Macro Midterm

What is Macro- questions?

 Why do recessions occur regularly? Can we do something about them? Can we predict them?
 Why do some countries grow so little? How high will future growth be? Is globalization good
or bad? Moreover, for whom?
 Can international aid help reduce poverty?
 Economics is the discipline that studies the allocation of scarce resources, while
macroeconomics studies the economy as a whole at the aggregate level and the backdrop of
economic conditions against which firms and consumers make decisions, which means: the
aggregate conditions that all agents take into account when they have to make an economic
decision.

Lecture 2
National Accounting
 How to measure output?
GDP measures the total value of goods and services produced in an economy in a given year.
in the consumer-choice equilibrium: price =
marginal benefit
the price is a measure of the value that
consumers assign to a good

If only prices move: increase in prices raises nominal output. Solution is Real Output.
Real GDP = sum of (quantities * prices in BASE YEAR)
Important: Real GDP is always expressed in the unit of a BASE YEAR and is calculated
keeping prices constant at the level of year 1.

 When prices change, people change choices and buy more of the more inexpensive goods.
Solution: Chain Weights
• Gradually adjust weights of each product
(prices) together with changes in prices
• How to:
1) calculate constant-old prices GDP
2) calculate constant-new prices GDP
3) take the average of the two growth rates!
p. 26
Calculate annual chain-weighted real GDP growth between year 1 and 2 as well as between
year 2 and 3.

The GDP Deflator

 How do we measure changes in prices?
We know: Change in nominal GDP = Change in real GDP + Change in Prices
Define: GDP Deflator = Nominal GDP/ Real GDP
.

Inflation = GDP Deflator (t+1) / GDP Deflator (t) - 1

Inflation measures %-change in GDP Deflator
Brief Discourse: Inflation
• Inflation is a big concern in current economic discussion
• Inflation as discussed in the media is typically not based on the GDP deflator, but on a consumer
price index (CPI)
1. CPI versus GDP-Deflator: The CPI also contains foreign goods, while the GDP deflator is only
based on domestic production
2. The CPI contains no government spending, but government spending can be part of the GDP
deflator

Output as Value Added

• Consider an economy which produces one final good (butter) and several intermediate goods:
farmer’s output: 500€ of milk
transport firm’s output: 1500€ of milk in cans
factory’s output: 3000€ of butter
supermarket: 4000€ of butter sold

• Total output = 9000 euros? How should we count?

Macroeconomics- Practice Midterm

When calculating the Expenditure Measure of GDP, Firms’ unsold inventory
a) is counted as investment
b) is not counted in GDP because it is excluded from consumption
c) is purchased by the government
d) is equal to the difference between imports and exports
e) is the difference between real and nominal GDP

2. Country A and B have the same levels of consumption, investment, and government purchases, but
country B sells twice as many exports and buys twice as many imports as country A. Which country
must have a larger GDP?
a) The answer depends on whether country A has positive or negative net exports
b) The GDP of country A must equal the GDP of country B
c) Country A
d) Country B
e) The answer depends on whether country A’s imports are greater than its domestic consumption

3. Consider our Neoclassical growth model of capital accumulation, where the production function
has a decreasing marginal product of capital (such that a steady state for capital exists). Imagine the
savings/investment rate exceeds the Golden Rule level, b>α. Which of the following statements is
true?
a) By decreasing its savings rate, the country can raise its consumption both in the short and in the
long run
b) By decreasing its savings rate, the country forgoes consumption in the short run, but can raise its
consumption in the long run
c) By decreasing its savings rate, the country can raise its consumption in the short run but forgoes
consumption in the long run
d) The country can never reach a steady state, because its investment is always higher than its
depreciation
e) The country’s consumption in the long run converges to zero

4. Consider the following graphical representation of our Neoclassical growth model of capital
accumulation. Which of the following statements is false?
a) By investing 30% of output instead of 20%, the country achieves a higher level of consumption in
the steady state
b) By investing 30% of output instead of 20%, the country achieves a higher level of output in the
steady state
c) Irrespective of how much this economy invests, it cannot grow from capital forever
d) By investing 30% of output, the country’s investment rate exceeds its Golden Rule level
e) If the country’s initial capital stock is very low (lower than KL), capital will start to grow until it
reaches the steady state
5. Suppose an economy has the production function Y = 0.8K, investment is 10% of income, and the
rate of depreciation is 5% of the capital stock per year. Which of the following statements is true?
a) Output in this economy grows 3% each year
b) The capital stock in this economy is constant
c) The capital stock in this economy converges to zero (poverty trap)
d) The steady state level for capital is KSS=120
e) The marginal product of capital (MPK) is decreasing in the capital stock

6. Assume an economy in which investment I=100, government spending G=400, net exports X-M=0,
and where consumption follows the Basic Keynesian model of consumption as C=1000+0.9Y. In this
economy, when the government increases its spending by 75 (such that now G=475) ...
a) ... consumption will rise by 675
b) ... investment will rise by 75
c) ... equilibrium output will rise by 75
d) ... equilibrium output will rise by 10%
e) ... government spending will rise by 750

7. Consider the simple two-period intertemporal consumption choice model (“permanent income
model”) that we have seen in class. Suppose the household has an income Y1=100 in the first and
Y2=0 in the second period. The interest rate is r=10%. Which of the following statements is true?
a) Following a change in the interest rate, the substitution and income effect on first period
consumption in this example go in opposite directions
b) The household will save, so as to consume equal amounts in both periods (“perfect consumption
smoothing”)
c) The household will not consume in the second period because the income in this period is zero
d) The household will consume 50 in the first and 55 in the second period, given that the interest rate
is 10%
e) If the interest rate rises, the marginal propensity to consume always falls in the first period

Which of the following is not a macroeconomic question?

a) What is the predicted market value for an initial public offering of a firm’s stock?
b) How does increasing government expenditure affect GDP?
c) What are the effects of stronger labor unions on unemployment?
d) Why do some poor countries remain so poor?
e) What is the GDP forecast for Austria?

9. Assume you can decompose GDP in Austria and Benin in the following way: In both countries,
each worker works 2000 hours. In Benin, the employment rate (defined as employed / labor force) as
well as the participation rate (defined as labor force / population) is 50%. In Austria, the employment
rate is 90%; the participation rate is 70%. GDP per capita in Benin is 2000, in Austria it is 50000.
Which of the following statements is true?
a) Hourly productivity in Austria must be roughly ten times higher than in Benin
b) If Benin’s employment rate and participation rate were at Austrian levels, it’s GDP per capita
would double
c) If Benin’s participation rate increased to 75%, GDP per capita would increase by 500
d) The Austrian unemployment rate is 30%
e) If Benin’s employment rate were as high as Austria’s, GDP per capita would be 3000
10. Consider our standard Cobb-Douglas production function:Y= TFP× Kα× L1α, where α is between
0 and 1. Which of the following statements is true?
a) If one doubles the inputs of capital K and lab or L, output Y will also double
b) The marginal product of labor (MPL) is decreasing in K
c) Higher TFP captures, among other things, the amount of computers that firms buy
d) If α = 1, the economy exhibits an increasing marginal product of capital (MPK)
e) None of the other statements is true

11. Consider our Solow model with human capital accumulation: Yt= Kt0.3× (HtxLt)0.5
It= b × Yt
Ht = Kth
Where K is capital, I is investment, H is human capital, and t is a subscript indicating time. The
evolution of capital over time works as seen in class and in the textbook. Also as seen in class, firms
do not internalize human capital formation. Labor is constant at L = 4, the investment rate is b = 0.5
and depreciation is 10% of the capital stock each year. The exponent of human capital formation is h =
0.4. Which of the following statements is false?
a) If h increase d to h = 0.7, the social MPK of this economy would be constant
b) The economy has a steady state at K = 100
c) If h increase d to h = 0.6, the investment rate should increase to b = 0.6 to maximize
consumption in steady state
d) From a social point of view, the economy’s steady state is at the Golden Rule
e) The social MPK of this economy is decreasing

12. Consider our flow approach to the natural unemployment rate. The probability of losing a job is p
= 5% and the probability of finding a job is f = 50%. Which of the following statements is false?
a) In the data, employment protection legislation (EPL) cannot clearly be associated with a lower
probability of job loss
b) The natural rate of unemployment is 9.1% (rounded)
c) If employment protection legislation (EPL) reduces p to 3%, it only has positive employment
effects if f remains higher than 30%
d) In the data, employment protection legislation (EPL) cannot clearly be associated with lower
unemployment
e) The natural rate of unemployment can be computed as u = p / (f+p)

13. Which of the following statements is false?

a) In developed economies, most value added comes from the service sector.
b) In developed economies, the share of income, which goes to labor, is around 2/3.
c) The employment rate is usually defined as employment divided by labor force.
d) Poor countries with a lot of their citizens working abroad, tend to have a higher GNI than GDP.
e) By using purchasing power parity (PPP) exchange rates rather than market exchange
rates, one tends to overstate the extent of poverty of poor countries
.
14. Which of the following statements is false?
a) To achieve the golden rule level of capital, the investment share has to equal the
depreciation rate.
b) Conditional convergence implies that poor countries do not always grow faster than rich countries.
c) A poverty trap cannot arise in our standard Cobb-Douglas production function, if the social and
private marginal products of capital are decreasing.
d) When controlling for factors like education, health, institutions, etc., the data suggests that lower
GDP is associated with higher growth.
e) Financial sophistication and ethnic diversity are notvery important for long run growth.

