Lecture 1 Notes :

For the study of economic growth, it is most helpful to examine movements in Trend GDP ; for
the study of business cycles, it is most helpful to examine movements in deviations from trend in
GDP

Rapid inflation occurs when growth in nominal gdp exceeds growth in real gdp

When we try to measure real gdp and the price level , if we underestiame the growth of real gdp
we will always overestimate the rate of inflation

Significant problems with measuring real GDP and the price level include changes in the quality
of goods over time

Problems with interpreting the unemployment rate as a measure of labour market tightness
include discouraged workers and variations in how intensively the unemployed search for work.

Lecture 2 Notes:

Firms Decisions:
- Firms are going to choose how many workers to hire
-​ More workers means more output
-​ More workers means higher wage bills

- Firms are going to have a fixed stock of capital

- Firms choose how much labor to hire in order to maximize profits

Production Function → Y = zF(K, N)

Y is the firms output
Z is the total factor productivity
K is Capital
N is Labour

Marginal Product of capital (MPK) = Partial Derivative of Y / Partial Derivative of K

Marginal Product of Labor (MPN) = Partial Derivative of Y / Partial Derivative of N

Properties of a Monotone Production Function: Monotone

More inputs produces more outputs
-​ MPK > 0
-​ MPN > 0

Properties of the production function : Decreasing Marginal Products

Adding more of one input produces less the more of that input you have
MPk decreases as K increases ( holding N constant)
MPn decreases as N increases ( Holding K constant)

Properties of the production function : Complements

The marginal product of a factor increases with the quantity of the other factor
MPn increases as K increases
MPk increases as N increases

That is, an increase in z will make both factors of production, K and , more productive, in that,
given factor inputs, higher z implies that more output can be produced.

Production Function Properties

1.​ The production function exhibits constant returns to scale , That is, if all factor inputs are
changed by a factor x, output changes by the same factor x. For example, if all factor
inputs double , then output also doubles. (x)(zF (K, N)) = zF ( xK , xN).
-​ Increasing returns to scale implies that large firms (firms producing a large
quantity of output) are more efficient than small firms
-​ decreasing returns to scale implies that small firms are more efficient than large
firms.
-​ Given a constant-returns-to-scale production function, the economy will behave
in exactly the same way if there were many small firms producing consumption
goods as it would if there were a few large firms, provided all firms behave
competitively
2.​ The production function has the property that output increases when either the capital
input or the labour input increases.
-​ the marginal products of labour and capital are both positive: MpK>0 and
MpN>0
-​ Positive marginal product is a quite natural property of the production function,
as this states simply that more inputs yield more output.
-​ these properties of the production function are exhibited by the upward slope of
the production function.
3.​ The marginal product of labour decreases as the quantity of labour increases.
(Diminishing Marginal product)
 -​ the declining marginal product of labour is reflected in the concavity of the
production function. That is, the slope of the production function which is equal
to MpN , decreases as N increases.
-​ Note that the marginal product schedule is always positive and that it slopes
downward.
4.​ The marginal product of capital decreases as the quantity of capital increases.
-​ decreasing slope, or concavity, of the production function.
-​ the marginal product of the second capital machine is smaller than the marginal
product of the first capital machine,
5.​ The marginal product of labour increases as the quantity of capital input increases.
-​ adding more capital increases the marginal product of labour for each quantity of
labour.
-​ increase in the quantity of capital from K1 to K2 shifts the marginal product of
labour schedule to the right

Change in Total Factor Productivity (z)

-​ An increase in total factor productivity, z, has two important effects. First, since more
output can be produced given capital and labour inputs when z increases, this shifts the
production function up. With the quantity of capital fixed at K*, there is an upward shift
in the production function when z increases from to
-​ Second, the marginal product of labour increases when z increases. This is reflected in
the fact that the slope of the production function is higher than the original slope given ,
for any given quantity of the labour input, .
-​ the marginal product of labour schedule shifts to the right when z increases as an
increase in capital stock
Causes for total factor productivity to increase
-​ One of these factors is technological innovation. Advances in technological innovation
can occur through new inventions
-​ A second factor that acts to increase z is good weather
-​ A third factor affecting z is government regulations.
-​ Finally, an increase in the relative price of energy is often interpreted as a decrease in z.

Cobb Douglas Production Function

-​ Y = z K^a (N)^1-a
-​ Alpha is a parameter that is greater than 0 but less than 1
-​ The exponents on K and N all sum to 1 ( A + 1-A = 1), which reflects constant returns to
scale which implies a = profits of firms and 1-a = wage income before taxes
 -​ We can solve the total factor productivity (z) = Y/K^a (N)^1-a, solow residual

Firm Optimization Problem Introduction

-​ At the profit-maximizing quantity of labour, N*, the slope of the total revenue function is
equal to the slope of the total variable cost function. Which makes MPn = w

Firms Optimization Problem

-​ Firms are trying to maximize their profits
-​ Static Model: K is fixed
-​ Perfect Competition
▶ Firm is a price taker: wage w is given
-​ Monopsony (Future courses)
▶ Firm is a price maker: wage w is chosen
-​ Profits:
π = zF(K, N) − wN
- MPn = W

Profit Maximization Key Idea

-​ If MPn - W > 0
- Additional workers will produce more than the wage cost
- Want to hire more workers
-​ If MPn - W < 0
- The last worker produces less than the wage cost
- Want to hire fewer workers

-​ If MPN - W = 0
- The last worker produces the exact same as the wage cost
- Want to hire exactly this many workers
- “Slope of the two function must be equal at the optimum”
• MPN is the slope of the production function
• w is the slope of the wage bill

Profit Maximization : Mathematical Approach

-​ Assume Perfect Competition : Only Choice is N
-​ π = zF(K, N) − wN
-​ The derivative tells us how profits changes when the firm changes number of workers
-​ ∂π / ∂N = MPN − w
 -​ The Marginal Product of Labour (MPN) is the amount of output we can get from more
labor
-​ The wage w is the cost to hire more labour
Step by Step process on how to solve general profit maximization problem
1.​ Determine the objective function: The function you want to maximize for example the
profit function (π = zF(K, N) − wN)
2.​ Take the derivative of the objective function w.r.t. each choice made , the only choice
here is the number of workers
3.​ Set the derivative of the objective function equal to zero and solve for each variable

Or
1.​ Derive production function to get MPL
2.​ Input #’s to find MPL and set it to W
3.​ Solve for N

Example :
Y = zK^αN^ 1−α
Assume z = 2, K = 4, α = 1 2 , and w = 0.5

1.​ Determine the objective function with the profit function - π = zK^αN^1−α − wN
2.​ Now take the derivative with respect to the choice variable ( N )
-​ ∂π/∂N = z(1 − α)K^αN^−α − w
3.​ Set the derivative equal to zero and solve the equation for N
-​ z(1 − α)K^αN^−α − w = 0
-​ N = (z(1 − α)K^α/w)^ 1/α
-​ Sub In the numbers and solve for N = 16

Labour Demand

Consumer Decisions

A representative consumer : Values Consumption (C) and Leisure (L) , also pay taxes (T) and
dividends (π)
The Utility Function - U( c, l) , (c1, ℓ1) is a consumption bundle.
U(c1, ℓ1) > U(c2, ℓ2) ⇒ individual strictly prefers (c1, ℓ1) to (c2, ℓ2).
U(c1, ℓ1) = U(c2, ℓ2) ⇒ individual indifferent between both consumption bundles.

