2 Micro-Foundation to Macro Variables General Equilibrium with a representative household and firmMarket price (p) and wage rate (w) such that:Y = CLD = LSLS +l = LWage payment, wLLabour supply, LEconomy(p, w, y, c, l, L)Households(consumers)Max U(C,L)Firms(producers)Max π(LS)Payments for goods, p.ySupply of GoodsQuestion: List 10 different things missingfrom this model.
3 Population, total2000East Asia & Pacific1,855,200,000Europe & Central Asia474,310,000European Monetary Union303,980,000Middle East & North Africa295,180,000South Asia1,355,100,000Sub-Saharan Africa658,940,000Latin America & Caribbean515,710,000United States281,550,000Others317,330,000Heavily indebted poor countries (HIPC)632,160,000Low income2,459,800,000High income902,850,000Low & middle income5,154,400,000High income nonOECD50,794,000High income OECD852,060,000Least developed countries (UN classification)660,030,000Lower middle income2,047,600,000Middle income2,694,600,000Upper middle income647,010,000World6,057,300,000
4 GDP (current US$)2,000.00East Asia & Pacific2,059,100,000,000.00Europe & Central Asia942,080,000,000.00European Monetary Union6,048,400,000,000.00Latin America & Caribbean2,000,500,000,000.00Middle East & North Africa659,690,000,000.00Sub-Saharan Africa322,730,000,000.00United States9,837,400,000,000.00United Kingdom1,414,600,000,000.00South Asia596,790,000,000.00World31,493,000,000,000.00Heavily indebted poor countries (HIPC)200,880,000,000.00High income24,927,000,000,000.00High income nonOECD857,350,000,000.00High income OECD24,073,000,000,000.00Least developed countries (UN classification)190,520,000,000.00Low & middle income6,560,600,000,000.00Low income1,048,300,000,000.00Lower middle income2,347,200,000,000.00Middle income5,513,200,000,000.00Upper middle income3,170,500,000,000.00
5 Solow Growth ModelProduction function with capital and labour as its inputs.Closed Economy without Government.Firm’s Production FunctionMarket clearing:Household’s Saving Decision:Investment requirement:Closure rule in the model:Dynamics: Capital accumulation:
6 Per Capita Output and Per Capita Capital Stock in the Steady State SST0.5ksks
7 Growth Accounting Take log of both sides: Differentiate with respect to time :
8 Capital Stock and output in the Steady State in the Solow Model with technical progress Fundamental equationof economic growth:Per Capita Effective Capital Stock in the Steady State:Per Capita Effective Output in the Steady State:
9 Results from the steady state: Countries with higher saving rate have higher steady state level of output and countries with lower saving rate have lower level of output in the steady state.Countries with higher level of technology have higher level of output and countries with lower level of technology have lower level of output in the steady state.Countries with higher rate of population growth rate have lower level of output in the steady state.Countries with higher capital share have higher output in the steady state.Countries which differ in the initial capital stock eventually reach to the same output level in the steady state.Growth of per capita income is zero in the steady state
10 Golden Rule for Saving and Capital Accumulation C-maxKgKssGolden ruleSteady State
11 How High Should be the Saving Rate How High Should be the Saving Rate? Saving Rate that Maximises ConsumptionC-max = 1.25y = 0.5*k0.5y=2.5Consumptionk = 25Cs5s4s1s2s*=0.5Saving rate
12 How Human Capital Contributes to the Economic Growth?
13 How does the technological advancement affect the per capita capital and per capita output in the steady state?Advanced TechnologyPrimitive Technology
15 Increase in Real Wage Rate with Human Capital MPKh2w1MPKh1Technologicaladvancement raiseswage rate but reducesWork hours.
16 Constant Marginal Product of Capital with Human Capital MPKh3MPKh1MPKh2k1k2k3
17 Meaning of Convergence and Divergence A poor country should growat faster rate than a richcountry as it has higher marginalproductivity of capital.Evidence from AfricanCountries shows divergence.
18 Who Gain and Who Lose From Globalisation? Capitalists in rich countries and workers in poor countries gain.rprRMPKRMPKPwRwp’wR’MPLRMPLP’wpMPLR’MPLP
19 Is this caused by the barriers to adopt a good technology Is this caused by the barriers to adopt a good technology? Or by Lauddites?