15. Which of the following statements on convergence in output is true?

a) We observe conditional convergence of poor and rich countries in the world.
b) We do not observe convergence in growth across US states.
c) We observed divergence across developed countries.
d) We observe unconditional convergence of poor and rich countries in the world.
e) An increasing marginal product of capital implies convergence in growth.

GDP as Output, Income and Expenditures

The 3 measures of output
1) Output as Production (c.f. Lecture 2)
 Sum of total added value in each sector

2) Income
 Sum of payments to factors of production (labor, capital)

3) Expenditure
 Sum of expenditure in final goods and services

Wages + Profits = Value Added

Aggregate Demand (AD) = Consumption by Individuals (C) + Investment by the private sector (I) +
Consumption and Investment by Government (G) + Exports (X)
National Product (Y) + Imports (M) = C + I + G + X
• GDP measures output as a geographical concept, output produced in an economy
• GNI adjusts GDP by the flows to and from other countries, income earned in an economy

• Real GDP tends to be higher if population is higher

 population growth over time
 different countries (e.g. USA vs. Canada, Germany vs. Austria)
• …what about the standard of living of each person?
• Simple solution: per-capita GDP
per capita GDP = Real GDP / Population

• Hourly productivity: level of technology, capital stock, education and skills of workers, working
practices…
• Avg. Hours per Worker,
Employment rate (1-Unemployment
rate), Labor force participation rate:
culture, preferences, laws,
demographics
• The only way to long-run sustained
growth is increasing hourly
productivity.
The Production Function
• Hourly productivity is the combination of:
1. Capital stock workers interact with
2. Skills and education of workers
3. Efficiency of firms in combining factors
4. Working practices
5. and more…
• Thinking in broad terms: GDP is produced by:
1. Labor
2. Capital
3. Total Factor Productivity

Total Factor Productivity

• TFP captures all factors affecting output but are not explicitly factors of production
• It is a measure of efficiency of combination of inputs
• Includes a lot of things that we understand only so much (technology, skills, institutions, …).
• Important: in the long run, roughly
 hours of work = const * population
• So the only long-run sources of growth of GDP per capita: capital accumulation and increases in
TFP.

The Cobb-Douglas Production Function

• What happens to GDP if one factor of production changes by one unit?
• The marginal products of capital and labor answer this question.
• How to compute marginal products?
 Need to assume a functional form to calculate it!
• Motivated by empirical observations and theoretical considerations, economists use an
approximation:

.
• GDP per capita, rather than GDP, measures improvements in the standard of living of the population.
• Countries grow because
– more people are willing to work
– more people who are willing manage to work
– people work harder (more hours)
– each hour is more productive (i.e. productivity)
• Productivity per hour worked is how to grow in long run
• This can be increased either through capital accumulation or TFP growth

Quiz 2
The relationship between an economy’s productive inputs and its outputs is called

the transformation correlation

the division of labor
the economic dialectic
the production function
the principle of economic creation

Consider a simple economy with only one final good (cars) and only one time period (2023). One
million cars are produced and sold in total. The production chain includes mining, steel production, car
manufacturing, and the car retail industry. Wages in 2023 amount to 1 billion EUR in the mining
industry, 2 billion EUR in the steel industry, 4 billion EUR in the manufacturing industry, and 5
billion EUR in the retail industry. Total profits in the four industries add up to 8 billion EUR. What is
the average price of a car in 2023?
26.000 EUR
22.000 EUR
18.000 EUR
20.000 EUR
24.000 EUR

GDP per capita in Phantasia in 2023 was equal to 23040 PD (phantasialand dollars). The labor force
participation rate was 40%, the employment rate was 90%, and hourly productivity was 40 PD. The
average number of hours worked yearly by an employed person in Phantasia was
1400
1800
1600
1700
1500
If everyone in the population were employed for a fixed number of hours per year, then

Labor productivity would equal GDP per capita multiplied by hours worked per person
Labor productivity times population would equal GDP
GDP would equal labor productivity multiplied by hours worked per person
GDP per capita would equal GDP divided by hours worked per person
GDP per capita would equal labor productivity multiplied by hours worked per person

What is the difference between GDP and GNI?

GDP is a nominal value, while GNI is a real value.

GDP accounts for imports and exports, while GNI does not.
GDP measures production within a country, while GNI measures the income earned by the
citizens of a country.
GDP is calculated annually, while GNI is calculated quarterly.
GDP only accounts for the production of goods, while GNI also includes services.

Growth and Capital Accumulation

• Countries differ in per-capita GDP because they differ in:
1. Labor Force Participation
2. Employment rate
3. Hours of work
4. Productivity per hour worked
• The latter is the only way to long-run sustained growth
• Productivity per hour worked depends on
– Capital accumulation
– Total Factor Productivity
• Relatively rich countries mostly grow by improving TFP (better machines) and less because of
accumulation of capital
• Poorer countries mostly add capital (more machines)

MPK = (change in output) / (change in capital)

• Last time we added a machine, it allowed to produce an additional 1000 cars per month
• If we buy another machine and we produce:
> 1000 additional cars: increasing MPK
= 1000 additional cars: constant MPK
< 1000 additional cars: decreasing MPK

• There are good reason to believe in decreasing returns!

• Why? Remember, only capital is changing!
• If our car company has 10 machines and 10 workers, each of them working at a machine…
• …who will man the additional machine? Maybe the men can share their time between machines…
• …but if we add more, we will have more problems!
• Is it profitable to add capital? It should be that
Added gain > cost of capital
• But the added gain is none other than
MPK × P of output good
• What is the cost of capital?  the interest rate at which you borrow money for capital goods!
• (which is also the opportunity cost of the money you could be investing in the capital market)

• Loanable funds markets: where investors and savers meet and the price and amount of loanable funds
are determined (loanable funds are the aggregate amount of money that economic participants decide
to invest instead of spend on consumption)
• Demand of loanable funds: people who want to invest for production and need the funds to do so
(e.g. firms)
• Supply of loanable funds: people, who saved money and want to lend it in order to earn some interest
(e.g. households)
• Equilibrium Interest Rate: the one at which
Demand for Loans = Supply of Loans

• If the MPK is decreasing

 Poor countries should grow faster than rich countries = Catching Up
• Why?
1. They find investment more attractive (higher MPK)
2. If they can borrow from abroad, they find relatively low interest rates (compared to their high
MPK)!
• When you have a lot of capital  MPK is low
• How to increase it?
• Back to production function:

• TFP becomes very important for rich countries!

• Better machines (TFP) vs. more machines (Capital)
• Economies cannot grow forever through capital accumulation alone.
• If TFP and Labor do not change the economy will reach a Steady State
• Steady State: situation in which economic aggregates do not change over time
• This is an equilibrium of the model economy with decreasing MPK.
Gross and Net Investment
• Machines and Buildings get old.
• Most of investment actually goes to replace them.
• Gross Investment (I): total new capital added to the economy.
• Depreciation (D): capital which stops being productive.
• Net Investment = Gross Investment – Depreciation

A Model Economy (Solow Model)

1) In the world, investment and savings must be equal  long-run interest rates are determined in the
capital markets to ensure that this happens.
2) Due to the decreasing marginal product of capital, growth through capital accumulation eventually
stops.
3) This is called a steady state – a situation in which capital today is equal to capital tomorrow.
4) Also, due to decreasing returns, poor countries should grow faster than rich countries if they have
the same production function (and hence employ the same technology i.e. TFP).
5) Economies eventually converge to the steady state in which investment equals depreciation. The
higher the investment rate  the higher the capital level and output will be.