Indifference Curves
-​ An indifference curve connects a set of points, representing consumption bundles,
among which the consumer is indifferent.
-​ Monotone: the more, the better =⇒ indifference curves will slope down
-​ Convex: prefers averages to extremes =⇒ indifference is bowed in toward the origin
-​ Strictly monotone: More is always better ▶ ∂U(·)/ ∂c > 0 → Marginal utility of
consumption is greater than 0
-​ Weakly monotone: More is at least as good ▶ ∂U(·)/ ∂c ≥ 0 → Marginal utility of
consumption is greater than 0 or equal to 0
-​ Strictly convex: Averages are always preferred ▶ U(c1, ℓ1) = U(c2, ℓ2) < U( c1+c2/2 ,
ℓ1+ℓ2/2 )
-​ Weakly convex: Averages are at least as good ▶ U(c1, ℓ1) = U(c2, ℓ2) ≤ U( c1+c2/2 ,
ℓ1+ℓ2/2 )

Marginal Rate of Substitution

The rate at which you would exchange two goods and remain indifferent

∂U(·,·)/∂c = the marginal utility of consumption = MUc = Uc(c, ℓ)

∂U(·,·)/∂ℓ = the marginal utility of leisure = MUℓ = Uℓ(c, ℓ)

MRSℓ,c = (∂U(·,·)/∂ℓ)/(∂U(·,·)/∂c) = MUℓ/MUc

The rate at which the consumer is just willing to substitute leisure for consumption goods

The MRSℓ,c is the negative of the slope of the indifference curve at a particular consumption
bundle (c0, ℓ0), Convex: diminishing MRSℓ,c

The Time Constraint

The consumer has a fixed time of h

The consumer can choose to spend this time: ▶ Working Ns ▶ Enjoying leisure ℓ
Therefore, h = ℓ + Ns
The Budget Constraint

W: Wage per unit of time

-​ Consumer is Wage taker
-​ Unit of consumption of good
π: Dividends, profits of the firm
T : Taxes
C : Consumption

c = wNs + π − T → Consumption = Labour income + profits from dividends - Taxes

→ c = wNs + π − T
→ c = w(h − ℓ) + π − T
→ c = −wℓ + wh + π − T
C and L are chosen and the rest are given

dc/dℓ = −w; The slope of the budget line

▶ This is the rate at which the labor market will transform leisure into consumption

The slope of the budget constraint is , and the constraint shifts with the quantity of nonwage
real disposable income, . All points in the shaded area and on the budget constraint can be
purchased by the consumer.

Slope of the budget constraint is -w and the vertical intercept is Wh + profits - Taxes

The horizontal intercept = h + (profits - taxes)/w

The vertical intercept is the maximum quantity of consumption attainable for the consumer,
which is what is achieved if the consumer works h hours and consumes no leisure. The
horizontal intercept is the maximum number of hours of leisure that the consumer can take and
still be able to pay the lump-sum tax.

Set C in budget constraint to 0 and solve for L to get max leisure

The budget constraint → profits - Taxes is more than 0

-​ the budget constraint is somewhat unusual, as it is kinked; the slope of the budget
constraint is over its upper portion, and the constraint is vertical over its lower portion.
 -​ There is a kink in the budget constraint because the consumer cannot consume more
than 24 hours of leisure.
-​

Consumer Optimization - The Graphical Approach

1.​ Point J : Inside the
budget set, cannot be
optimal since you can
afford more, Monotone
preferences.
2.​ Point F : MRSℓ,c >
w, You are willing to give
up more consumption for
a unit of leisure than your
wage, Ex. Mrsl,c = 2 and w
=1
3.​ Point E: MRSℓ,c < w,
You are willing to give up
less consumption for a unit
of leisure than your wage,
E.g. MRSl,c = 0.5 and w = 1
4.​ Point H: MRSℓ,c =
w; this is optimal. The amount of consumption you are willing to give up is exactly equal
to your wage. MRSℓ,c = 1 and w = 1

The consumption bundle represented by point H, where an indifference curve is tangent to the
budget constraint, is the optimal consumption bundle for the consumer

The optimal consumption bundle is the point representing a consumption–leisure pair that is
on the highest possible indifference curve and is on or inside the consumer’s budget constraint.

If MRS l,c is greater than W then the rate at which the consumer is willing to trade leisure for
consumption is greater than the rate at which the consumer can trade leisure for consumption
in the market.

At Point H (optimal consumption bundle) the rate at which the consumer is willing to trade
leisure for consumption is equal to the rate at which leisure trades for consumption in the
market, and thus the consumer is at his or her optimum.
Changes in profits - taxes

-​ We hold W constant, In any case, we will think of the increase in as producing a pure
income effect, the effect on a consumers consumption bundle because of a change in
real disposable income, on the consumer’s choices, since prices remain the same (w
remains constant) while disposable income increases.
-​ if we hold the real wage constant, an increase in income will imply that the
representative consumer will choose more consumption and more leisure
-​ Though nonwage income increases, wage income falls since the consumer is working
less. The reduction in income from the decrease in wage income will not completely
offset the increase in nonwage income, as consumption has to increase because it is a
normal good.
-​ More is available at L = H and the slope of budget line remains unchanged
-​ When either of proifts or taxes changes there is only an income effect

Income and sub effect

-​ given that consumption and leisure are normal goods, consumption must increase but
leisure may increase or decrease in response to an increase in the real wage.