20 y=f(k) y Max Subject to: k MPK= k* Profit Maximisation Problem of FirmsMarginal Product of Capital = User Cost of Capitaly=f(k)yMaxSubject to:kInvestor Compare user cost of capital with its productivityMPK=k*
21 Analysis of Earnings (R) and Cost (C) from an Investment Project K = ; d = 0.08; R (Earning) =18000C =(r+d)*K23,000C > RCostAndEarningBreak Even18,000Earning (R)C < R13,0000.10.15r0.05
22 Role of Investment Tax Credit in Promoting Investment Why Manufacturers Lobby for a Tax Credit?MPKMPK =K1K2K
23 Optimal Capital Stock for the Car Company The user cost of capital := 6% +3%-3% =6%LetMarginal product of capital:Optimal Investment condition:= 6.25 million
24 Two Period Model of Consumption and Saving C2w2Subject to:c2BorrowingUc1w1C1
25 Two Period Model of Consumption Consumers’ problem:Budget constraint in period 1:Budget constraint in period 2:: Consumption in period 1 = subjective Discount factors: Consumption in period 1b = borrowing or lending: Income in period 1r = interest rate:Income in period 12U = utility
26 Life Cycle Model of Consumption and Saving Modigiani-Ando-Brumberg life cycle hypothesisSavingC,S,YC-SmoothingBorrowingDissavingOldYoungAdultSmooth consumption and erratic income over life
27 Phillips Curve and Expectation Augmented PC (NAIRU)
28 Classical, Keynesian and New Keynesian Aggregate Supply curves Classical SupplyNew Keynesian SupplycbKeynesian Supplyaa1Y = ADdAD2AD1Output
29 Aggregate Supply, Inflation and the natural rate of unemployment hypothesis LASSASoSummary:
30 Supply Shock and Stagflation LASAS1AS=f(w,pe)StagflationAD =f(M,G, T)o
32 Macroeconomic Stabilisation Role of Tax and Spending T = tYT > GSurplus in boomG = TTaxandSpendingGGT < GDeficit inrecessionYFIncomeT
33 Balanced Budget Multiplier with Lump-Sum Taxes The real national income is given by the IS Curve:Positive Government expenditure multiplier:.Negative tax multiplier:The balanced budget multiplier:=1/(1-c1) - c1/(1- c1) = 1A change of 100 in both G and T also raised income by 100.Balanced change in G and T is not macro economically neutral.
34 Automatic Stabiliser with Proportional Taxes Consumption:Disposable income:Tax RevenueIncome (IS curve):Y = c0 + c1YD + I + GHigh T when Y is high.Low T when Y is low.The multiplier = 1/(1-c1+c1t1) <1/(1- c1),so the economy responds less to changes inautonomous spending when t1 is positive.
35 How much should be the tax rate to maximise the government revenue ? Tax complianceR-maxRevenueTax avoidanceTax evasionR-lowRevenue=F(t)Tax ratetHt-Lowt-Rmax
37 Debt Dynamics: Determinants of Debt/GDP Ratio (5)Higher the interest rate causes a rise in B/YLower the growth rate of output causes a rise in B/YHigher the current deficit (G -T) leads to higher B/YHigher initial B/Y implies higher B/Y in subsequent yearsExampleDebt ratio = 100% r = 3% g = 2%T-G = 1% is required to keep B/Y constant
38 Revenue from Inflation Tax and Its Limitations Inflation rate equalsgrowth rate of moneysupply in the steady state.S-MaxSeigniorageS-lowS = F()-maxInflation tax-low-high
39 Seigniorage (Inflation Tax) : A Numerical Example Si10009050.019.058190.0216.386070.0530.353680.136.81350.227820.2520.570.53.5
40 Basic Proposition of the Ricardian Equivalence Tax or Borrowing Does not Make Any Difference TomorrowC2Before BorrowingBudget ConstraintAfter borrowingbudget constraintC1Today
41 Bank of England’s View on Transmission Mechanisms of Monetary Policy: How Does Money Supply Affect the Price Level?i,r,er,PePC+I+GMSYπX,MTwo Conditions to have real effect of Monetary policyCentral bank controls monetary base M1 = R + CuPrices do not adjust instantaneously
42 An Increase in Money Supply Can Lower Real and Nominal Interest Rates in the Short but not in the Long RunFisher EquationirTtimet0Monetary policy can have some real effect in the short run but not in the long run. Short runs become shorter with more accurate expectations
43 Link Between Financial System and the Economy Y= F(K,L)CTSFundsKFADepositBanksPension FundsTreasuryBondsProfitEquity
44 Financing of an Investment Project Need for CapitalDemandfor outputFinancing anInvestmentProjectSelfFinanceBequestsBonds:Debt FinanceBanks, BuildingSociety, InsuranceEquity FinanceStock Market(LSE)RisksAAABBBCCCMaturityInstalmentMethodRepaymentMethodNoRiskRiskHighRisk
46 Price of a Stock: An example PShare = Price of a StockD = expected Dividendr = interest rateg = growth rate of dividendx = risk premiumD = 1000 and r =5% and g=3% has a risk x =0;If r =8%
47 Observations From the above Analysis of Stock Markets Lower the market interest rate, higher is the value of stock. Because future earnings are discounted at lower rate.Higher the growth rate of dividend higher the value of stock. As dividend grows earning from the share rises and hence price rise.Higher the risk premium lower is the value of the share. A decrease in the risk premium will increase the market value of a stock.Arbitrage implies same rate of risk adjusted returns in both stocks and bonds.(in the short run) Higher the resale value of the stock higher is its price.