• If TFP is the only source of long-run growth, why

should we save?
• In our example: a country, which invests 30% of
its output has higher capital than one which invests
20%
• Thus, it produces more output
• Does it enjoy a higher standard of living?
• Is welfare higher?

Investing 100% of your production is a very bad idea

 producing only investment goods = 0 enjoyment
• Investing 0 does not seem very good either
 the result will be low future output (and no output in the long run)
• We would like to sustain a level of output as high as possible – but also have enough to consume!
• Ignoring the government sector: C = Y - I
• In steady state, I = d K
• Thus, C = Y – dK
• Capital Accumulation crucial for economic growth.
• How important this is depends on the marginal product of capital – and on whether it’s increasing,
constant or decreasing.
• Most likely capital has decreasing marginal product – and this implies that economies cannot grow
forever through capital accumulation.
• It also implies that poor countries should be able to “catch up” with rich ones.
• Decreasing marginal product of capital also implies that economies reach a steady state in which
capital stays constant.
• The higher the level of investment
 the higher steady state capital  the higher output
• How much should we save? That depends on the productivity of capital and on how fast it
depreciates.
• The Golden Rule: Marginal Product of Capital = Depreciation Rate
• When applied to Cobb-Douglas Production Function:
Investment rate = Productivity of Capital (α)

Lecture 7

Technological Progress and Capital

The Steady State

How much should a country invest?

The Golden Rule: MPK = d
In Cobb-Douglas case: b (Y / K) = α (Y / K)  b = α

TFP and its role

Increasing TFP and the Boost in GDP

1) Higher TFP  Higher GDP given capital
2) Higher GDP given capital  Higher Investment
 Higher Capital  Even Higher GDP

Labor can contribute in the form of Human Capital.

Higher skilled workers are more productive
Like physical capital, human capital is durable and depreciates.
• TFP is different from TFP because now we include Human Capital, so we allow for a smaller role of
residual explanations.
• If we increase a country’s Human Capital (HC):
1. The country becomes more productive for each level of physical capital
2. So it has higher levels of growth
3. And a higher steady state

How to improve Human Capital: Spend on education, encourage skills acquisition, improve life
expectancy
• Capital differences important for very poor countries
• Education differences important for every group
• TFP differences important for every group except very rich, more important than education in poorer
countries
The most important factor remains technological progress!
• Before the Steady State, you can do many things:
– Capital Accumulation
– Human Capital Accumulation
– Improving Institutions
• …but when you are in Steady State, you really need technological progress!

• Total Factor Productivity is crucial for explaining GDP differences across countries.
• Part of these are explained by differences in Human Capital…
…another part explained by differences in Institutions…
…and, most importantly, to differences in Technology!
• Differences in TFP translate in different Steady States
– Different levels of Capital and Human Capital accumulation.
Quiz 4
Developed economies need to engage in research and development more than do developing
economies because developed economies

have greater capital depreciation rates

have largely exhausted the gains from capital accumulation
are inherently less innovative than developing economies
need to exploit rent-seeking opportunities in order to continue growing
have smaller workforces

In which respect is human capital unlike physical capital?

human capital does not depreciate

the stock of human capital cannot be increased
human capital cannot be measured
human capital does not affect output
none of the above

Cultural and social forces, such as religious prohibitions on certain activities or ethical norms
regarding effort

have no effect on economic output, and so are deliberately excluded from growth accounting
are not captured in the production functions used for growth accounting
are assumed to influence total factor productivity
are measured as part of labor input
are treated as ‘social capital’ in the production function

Suppose the economy has TFP = 10, there are 400 hours worked, and 60 unit of capital and 210 units
of land the Cobb-Douglas production function is:
Output = TFP x hours0.3 x Capital0.3 x Land0.2.
For this hypothetical economy, the share of output paid to land is

70%
20%
50%
10%
90%
An increase in TFP

steepens the aggregate supply curve

shifts the aggregate supply curve upward
shifts the production function upward
increases the rate of depreciation
cannot occur once a steady state has been achieved

Endogenous growth & Convergence

• Our model until now: Solow neoclassical growth model
• TFP is a black box and somehow grows; capital adjusts as a consequence.
• Not very satisfactory for explaining long-run growth:
– TFP has a huge role
– We just take it as a given residual
• We should try to explain growth endogenously!

Idea 1: there is no end

• What if we remove the Decreasing MPK…
…and we assume Constant MPK instead?  no Steady State!

Does Constant MPK make sense?

• Not really…
• But: If there is positive interaction between physical and human capital we could get constant MPK.
• Having more machines makes workers acquire more skills because
1. Skills might be complementary to machines
2. Higher capital = Higher return to investing in skills
 this interaction might yield a total Constant MPK
The virtuous circle of HC and K

.
How to reconcile the evidence?
• Over the world  no convergence
• But across similar economies  convergence
• So what about MPK and our Solow neoclassical growth model?

• So what about MPK and our Solow neoclassical growth model?

• Similar countries appear to (same same) steady state!
• The Steady State depends on
• Technology
• Level of human capital
•“there is no end” is ruled out!
• Observation II. implies there cannot be just one steady state!
• Idea 2 “conditional convergence”
•Key point: countries might have different Steady States.

According to our standard neoclassical growth model:

Growth in GDP per capita = b × ( Steady State GDP – GDPt )

And we said that Steady State depends on several things:

Unemployment and the Labor Market
Preliminaries: Labor Market Data
• Working-age population: individuals aged 15-64 (not all of them work for many reasons)
• Labor Force: those who are of working age and are willing to work.
• (Labor Force) Participation Rate* = (Labor Force) / (Working-age Population)
*Note: In the US, the standard definition is participation rate = labor force/total population
• Employed: those who are willing to work and have a job (people disagree what a “job” is)
• Employment rate* = Employed / (Labor Force)
• Unemployment rate = Unemployed / (Labor Force) = 1 – Employment rate
*NOTE: in the USA it is also standard to call Employment rate = Employed / (Working-age
Population)
Macro Endterm
Quizzes:
Midterm:
Generally speaking technological progress leads to higher output

purely because it raises the productivity of capital

purely because it raises the steady-state capital stock
because it raises both the productivity of capital and the steady state capital stock
purely because it increase the capital stock for a given production function
purely because it raises the output produced by a given capital stock

Macroeconomics and microeconomics are complementary in that

macroeconomics explores the context within which microeconomic decisions are made
microeconomics takes a broader look at the issues upon which macroeconomics is more
narrowly focused
microeconomics seeks to understand the economy as it is, while macroeconomics seeks
to determine how the economy ought to be designed
microeconomics examines market-based economies, whereas macroeconomics
examines command economies
macroeconomics studies private behavior, while microeconomics studies public behavior

Which of the following is probably the least relevant to a country’s long-run growth rate?

infrastructure such as roads or computer networks

the education of the workforce
new technological inventions
legal restrictions on capital mobility and investment
short-term interest rates

When interest rates rise,

investment increases
investment declines
savings decrease
shortages occur in the market for loans
long run economic growth is encouraged

For any economy with an existing capital stock of $800 million and annual depreciation of
5%, a steady state occurs if
 gross investment = $840 million
gross investment = $1600 million
gross investment = $40 million
net investment = $5 million
net investment = $800 million

Which of the following statements is correct?

To calculate inflation, the only measure we need is real GDP growth between two time
periods.
Total revenue tends to overstate total output in an economy, which is why total value
added is a more appropriate measure.
If there is a nominal GDP increase in an economy, it means that welfare has definitely
increased as well.
Real GDP does not depend on the choice of the base year.
If there is a nominal GDP decrease in an economy, it means that welfare has definitely
decreased as well.

