p t 1 b 1 x x t 1 t 1 + p + p t 2 b 2 x x t 2 t 2 Laspeyres price index: p p p t 1 b 1 x x b 1 b 1 + p + p t 2 b 2 x x b 2 b 2

11 11 Chapter 4 Conclusion from book The idea of equilibrium explains how employment, output, and the real wage are determined. The real wage is the wage measured in units of commodities. Firms maximize profits an demand more labor when the real wage falls. The labor demand curve is the relationship between the real wage and the quantity of labor demanded. Households maximize utility and supply more labor when the real wage rises. The relationship between the real wage and the quantity of labor supplied is the labor supply curve. Classical economists believed that the point at which the labor demand curve and labor supply curve intersect determines employment. Recently, an influential group of economists from the real business cycle school argued that we should not dismiss the classical model too quickly. These economists maintained that the Great epression was an unusual event; most of the time the classical model does a good job of explaining economics. My own conclusion Theory of production Representative agent economy Is an economy in which all output is produced from labor and capital, and in which everyone has the same preferences. roduction is the activity of transforming resources, such as labor and row materials, into finished goods. A method for transforming resources into finished goods is called a technology. Classical theory assumes that no one individual can influence prices. In a competitive market the power of any single buyer or seller to influence the price is arbitrarily small. The nominal wage is the money paid to the worker for each hour of work. The real wage is the amount of the final commodity that a firm must give up in order to purchase an hour of labor time. The demand for labor Labor demand curve w, p given (w/p) Y w L p rofit of the commodities cost of labor L family firm supplied demanded Quantity of labor demanded π

12 12 As long as the marginal product is greater than the real wage, the firm should keep adding more workers, since each additional worker adds more to revenue than to cost. The firm should stop hiring workers when marginal product real wage eriving the labor demand curve: Y L ( L ) L 1 max π Y w L p L 1 2 ( L ) output produced by L labor hours total product 2 w L p total cos t of L labor FOC π' 1 L m arg inal product 1 L w p w p m arg inal cos t 0 The supply of labor Budget constraint Y emand for com mod ities w p L selling income labor from + π profit from the family firm ubstitution effect As the real wage goes up, leisure becomes relatively more expensive and tends to make the households to substitute consumption goods for leisure so they work harder. Wealth effect An increase in the real wage makes households wealthier and tends to make the households consume more of all commodities including leisure. If substitution effect > wealth effect, then the supply curve slopes upward substitution effect < wealth effect, then the supply curve slopes downward.

13 13 eriving the labor supply curve max U w p U FOC : Y U' L w L p 1 2 ( L ) + π ( L ) w L p 2 0 hifts in the labor demand curve to the left because of taxes wealth The classical theory of aggregate supply eriving the Aggregate supply curve: 1. Labor emand curve Labor upply curve 2. Assumption L L L E solve the equation above with respect to this assumption 3. Use this solution in either the labor demand or labor supply curve E w expression for p 4. ut this two solutions back into the production function equilibrium output Using classical theory Business fluctuations The explanation lies with the factors that determine equilibrium in the labor market. There are three of these factors: 1. preferences 2. endowments 3. technology The factors that cause fluctuations in the level of output are those that cause shifts in the demand or supply curve of labor. productivity of techno log y shift labor demand increases in the endowments of resources change in preferences shift labor sup ply

