MACROECONOMICS I, Phd Programme
Lecture 1: The Centralized Economy
Sarantis Kalyvitis
1
Modern Macroeconomics
Dynamic general equilibrium (DGE) macroeconomics: The aggregate
economy with microeconomic foundations (no ad hoc assumptions)
DGE models have emerged in recent years as the latest step in the
development of macroeconomics from its origins in the work of
Keynes in the 1930s
DGE models can cover all aspects of macroeconomics, e.g.:
¾ neoclassical and (new)Keynesian models
¾ fiscal and monetary policy with rigorous implications
¾ asset pricing
2
What is a DGE model?
A system that reflects the collective decisions of rational individuals
over a range of variables that relate to both the present and the future.
Individual decisions are then coordinated through markets to produce
the macroeconomy.
The economy is viewed as being in continuous equilibrium in the
sense that, given the information available, people make decisions
that appear to be optimal for them, and so do not make persistent
mistakes.
Behavior is said to be rational: any errors are attributed to
information gaps, such as unanticipated shocks to the economy.
3
Shortrun and longrun equilibria
The economy is assumed to always be in shortrun equilibrium.
The long run, or the steady state, is a mathematical property of the
macroeconomic model that describes its path when all past shocks
have fully worked through the system.
¾ static equilibrium: all variables are constant
¾ growth equilibrium: in the absence of shocks, there is no tendency
for the economy to depart from a given path in which the main
macroeconomic aggregates grow at the same rate
The (short or long run) equilibrium is general because all variables
are assumed to be simultaneously in equilibrium not just some of
them or a particular market, known as partial equilibrium).
4
Individual decisions
Individual decisions are assumed to be based on maximizing the
discounted sum of current and future expected welfare subject to
preferences and four constraints:
¾ budget or resource constraints
¾ endowments
¾ available technology
¾ information.
DGE macroeconomics is intertemporal: whether to consume today,
or save today in order to consume in the future.
This entails being able to transfer today’s income for future use, or
future income for today’s use.
5
Achieving equilibrium in DGE models
Transfers may be achieved by holding financial assets or by
borrowing against future income.
The different decisions are reconciled through the economywide
market system, and by market prices (including asset prices).
Stock (not only flows) are important
The focus of modern macroeconomics is, therefore, on:
¾ the responses of individuals to shocks
¾ how these are likely to affect multiple markets simultaneously,
both in the present and in the future.
6
Decisions by agents
Three main types of decisions are taken by economic agents:
¾ goods and services
¾ labor
¾ assets: physical assets (capital stock, durables, housing, etc.) or
financial assets (money, bonds, and equity)
Decisions of individuals are made according to its type:
¾ Household: consumption, labor supply, and asset
¾ Firm: supply of goods and services, labor demand, investment,
productive and financial capital, and the use of profits.
¾ Government: spending, taxes, transfers, base money, public debt.
7
Forwardlooking decisions
Current decisions are affected by expectations about the future.
We need intertemporal dynamic optimization, in which people are
treated as rationally processing current information about the future
when making their decisions; this is linked to rationality.
Traditional macroeconomics: myopic decision making in which
mistakes, even when realized, were often persistent.
Rational expectations: people do not make persistent mistakes once
they are identified.
8
Information and mistakes
RE do not imply that people have more or less complete knowledge 
the mistakes are largely the result of shocks or unanticipated
information gaps.
In RE it is sufficient to suppose that mistakes are not repeated.
As forwardlooking decisions must be based on expectations of the
future, they may be incorrect; decisions that seem correct ex ante may
not therefore be correct ex post.
The economy is in disequilibrium only as a result of this type of
mistake.