If everyone in the population were employed for a fixed number of hours per year, then

GDP per capita would equal labor productivity multiplied by hours worked per person
GDP would equal labor productivity multiplied by hours worked per person
Labor productivity would equal GDP per capita multiplied by hours worked per person
GDP per capita would equal GDP divided by hours worked per person
Labor productivity times population would equal GDP

A steady state may be defined as

an equilibrium between the supply and demand for consumer goods

a point at which the capital stock per worker is stabilized
an economy without short run fluctuations in GDP
a state in which the marginal product of capital is neither increasing nor decreasing
an economy in which monetary policy is conducted by rules rather than discretion

Consider a simple economy with only one final good (cars) and only one time period (2023).
One million cars are produced and sold in total. The production chain includes mining, steel
production, car manufacturing, and the car retail industry. Wages in 2023 amount to 2 billion
EUR in the mining industry, 2 billion EUR in the steel industry, 2 billion EUR in the
manufacturing industry, and 2 billion EUR in the retail industry. Total profits in the four
industries add up to 10 billion EUR. What is the average price of a car in 2023?
 24.000 EUR
22.000 EUR
26.000 EUR
20.000 EUR
18.000 EUR

Cultural and social forces, such as religious prohibitions on certain activities or ethical norms
regarding effort

have no effect on economic output, and so are deliberately excluded from growth
accounting
are not captured in the production functions used for growth accounting
are assumed to influence total factor productivity
are measured as part of labor input
are treated as ‘social capital’ in the production function

Consider our standard Solow Growth Model. The production function is Cobb-Douglas: Y =
AKaL1-a Assume a = 0.5, b = 0.2 of output is invested, d = 0.05 of the capital stock
depreciates each period, A = 1, and L = 2 is the total number of workers.

Which of the following statements are correct?

If L increases to Lnew = 4, output per worker in the new steady state decreases to
Ynew*/Lnew = 2.
Output per worker is Y*/L = 4 in steady state.
The steady state capital stock per worker is K*/L = 16 in steady state.
If L increases to Lnew = 4, the new steady state capital stock is Knew* = 64.
Investment is I* = 1.6 in steady state.

Which of the following statements about Total Factor Productivity (TFP) in the Solow model
are correct?

An increase in TFP raises the marginal product of labor.

TFP captures, among other things, increases in the capital stock.
TFP captures, among other things, improvements in the quality of institutions.
In the Cobb-Douglas production function, TFP exhibits a decreasing marginal product.
An increase in TFP raises the marginal product of capital.
Consider our standard Solow Growth Model. Output is produced using the production
function Y = K0.5 where we have set L=1 and A=1 for simplicity. Each period, 10% of the
capital stock depreciates. Output is either consumed or invested (i.e. you can abstract from
the government, exports, and imports). Which of the following statements about the Golden
Rule steady state are true?

Investment is equal to IGR = 4.

 Each period, total depreciation is DGR = 2.5.
Output is equal to YGR = 5.
50% of output is invested, i.e. b = 0.5.
The capital stock is KGR= 25.

Which of those questions are of interest to macroeconomists?

What will the stock price of Volkswagen be in 3 months?

Which distribution system should voestalpine choose for its new product?
What are the economic consequences of a potential energy embargo on Russia?
What is the effect of Brexit on unemployment in the UK?
How should the European Central Bank respond to increasing inflation in the EU?

Which of the following statements about economic growth is correct?

GDP cannot grow forever in a given country.

Spillover effects help to explain why some countries' GDP levels do converge, but poor
countries often do not catch up to rich countries.
All countries with low levels of GDP today will continue to have low GDP levels in the
future.
The quality of institutions is important for economic growth.
In the Solow model, a country's welfare level is strictly increasing in its capital stock.

Which of the following statements about GDP are correct?

GDP is always larger than GNI.

GNI tends to be larger than GDP if a lot of income flows into the country from abroad.
Nominal GDP and Real GDP are identical in the base year.
Due to accounting identities, total factor payments and total value added in an economy
are identical in theory.
Real GDP is a reliable standard of living measure, because it measures the consumption
possibilities of people living in an economy.

Consider a world with only two countries and two goods. Country A produces only good A,
and Country B produces only good B. Residents in both countries consume both goods,
meaning there is international trade. Over the course of a year, the price of good A rises from
100 to 106 currency units (CU), while the price of good B increases from 104 to 107 CU.
Which of the following statements is correct?

The GDP deflator in country A increased by more than the consumer-price-index in

country A.
 The Consumer Price Index in country B increased by more than the GDP deflator in
country B.
The GDP deflator in country A increased by less than the consumer-price-index in
country A.
The Consumer Price Index in country B increased by less than the GDP deflator in
country B.
The GDP deflator in country A increased by less than the GDP deflator in country B.

Which of the following statements about economic growth and human capital are correct?

Higher levels of human capital lead to a higher marginal product of capital (MPK).
Modeling human capital can lead to a model that has increasing social MPK.
After controlling for human capital, total factor productivity (TFP) does not matter
anymore when explaining income differences across the world.
Spending in education can help increase human capital.
In a model with human capital and increasing social marginal product of capital (MPK),
there are no poverty traps.

The following table documents all factor payments in Imaginecountry. There are two factors
of production (labor and capital) and three sectors (agriculture, manufacturing, and services).
Factor Payments
Labor Capital
Agriculture 90 100
Manufacturing 110 420
Services 50 230
Which of the following statements are true?

Value added in Manufacturing is 530.

Total GDP is 1000.
The labor share is 50%.
The labor share is 30%.
Total GDP is 750.

Suppose the economy has the production function Y=0.8K, gross investment is 10% of
national income and the rate of depreciation is 5% of the capital stock. The capital stock of
this economy:

is constant
will grow at 5% per year
will grow at 3% per year
 will grow at 2% per year
will grow at 6% per year

Rent seeking behavior can affect economic growth because

it stimulates innovation
it allows arbitrageurs to capture profits that would otherwise go unrealized
it reduces the level of risk in the economy
it provides an efficient use of land
it shifts labor away from entrepreneurial activity

Consider a world with only two countries, A and B. Country A residents earn positive factor
income abroad. Which of the following statements are certainly correct?

The GDP of country A is larger than the GDP of country B.

The GDP of country A is smaller than the GDP of country B.
The GDP of country A is larger than the GNI of country B.
The GNI of country A is larger than its GDP.
The GDP of country B is larger than its GNI.

Consider our standard Solow Growth Model. Output in period t is produced using the
production function Yt=Kαt. where α=0.5 and we set L=1 and TFP=1 for simplicity. The
depreciation rate is d=0.1, and b=0.3 of total output is invested. The initial level of capital
is K0=6. Which of the following statements are correct?

Investment is larger than depreciation in period 0.

The capital stock will grow this period, i.e. K1 > K0.
Investment is smaller than depreciation in period 0.
The capital stock will decline this period, i.e. K1 < K0.
The economy is in steady state.

Country A and B have the same levels of consumption, investment, and government
purchases, but country B sells twice as many exports and buys twice as many imports as
country A. Which of the following statements are correct?

If country A has positive net exports, country B has larger GDP.

If country A has negative net exports, country A has larger GDP.
 Independent of country A’s net exports, both countries have the same GDP.
If country A has positive net exports, country A has larger GDP.
If country A has negative net exports, country B has larger GDP.

Practice Questions
When calculating the Expenditure Measure of GDP, Firms’ unsold inventory...

is purchased by the government

is counted as investment.
is equal to the difference between imports and exports
is not counted in GDP because it is excluded from consumption
is the difference between real and nominal GDP

Country A and B have the same levels of consumption, investment, and government
purchases, but country A sells twice as many exports and buys twice as many imports as
country B.
Which country must have a larger GDP?

Country A.
Country B.
If A has positive net exports, country A has higher GDP.
The GDP of country A must equal the GDP of country B.
If A has negative net exports, country B has higher GDP.

Assume you can decompose GDP in Austria and Benin in the following way:
In both countries, each worker works 2000 hours. In Benin, the employment rate (defined as
employed / labor force) is 50% and 50% of the population are in the labor force. In Austria,
the employment rate is 90%, and 70% of the population are in the labor force. GDP per
capita in Benin is 2000, in Austria it is 50000.
Which of the following statements is true?

If Benin’s employment rate were as high as Austria’s, GDP per capita would be 3600
The Austrian unemployment rate is 10%
If 75% of Benin’s population joined the labor force, GDP per capita would increase by
500.
Hourly productivity in Austria must be roughly ten times higher than in Benin
If Benin’s employment rate and participation rate were at Austrian levels, it’s GDP per
capita would double
Select the correct statements about GDP accounting.

By using purchasing power parity (PPP) exchange rates rather than market exchange
rates, one tends to overstate the extent of poverty in poor countries.
We defined the employment rate as employment divided by labor force.
Poor countries with a lot of their citizens working abroad, tend to have a lower GNI than
GDP.
In developed economies, the share of income which goes to labor is around 2/3.
In developed economies, most value added comes from the service sector.

Which of these statements about long run growth are correct?