14 14 Chapter 5 Conclusion from book The quantity theory of money, the classical theory of price level, and the classical theory of aggregate demand are different names for the same theory. The theory assumes that the use of money in exchange has costs and benefits. The cost is in resources that are tied up in cash resources that could be used to purchase additional commodities. The benefit is in the utility yielded by the use of money to bridge the uneven timing of purchases and sales. The theory assumes that the quantity of money demanded is proportional to G with a constant k, the propensity to hold money. To move from a theory of the demand and supply of money to a theory of aggregate demand, we assume that for the community as a whole, the quantity of money demanded must always equal the quantity supplied. If the price level falls, the real value of the existing stock of money will increase and individual households will experience an excess supply of cash. As they attempt to spend this excess cash, the aggregate quantity of commodities demanded will increase. The classical theory of aggregate demand can be combined with the classical theory of aggregate supply to explain how output, employment, the real wage, the nominal wage, and the price level are determined. The classical theory implies that if the nominal quantity of money is doubled; all nominal variables will also double; butt all real variables will remain unchanged. This is the neutrality of money. The classical theory of the price level works well for countries that are experiencing very rapid inflations, such as Argentina, Israel, and Brazil. It does not work as well in low-inflation countries, such as the United tates, the United Kingdom, and Japan, because the propensity to hold money is, in reality not a constant. in highinflation countries, movements in k are swamped by movements in the money supply; in low-inflation countries, this is not the case. The biggest problem with the classical theory is that it cannot explain why prices were procyclical during the Great epression. My own conclusion The classical theory of the price level is sometimes called the quantity theory of money or the classical theory of aggregate demand. The classical theory provides good explanation for the cause of inflation particularly where the rate of inflation is or has been very high. The theory of the demand for money Money yields a flow of exchange services that increase the convenience of buying and selling goods. The cost of holding money is the opportunity cost of forgoing consumption of some other commodity. The marginal benefit is the additional usefulness gained by having cash on hand to facilitate the process of exchange. Money imposes an opportunity cost because the decision to use money reduces the resources available for other goods.

15 15 Budget constraint in the static barter economy measured in dollars: Y π + w L demand for com mod ities profit labor income ynamic monetary economy Cash held at the end of the week house hold s demand for money Budget constraint in a dynamic economy demand for money demand for com mod ities profit L labor income M + Y π + w + M sup money ply of Opportunity cost The lost opportunity that arises from holding money is the additional utility that could have been gained by purchasing additional commodities. Benefit of holding money To classical theorists the benefit of money was the advantage that comes from being more easily able to exchange commodities with other households in the economy. money is a generally acceptable medium of exchange. ouble coincidence of wants this implies that in a barter economy one must find anybody who has the commodity he wants and wants the commodity he has. Classical theorists argued that the stock of money that the average household needs at any point in time is proportional to the dollar value of its demand for commodities. M k propensity to hold money Y of no min al value com mod demanded ities Aggregate demand and the demand and supply of money Assumption in the development of the classical theory: quantity of money demanded always equal the quantity of money supplied This relationship between price and the flow of G demanded is called the classical aggregate demand curve. price level M classical aggregate demand curve k Y sup ply of money propensity to hold money aggregate demand for com mod ities It is an equation that shows how the price level would have to be related to the level of G, if the quantity of money demanded and the quantity of money supplied were equal.

16 16 Nominal value of G is constant with movements along the aggregate demand curve. Velocity of circulation: number of transactions per unit of time V T M T Y V VM Y 1 k ( Fisher) The classical theory of the price level The important feature of the classical analysis is that households and firms care only about the real wage because the ratio of w to indicates how many commodities the household will receive for a given labor effort. 4 steps in the classical theory: 1. determination of equilibrium level of labor demanded and supplied (labor demand and supply diagram) 2. with this equilibrium level of employment determination of the equilibrium output (production function) 3. setting the aggregate supply curve as a vertical line at the quantity of the equilibrium output derived at the production function 4. Intersection of aggregate demand and supply determines the price level. Because the equilibrium quantity of employment depends only on the real wage and not on the price level, the assumption of labor market equilibrium generates the same supply of output for every possible value of the price level. Neutrality of money nominal variables will move in proportion to changes in the quantity of money, real variables will be invariant to these changes. Real variables are not altered by a drop in the money supply, but nominal variables fall in proportion, this called the neutrality of money. Using the classical theory to understand data Classical theory determines the price level as the point of intersection of the aggregate demand curve with a vertical aggregate supply curve (explains also inflation). In classical theory there is the assumption that output is determined by equilibrium in the labor market. inf rate lation of k Y M E M M rate of money sup ply growth Y Y growth rate of output

