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Slides 4

Slides 4. For the Final Exam. Homework A. Budget line stays the same due to unchanged Indifference curve stays the same due to unchanged preference Optimum stays the same P doubles Monetary policy has no effect on optimum since income and price both double.

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Slides 4

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  1. Slides 4 For the Final Exam

  2. Homework A • Budget line stays the same due to unchanged • Indifference curve stays the same due to unchanged preference • Optimum stays the same • P doubles • Monetary policy has no effect on optimum since income and price both double

  3. Intertemporal Budget Constraint (IBC) • Idea: no one borrows or saves forever • Before she dies, • Dividing on both sides gives (IBC) So what really matters is permanent income, not current income. Exercise: what happens if rises?

  4. Preference • Intertemporal (Total) Utility: • Instantaneous (Each Period) Utility: • Two properties: • For example,

  5. Dynamic Optimization • Constraint optimization • Can be transformed to an unconstraint optimization problem by substituting into the utility function • Then take derivative of with respect to and let

  6. Calculus • Consider where are both functions of • Then + • For our problem

  7. Calculus Two + + +

  8. Euler Equation (First Order Condition) This looks similar to marginal rate of substitution equals relative price at optimum.

  9. Interpretation • So at optimum a person is indifferent between two options: (I) consume one more unit now; (II) save that one unit and consume later. At optimum the two options yield the same change in utility.

  10. Log Utility Function • For log utility function the Euler equation is or This shows the dynamic path of consumption

  11. Solution of Dynamic Optimization • Plugging the Euler Equation into the IBC gives and we have the solution where denotes permanent income.

  12. Exercise • What if falls? • What if rises? • So whether a person saves or borrows in the first period does not matter. Kind of counter-intuitive

  13. Ricardian Equivalence • Consider the effect of temporary tax cut. The permanent after-tax income is • Temporary tax cut has no effect on as long as the present value of tax stays the same (so stays the same), i.e., as long as a current tax cut will be followed by a future tax hike.

  14. Smooth Consumption • Let then Euler equation implies that So the optimum is smooth consumption. The reason is diminishing marginal utility.

  15. Random Walk • Let’s add randomness to Euler equation This shows that consumption follows random walk (RW). • RW has the property that its change is unpredictable, i.e.,

  16. New-Keynesian Theory I • Use micro foundation • IBC assumes no borrowing constraint. If borrowing constraint (market imperfection) exists, then for poor people the budget constraint is (IBC2) • Now current income matters again. Tax cut will be very effective in stimulating expenditure.

  17. New-Keynesian Theory II • Consider doubling money supply • But assume prices of some markets are flexible, others sticky (market imperfection) • Then will change disproportionally. • Then optimum will change since budget line shifts. • Monetary policy can be very effective.

  18. Let’s Summarize • http://www.youtube.com/watch?v=GTQnarzmTOc • http://www.youtube.com/watch?v=3u2qRXb4xCU

  19. History of Macroeconomics • Classical model (Adam Smith, David Ricardo, Thomas Malthus) • Markets clear by themselves • Key assumption: prices are flexible • Policies (and government) are not needed • Policies can create inefficiency, e.g., tax, minimum wage, tariff

  20. What’s Wrong?

  21. Great Depression • Widespread and sustained unemployment (surplus in labor market) • Signal for market failure • Classical model cannot explain • Here comes Keynesian theory which focuses on insufficient demand (after stock market crash)

  22. Model of Sticky Prices • Keynes believes that one reason for unemployment is sticky nominal wage • Keynes believes more spending is needed to raise the price level and lower real wage • Can you draw a graph?

  23. World War II • Keynes believes WWII cut short of great depreciation • Government expenditures rises • Through multiplier effect, income rises more than the increase in G • So broken window can be good. In long run we are all dead.

  24. Phillips Curve • Keynes ignores the role of expectation • Therefore he believes in a negative relation between inflation and unemployment, i.e., a fixed Phillips curve • Can you draw a graph? • Then here comes stagflation in 1970s

  25. What’s Wrong?

  26. Stagflation • In 1970 both unemployment rate and inflation rate rose • can be explained by expectation-augmented Phillips curve • Lucas critique: econometrics cannot be used to estimate Phillips curve because we cannot assume fixed expectation

  27. Micro Foundation • Hayek and Lucas emphasize the microeconomic foundation for macroeconomics, Keynes does not. • The basic model is a two-period utility maximization problem

  28. New Classical Theory • Permanent income hypothesis • Random walk hypothesis for consumption • Ricardian equivalence • Smooth consumption • The new classical theory indicates very small multiplier effect.

  29. Real Business Cycle Theory • is built upon the new classical theory • Emphasizes that markets clear by themselves, economy can be self-correcting • Unemployment (intertemporal labor substitution) is voluntary • Fluctuation in income (business cycle) is a Pareto Efficient. Government had better do nothing.

  30. Dynamic Stochastic General Equilibrium (DSGE) models • The simple two-period model can be generalized • Multiple periods • Random variables • General equilibrium • To much for this course

  31. New Keynesian Theory • Keynesian school is fighting back • Micro foundation is used • Market can still fail due to various reasons • Borrowing constraints, sticky prices, etc • So policy is needed to fix market failure

  32. Who are they? • Classical approach: Friedrich Hayek*, Robert Lucas*, Robert Barro, Edward Prescott* • Keynesian approach: John Keynes, Paul Krugman*, Larry Summers, Ben Bernanke, Joseph Stiglitz*, Gregory Mankiw • Extreme Keynesian approach: ?

  33. Yeah. It’s Me!

  34. Marxian Economics • People are greedy • Income gap and social instability are inevitable • Widespread market failure (e.g., no health insurance market for the poor, great depression) • Government needs to do everything (planned economy) • Fatal drawback: incentives are ignored

  35. (Most) People are Thin • in Planned Economy • http://www.youtube.com/watch?v=UMLtkp4AFkc

  36. Truth? • Somewhere in middle. • Macroeconomics is still a growing baby. • There are many unsettled issues • For example, introduce game theory to Macro?

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