To achieve the golden rule level of capital, the investment share has to equal the
depreciation rate.
Conditional convergence implies that poor countries do not always grow faster than rich
countries.
Financial sophistication and ethnic diversity are very important for long run growth.
A poverty trap cannot arise with our standard Cobb-Douglas production function, if the
social and private marginal products of capital are decreasing.
When controlling for factors like education, health, institutions, etc., the data suggests
that lower GDP is associated with higher growth.

Which of the following statements on convergence in output are true?

We observed divergence across developed countries.

We observe unconditional convergence of poor and rich countries in the world.
An increasing marginal product of capital implies convergence.
We observe convergence in growth across US states.
We observe conditional convergence of poor and rich countries in the world.

Consider our Neoclassical growth model of capital accumulation, where the production
function has a decreasing marginal product of capital (such that a steady state for capital
exists). Imagine the savings/investment rate exceeds the Golden Rule level: s>α.
Which of the following statements is true?

The country can never reach a steady state, because its investment is always higher than
its depreciation
By decreasing its savings rate, the country can raise its consumption in the long run
The fraction of capital that depriciates each period (d) is larger than the marginal product
of capital (MPK).
By decreasing its savings rate, the country can raise its consumption in the short run
 The country’s consumption converges to zero in the long run

Suppose an economy has the production function Y = 0.8K,

investment is 10% of income, and the rate of depreciation is 5% of the capital stock per year.
Which of the following statements is true?

The marginal product of capital (MPK) is decreasing in the capital stock

Output in this economy grows 3% each year
The capital stock in this economy converges to zero (poverty trap)
The steady state level for capital is KSS = 120
The capital stock in this economy will grow forever

Consider our Solow model with human capital accumulation:

Yt = Kt0.3 × (Ht x Lt)0.5
It = s × Y t
Ht = Kth
where K is capital, I is investment, H is human capital, and t is a subscript indicating time.
The evolution of capital over time works as seen in class and in the textbook. Also as seen in
class, firms do not internalize human capital formation. Labor is constant at L = 4, the
investment rate is s = 0.5 and depreciation is 10% of the capital stock each year. The
exponent of human capital formation is h = 0.4.

The economy has a steady state at K = 100

If h increased to h = 0.7, the social MPK of this economy would be constant
If h increased to h = 0.6, the investment rate should increase to s = 0.6 to maximize
consumption in steady state
From a social point of view, the economy’s steady state is at the Golden Rule
The social MPK of this economy is decreasing

Consider our standard Cobb-Douglas production function:

Y = TFP × Kα × L1-α,
where α is between 0 and 1. Which of the following statements is true?

The marginal product of labor (MPL) is decreasing in TFP.

If α = 1, the economy exhibits an increasing marginal product of capital (MPK)
If one doubles the inputs of capital K and labor L, output Y will also double
The marginal product of labor (MPL) is increasing in K
The marginal product of capital (MPK) is increasing in K

Which of the following statements concerning GDP and the price level are true?
 Nominal GDP does not react to pure price changes.
Real GDP is lower than nominal GDP.
When inflation is positive, the GDP deflator increases.
The GDP deflator represents inflation by measuring the gap between nominal and real
GDP.

Which of the following statements concerning inflation is true?

The GDP Deflator is a price index that measures only price inflationneglecting deflation.
Inflation = (Deflator_year2/ Deflator_year1)×100
1=Nominal GDP/(GDP Deflator×Real GDP)
Real GDP= GDP Deflator·Nominal GDP

The golden rule states that...

net investment is equal to gross investment minus depreciation.

the marginal product of capital should be equal to the depreciation rate.
rich countries grow faster than poor countries.
in rich countries, TPF growth is more important than in poor countries.

Quiz 5

Suppose that 30% of a country’s population is institutionalized in schools, hospitals, or

prisons; 10% are full-time homemakers; another 10% are retired; 45% of the population is
employed either full-time or part-time; and 5% of the population is unemployed and seeking
work. Then the unemployment rate is

15%
25%
5%
10%
55%

If the marginal product of capital were increasing in all nations

technology would spill over rapidly from rich nations into poor nations
poverty traps would be avoided
the marginal product of labor would also be increasing in all nations
nations would experience a rapid convergence to a steady state in which GDP per capita
would be the same across countries
nations with large capital stocks would invest more than nations with small capital stocks
Suppose the economy has the production function Y = 0.8K, gross investment is 10% of
national income, and the rate of depreciation is 5% of the capital stock.
If the capital stock suddenly doubles, output will rise by

80%
5%
100%
a factor of 1.6
10%

Endogenous growth theory explains poverty traps as the result of

discrimination
more rapid depreciation of human capital among some groups than others
mismanaged government policy
interdependencies which make investments more valuable in wealthy regions
wide variations in basic human attitudes, motivation, and risk-taking

One reason to believe that the marginal product of capital may be constant is that

capital and labor are substitutes in production

physical capital and human capital may be complementary inputs
technology rarely changes
beyond the optimal level, the extra output produced by another machine is always zero
firms treat unsold output as inventory investments

Quiz 6
The natural rate of unemployment is a measure of

long run equilibrium in the labor market

the size of the private sector relative to the public sector
the rate at which natural resources are extracted and depleted
human capital
the rate at which marginal returns to labor are diminishing according to the economy’s
long run production function
The Beveridge Curve is the relationship between

Unemployment and the output gap

Unemployment and regional mismatch
Unemployment and vacancies
Unemployment and Union membership
Unemployment and unemployment benefits

Increases in labor productivity from improved technology

reduce real wages

increase the long run supply of labor
reduce the demand for labor
have no long run effect on total hours worked
induce firms to substitute capital for labor

When the unemployment rate is below the natural rate,

wages and prices will begin to rise and employment will fall
the unemployment rate will rise, but neither prices not wages will change
the natural rate will increase to restore equilibrium
prices will fall, and unemployment will rise
real wages will fall and employment will increase

If a firm’s marginal product of labor is currently 75 units of output, the wage is $15 per unit of
labor, and output sells for $0.80 per unit, the firm should

hire more labor

shut down production
hire fewer workers
keep the current number of employees and hours worked
maintain its current workforce, but at fewer hours per worker

Quiz 7
The marginal propensity to consume is

the inverse of the expenditure multiplier

identical to the average propensity to consume
equal to the income tax rate
 the inverse of the marginal propensity to save
the slope of the consumption function
If the consumption function is C = 750 + 0.75Y and there are no income taxes, then the
expenditure multiplier is

4.0
0.75
0.25
1,000
3.0

An individual is endowed with $100 of income in period 1, and will receive an

income of 121 in period 2. The interest rate is 10%, and there are only 2 periods.

In order to have the same level of consumption in both periods, each period’s consumption
must be

80
110
100
110.5
121

Which of the following would encourage greater investment in capital?

a reduction in the rate of interest

an increase in the corporate profits tax
an increase in the price of capital
greater uncertainty regarding the rate of return
an increase in the rate of depreciation or obsolescence

Investment is important to the short run health of the economy because it

is countercyclical, and thus stabilizing

can be easily controlled by government
is the largest component of GDP
is highly predictable, and thus useful for forecasting
is highly volatile, and thus contributes largely to business cycles
Quiz 8
Okun’s law refers to

The generally stable negative relationship between the output gap and deviations of
unemployment from the natural rate
The negative relationship between unemployment and job vacancies
The generally stable positive relationship between the output gap and deviations of
unemployment from the natural rate
The tendency for business cycle volatility to fall over time
The tendency for recessions in the USA to spread throughout the world

The impact of recession

is most severe for the poorest members of society

is more severe for professionals than for semi-skilled manual laborers
is more severe for skilled workers than for unskilled workers
causes larger declines in consumption among those aged 26 to 45 than among
teenagers
is, in the aggregate, a more significant factor in social welfare than long run growth

A growth recession occurs when

GDP grows at a slower rate than its long run trend

economic growth is so rapid that it creates inflation
there are two successive quarters of negative GDP growth
potential GDP declines
real GDP is growing but nominal GDP is not

A traditional definition of recession is

deflation or a slowing of the inflation rate for one year or more

a temporary shock to the economy resulting in the need for fiscal or monetary stimulus
negative GDP growth for half a year or more
any GDP gap which persists for 9 months or more
at least two successive quarters of positive unemployment
Consider the following hypothetical annual growth rates of real GDP:
Long run trend 2017 2018 2019 2020 2021 2022 2023 2024
2.5% 3.0% 2.5% 2.0% -1% 0.5% 2.0% 2.5% 3.0%
2019 appears to have been a year of

recession
growth recession
stagflation
economic expansion
depression

Lecture 10- A model of the labor market

П = Price*Output- Wage*Labor

= P*Y(L)-W*L

Maximize dП/dL = P*dY/dL – W = 0  dY/dL = W/P

If MPL > real wage  hire more labor

If MPL < real wage  hire less labor

Leisure more expensive  substitution effect

Worker is richer  income effect

Income effect = substitution effect in the long run

NRU

P = W(1+x)