17 17 The connection between money growth and inflation is strong in countries with very high inflation because movements in the propensity to hold money and movements in real G growth are very small relative to huge movements in the stock of money. eignorage this means that the government can generate revenue by issuing money. Inflation erodes the value of money. If the stock of money increases at the same rate as the underlying rate of real economic growth, there would be no inflation. If the government creates money at a faster rate than the rate of growth, then the purchasing power of the existing bills in the economy will be eroded. The erosion of purchasing power on the part of private agents is watched by an increase in purchasing power on the part of government. Raising revenue from eignorage inflation tax. Main feature of the classical explanation of inflation Concept of a demand function for money, that is stable over time. tability is represented by the assumption the k (propensity to hold money) is a constant.

18 18 Chapter 6 Conclusion from book We can use the tools of demand and supply to study the allocation of commodities over time. Investing is a way of transferring goods from the present to the future, and firms invest to maximize profit. aving is a way of deferring consumption, and households save to maximize utility. The interest rate is the relative price of current and future commodities and, in the capital market, is determined at the point where the quantity of investment demanded equals the quantity of saving supplied. Over the business cycle, investment is very volatile and consumption is relatively smooth. New classical economists of the real business cycle school believe that investment fluctuates in response to changes in productivity caused by new inventions. Keynesian economists believe that many of the changes in investment are due to changes in the beliefs of investors, called animal spirits. Both groups believe that the model of the demand and supply of capital can be used to explain the determination of the rate of interest. The apparatus of the demand an supply of capital helps us to understand the effect of changes in productivity an changes in population demographics on the capital market. We can also use it to study the effect of U.. government borrowing on the international capital market. My own conclusion Theory argues that the rate of interest is a price that equates the demand for investment to the supply of saving. The decision to reallocate time between work and leisure results in employment fluctuations that are highly correlated with G. The decision to reallocate production between consumption goods and other investment goods provides a way of redistributing commodities over time. Classical economists believe that business fluctuations are caused by a series of shocks to technology. These shocks are transmitted to the capital market through changes in investment. Keynesian economists only accept the classical view, that explains how these shocks are transmitted to the rate of interest. aving, investment and the capital market A more volatile series has a higher standard deviation. According to the classical economists, investment fluctuates because firms respond to changes in technology this is called a fundamental explanation. Keynes suggested that highly volatile investment does not reflect changes in preferences, endowments or technology. Instead it represents changes in the mass psychology of investors, called animal spirits. Keynesian economists government intervention is necessary new classical economists business cycles are a necessary and unavoidable feature of the market economy

19 19 Consumption is smooth because households borrow and lend in the capital market in an effort to redistribute their income more evenly over time. The theory of investment The determination of the rate of interest and the quantity of resources saved and invested is at equilibrium where the two curves intersect. When the price of commodities changes from one year to the next, the real rate of interest is calculated from the nominal value of interest by subtracting the rate of inflation. r real interest rate i nominal interest rate inf rate lation In the theory of the demand for investment, the firm equates the marginal product of investment to the real interest rate. Households and the saving supply curve The rate of investment is the price at which consumption in the present can be exchanged for consumption in the future. present value Y 1+ r intertemporal budget constraint C present 1 consumption + 1 C 1+ r 2 present value of future consumption Y 1 current resources + 1 Y 1 + r 2 presentvalueof futureresources ubstitution effect When the real interest rate goes up, current consumption becomes relatively more expensive, this effect tends to make the household want to substitute consumption today for consumption tomorrow the household tend to save. Wealth effect An increase in the real interest rate makes households wealthier, this effect has an ambiguous effect on saving. Assumption substitution effect > wealth effect upward sloping saving supply curve eriving saving supply curve see Box 6.2 in book Equating demand and supply Although the animal spirit theory and the real business theory have similar implications for investment and saving, they have very different implications for the role of economic policy.