Sub effect
-​ The movement from F to O is a pure substitution effect in that it just captures the
movement along the indifference curve in response to the increase in the real
wage. The real wage increases, so that leisure becomes more expensive relative
to consumption goods, and the consumer substitutes away from the good that
has become more expensive (leisure) to the one that has become relatively
cheaper (consumption). Therefore, the substitution effect of the real wage
increase is for consumption to increase and for leisure to decrease, and so the
substitution effect is for labour supply, , to increase.
-​ Wage increase , so leisure more expensive since not working when you have a
high wage means you are sacrificing making good money for leisure, so
substitute L for C
Income effect
-​ as the real wage stays the same as the budget constraint shifts out from JKD to EBD, and
nonwage income increases. Since both goods are normal, consumption increases and
leisure increases in moving from O to H. Thus, when the real wage increases, the
consumer can consume more consumption goods and more leisure, since the budget
 constraint has shifted out. On net, then, consumption must increase, since the
substitution and income effects both act to increase consumption. However, there are
opposing substitution and income effects on leisure, so that it is ultimately unclear
whether leisure will rise or fall. Therefore, an increase in the real wage could lead to an
increase or a decrease in labour supply .
-​ Individuals are wealthier so they chose to increase both leisure and consumption more

Labour Supply
-​ Consumers wage income is taxed at a constant rate tw(h-l) and the consumers budget
constraint would be c = wage( 1 - taxes) (hours - leisure) + profits.
-​ theory tells us that an increase in the income tax rate t may cause an increase or a
decrease in the quantity of labour supplied
-​ So, the statement is saying that for a tax increase to cause people to work fewer hours,
the feeling of "it's not worth it to work" (substitution effect) has to be stronger than the
need to "make up for lost money" (income effect). If the substitution effect is large
enough, the increase in taxes creates a strong disincentive to work, leading people to
reduce their hours. The labour supply curve shifts to the left (decreases)
-​ the key idea is that what matters for aggregate economic activity is total labour input,
which is determined by three factors: (i) how many hours each individual works, (ii) how
many individuals are working, and (iii) the quality of the labour hours supplied.
-​ suppose l(w) is a function that tells us how much leisure the consumer wants to
consume, given the real wage w. Then, the labour supply curve is given by Labour
supplied (w) = hours - leisure (wage)
-​ Assuming that the substitution effect is larger than the income effect of a change in the
real wage, labour supply will increase with an increase in the real wage, and the labour
supply schedule will be upward-sloping, we will typically assume that the substitution
effect of an increase in the real wage dominates the income effect, so that the labour
supply curve is upward-sloping
-​ we know that, since the quantity of leisure increases when nonwage disposable income
increases, an increase in nonwage disposable income will shift the labour supply curve
to the left.

Perfect Complements
-​ Goods are perfect complements for the consumer if he or she always wants to consume
these goods in fixed proportions.
-​ If consumption and leisure are perfect complements, the consumer always wants to
have c/l equal to some constant, or c = (a)(L) → where A is a constant greater than 0
-​ With perfect complements, the indifference curves of the consumer will be L-shaped,
 -​ Note that perfect complements preferences do not satisfy all the properties for
preferences that we assumed in general. More is not always preferred to less, as the
consumer is not better off with more of one good unless he or she has more of the other
good as well. However, the consumer does have a preference for diversity, but of a very
dramatic sort. That is, as we move downward along the indifference curve, the slope
does not become flatter smoothly, but goes instantly from vertical to
horizontal
-​ The optimal consumption bundle for the consumer will always
be along the line c = (a)(l)
-​ With the budget constraint, C = (a(wh + profits - taxes)/ a + w)
and L = (wh + profits - taxes) / (a + w )
-​ Leisure and consumption therefore increase with nonwage
disposable income, , and we can also show that consumption and
leisure both increase when the real wage, w, increases.
-​ Further, if a increases, so that the consumer prefers more consumption relative to
leisure, then it seems obvious the consumer will choose more of C and less of l at the
optimum.

Consumer Optimization - Setting Up Mathematical Approach

Budget constraint - c = −wl + wh + π − T

The Question:
How can we choose c and ℓ to maximize preferences while making sure the budget constraint
holds? This requires a basic understanding of constrained-optimization problem

max (x1,x2) f(x1, x2) = x1x2 subject to x1 + 4x2 = 16

where:
• f (x1, x2) is the objective function
• x1 + 4x2 = 16 is the constraint
• x1, x2 are the choice variables

Construct and Maximize the Lagrangian Function :

max (x1,x2,λ) L = x1x2 − λ(x1 + 4x2 − 16)
Textbook Notes

Chapter 4

Representative consumer preferences have three properties

1.​ More is always preferred to less. - A consumer always prefers a consumption bundle
that contains more consumption, more leisure, or both.
2.​ The consumer likes diversity in his or her consumption bundle. - At the extreme,
suppose that the consumer is indifferent between a consumption bundle that has 6
units of consumption and no leisure, and another bundle that has no consumption
goods and 8 units of leisure. Then, a preference for diversity implies that the consumer
would prefer a third consumption bundle, consisting of half of each of the other
bundles, to having either of the other consumption bundles. This preferable third
consumption bundle would have 3 units of consumption goods and 4 units of leisure.
3.​ Consumption and leisure are normal goods. - A good is normal for a consumer if the
quantity of the good that he or she purchases increases when income increases. For
example, meals at high-quality restaurants are a normal good for most people; if our
income increases, we tend to eat out more in good places.

Indifference curves: If two consumption bundles lie on the same indifference curve , they have
the same utility.

Since indifference curve A lies above indifference curve B , and we know more is preferred to
less, consumption bundles on A are strictly preferred to consumption bundles on B .

Indifference Curve Properties :

1.​ An indifference curve slopes downward - More is preferred to less
2.​ An indifference curve is convex, that is, bowed in toward the origin. - Consumers like
diverse bundles
The marginal rate of substitution of leisure for consumption, denoted , is the rate at which the
consumer is just willing to substitute leisure for consumption goods.

MRS is the negative slope of the indifference curve

Time constraint → Leisure + Ns ( time spent working) = Hours

Consumers disposable income = Wage income + dividend income - Taxes

Real wage income = (w)(Ns)

Real wage income plus real dividend income minus taxes is the consumer’s real disposable
income, and this is what the consumer has available to spend on consumption goods.

Consumer’s budget constraint = wNs + Profits - Taxes

Substituting wNs = wage ( hours - leisure) + profits - taxes

Slope of the budget constraint is -w and the vertical intercept is Wh + profits - Taxes

The horizontal intercept = h + (profits - taxes)/w

The vertical intercept is the maximum quantity of consumption attainable for the consumer,
which is what is achieved if the consumer works h hours and consumes no leisure. The
horizontal intercept is the maximum number of hours of leisure that the consumer can take and
still be able to pay the lump-sum tax.