9
A note on macroeconomic modelling
All models are abstractions from reality
Macroeconomic models are highly stylized
Assumptions are crucial
We proceed from simple to more complex models
We try to verify the robustness of the results and relax or add
assumptions as necessary
10
The Ramsey model: Centralized economy
National income identity:
Capital accumulation:
Production function:
,
,
Inada conditions:
Constant population N :
11
The economywide resource constraint
Combining the structural equations:
(economywide resource constraint)
Given an initial stock of capital, kt (the endowment), the economy
must choose its preferred level of consumption for period t, namely
ct, and capital at the start of period t +1, namely kt+1.
This can be shown to be equivalent to choosing consumption for
periods t, t+1, t+2, . . . , with the preferred levels of capital, output,
investment, and savings for each period obtained from the model.
12
Preferences in the economy
Consumption at period t:
Consumption should be sustainable: in each period investment is
required to maintain the capital stock and to produce next period’s
output.
In effect, we are assuming that the aim is to maximize consumption
in each period.
With no distinction being made between current and future
consumption, the problem has been converted from one with a very
shortterm objective to one with a very longterm objective.
13
Longrun consumption
In the long run kt+1=kt:
Consumption in the long run is output less that part of output
required to replace depreciated capital in order to keep the stock of
capital constant.
In the long run the only investment undertaken is that to replace
depreciated capital; the output that remains can be consumed.
Choose k to max c:
,
Capital should be accumulated up to the point where its marginal
product equals the depreciation rate.
14
Maximum level of consumption
, with ∆k=0 in the long run
15
Maximum level of output and the ‘golden rule’
k# is the ‘golden rule’ capital stock.
16
Stability and the ‘golden rule’
Due to the constraint that the capital stock is constant, c# is
sustainable indefinitely if there are no disturbances to the economy.
If there are disturbances, the economy becomes dynamically unstable
at {c#, k#}.
To maintain c#, it would be necessary to consume some of the
existing k (∆k < 0), and k would no longer be constant. Future output
would be even smaller and attempts to maintain consumption at c#
would cause further decreases in the capital stock.
The economy can reduce its consumption temporally and divert
output to rebuilding the capital stock to a level that restores the
original equilibrium.
17
Optimal determination of consumption
Intertemporal discounting of utility
Discount factor:
The problem is to maximize Vt subject the economywide resource
constraint.
18
Lagrangian and FOCs
Lagrange equation:
Firstorder conditions with respect to ct+s , kt+s (kt is predetermined!)
Transversality condition:
19
The Euler equation
Eliminating the Lagrange multiplier from the FOCs:
(Euler equation)
The Euler equation is the fundamental dynamic equation in
intertemporal optimization problems in economics with dynamic
constraints.
20
Interpretation of the Euler equation
Twoperiod utility:
reduction by dct = gain in dct+1:
current utility loss + future utility gain = 0
By the resource constraint:
21
Intertemporal Production Possibility Frontier
Concave relation between ct+1 and ct:
22
Intertemporal PPF: graphical illustration
Equilibrium:
23
Static equilibrium
This is different from the ‘golden rule’ due to discounting.
The required capital return is higher and thus the capital stock is
lower in the steady state.
24
Optimal longrun consumption
25
Dynamics of optimal solution
Dynamic equations:
Linearization of the Euler equation:
26
Graphical illustration of dynamics for c and k
Consumption Capital
27
Phase diagram
28
The effect of a positive technology shock
29
Endogenous labor supply
Up to now, the labor supply by households is assumed to be
exogenous (vertical labor supply).
We can introduce an upward sloping labor curve by assuming that
labor supply depends on the wage rate through the utility function.
Higher leisure (less labor) increases utility, like consumption.
The household needs to be compensated by a higher wage rate to
offer more units of labor.
30
Leisure in the utility function
There is one unit of time divided between labor, n, and leisure, l:
nt + lt = 1
Instantaneous utility function: U = U(nt , lt )
with Uc > 0, Ul > 0, Ucc ≤ 0, Ull ≤ 0
Production function: F = F(nt , kt )
with Fn > 0, Fk > 0, Fnn ≤ 0, Fkk ≤ 0, Fkn ≥ 0, Inada conditions
Resource constraint:
31
Utility maximization with endogenous labor supply
Lagrange:
w.r.t.