20 20 An increase in productivity will shift the investment demand curve to the right. In modern business cycle theories, shifts in the investment demand curve are the most important source of business cycle fluctuations. Investment demand curve: A I (1 + r) aving supply curve: Y 1 + r I in equilibrium Y 1+ r Y 1+ r 2r r ( 1+ r) + A 1 r + A A Y A Y I A Y Y Y 2 + A Y Y 2 + A Y + A 1 2 aving and investment in an open economy In an open economy domestic saving does not equal domestic investment; the deficit is made up by net borrowing from abroad. emand for capital from the world ifference between national domestic investment and national domestic saving.

21 21 Chapter 7 Conclusion from book Unemployment has typically averaged 6% to 7% in the United tates. But there have been some major recessions, such as in the 1890s when unemployment reached 18% and the Great epression during the 1930s when it reaches 25%. Unemployment has been falling recently, and U.. unemployment in 2000 was equal to 4.9%. European unemployment is much higher, averaging 10% in 1998 across the 15 countries of the European Union. Modern theories on the causes of unemployment began with John Maynard Keynes, who argued that the system does not typically return quickly to the classical equilibrium. Instead, Keynes thought that the economy could experience prolonged periods of high cyclical unemployment, periods that he thought were inefficient. Keynes was responsible for the modern view, according to which governments should be held responsible for maintaining a low and stable unemployment rate throughout the operation of governmental policy. Unemployment rates differ across countries for institutional reasons. ome of these differences can be influenced by government policies that regulate microeconomic aspects of labor markets. These include minimum wage laws, levels of unemployment insurance benefits, and the duration for which unemployment benefits are paid. Currently, there is an active debate over the best way to deal with high levels of unemployment in Europe, and some economists have advocated reforms to make labor markets more flexible. My own conclusion Countercyclical fiscal policy argued by Keynes Government should spend more in a recession and less in a boom. Explaining unemployment Frictional unemployment is resulting from labor turnover Cyclical unemployment is the increased unemployment that occurs during a recession Keynesian economists believe that cyclical unemployment occurs because the economy does not respond to shocks as efficiently as it should. New-Keynesian economists ask: How can a pool of unemployed workers exist, when the labor market is in equilibrium? Efficiency wage theory It argues that firms choose to pay a higher wage than the classical equilibrium wage because it is in their best interest to keep their workers happy. The real wage paid by firms is higher than the wage at which the stock of workers employed is equal to the labor force, the model predicts there will be unemployment in equilibrium.

22 22 Three main stands to efficiency theory a firm that has happy, conscientious workforce will make more profits because happy workers will likely be more productive firms that offer higher wages will attract high-quality applicants (rincipal / Agent) Firms use the wage as a device to minimize turnover costs. If fewer workers quit, recruiting costs incurred to replace workers will be minimized. earch theory It studies the costly and time-consuming process of matching workers with firms. The new-keynesian theory of unemployment In contrast to the classical model, the new Keynesians assume that the firm explicitly recognizes its pool of workers as a stock. The stock of workers sent to the labor market by households is called the labor force. The stock of workers employed by the firm is called employment The real wage chosen by firms is called the efficiency wage, and the level of unemployment associated with the efficiency wage is called the natural rate of unemployment. The firm chooses its wage to minimize its wage bill. One element of the wage bill is the wage paid to each worker. A second component is the cost of recruiting new workers. The turnover cost is a decreasing function of the real wage. Marginal benefit of an the reduction in the turnover cost increase in the real wage for a given increase in the real wage In new-keynesian theory, the firm chooses its wage rate to minimize the cost of maintaining a pool of employed workers. new-keynesian profit equation π rofit Y commodities supplied w L cost of labor demanded w c L turnover cost The efficiency wage is found by equating the marginal cost of raising the wage to its marginal benefit. ince the efficiency wage exceeds the classical market-clearing wage, there will be a stock of unemployed workers in equilibrium.