48 Income, Saving and Outstanding Asset or Debt in Life Cycle Model =:t;=
49 Interest Determination Rule to Achieve the Inflation Target: Taylor Rule
50 Reduced Form Equation of the Interest Determination Model
51 Why Should the Central Bank Be Independent Why Should the Central Bank Be Independent? Inflation Biases of a Government and a Central Bank
52 An Example of an Open Economy Model National IncomeConsumptionInvestmentTax and SpendingT =100 G = 100Net exportsReal exchange rateFinancial integrationDemand for MoneyParameters
53 Three GAPs: Investment-Saving, Government Budget and Three GAPs: Investment-Saving, Government Budget and Trade Gaps in a Keynesian ModelS(Y)Trade SurplusK-outflowiPrivate saving +public saving= net exportiI(r)Trade deficitK-inflowSaving and Investment
54 IS-LM Model in an Open Economy: Mundell-Fleming Model LM (y, i)Exchange RateAssumption:Money supply does notdepend on exchange ratee*IS*oOutputy
55 Impact of Fiscal Policy under Fixed and Flexible Exchange Rate Systems Fixed Exchange Rate SystemLMLM1LM2e2IS*’ee1IS*’IS*IS*Y1Y2YNo Impact of Fiscal PolicyFull Impact of Fiscal Policy
56 Impact of Monetary Policy under Fixed and Flexible Exchange Rate Systems Fixed Exchange Rate SystemLMLM1LM2e2eIS*’e1IS*IS*Y1Y2Y1Y2Full Impact of Monetary PolicyNo Impact of Monetary Policy
57 IS-LM and Uncovered Interest Parity Model 21iiIS1ISUIPY1E0E1Y0AppreciationExchange rate
58 J-Curve Hypothesis: Impact of Devaluation on Net Exports Export creation andImport substitution ordemand switching takes timeNetExportsoTime
61 Triangular Exchange Rates and Appreciation and Depreciation with respect to the Third Currency
62 Cooperation or non-Cooperation? Nash Solution is non-cooperation (NC,NC) =(4,4)Cooperative Solution (C,C) =(5,5)Cooperative solution Pareto dominated Non-cooperative solution.Pareto efficiency: at least one party gains without hurting the other.
63 Extensive Form of International Cooperation Game (4,4)NCAdvancedeconomiesNCC(6,3)(3,6)DevelopingEconomiesNCAdvancedeconomiesCC(5,5)
64 Dynamics of International Policy Cooperation Game: Solution by Backward Induction (4,4)NCAdvancedeconomiesNCC(6,3)(3,6)DevelopingEconomiesNCAdvancedeconomiesCC(5,5)
66 Fiscal and Monetary Policy Game in a Diagram (Nardhaus (1994) Model)BudgetSurplus, S+Monetary Bliss (MB)FInterest rate, r-Nash equilibrium (N)BudgetDeficit, DFiscal Bliss (FB)MF
67 1,2,3,4 Iso social cost functions 3 ASr 4 PR ASddASrDiscretionPolicy Rule, Discretion, Cheating and Time Inconsistency in Economic Policy MakingchCheatingASdr =0Bliss1y = y*yTy-y*Policy rule21,2,3,4 Iso social cost functions3ASr4PRKydland and Prescott (1977)
68 BOP Surplus a b d c e h i g f BOP Deficit Adjustment of Budget Surplus or Interest Rate for Internal and External StabilityTwo objectives:Internal Stability: Full EmploymentExternal Stability: Trade BalanceTwo instruments:Budget surplus or deficit and interest rateBOP SurplusabdInflation: BoomceUnemployment: RecessionBudget surplus : fiscal policy InstrumenthigfInternal BalanceBOP DeficitExternal BalanceInterest rate: Monetary Policy instrument
69 Assignment Problem in the Mundell-Fleming Model LM2+BOPi-cTargetsInternal stability y*External stability BOPInstruments:Monetary policy (i)Fiscal policy (G,T)baIS2IS1LM1yy*a: initial point of internal balance but external imbalance (IS1=LM1)b: use of monetary policy (LM2) for external balance creates internal imbalancec: accommodative fiscal policy (IS2) restores the balance
70 General Equilibrium Set-up of Household and Firms’ Problem
71 Derivation of Labour Supply, Consumption and Leisure Demand Functions (7)(8)(9)(10)(11)
77 Household Problem in Presence of Consumption and Income Taxes (1’)(2’)(3’)
78 Determination of Real Wage Rate in the Presence of Taxes
79 Leisure and Consumption in the Presence of Taxes
80 Efficiency Gains in the UK from elimination of all taxes and transfers (Measured as a percent of benchmark utility level of a representative household)Equivalent Variation =Compensating Variation =Efficiency Gains from Switching to Labour income TaxesEquivalent Variation =Compensating Variation =Efficiency Gains from Switching to Consumption TaxesEquivalent Variation =Compensating Variation =