W/P = 1/(1+x)

W/P = A=bu

1/(1+x) = A-bu

U*= A-1/(1+x)/b

Influences on the NRU:

Product Market Power: Higher x  Higher u

Sensitivity of Wage Demands to U: Higher b  Lower u

Monopoly power of Workers: Higher A  Higher u

A Flow Approach to the NRU

- Inflow into unemployment:

Employed × Prob. Of Losing Job  E × p
- Outflow from unemployment:
Unemployed × Prob. Of Finding Job  U × f

Inflow = outflow

Exp=Uxf

Unemployment rate u = U/(E+U)

Employment rate (1-u) = E/ (E+U)

• The unemployment rate depends on:

– How fast the employed lose jobs (p)  u↑

– How fast the unemployed find jobs (f)  u↓

Lecture 11- Consumption

The basic Keynesian Model of Consumption

• Idea: people consume their income and they consume more as their income increases

…but not as much as the increase in income!

• For every extra dollar, they consume c%

• c is called the Marginal Propensity to Consume

• E.g.: c = 80%

Income increases by $100

Consumption increases by $80

• Assume c does not change with income.

• Autonomous consumption A is the consumption if income=0

C = A + (c x Y)

C/Y = 1 – S/Y

Y = A+G+I/1-c

1. Basic Keynesian Idea: Demand drives economic cycles

• The multiplier: changes in autonomous demand components translate into bigger changes in output

2. The permanent income model: current income matters only up to a point – it’s lifetime income that
matters

• Limits of the permanent income model: precautionary savings and borrowing constraints

• Interest rates have ambiguous effects on current consumption.

Lecture 12

• Investment: expenditure on structures, machines and equipment (durable goods used in production)
by private agents.

• Consumption is what people enjoy of GDP today…

…but investment = determines the level of production of tomorrow!

• Investment is an important component of GDP. …but not as big as consumption.

• In equilibrium: the marginal product of capital equals the real interest rate!

Lectures 13,14- Business Cycles

 The fluctuations of output around its trend

An economy is in recession if it experiences two consecutive quarters of negative growth.

• Growth Recession: when the economy keeps growing, but growth is lower than the long-run trend

• Depression: no precise definition here. Used to refer to a particularly bad and long-lasting recession

• Great Depression: 1929-1932

• Great Recession: 2007-2009

1. Estimate trend (normal times): use statistical techniques to define the trend and then define

 business cycle = actual GDP – trend (absolute measure)

 output gap = actual GDP / trend – 1 (%-deviation)

2. Estimate a production function as in Chapter 3 and use it to generate estimates of potential output

3. Use business surveys on capacity utilization

• Examples of shocks affecting our economies:

1) Productivity shocks - droughts/floods - technology shocks(E.g. Industrial Revolution, arrival of

Internet)

2) Shifts in preferences - changes in desire to consume, save etc.

3) Changes in policy - monetary shocks, fiscal shocks

4) Terms of Trade shocks - oil shocks

5) Covid-19, Wars …

1) Real Business Cycle Theory: business cycles are the efficient response of markets to the shocks
that affected the economy

2) Keynesian Theory: markets malfunction and the government should intervene to stabilize the
economy

• The idea: profit-maximizing decisions of firms and consumers respond to changes in TFP

- Better tech  firms want to hire more K and L

 interest rates and wages rise

 people consume more

- Worse tech  the opposite: a recession

• Thus: the propagation mechanism is actually the efficient response of agents to mutated conditions
in the market!

• The punch-line: it’s not good to be in a recession – but it’s the best thing you can do given the
circumstances.

1. Aggregate Demand Shocks: shifts in the Aggregate Demand Curve

AD = C + I + G + X – M

For example: changes in r affect C and I, changes in G

2. Aggregate Supply Shocks: shifts in the Aggregate Supply Curve

AS = production function

For example: changes in TFP, in labor/capital utilization etc.

Lectures 15,16

• The Real Business Cycle Theory:

– The economy is perfectly competitive

– Recessions are caused by supply shocks

– As such, recessions are the optimal response of the economy to mutated conditions

• The Keynesian Theory:

– Markets can fail (e.g. sticky prices)

– Recessions are mainly caused by demand shocks

– They are not an efficient response and the government should dampen the business cycle

• CPI: Consumer Price Index

− sometimes called also RPI (Retail Price Index)

− measure cost of living for consumers

− based on a representative basket of commodities

− includes goods and services

− stuff bought in shops, through mail order, on the internet, domestically and from abroad

• The CPI is the most important inflation measure

• Reported in the media and used often by central banks as their target.

• Producer Input Price Indexes: used to measure changes in the prices of inputs used for production

• Producer Output Prices: used to measure changes in “factory gate prices,” excluding consumer taxes
and distributors/retailers markups

• Using different indexes can give different measures of inflation

• The basket of goods has to be changed in all indexes

 people did not buy computers 50 years ago.

• Also, if inflation is high, it is often volatile

 making predictions for the future becomes harder

 uncertain environment
 this can have redistributive effects
Quiz 9

Inflation is primarily a problem

Frage 1Antwort
because it is severely underestimated, especially when products are improving in quality
because even low inflation rates severely hamper GDP growth
when it is volatile and thus unpredictable
for accounting and record-keeping, but it does not affect the actual trading of goods and services
for those who are heavily indebted

Consider the following hypothetical data:

Year price index
2020 100.00
2021 102.64
2022 105.09
2023 107.76
2024 110.22
According to the data in the table, the inflation rate for 2024 was

11.022 %
2.46 %
10.22 %
1.1022 %
2.28 %

The inflation tax is

an additional income tax levied during periods of inflation to prevent government revenue from
losing value
a tax on trucking, so called because of the inflation of the tires
the reduction in the value of cash due to inflation
the federal sales tax on goods whose prices rise by more than the general inflation rate
the movement of taxpayers into higher tax brackets due to inflation

Which of the following is not a likely consequence of inflation?

Some taxpayers are pushed into higher tax brackets

Firms incur the “menu costs” of changing advertisements
Banks reduce nominal interest rates to reflect expected inflation
The value of currency is reduced
Price signals sent by consumers to firms are distorted
If incomes rose proportionately with prices, then in the absence of taxes

real GDP would increase

money would cease to be a veil
everyone would be worse off
prices would have no effect on output or well-being
resources would be over allocated to the present at the expense of future generations

Quiz 10
Central banks commonly aim to keep the price level

perfectly constant
rising by about 2% per year
increasing by about 5% per year
declining slightly
growing by about 1% per year

Which of the following is most likely to be an intermediate target for monetary policy?
gross domestic product
short term interest rates
investment expenditures
the money supply
the unemployment rate

Which of the following is most likely to be an ultimate target for monetary policy?

exchange rates
short term interest rates
reserve ratios
stock market indexes, such as the S&P 500
the inflation rate

According to the quantity theory of money,

the amount of money in the economy determines the long run quantity of output
the quantity of money determines the long run equilibrium price level
the money supply only affects the economy in the long run, not in the short run
money affects the aggregate supply curve, while the aggregate demand curve determines real
output
 the full-capacity level of output determines the supply of money needed in the economy

According to the simple Quantity Theory of Money, if velocity is constant and real GDP grows by 2%
per year, then money supply growth of 3% per year generates

an interest rate of 1%
an exchange rate of 1%
an unemployment rate of 1%
an output gap of 1%
an inflation rate of 1%

When no one can be made better off without making someone else worse off, the economy is

in a steady state
operating under oligopolistic conditions
autarkic
Pareto efficient
operating at full capacity

Suppose the central bank follows the Taylor Rule nominal interest rate = 0.03 + 0.5(output gap) +
1.5(inflation rate - 0.02).
For an economy at full employment with an inflation rate of 0.04, the central bank will set its nominal
interest rate equal to

0.09
0.05
0.03
0.065
0.06

In most developed economies, government’s share of GDP

fell during the Great Depression, and is now at World War I levels
has dropped dramatically since World War II
is less than 30%
exceeds 60%
rose continually throughout the twentieth century