23 23 The aggregate labor market and the natural rate of unemployment When the real wage is equal to the efficiency wage, the number of unemployed workers as a percentage of the labor force is the natural rate of unemployment. Unemployment and economic policy olicies designed to control the natural rate are called structural policies and the unemployment that results from poorly designed labor-market institutions is called structural unemployment.

24 24 Chapter 8 Conclusion from book To understand cyclical unemployment, the new Keynesians begin with the efficiency wage model. They modify this model by adding the assumption that the nominal wage is sticky, and this modification leads to a theory in which the aggregate supply of output slopes upward as a function of the real wage. According to the new- Keynesian theory of recessions, shifts in aggregate demand cause employment to fluctuate over the business cycle because the nominal wage adjusts slowly to shocks. The new Keynesians use this theory to explain why unemployment increased and the price level fell during the Great epression. Economists disagree over whether government policy should seek to stabilize cyclical unemployment. Real business cycle economists think that most business cycles are caused by fluctuations in the natural rate that are induced by supply shifts. New Keynesians think that some recessions are induced by changes in aggregate demand. They argue that government has a role in stabilizing the business cycle. My own conclusion The neutrality of money in the classical theory is depicted in the graph of aggregate supply as vertical. In the new-keynesian theory of aggregate supply, the quantity of output supplied slopes upward as a function of the price level because the nominal wage is assumed to be sticky. In the new-keynesian model, after a shock, the nominal wage and the nominal price level don not adjust instantly to their new long-run equilibrium levels. As a consequence, output falls after a negative shock and unemployment increases. With a positive shock output increases and unemployment falls. In the new-keynesian theory, the nominal wage rises if unemployment is too low, and the nominal wage falls if unemployment is to high. In the long run change in aggregate demand in new Keynesian theory is the same as a change in classical theory. In the short run, the new-keynesian model allows quantities to adjust in response to a change in the price level. The theory of nominal rigidity There are two approaches to the theory of nominal rigidity: menu cost: slow nominal price adjustment contract theory: slow nominal wage adjustment (uring the Great epression, the price level and output both fell and unemployment rose).

25 25 The link between unemployment and output at business cycle frequencies is called Okun s law: Okun s law says that when unemployment increases by 1 percentage point, G will fall 3 % below trend. Getting from the short run to the long run When the real wage equates the efficiency wage, we say that unemployment is equal to its natural rate, and we refer to the quantity of output produced as the natural rate of output. Natural rate of unemployment and natural rate of output depend only on the fundamentals. Classical and new-keynesian economists have the same predictions in the long run An increase in the quantity of money will cause a proportional increase in all nominal variables and leave all real variables unchanged. New-Keynesian theory and economic policy The neutrality of money is a statement to describe events resulting from a change in the supply of money. Keynes did not disagree with the proposition that the neutrality of money would hold in the long run but he argued that the establishment of a new equilibrium might take a very long time.

26 26 Chapter 9 Conclusion from book Assets have different degrees of liquidity depending on how useful they are in exchange. Less-liquid assets pay a higher interest rate to induce us to hold them. We model this by assuming that there are two kinds of assets: bonds that pay interest and money that does not. In order to explain why households use money, we assume that the real value of money yields utility. Holding money is costly because more income can be earned by holding bonds; this income can be used to purchase commodities. Households balance the marginal utility of real money against the interest lost by holding money. The resulting money demand function generalizes the quantity theory of money by allowing the velocity of circulation (the inverse of the propensity to hold money) to depend on the interest rate. The date support the utility theory of money over the quantity theory of money that sets the velocity of circulation as constant. We consider a century s worth of data and find that the velocity of circulation has not been constant; it varies directly with the interest rate. In equilibrium, the quantity of money demanded equals the quantity supplied. Higher income causes the quantity of money demanded to increase; households hold additional cash to finance additional transactions. A higher interest rate causes the quantity of money demanded to fall because holding cash becomes more costly in terms of income forgone. There is an upward-sloping locus of points on a graph of income against the interest rate; this graph, the LM curve, describes combinations of income and the interest rate for which the quantity of money demanded equals the quantity supplied. My own conclusion In the classical theory of aggregate demand, the only variable that shifts the aggregate demand curve is the quantity of money. The Keynesian theory of aggregate demand is essential to Keynes idea of demand management. emand management is the active intervention by government through fiscal policy or monetary policy in an attempt to maintain the economy s steady growth rate without deep recessions or bouts of high inflation. The classical theory of aggregate demand is based on the quantity theory of money and assumes that k (the propensity to hold money) is constant. In practice k is a variable that depends on the interest rate. The opportunity cost of holding money The theory of why private agents hold money when they could earn interest by holding bonds is called the theory of liquidity preferences. The theory of liquidity preference asserts that households hold money because it is commonly accepted in exchange for services or commodities. Assets that are useful because other agents will accept them in exchange are called liquid assets. Another reason why some assets pay higher rate of return is that they are riskier.