Set C in budget constraint to 0 and solve for L to get max leisure

Lecture 5 :

Competitive Equilibrium
-​ Find situation where the behaviour of all these agents is consistent
-​ Given market prices:
-​ • All individual agents make optimal decisions
▶ Firms
▶ Consumers
-​ • All markets clear
-​ • Government budget is balanced

Production possibility frontier

-​ A graphical tool that shows us the combination of consumption bundles that is possible
to consume in the economy
-​ C + G = Y , C + G = zF(K,N) , C + G = zF(K, h-l)
Static model :
-​ Shows us the possible combinations of consumption and leisure,
-​ Given the level of z , h and G as well as the production function F(K,L)
Draw a graph with Y on the vertical axis and N on the horizontal axis which shows the
production function ( zF(K,N)) which has the slope = MPN

Also slope of PPF (-) = The marginal rate of transformation; The rate at which one good (e.g.,
leisure) can be converted into another (e.g., consumption)

Profit = Y - Wn → Y - W(h - l)

Mathematical approach to competitive equilibrium

Utility Function -λ( Budget constraint)

Chapter 5 notes
-​ A public good is a commodity or service that every member of a society can use without
reducing its availability to all others. ( National Defense)
-​ We will show how increases in government spending increase aggregate output and
crowd out private consumption expenditures, and how increases in productivity can lead
to increases in aggregate output and the standard of living. Finally, we will consider a
version of the model where the economic outcome is not socially efficient in an
economy with unregulated private markets, because of the incentive effects of income
taxation, and we also consider a simple model of how the government should determine
government spending.
-​ The government's behavior : It wants to purchase a given quantity of consumption
goods, G, and finances these purchases by taxing the representative consumer.
-​ Government spending uses up resources, and we will model this by assuming that
government spending simply involves taking goods from the private sector.
-​ An exogenous variable is determined outside the model, while an endogenous variable
is determined by the model itself.
-​ Government spending is exogenous in our model, as we are assuming that government
spending is independent of what happens in the rest of the economy. The government
must abide by the government budget constraint, which we write as G = T , government
purchases are equal to taxes
-​ In a static model government spending equals taxes and there is no surplus or deficit

Consumption bundles for each type of tax

-​ Lump sum taxes T → c =wN + π−T or G=T
-​ Proportional labour income taxes → c =(1−τy )wN + π or G =τywN
Competitive equilibrium
-​ In the model we are working with here, the exogenous variables are G, z, and K—that is,
government spending, total factor productivity, and the economy’s capital stock,
respectively.
-​ The endogenous variables are C, Ns ,Nd , T, Y, and w—that is, consumption, the quantity
of labour supplied, the quantity of labour demanded, taxes, aggregate output, and the
market real wage. And leisure L.
-​ competitive equilibrium: Here, competitive refers to the fact that all consumers and
firms are price-takers, and the economy is in equilibrium when the actions of all
consumers and firms are consistent. All markets are clear.
-​ When demand equals supply we call that market clearing
-​ A competitive equilibrium is achieved when, given the exogenous variables G, z, and K,
the real wage w is such that the quantity of labor the consumer wants to supply is equal
to the quantity of labor the firm wants to hire. Also, note that the consumer’s supply of
labor is in part determined by taxes T and dividend income π. In a competitive
equilibrium, T must satisfy the government budget constraint, and π must be equal to
the profits generated by the firm.
A competitive equilibrium is a set of endogenous quantities, C (consumption), Ns (labour
supply), (labour demand), T (taxes), Y (aggregate output), and an endogenous real wage, w,
such that, given the exogenous variables G (government spending), z (total factor productivity),
and K (capital stock), the following are satisfied:
1.​ The representative consumer chooses C (consumption) and Ns (labour supply) to make
himself or herself as well off as possible subject to his or her budget constraint, given w
(the real wage), T (taxes), and π (dividend income). That is, the representative consumer
optimizes given his or her budget constraint, which is determined by the real wage,
taxes, and the profits the consumer receives from the firm as dividend income.
-​ In simple terms, the consumer is trying to balance work and spending to get the
most satisfaction possible, while sticking to a budget. The consumer makes
decisions about how much to work (labor supply) and how much to spend on
things (consumption), trying to maximize happiness without spending more than
they have.

2.​ The representative firm chooses Nd (labour demand) to maximize profits, with
Y=zf(K,Nd) maximized output and π = Y - wNd maximized profits. The firm treats z (total
factor productivity), K (the capital stock), and w (the real wage) as given. That is, the
representative firm optimizes given total factor productivity, its capital stock, and the
 market real wage. In equilibrium, the profits that the representative firm earns must be
equal to the dividend income that is received by the consumer.
-​ In simple terms, the firm is trying to make the most profit possible by deciding how
many workers to hire (labor demand). To do this, it looks at:
1.​ Total Factor Productivity (z): How efficiently it can turn inputs like labor and capital into
output.
2.​ Capital Stock (K): The equipment, buildings, and other assets it already owns.
3.​ Real Wage (w): The cost of hiring each worker.

The firm wants to produce as much as it can with what it has, while paying workers a wage that
lets it stay profitable. In a balanced market (equilibrium), all profits the firm makes go to the
consumers (or shareholders) as dividends, which becomes extra income for them. So, the firm's
goal to maximize profits aligns with consumers receiving income from those profits.

3. The market for labour clears, that is, Ns = Nd . The amount of labour that the representative
firm wants to hire is equal to the amount of labour the representative consumer wants to
supply.

4. The government budget constraint is satisfied—that is, The taxes paid by consumers are
equal to the exogenous quantity of government spending.

5. Another property that is important is the good market clears:

-​ Y = C + G
-​ In a closed economy there is no exports or imports (NX) and this is a one period
economy so there is no investments (I)

The production function shows the maximum amount of output

with labor input . The slope is the marginal product of labor

The output as a function of leisure graph shows how much output

would occur based on how much the consumer uses leisure.
Slope= - MPn

We show the production possibilities frontier (PPF), which is the

technological relationship between C and l, determined by shifting
the relationship in (b) down by the amount G. The shaded region
in (c) represents consumption bundles that are technologically feasible to produce in this
economy.

-​ The Production Possibility Frontier is a graphical tool that shows us the combination of
consumption bundles that it is possible to consume in the economy.
-​ The ppf is the relationship in the output as a function of leisure graph shifted down by
the amount G, since consumption is output minus government spending in equilibrium.
-​ In simple terms, the PPF (Production Possibility Frontier) shows the balance or tradeoff
between how much people in the economy can consume (buy and use goods) and how
much leisure time they can have (time not working). In short, only points on DB make
sense because they ensure both the government and individuals have enough goods
available.
-​ The negative of the slope of the PPF is the Marginal product of labour but it is also the
Marginal rate of transformation which means , The rate at which one good (e.g., leisure)
can be converted into another (e.g., consumption).
-​ MRT = MPn = - slope of the ppf
-​ Namely, the representative firm chooses the labour input to maximize profits in
equilibrium by setting MPn = w
-​ Maximized profits for the firm are π = zF(k , h - l) - w(h - l) (total revenue minus the cost
of hiring labour).
-​

This figure brings together the representative consumer’s

preferences and the representative firm’s production
technology to determine a competitive equilibrium. Point J
represents the equilibrium consumption bundle. ADB is
the budget constraint faced by the consumer in
equilibrium, with the slope of AD equal to minus the real
wage and the distance DB equal to dividend income minus
taxes.