32
Optimality conditions with endogenous labor supply
Euler equation:
33
Role of leisure in optimal behavior
Consider giving up dlt = dnt < 0 units of leisure.
Loss of utility is Ul,t dlt < 0 (lefthand side).
This is compensated by an increase in utility due to producing extra
output of Fn,t dnt
= Fn,t dlt .
When consumed, each unit of output gives extra Uc,t in utility,
implying a total increase in utility of Uc,tFn,t dlt > 0 (righthand side
when dlt = 1).
34
Steady state with leisure
Capital return:
Constant returns to scale:
since
we get:
Real wage rate:
In the steady state rt = θ:
35
Comparison with exogenous supply model
Exogenous supply: nt = 1
Implied wage rate:
Equilibrium:
The solutions for consumption and capital do not change
36
Investment
The basic model obtains the optimal levels of consumption and
capital, which implies a theory of net investment.
Following a permanent change in the steady state capital stock, the
adjustment to the new equilibrium is gradual along the saddle path.
The adjustment path implies an optimal level of investment each
period, which will differ each period until the steady state is reached,
where investment is only replacing depreciated capital.
Investment adjusts instantaneously to the optimal level.
In practice, however, due to costs of installation, optimal investment
adjusts slowly.
37
Adjustment costs for investment
Additional resource costs for investment:
Resource constraint:
Lagrange:
38
Optimality with adjustment costs for investment
By FOC for investment:
Tobin’s q:
39
Interpretation of q
An extra unit of capital raises output, and hence consumption and
utility
λ : marginal benefit in terms of the utility of sacrificing a unit of
current consumption in order to have an extra unit of investment, and
hence the extra capital.
µ : marginal benefit in terms of utility of an extra unit of investment.
q : benefit from investment per unit of benefit from capital.
Expressing utility in terms of units of output, q can also be
interpreted as the ratio of the market value of one unit of investment
to its cost.
40
Steadystate value of q
In the long run:
Investment demand:
Longrun value of q:
41
Solution for capital
FOCs:
By the longrun value of q:
In the absence of costs of installation, φ = 0:
qt = 1 and Fk = θ+δ (basic closedeconomy model)
Fk > θ+δ implies a lower capital stock because installation costs
reduce the resources available for consumption and investment.
42
Shortrun solution with investment adjustment costs
Linear approximation:
Deviations from equilibrium at steadystate values:
Forwardlooking solution for q:
qt is the present value of the extra output produced by undertaking
one more unit of investment.
43
Interpretation of q and measurement problems
The greater the value of q, the more investment will be undertaken in
period t.
Since the price of one unit of investment is 1, qt 1 is the increase in
the implied value of the firm.
Although qt can be interpreted as the ratio of the market value of one
unit of investment to its cost, it is often estimated by the ratio of the
market value of a firm to its book value.
This implies using the average value of current and past investment
instead of the marginal value of new investment.
Hayashi (1982) proved that this can hold under strict conditions.
44
Dynamics of k and q
Capital dynamics:
Dynamics of q and k:
Approximation around the steady state:
Negative relation between k and q:
45
Graphical analysis of dynamics between k and q
46
Effects of a productivity increase
A productivity increase raises qt so that qt > 1. This induces a rise in
investment above its normal replacement level δk.
Initially, kt remains unchanged and so the economy moves to point B.
New investment increases the capital stock each period until the
economy reaches its new longrun equilibrium at C by moving along
the saddle path from B.
At this point qt is restored to its longrun equilibrium level of one and
the equilibrium capital stock, output, and consumption are
permanently higher.
47
Timetobuild investment
Kydland and Prescott (1982): investment expenditures recorded at
time t are the result of decisions to invest is t made earlier.
A proportion φi of recorded investment in period t is investment starts
made in period (ti):
Α proportion φi of investment undertaken in period t is installed and
ready for use as part of the capital stock by period (t+i):
where
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