27 27 Wealth it s the sum of the value of bonds and money held by households net worth W M + wealth money B B bonds held by households Households accumulate wealth by adding to their stocks of money and bonds. W Y C ortfolio allocation households decide how to allocate their existing wealth between alternative assets. Households budget constraint B B Y i + income owning from bonds w L income from labor maximal income w Y max i + w income by holding money L Y Y max M i The utility theory of money The utility theory of money explains how the representative household chooses a point on its budget constraint. The utility function describes the utility attained by the household for alternative combinations of money and income. Income yields utility because it can be used to purchase commodities. Money yields utility because of its liquidity. Money is useful only because we can exchange it for other commodities. The value of money measured in units of commodities is called real money M balances.

28 28 Money demand and the interest rate According to the utility theory of money, households are better off if they hold more real balances. But the utility gained from holding an extra unit of money decreases as the household holds a larger portion of its wealth in the form of cash. The household transfers wealth up to the point where the marginal utility of transferring an extra dollar from bonds into money is exactly equal to its cost the interest rate. The quantity of real balances expressed as a function of the nominal interest rat is called the demand for money. Money demand and income As income increases, the household must hold more cash to yield the same utility. For this reason, the demand for money, as a function of the interest rate increases as income increases. Mathematical representation of the theory U M U Y, From the viewpoint of individual households, the interest rate, price level and household income are taken as given, households choose how much money to hold. From the viewpoint of the economy as a whole, the quantity of money demanded must equal the quantity of money supplied. Income, the price level, and the interest rate must adjust to ensure that this equality holds. Three main variables on which the demand for (nominal) money depends: income Y the interest rate I the price level In the Keynesian theory the price level is slow to adjust because there are nominal rigidities in the system. Income is also slow to adjust because it takes time for firms to hire and fire workers. In the Keynesian theory, the immediate effect of a change in the money supply, caused by an open market operation, is a change in the interest rate. Using the theory of money demand Mathematics of the utility theory of money U M demand for real balances M Y h measures the relativeimprotance of liquidity to the household h i Y G propensity to hold money

29 29 Unlike the classical theory, k is not a constant in modern theory, it is equal to the parameter h divided by the interest rate i. Velocity of circulation, V This is the number of times per year that the average dollar bill circulates in the 1 economy, measured in units of. years The propensity to hold money, k This is the fraction of a years income that is held on average as a stock of money. 1 V k The LM curve Monetary policy Manipulation of the money supply in order to influence endogenous variables, such as the interest rate or the income level. Money supply exogenous M The theory of the money supply is a theory of how the nominal quantity of money is controlled by the Federal Reserve Board. The real supply of money depends not only on the behaviour of the Federal Reserve Board; it also depends on the price level. LM curve relationship between interest rate and G The combinations of Y and i that lie on the LM curve are the only Y and i combinations for which the quantity of money demanded is equal to the quantity supplied. Algebra of the LM curve M M M M M i h Y i h Y M LM curve The slope and position of the LM curve are determined by the real value of the supply of money because money is held for its ability to buy goods and not for its own sake. Change in the real value of the money supply either as a deduction or increase in or as a result of a fall in the nominal quantity of money the price of commodities, The net effect of an increase in the quantity of money is a drop in the nominal interest rate. When the quantity of money supplied is greater, the equilibrium interest rate that causes the quantity of money demanded to equal the quantity supplied is lower at every level of income.