Central banks commonly aim to keep the price level

declining slightly
perfectly constant
 increasing by about 5% per year
rising by about 2% per year
growing by about 1% per year
When calculating the Expenditure Measure of GDP, Firms’ unsold inventory
a)is counted as investment
b)is not counted in GDP because it is excluded from consumption
c)is purchased by the government
d)is equal to the difference between imports and exports
e)is the difference between real and nominal GDP

Country A and B have the same levels of consumption, investment, and government purchases, but
country B sells twice as many exports and buys twice as many imports as country A. Which country
must have a larger GDP?
a)The answer depends on whether country A has positive or negative net exports
b)The GDP of country A must equal the GDP of country B
c)Country A
d)Country B
e)The answer depends on whether country A’s imports are greater than its domestic consumption

Consider our Neoclassical growth model of capital accumulation, where the production
function has a decreasing marginal product of capital (such that a steady state for capital
exists). Imagine the savings/investmentrate exceeds the Golden Rule level, b>α. Which of the
following statements is true?
a)By decreasing its savings rate, the country can raise its consumption both in the short and in the
long run
b)By decreasing its savingsrate, the country forgoes consumption in the short run, but can raise its
consumption in the long run
c)By decreasing its savingsrate, the country can raise its consumption in the short run but forgoes
consumption in the long run
d)The country can never reach a steady state, because its investment is always higher than its
depreciation
e)The country’s consumption inthe long run converges to zero

Consider the following graphical representation of our Neoclassical growth model of capital
accumulation. Which of the following statements is false?
a)By investing 30% of output instead of 20%, the country achieves a higher level of consumption in the
steady state
b)By investing 30% of output instead of 20%, the country achieves a higher level of output in the
steady state
c)Irrespective of how much this economy invests, it cannot grow from capital forever
d)By investing 30% of output, the country’s investment rateexceeds its Golden Rule level
e)If the country’sinitial capital stock is very low (lower than KL), capital will start to grow until it reaches
the steady state
Suppose an economy has the production function Y = 0.8K,investment is 10% of income, and the rate
of depreciation is 5% of the capital stock per year. Which of the following statements is true?
a)Output in this economy grows 3% each year
b)The capital stock in this economy is constant
c)The capital stock in this economy converges to zero (poverty trap)
d)The steady state level for capital is KSS=120
e)The marginal product of capital (MPK) is decreasing in the capital stock
Assume an economy in which investment I=100, government spending G=400, net exports X-
M=0, and where consumption follows the Basic Keynesian model of consumption as
C=1000+0.9Y. In this economy, when the government increases its spending by 75 (such that
now G=475) ...
a)... consumption will rise by 675
b)... investment will rise by 75
c)... equilibrium output will rise by 75
d)... equilibrium output will rise by 10%
e)... government spending will rise by 750

Consider the simple two-period intertemporal consumption choice model (“permanent income
model”) that we have seen in class. Suppose the household has an income Y1=100 in the first
and Y2=0 in the second period. The interest rate is r=10%. Which of the following statements is
true?
a)Following a change in the interest rate, the substitution and income effect on first period
consumption in this example go in opposite directions
b)The household will save so as to consume equal amounts in both periods (“perfect consumption
smoothing”)
c)The household will not consume in the second period because the income in this period is zero
d)The household will consume 50 in the first and 55 in the second period, given that the interest rate is
10%
e)If the interest rate rises, the marginal propensity to consume always falls in the first period

Which of the following is not a macroeconomic question?

a)What is the predicted market value for an initial public offering of a firm’s stock?
b)How does increasing government expenditure affect GDP?
c)What are the effects of stronger labor unions on unemployment?
d)Why do some poor countries remain so poor?
e)What is the GDP forecast for Austria?

Assume you can decompose GDP in Austria and Benin in the following way: In both countries,
each worker works 2000 hours. In Benin, the employment rate (defined as employed / labor
force) as well as the participation rate (defined as labor force / population) is 50%. In Austria,
the employment rate is 90%; the participation rate is 70%. GDP per capita in Benin is 2000, in
Austria it is 50000. Which of the following statements is true?
a)Hourly productivity in Austria must be roughly ten times higher than in Benin
b)If Benin’s employment rate and participation rate were at Austrian levels, it’s GDP per capita would
double
c)If Benin’s participation rate increased to 75%, GDP per capita would increase by 500
d)The Austrian unemployment rate is 30%
e)If Benin’s employment rate were as high as Austria’s, GDP per capita would be 3000

Consider our standard Cobb-Douglas production function: Y= TFP× Kα× L1-α, where α is
between 0 and 1. Which of the following statements is true?

a)If one doubles the inputs of capital K and labor L, output Y will also double
b)The marginal product of labor (MPL) is decreasing in K
c)Higher TFP captures, among other things, the amount of computers that firms buy
d)If α = 1, the economy exhibits an increasing marginal product of capital (MPK)
e)None of the other statements is true

Consider our Solow model with human capital accumulation:

Yt= Kt^0.3× (Ht x Lt)^0.5
It= b× Yt
Ht= Kt^h
whereK is capital, I is investment, H is human capital, and t is a subscript indicating time.The
evolution of capital over time works as seen in class and in the textbook. Also as seen in class,
firms do not internalize human capital formation. Labor is constant at L = 4, the investment rate
is b = 0.5and depreciation is 10% of the capital stock each year. The exponent of human capital
formation is h = 0.4.Which of the following statements is false?
a)If h increased to h = 0.7, the social MPK of this economy would be constant
b)The economy has a steady state at K = 100
c)If h increased to h = 0.6, the investment rate should increase to b = 0.6 to maximize consumption in
steady state
d)From a social point of view, the economy’s steady state is at the Golden Rule
e)The social MPK of this economy is decreasing

Consider our flow approach to the natural unemployment rate. The probability of losing a job is
p = 5% and the probability of finding a job is f = 50%. Which of the following statements is
false?
a)In the data, employment protection legislation (EPL) cannot clearly be associated with a lower
probability of job loss
b)The natural rate of unemployment is 9.1%(rounded)
c)If employment protection legislation (EPL) reduces p to 3%, it only has positive employment effects if
f remains higher than 30%
d)In the data, employment protection legislation (EPL) cannot clearly be associated with lower
unemployment
e)The natural rate of unemployment can be computed as u = p / (f+p)

Which of the following statements is false?

a)In developed economies, most value added comes from the service sector.
b)In developed economies, the share of income which goes to labor is around 2/3.
c)The employment rate is usually defined as employment divided by labor force.
d)Poor countries with a lot of their citizens working abroad, tend to have a higher GNI than GDP.
e)By using purchasing power parity PPP exchange rates rather than market exchange rates, one
tends to overstate the extent of poverty of poor countries.

Which of the following statements is false?

a)To achieve the golden rule level of capital, the investment share has to equal the
depreciation rate.
b)Conditional convergence implies that poor countries do not always grow faster than rich countries.
c)A poverty trap cannot arise in our standard Cobb-Douglas production function, if the social and
private marginal products of capital are decreasing.
d)When controlling for factors like education, health, institutions, etc., the data suggests that lower
GDP is associated with higher growth.
e)Financial sophistication and ethnic diversity are not very important for long run growth.

Which of the following statements on convergence in output is true?

a)We observe conditional convergence of poor and rich countries in the world.
b)We do not observe convergence in growth across US states.
c)We observed divergence across developed countries.
d)We observe unconditional convergence of poor and rich countries in the world.
e)An increasing marginal product of capital implies convergence in growth.
Practice exam

Which of the following is not a cost of inflation?

a)Inflation drives up the real interest rate, which lowers investment and consumption.
b)Tax systems are usually defined in nominal terms and do not react to inflation.
c)Inflation decreases the value of cash holdings.
d)Businesses face menu costs when adjusting their prices.
e)If prices changes are staggered, relative prices might be distorted.

Which of the following statements about money is false?

a)If households hold less cash, the money multiplier will fall.
b)M2 includes less liquid forms of money than M0.
c)It is natural to assume that the velocity of money increases if interest rates are higher.
d)If some money leaves the country, the multiplier will fall.
e)If banks hold excess reserves, the multiplier will fall.