In other words, the marginal rate of substitution of leisure for consumption is equal to the
marginal rate of transformation, which is equal to the marginal product of labour.

That is, because the consumer and the firm face the same market real wage in equilibrium, the
rate at which the consumer is just willing to trade leisure for consumption is the same as the
rate at which leisure can be converted into consumption goods by using the production
technology.

Changes in government spending :

Indeed, since an increase in government spending must necessarily increase taxes by the same
amount, which will reduce the consumer’s disposable income. It should not be surprising, then,
that the effects of an increase in government spending essentially involve a negative income
effect on consumption and leisure.

an increase in G from G1 to G2 shifts the PPF from PPF1 to PPF2 , where the shift down is by
the same amount, for each quantity of leisure, l. This shift leaves the slope of the PPF
unchanged for each l. The effect of shifting the PPF downward by a constant amount is very
similar to shifting the budget constraint for the consumer through a reduction in his or her
nonwage disposable income

There are negative income effects on consumption and leisure, so that both C and l fall, and
employment rises, while output (equal to C + G ) increases.

Why do consumption and leisure decrease? This is because consumption and leisure are normal
goods. Given the normal goods assumption, a negative income effect from the downward shift
in the PPF must reduce consumption and leisure.

Since leisure falls, then employment , which is N2 = h - L2 must rise. This also makes output
increase.

there is a negative income effect on leisure and therefore a positive effect on labour supply, a
larger government reduces private consumption through a negative income effect produced by
the higher taxes required to finance higher government spending. As the representative
consumer pays higher taxes, his or her disposable income falls, and in equilibrium he or she
spends less on consumption goods and works harder to support a larger government.

Thus, since minus the slope of the PPF at the equilibrium point is equal to the equilibrium real
wage, the real wage falls because of the increase in government spending. The real wage must
fall, as we know that equilibrium employment rises, and the representative firm would hire
more labour only in response to a reduction in the market real wage.

Math part for solving equilibrium *

Limitations of the static model

What is this model missing? Static:

-​ No savings
-​ Closed Economy: No foreign trade or capital flows
-​ Government spending is not valued

What is this model useful for?

-​ Interaction of consumer decisions, firm decisions, and the government’s decisions

-​ How firm decisions impact consumers
-​ How consumer decisions impact firms
-​ How government decisions affect both

Optimality

A competitive equilibrium is Pareto-optimal if there is no way to rearrange production or to

reallocate goods so that someone is made better off without making someone else worse off.

the Pareto optimum is located at point B, where an indifference curve is just tangent to the PPF

The Pareto optimum is the point that a social planner would choose, where the representative
consumer is as well off as possible given the technology for producing consumption goods by
using labour as an input.

the Pareto optimum has the property that MRT = MPn = MRS

A key result of this chapter is that, for this model, the competitive equilibrium is identical to the
Pareto optimum.

First welfare theorem - states that, under certain conditions, a competitive equilibrium is
Pareto-optimal.

Second welfare theorem - states that, under certain conditions, a Pareto optimum is a
competitive equilibrium.

In simple terms, the competitive market outcome is as good as what a wise, all-knowing
planner would have chosen for society. This is because, in a well-functioning market, people’s
self-interested actions lead to an outcome where resources are allocated efficiently without
anyone needing to control or plan it directly.

Chapter 9 :

-​ In intertemporal choice, a key variable of interest is the real interest rate, which in the
model is the interest rate at which consumers and the government can borrow and lend.
-​ The real interest rate determines the relative price of consumption in the future in terms
of consumption in the present.
-​ An important principle in the response of consumption to changes in income is
consumption smoothing. That is, there are natural forces that cause consumers to want
to have a smooth consumption path over time, as opposed to a choppy one.
Consumption-smoothing behavior is implied by particular properties of indifference
curves.
-​ As well, consumption-smoothing behavior has important implications for how
consumers will respond in the aggregate to changes in government policies or other
features of their external environment that affect their income streams.
-​ the Ricardian equivalence theorem establishes conditions under which the timing of
taxation does not matter for aggregate economic activity.
-​ A key implication of the Ricardian equivalence theorem is that a tax cut is not a free
lunch. A tax cut may not matter at all, or it may involve a redistribution of wealth within
the current population or across generations.
-​ By saving, a consumer gives up consumption in exchange for assets in the present, in
order to consume more in the future. Alternatively, a consumer can dissave by
borrowing in the present to gain more current consumption, thereby sacrificing future
consumption when the loan is repaid. Borrowing (or dissaving) is thus negative savings.
-​ In this model, we will denote the first period as the current period and the second period
as the future period

Intuition behind dynamic model :

-​ Consumers receive some income in both periods

-​ Consumers consume in both periods
-​ Suppose there is m consumers ( large number)

We will further suppose that consumers do not make a work–leisure decision in either period
but simply receive exogenous income
y is consumers real income in current period and y’ be consumers real income in second period

Each consumer pays lump-sum taxes, t, in the current period and t’ in the future period.

Consumers savings = s

So the consumers budget constraint is c+s = y -t , consumption plus savings in the current period
must equal disposable income in the current period

Note that we assume that the consumer starts the current period with no assets.

if s > 0 then the consumer will be a lender on the credit market, and if s < 0 the consumer will
be a borrower.

Assume that the financial asset being traded is bonds, If a consumer lends, he or she buys
bonds; if he or she borrows, they are selling bonds.

Assumptions : Bonds have no risk , Bonds are traded directly

Real interest rate is r

1 consumption unit today buys (1 + r) consumption units tomorrow

(1 + r) is the price of current relative to future consumption

the relative price of future consumption in terms of current consumption is 1/1+r

In the future period, the consumer has disposable income y’ - t’ and receives the interest and
principal on his or her savings, which totals (1 +r)s

Consumption in the future period is y’ - t’ + (1 +r)s. This is because we assume they consume all
their money in the second period. No money given to descendants

Life time Budget Constraint

-​ C + c’/1+r = y+ y’/1+r - t - t’/1+r

-​ It states that the present value of lifetime consumption = to the present value of lifetime
income minus the present value of lifetime taxes
-​ t + t’ x 1/1+r = present value of life time taxes
-​ y + y’ x 1/1+r = present value of life time income
-​ c + c’ x 1/1+r = present value of life time consumption
Life time wealth

-​ The present value of lifetime disposable income for a consumer

-​ we = y + y ′/ (1 + r) − t − t ′/(1 + r)
-​ c + c ′/ (1 + r) = we
-​ equation in slope–intercept form, we have c ′ = −(1 + r)c + we(1 + r)

The lifetime budget constraint defines the

quantities of current and future consumption the
consumer can acquire, given current and future
income and taxes, through borrowing and
lending on the credit market. To the northwest of
the endowment point E, the consumer is a lender
with positive savings; to the southeast of E, he or
she is a borrower with negative savings.