30 30 Chapter 10 Conclusion from book Commercial banking began with the practice of depositing gold and silver coins with goldsmiths for safekeeping. ince their customers did not typically demand access to their coins at the same time, the goldsmiths could lend them at interest to other traders, crating deposits that themselves began to circulate in the form of promissory notes. Our modern banking system mirrors this medieval system, with the difference that coins and paper money have replaced gold as the ultimate means of payment. The Federal Reserve ystem controls the money supply by setting the discount rate and choosing reserve requirements ; but its major tool is open market operations, the purchase and sale of government bonds on the open market. Open market operations result in changes in the outstanding liabilities of the Federal Reserve ystem. The Federal Reserve ystem s own liabilities, called the monetary base, are partly held by commercial banks and partly held by the public in the form of circulating bank notes. The money supply consists of circulating currency in the hands of the public plus the deposits of household and firms with commercial banks. Although the federal Reserve Board cannot control the money supply directly, it can control the monetary base, and, because the money supply is a multiple of the monetary base, the Federal Reserve can indirectly control M1.

31 31 Chapter 11 Conclusion from book In this chapter, we learned two different definitions of the real interest rate: ex ante and ex post. we used two facts that investment depends on the real interest rate and that saving depends on the real interest rate and income to derive a downward-sloping graph called the I curve. at every point on the I curve, investment equals saving. We showed that government spending, taxes, and the expectations of investors are three different factors that cause the I curve to shift. eriving the I curve is a lot work without an obvious, immediate payoff. But now that we understand how it works, we will be able to use the ideas that we have developed to explain the Keynesian theory of aggregate demand. This theory has rich implications for the causes of business cycles and for the kinds of policies that might be used to stabilize them. My own conclusion The two most important assumptions of classical economists 1. employment is always equal to its natural rate 2. the quantity of money demanded is independent of the interest rate In the real world these assumptions are false. The theory of the capital market In the classical theory of the capital market, the real interest rate equates investment and saving, this theory does not consider output which is fixed at its natural rate. In the Keynesian model, output can fluctuate and we must account for this possibility. Real interest rate this is the nominal rate adjusted for a change in the purchasing power or money. It s the real rate, that influences saving and investment decisions But, nominal interest rate is observed directly. Ex ante real rate this is the real rate that agents expect E r i E s tan ds for exp ected E Ex post real rate this is the real rate that actually occurs r i nominal interest rate inf lation rate

32 32 In times of rapid, unexpected inflation, the ex post real interest rate and the ex ante real interest rate may be very different from each other. When income is high, there will be a relatively large supply of saving to the capital market. High income will be associated with a low equilibrium interest rate. Low income (high unemployment) will be associated with a high equilibrium interest rate. To derive the I curve, we need to recognize that saving may depend not only on the real interest rate, but also on income. We must also recognize that the real interest rate is equal to the nominal interest rate minus expected inflation. saving function investment function Y, i I i E E The increase in the equilibrium nominal interest rate is exactly equal to the increase in expected inflation. eriving the I curve Variables that shift the I curve government spending taxes factors that affect the beliefs of investors about future productivity Government deficits influence the equilibrium interest rate because the government competes with investors for private saving. eficits also influence the capital market equilibrium by shifting the saving schedule households have less disposable income. capital market equilibrium equation I i E + Y, T TR, i E What happens if the deficit goes up? This depends on part on whether government purchases of goods and services go up or net taxes go down If the government increases purchases the I curve shifts to the right (the private saving schedule is unaffected by an increase in government purchases)