CHAPTER 2 The Data of Macroeconomicsslide 0Review: objectives Remind you of the main theories. Overview of how parts of the course all fit together. Draw the most important and general lessons to remember from the course.CHAPTER 2 The Data of Macroeconomicsslide 1Financial MarketGoods MarketLabor MarketHouseholds GovernmentFirmssavingborrowing borrowingconsumptiongovernmentspendinginvestmentproductionworkhiringMacroeconomic model with Three Markets & Three agentsCHAPTER 2 The Data of Macroeconomicsslide 2Building blocks of theories Production: depends on factors capital and labor Demand for goods comes from C + I + G Consumption behavior: responds to current income by a MPC: Fisher model suggests should include future income and the interest rate also.CCbY (,)sYFKLCHAPTER 2 The Data of Macroeconomicsslide 3Building blocks continued Investment behavior: responds to the interest rate Money demand behavior: responds to both the interest rate and income, as well as proportional to price level. These building blocks summarize our assumptions about hoe people behavior, and can be combined in different ways.IIdYMeY frPCHAPTER 2 The Data of Macroeconomicsslide 4Equilibrium in the Long Run Key assumption: Prices are flexible to clear markets (Supply=demand) This is assumed by the Neoclassical model. Equilibrium condition:or equivalently: So  And the interest rate adjusts to make investment equal available saving in the economy.sYCIG(,)YYFKL() ()YCY I r GSICHAPTER 2 The Data of Macroeconomicsslide 5Equilibrium in the Long RunBig Lesson #1: In the long run, the level of GDP is determined by the supply side of economy (available factors and technology).CHAPTER 2 The Data of Macroeconomicsslide 6Equilibrium in the Long Run Nominal side of the economy: Money supply set by central bank:  Equilibrium in money market: Since Yand rare already determined, the money market determines the price level. So a rise in Mswill raise P(inflation) proportionately.sMMMeY frPsPM eYfrCHAPTER 2 The Data of Macroeconomicsslide 7Equilibrium in the Long RunBig Lesson #2: Classical DichotomyIn the long run, a change in money supply only affects nominal variables (like price level and inflation), without affecting real variables (like GDP or unemployment).CHAPTER 2 The Data of Macroeconomicsslide 8Equilibrium in the Short Run Key assumption: Prices are fixed, so markets do not clear (Supply demand)use not This is assumed by the Keynesian model  Goods market equilibrium: production adjusts to planned expenditure:YCIGCbYIdrGPP(,)YYFKLCHAPTER 2 The Data of Macroeconomicsslide 9Equilibrium in the Short Run This is an IS curve: Which says output and interest rate can be affected by changes in fiscal policy like G.11YCIGdrbYCIGCbYIdrGCHAPTER 2 The Data of Macroeconomicsslide 10Equilibrium in the Short Run Money market: With r and Y now free, the money equilibrium becomes an LM curve: Which says output and interest rate can be affected by changes in money supply.sMeY frP 1seMrYffPCHAPTER 2 The Data of Macroeconomicsslide 11Equilibrium in the Short Run Big Lesson #3:In the short run, changes in demand side of economy affects amount of goods produced Big lesson #4: Break Classical Dichotomy: In short run, a rise in money supply does affect the level of GDP and other real variables.CHAPTER 2 The Data of Macroeconomicsslide 12AD1SRASP1LM(P1)The SR and LR effects of an IS shockYrYPLRASYLRASYIS2P2LM(P2)IS1AD2A rise in G shifts the IS curve right…13123raising output and the interest rate in the short run.In the long run, the price level rises…which shifts the LM curve left…Until output returns to its normal level.2CHAPTER 2 The Data of Macroeconomicsslide 13AD1SRASP1The SR and LR effects of an LM shockYrYPLRASYLRASYIS2P2LM(M1/P1)AD2A rise in M shifts the LM curve right…13,123Lowering the interest rate and raising output in the short run.In the long run, the price level rises…shifting the LM back to its original positionUntil output returns to its normal level.2LM(M2/P1)=LM(M2/P2)CHAPTER 2 The Data of Macroeconomicsslide 14Other things to know:A Phillips curve describes the tradeoff policy makers can choose, between reductions in unemployment and inflation.So if monetary or fiscal policy is used to raise output and reduce unemployment, this typically comes at the cost of extra inflation. enuu CHAPTER 2 The Data of Macroeconomicsslide 15Main ideas from Solow Growth Model The steady state condition (where a country ends up in the long run) depends on its saving rate, population growth rate, and technological progress:s f(k)= (+n +g)k The golden rule condition (where consumption per person is highest) is also determined by these same things: MPK =  + n+g Getting to the golden rule requires the right saving rate and good policies.CHAPTER 2 The Data of Macroeconomicsslide 16Factors market In a well-functioning factors market, the rate of payment is determined by the marginal productivity:labor: capital:  Natural rate of unemployment comes from:– Structural causes: wage rigidity, unions– Frictional causes: sectoral shocks, unemployment insurancereal rental rate MPKreal wageMPLCHAPTER 2 The Data of Macroeconomicsslide 17More on Consumption TheoryFisher’s theory of intertemporal choice Consumer chooses current & future consumption to maximize lifetime satisfaction subject to an intertemporal budget constraint. Shows that current consumption depends on lifetime income (including both current and future income), as well as the interest rate.This theory helps explain the ‘Consumption Puzzle’: why a temporary rise in income leads to a drop in average propensity to consume (APC), but a permanent rise in income leaves APC