The slope of the lifetime budget constraint is

-(1+r)

the endowment point, which is the consumption bundle the consumer gets if he or she simply
consumes disposable income in the current period and in the future period. consumption is
equal to disposable income in each period.

Consumers preferences :

-​ Monotone : More is always preferred to less. More current consumption or more future
consumption always makes the consumer better off.
-​ The consumer likes diversity in his or consumption bundle, averages are preferred to
extremes. Consumption smoothing
-​ Consumption and leisure are normal goods; This implies that if there is a parallel shift to
the right in the consumer’s budget constraint, current consumption and future
consumption will both increase. This is related to the consumer’s desire to smooth
consumption over time. If there is a parallel shift to the right in the consumer’s budget
constraint, it is because lifetime wealth, we, has increased. Given the consumer’s desire
to smooth consumption over time, any increase in lifetime wealth will imply that the
consumer will choose more consumption in the present and in the future.

Consumer optimization
 -​ the marginal rate of substitution of current consumption for future consumption which
is minus the slope of the indifference curve is equal to the relative price of current
consumption in terms of future consumption ( which is minus the slope of the
consumer’s lifetime budget constraint).
-​ Here, the consumer optimizes by choosing the consumption bundle on his or her
lifetime budget constraint where the rate at which he or she is willing to trade off
current consumption for future consumption is the same as the rate at which he or she
can trade current consumption for future consumption in the market (by saving).
-​ The consumer is a lender if the savings is positive , this is if y-t ( disposable income) is
greater than consumption
-​ The consumer is a borrower if the savings is negative , this is if y-t(disposable income) is
less than consumption

Changes in interest rate

-​ responds to a change in the real interest rate, which will change the slope of the budget
constraint.
-​ An increase in the real interest rate holding others constant makes the budget
constraint steeper
-​ Further, under the assumption that the consumer never has to pay a tax larger than his
or her income, so that y’-t’ > 0 , an increase in r will decrease lifetime wealth, we
-​ and since y > t there will be an increase in we(1 +r) when r increases. Therefore, we
know that an increase in r will cause the budget constraint to pivot,
-​ We also know that the budget constraint must pivot around the endowment point E,
since it must always be possible for the consumer to consume his or her disposable
income in each period, no matter what the real interest rate is.
-​ that is, an increase in r causes future consumption to become cheaper relative to
current consumption. A higher interest rate implies that the return on savings is higher,
so that more future consumption goods can be obtained for a given sacrifice of current
consumption goods.
-​ Current consumption is more expensive with an increase to the interest rate
-​ The slope of the budget constraint becomes -(1+ r2)

An increase in interest rate : A lender

-​ Substitution effect : Increase in future consumption and decrease in current

consumption
-​ Income Effect : Increase in future consumption and increase in current consumption
-​ Future consumption rises unambiguously
 -​ The changes in current consumption and savings are ambiguous
-​ If sub effect dominates : Current consumption decreases and savings increase
-​ If income effect dominates : Current consumption increases and savings decreases

An increase in the interest rate : A borrower

-​ Sub effect : future consumption increases and current consumption decreases

-​ Income effect : Both current and future consumption decrease
-​ Current consumption decreases unambiguously and therefore savings increase
-​ The changes in future consumption are ambiguous
-​ If sub effect dominates , future consumption increases
-​ If income effect dominates , future consumption decreases

Households smooth their consumption over time , even if their income is volatile they can
smooth their consumption by either borrowing or saving

Consumption smoothing is the tendency of consumers to seek a consumption path over time
that is smoother than income.

Durable Goods: long term goods that are not entirely consumed in the year that they are
purchased

-​ ▶ e.g. Cars, Refrigerators, Computers, Sports Equipment, Jewellery

-​ Durables and Semi-durables are consumed much more volatile than GDP

Non-Durable Goods: goods that are entirely consumed after purchase

-​ ▶ e.g. Groceries, Cleaning Products, Alcohol, Pens and Paper

-​ Nondurables and services are consumed less volatile than GDP

The permanent income hypothesis : only permanent income should matter for consumption

-​ Permanent income is closely related to lifetime wealth

-​ that the increase in current consumption is less than the increase in current income, as
saving increases because of consumption-smoothing behaviour.
 -​ If individuals have monotone and convex preferences: Save when y is high and Borrow
when y is low
-​ Therefore, if income increases permanently, this has a larger effect on current
consumption than if income increases only temporarily.

What data could falsify this hypothesis?

▶ (Non-durable) consumption is less volatile than income

▶ Permanent income hypothesis gives us one explanation for why

Why is consumption still volatile?

▶ Changes in permanent income

▶ Imperfect credit markets: people cannot always borrow

• Suppose we have T periods (e.g., 60 years), Consider an increase in period t income, yt , by

$1,000

▶ Temporary: ↑ in permanent income is small ⇒ ↑ in ct is small

-​ • If preferences are perfect compliments: ∆ct = $1,000 60 = $16.67

▶ Permanent: ↑ in permanent income is large ⇒ ↑ in ct is large

-​ If preferences are perfect compliments: ∆ct = $1, 000

Cut taxes : taxes decrease and consumption increases

-​ Permanent cut → will have a large impact on consumption

-​ Temporary cut → will have a small impact on consumption

The property of diminishing marginal rate of substitution follows from the property of the
indifference curve that bowed in toward the origin

Government :

The aggregate tax amount collected = T and for the future period → T’

And m is consumers and t is current tax, so T = mt

Government's current period budget constraint → G = T + B → B = Bonds issued by government

Governemnts future period budget constraint → G’ + (1+r) B = T’

Deficit: B > 0 , Surplus: B < 0

Government’s lifetime budget constraint G + G ′ /(1 + r) = T + T ′/ (1 + r)

The Ricardian Equivalence Theorem states that changes in the timing of taxes will not affect the
equilibrium real interest rate or the consumption of individuals.

-​ Assuming the present-value of government expenditure, and therefore the

present-value of total taxes does not change

The Ricardian Equivalence Theorem states that if current and future government spending are
held constant, a change in current taxes with an equal and opposite change in the present value
of future taxes leaves the equilibrium real interest rate and the consumptions of individuals
unchanged.

States that the timing of taxes is neutral

If future income increases and current income decreases and lifetime wealth is unchanged than
a consumer will reduce its current savings

The timing of taxes changes the position of the endowment point, but not the shape or position
of the budget constraint

Lecture 5 : Imperfect Credit Markets

The phenomenon that some consumers pay a higher interest rate when they borrow than the
interest rate they receive when they lend is best described as an example of credit market
imperfections.

In a simple model of credit imperfections, when consumers borrow and lend at different
interest rates, the budget line is kinked because the consumer lends at a lower rate than they
borrow.

Asymmetric information means some market participants have more information than others.

If there are fewer bad borrowers in the population when there is asymmetric information, the
interest rate spread declines.If there are more bad borrowers in the population when there is
asymmetric information , the interest rate spread grows
If the value of collateral falls for a consumer , current consumption must fall. If the value of
collateral rises for a consumer , current consumption must rise

Limited commitment means one cannot credibly promise something

If consumers use their house as collateral for lending and the value of housing in general falls
then lending and aggregate consumption decreases

For a consumer not bound by the collateral constraint, a reduction in the price of the collateral
leads to a decrease in current and future consumption.

In a pay-as-you-go system , the young transfer resources to the old.

In a pay as you go system it benefits everyone if the population growth rate is higher than the
real interest rate. The rate of return on private savings is r , The rate of return of the pension
system is n.

In the real world there can be problems if :

People live longer: draw benefits for longer

Population growth slows down below r

Consumers benefit from the pay as you go system , With sufficiently high population growth,
many young contribute to the benefits of the old.

-​ in practice the interest rates at which consumers and firms can lend are lower than the
interest rates at which they can borrow, consumers and firms cannot always borrow up
to the quantity they would like at market interest rates, and borrowers are sometimes
required to post collateral against a loan.

Different Rates intuition

-​ Borrowing rates are typically higher than savings rates

-​ Banks need to pay for real costs in order to provide services
-​ Make money on the interest rate spread

When solving the question for different intrest rates

 -​ If zero valid answers: the endowment point is optimal
-​ ▶ If one valid answer: this is optimal
-​ ▶ If two valid answers: check the utility of each! (Rare)

Assymetric information

-​ During a financial crisis, the quality of information in credit markets declines, with
important implications for market interest rates, the quantity of lending, and aggregate
economic activity.
-​ In the model, a bank borrows from its depositors in the current period, and each
depositor is an ultimate lender in the economy, with a depositor receiving a real interest
rate on his or her deposits, which are held with the bank until the future period. The
bank takes all of its deposits in the current period (which in the model are consumption
goods), and makes loans to borrowers.
-​ To make things simple, suppose that a fraction a of the borrowers in the economy are
good borrowers who have positive income in the future period, while a fraction of
borrowers are bad, in that they receive zero income in the future period and therefore
will default on any loan that is extended to them.

Can banks still be profitable ? Yes , if they If they pick an interest rate so that

▶ They make profits when lending to good borrowers

▶ They make losses when lending to bad borrowers

▶ Their profits from good borrowers exceed losses from bad borrowers

Borrowers pay interest rate rb and banks pays lenders interest rate rL

Banks profits will be: aL × (1 + rb) + (1 − a)L × 0 − L × (1 + rℓ)

To make a profit the interest rate to borrowers has to be higher than the interest rate they pay
to lenders.
In equilibrium, each bank must earn zero profits, since negative profits would imply that banks
would want to shut down and positive profits would imply that banks would want to expand
indefinitely. Therefore to have 0 profits the borrowing interest rate must be :

Rb = (1 + rL / a) - 1

As more people are unable to pay a → 0 , interest rate for all borrowers increase

As a result:

Consumers consume less today

Firms invest less today

GDP falls further

Asymmetric information problems can amplify shocks

For a consumer who is a borrower, consumption in the current period and borrowing must
decrease as bad borrowers grows ( a declines) .

To find rb → 1/a (1 + rL) -1 = rb

Evaluating the asymmetric model :

The model is missing

-​ Why some borrowers receive income in the future and some do not
-​ Investing in themselves or others , or just partying
-​ Some are lucky/unlucky

Actual risk

-​ In the model borrowers know their type

-​ In the real world , some things are risky and some people who believe they will have
future income wont actually have any ( layoffs , massive debt)

What is this model useful for?

• How banks make loans and diversify risk across many borrowers

• How economic conditions will impact default and consumption

• One possible explanation for why interest rates for lenders are lower than interest rates for
borrowers

Limited Commitment

-​ Any loan contract represents an intertemporal exchange—the borrower receives goods

and services in the present in exchange for a promise to give the lender claims to goods
and services in the future. However, when the future arrives, the borrower may find it
disadvantageous to keep his or her promise.
-​ One incentive device used widely by lenders is the requirement that a borrower post
collateral. In general, collateral is an asset owned by the borrower that the lender has a
right to seize if the borrower defaults on the loan (does not meet the promised
payment).

Limited commitment setup

-​ Borrower has an asset H

-​ The price of the asset is p
-​ The asset is illiquid , which means you cannot sell it in the current period and its hard to
liquidate quickly

The consumers lifetime wealth budget constraint is :

We = = y − t + (y ′ − t ′/ + pH 1 + r)

The bank will now only lend the borrower the price of the collateral asset

pH >/= -s(1 + rb)

As -s(1 + rb) is the loan payment for the consumer in the future period, and pH is the value of
the collateral in the future period

Consumers lifetime budget constraint = c + C’/ 1+r = we

Limited commitment and financial crises

-​ When the economy contracts, prices for collateral p fall

-​ People can borrow less today
-​ As a result:
-​ Consumers consume less today
-​ Firms invest less today
-​ GDP falls further
 -​ Limited commitment can amplify economic shocks

Investment model chapter 11 lecture 6

-​ Consider a firm in the two-period investment model the produces output according to: Y = zKαN β and Y ′
= z ′ (K′ ) α (N ′ ) β The current-period total factor productivity z = 1, and the future-period total factor
productivity z ′ = 1. Other variables follow the same notation, with a prime (′) indicating the future period.
Initial capital K = 50, capital depreciates at rate d = 0.05, wages are w = 0.75 and w ′ = 0.85, and the real
interest rate is r = 0.06. Parameters α = 0.3 and β = 0.6.

decisions made by the representative consumer in the real intertemporal model:

-​ The consumer will make a work–leisure decision in each of the current and future
periods, and he or she will make a consumption–savings decision in the current period.
-​ The consumer’s current budget constraint is then C + S = w(h−l)+π−T.
-​ so that the consumer’s future budget constraint is C′=w′(h−l′)+π′−T′+(1+r)Sp
-​ lifetime budget constraint for the representative consumer :
C+(C′/1+r)=w(h−l)+π−T+(w′(h−l′)+π′−T′/1+r) .
-​ It is straightforward to describe the consumer’s optimizing decision in terms of three
marginal conditions we studied :
-​ 1. MRSl,c = w , the current real wage, w, is the relative price of leisure in terms of
consumption goods.
-​ 2. Similarly, in the future the consumer makes another work–leisure decision, and he or
she optimizes by setting , MRSl’,c’ = w’ at the optimum, the marginal rate of substitution
of future leisure for future consumption must be equal to the future real wage.
-​ 3. MRSc,c’ = 1 +r , when the consumer is optimizing the marginal rate of substitution of
current consumption for future consumption equals the relative price of current
consumption in terms of future consumption.

decisions made by the representative firm in the real intertemporal model

-​ In the current period, the representative firm produces output according to the
production function, Y=zF (K, N),
-​ Similarly, in the future period, output is produced according to Y′=z′F(K′, N′),
-​ That is, for simplicity we assume that it requires one unit of consumption goods in the
current period to produce one unit of capital.
-​ The representative firm invests by acquiring capital in the current period, and the
essence of investment is that something must be forgone in the current period in order
to gain something in the future. What is forgone by the firm when it invests is current
 profits; That is, the firm uses some of the current output it produces to invest in capital,
which becomes productive in the future.
-​ capital depreciates at the rate d when used. Then, letting I denote the quantity of
current investment, the future capital stock is given by K′=(1−d) K+I;
-​ Further, the quantity of capital left at the end of the future period is (1−d) K′
-​ (1−d) K′. Since the future period is the last period, it would not be useful for the
representative firm to retain this quantity of capital, and so the firm will liquidate it
-​ We will suppose that the firm can take the quantity
-​ (1−d) K′, the capital left at the end of the future period, and convert it one-for-one back
into consumption goods, which it can then sell.
-​ Current period Profits → π = Y − wN − I
-​ Future period profits are: π ′ = Y ′ − w ′N ′ + (1 − d)K ′
-​ Present value of profits are V = π + π ′/ 1 + r
-​

Current Labor supply

-​ How does an increase in the current wage affect the supply of current labour?
- The substitution effect decreases leisure
- The income effect increases leisure
- Typically assume that Sub effect > income effect

-​ How does an increase in the interest rate affect the supply of current labour?
- the price of current leisure in terms of future leisure increases
- Intertemporal substitution of leisure: less leisure today and more tomorrow
- Shifts labor supply curve to the right increasing labor supply

-​ How does an increase in lifetime wealth affect the supply of current labour?
- Shifts labor supply curve to the left decreasing labor supply
- Higher profits today increases the amount of leisure demanded today

-​ The labour supply curve slopes upward, as we are assuming that the substitution effect
of an increase in the real wage dominates the income effect, and recall that the position
of the labour supply curve depends on the real interest rate, r.
-​ Thus, with the increase in the real interest rate, the current labour supply curve shifts to
the right, the current equilibrium real wage falls from w1 to w2, and current
employment increases from N1 to N2.
 -​ If the real interest rate is higher, the representative consumer will choose to supply
more labour, resulting in an increase in employment and output.

Increases in taxes reduces Lifetime wealth of current consumers

-​ Income effect : Consume less leisure and less consumption

-​ Labor supply increases
-​ General equilibrium effects: wage falls , firms hire more labor , more output is produced
-​ Therefore the higher taxes increases current output supply
-​ An increase in government spending shifts the output supply curve to the right because
lifetime wealth decreases, a negative income effect that shifts labour supply to the right.

Increases in total factor productivity (z) increases output supply

-​ With the increase in total factor productivity , forms get more profits and want to hire
more labor
-​ Labor demand curve shifts to the right
-​ General equilibrium effects: wage increases, consumers supply more labor ( assuming
sub effect dominates)
-​ Therefore the higher productivity increases current output supply and shifts the current
output supply curve to the right
-​ Output supply is how much gets produced by firms
-​ Output demand is what output is used for ( consumption, investment , government
expenditure)

The marginal propensity to consumer is the amount that current consumption increases when
income increases by $1. Usually between 0 and 1. MPC + MPS = 1 , MPS is the marginal
propensity to save. MPC is the derivative of consumption w.r.t income.

As household income increases , they consume more and save more

Increase in the interest rate reduce output demand

-​ HIgher interest rate

-​ Households consume less today and more tomorrow
 -​ Firms investment reduces
-​ Output demand falls
-​ Output demand curve shows the negative relationship between the real interest rate
and current aggregate output.

Shifts in the output demand curve

-​ A decrease in the present value of taxes shifts the output demand curve to the right
-​ An increase government spending shifts the output demand curve to the right
-​ An increase in the future total factor productivity z ′ shifts the output demand curve to
the right
-​ A decrease in the current capital stock K shifts the output demand curve to the right
-​ When drawn against the real interest rate, the output demand curve shifts to the right
when . current capital stock decreases.

Output demand and Output supply

-​ Higher interest rates lead to more labor supplied today

-​ Higher interest rates lead to less consumption and investment today

Show how the firm’s investment decision is structured, and determine how changes in the
environment faced by the firm affect investment.

-​ which will involve equating the marginal cost of investment with the marginal benefit of
investment. We will let MC(I) denote the marginal cost of investment for the firm,
where MC(I) = 1
-​ The marginal benefit from investment, denoted by MB(I), is what one extra unit of
investment in the current period adds to the present value of profits, V
-​ First, an additional unit of current investment adds one unit to the future capital stock,
K′. This implies that the firm will produce more output in the future, and the additional
output produced is equal to the firm’s future marginal product of capital, MP′K.
-​ Second, each unit of current investment implies that there will be an additional 1−d
units of capital remaining at the end of the future period (after depreciation in the
future period), which can be liquidated. Thus, one unit of additional investment in the
current period implies an additional MP′K+1−d units of future profits,π′.
 -​ The firm will invest until the marginal benefit from investment is equal to the marginal
cost—that is, MB(I) = MC(I) , MP ‘ K = r + d
-​ If the real interest rate decreases the demand for investment increases
-​ the optimal investment schedule will shift because of any factor that changes the future
net marginal product of capital. The optimal investment schedule shifts to the right if
future total factor productivity, z′, increases. Which means demand for investment
goods increases. This is because if firms thing future total productivity is going to
increase then they will invest in more capital now. Higher investment in the current
period leads to higher future productive capacity so that the firm can take advantage of
high future total factor productivity. The optimal investment schedule shifts to the left
if the current capital stock, K, is higher. That is, if K is larger, there is more of this initial
capital left after depreciation in the current period to use in future production.
Therefore, higher K implies that the future marginal product of capital, MP′K, will
decrease for each level of investment, and the optimal investment schedule will then
shift to the left.
-​ So if future productivity is to decrease then the optimal investment schedule will shift to
left. If the current capital stock is lower then the optimal investment schedule will shift
to the right.

Chapter 7 lecture 7 economic growth

-​ we assume that consumers consume a constant fraction of income in each period; that
is, C = (1 - s)Y , s is the savings rate
-​ The slope of the per-worker production function is the marginal product of capital, .

Economic history
-​ Before the Industrial Revolution (1800’s), standards of living differed little over time and
across countries
-​ Since the Industrial Revolution, a set of countries experienced a large amount of
economic development
-​