Which of the following is not a way to conduct monetary policy?

a)Fiscal deficit targeting
b)Inflation targeting
c)Money supply targeting
d)Exchange rate targeting
e)Inflation targeting while also supporting full employment and growth

After introducing the Block chain for processing payments, assume that the velocity of
circulation decreases by 10%. GDP grows by 5%. According to the quantity equation, which of
the following statements is false?
a)If the central bank keeps the amount of money constant, inflation should be 15%.
b)To achieve stable prices, the central banks has to grow the amount of money by 15%.
c)If inflation turned out to be 5% in that period, money growth must have been 20%.
d)Money growth below 15% will result in deflation.
e)If money supply grows by 5%, deflation will be 10%.

Assume that last year the output gap was -5% and inflation was 4%. The inflation target is
2%andthe equilibrium nominal interest rate is 1%.Further, assume that the Central Bank
follows a Tailor Rule where α is the reaction to excess inflation and λ is the reaction to the
output gap. It set last year’s nominal interest rate to 3%.Which of the following is true?
a)The question cannot be answered unambiguously.
b)α= 1.5and λ = 0.2
c)α = 2 and λ= 0.4
d)α = 1.75and λ = 0.6
e)α= 1.5 and λ = 0.5

Consider the following labor supply for different tax rates:

The before-tax hourly wage is 10€/h. Which of the following statements is false?
a)Higher tax rates create higher tax revenue for the government.
b)This is an example of the Laffer Curve.
c)Among the tax rates in the table, 40% maximizes tax revenues for the government.
d)Tax revenue at a tax rate of 30% and 50% are equal.
e)Tax revenue at a tax rate of 0% and 100% are equal.

Which of the following statements is false?

a)There is clear evidence, that bigger government (i.e. higher spending and higher taxes) is
associated with higher growth.
b)Market failures create a role for government.
c)Social desire for reallocation creates a role for government.
d)Most taxation creates distortions.
e)Government debt can increase equity (=fairness)and/or efficiency

Which of the following statements about investment is false?

a)An increase in interest rates tends to lead to more investment, because it becomes more attractive
to save
b)Investment is pro-cyclical
c)Investment is more volatile than GDP
d)Unsold output (inventories) are counted as investment
e)An increase in interest rates tends to lead to less investment, because the cost of capital rises

Consider the AS-AD model with short-run AS curve (not vertical, but upward sloping). In this
model, a negative supply shock
a)... may reflect, for instance, a sudden increase in oil prices
b)... leads to a drop in prices and output
c)... leads to a drop in prices but a rise in output
d)... can be fully offset (that is, no price and output response) by monetary policy by changing the
money supply appropriately
e)None of the other options is correct.

Which of the following would be an appropriate stabilization policy in response to a negative

demand shock?
a)A reduction in interest rates
b)An income tax increase
c)A reduction in government purchases
d)A reduction in transfer payments
e)A reduction in the money supply

Consider the IS-LM, AS-AD model (short run AS curve: not vertical, but upward sloping) in the
face of a sudden reduction in net exports due to a recession overseas. Which of the following
would the model not predict:
a)A decline in the price level and output, but a rise in interest rates
b)A left-ward shift in the IS curve
c)A left-ward shift in the AD curve
d)The AS curve does not shift.
e)A decline in the price level, output and interest rates

The empirical relationship between the output gap and unemployment is known as
a)... Okun’s law
b)... the short-run aggregate supply curve
c)... the Phillips curve
d)... Ricardian equivalence
e)... the Laffer curve

Crowding out refers to

a)... the negative effect of government budget deficits on private demand
b)... excess demand of a good for which there is a shortage
c)... consumers saving tax cuts in anticipation of future tax increases
d)... the implementation lag associated with fiscal policy
e)... the fact that policies may not be effective if they are not credible

Consider the Phillips curve π = π(e) + 2*( u(n) –u ), where πis inflation, π(e)is inflation expected
by the public, u(n)is natural unemployment and u is actual unemployment. Initially,
u=u(n)=5%and π=π(e)=2%. Assume a policy maker wants to reduce unemployment to 4% by
creating inflation. Which of the following statements is false?
a)The policy maker should reduce unemployment simply by credibly announcing a lower
unemployment rate.
b)If inflation expectations do not change, inflation must rise by 2%.
c)If inflation expectations rise by 2%, inflation must rise by 4%.
d)If inflation expectations rise by 4%, inflation must rise by 6%.
e)If the public’s inflation expectations always coincide with actual inflation, the policy maker cannot
reduce unemployment to 4% by creating inflation.

Which of the following statements about the costs of Business Cycles is true?
a)The effect of Business Cycles is very heterogeneous: some people are barely hurt; some people are
badly hurt.
b)High-skilled workers suffer most during recessions.
c)Robert Lucas argues that Business Cycles are very costly.
d)There is clear empirical evidence that larger Business Cycles decrease growth.
e)There is clear empirical evidence that larger Business Cycles increase growth.
Lecure 11
Consumption: the biggest expenditure component of GDP (50 – 70%)
The basic Keynesian Model of Consumption
• Idea: people consume their income and they consume more as their income increases
…but not as much as the increase in income!
• Indeed, we see a close relationship between consumption and income.
• For every extra dollar, they consume c%
• c is called the Marginal Propensity to Consume
• E.g.: c = 80%
Income increases by $100
Consumption increases by $80
• Assume c does not change with income.
• Autonomous consumption A is the consumption if income=0

Consumption = A + (c × Disposable Income)

C = A + (c×Y)

•Average propensity to consume = C/YC/Y = [A + c × Y]/Y = 𝐴/𝑌+𝑐

•If income goes up by 1 consumption goes up by c

Geometric series: 1/(1-c)  That’s what we call the Keynesian Multiplier.

C/Y = 1 – S/Y

• Keynes’ idea: changes in demand determine economic fluctuations

• Think of the Great Depression!
• Consider the National Accounts identity:
Output = Consumption + Gov. Expend. + Investment
Y=C+G+I

• Using our consumption function: C = A + (c × Y)

Y = A + (c × Y) + G + I
Y = A+G+I/1-c

The Permanent Income Model

• Individuals make complex plans throughout their lives
• They form expectations about the future
• They can predict, to some extent, the lifetime pattern of their income
…and they plan consumption accordingly
• Our three example individuals before are going to consume very different fractions of their current
income…
A setup to better understand consumption choice
• Suppose an individual lives two periods:
today (1) and tomorrow (2)
• She gets
−income today Y(1)and tomorrow Y(2)
• and has to decide how much to
−consume today C(1)and tomorrow C(2)
• If she does not consume everything in period 1 but saves instead, she can get an interest rate on her
savings:
(1 + r) × [ Y(1) – C(1) ]
• So, in period 2 she can spend:
Y(2) + (1 + r) × [ Y(1) – C(1) ]
• If she does not leave any inheritance, she will just consume what she has:
C(2) = Y(2) + (1 + r) × [ Y(1) – C(1) ]

• Let us rearrange the expression into lifetime consumption and lifetime income:
(1+r) C(1) + C(2) = (1+r) Y(1) + Y(2)
• Dividing by (1+r) we have the intertemporal budget constraint
C(1) + C(2)/(1+r) = Y(1) + Y(2)/(1+r)

Implications of the Permanent Income Model

1. Consumption varies less than income today, because changes are distributed over periods
−It will not fall as much in recessions
−It will not rise as much in booms
2. A temporary increase in income has a lower impact on consumption than a permanent increase
−Crucial when thinking about tax rises/cuts
−Temporary increase gives a low MPC  Lower multiplier
3. Expectations about future income can change consumption today
−What happens when there is economic uncertainty?
4. Savings can be lower if individuals expect their income to grow
Higher levels of uncertainty about tomorrow
−higher levels of savings
−lower consumption
−lower MPC
−lower multiplier!

• If you cannot borrow against your future income…

… you are forced to use only your current income.
• Timing of income matters
• Reason: you would like to consume more today and less tomorrow by borrowing but you can’t.
• So Consumption = Current Income
• Implication: If current income increases, consumption rises almost one-to-one with income
 you wanted to consume more already before!

• Consumption crucial to understand welfare

1. Basic Keynesian Idea: Demand drives economic cycles
•The multiplier: changes in autonomous demand components translate into bigger changes in output
2. The permanent income model: current income matters only up to a point – it’s lifetime income that
matters
•Limits of the permanent income model: precautionary savings and borrowing constraints
•Interest rates have ambiguous effects on current consumption.

Lecture 12
• Consumption crucial to understand welfare
• Basic Keynesian Idea
•Demand drives economic cycles
•The multiplier: changes in autonomous demand components translate into bigger changes in output
• The permanent income model:
•current income matters only up to a point –it’s lifetime income that matters
•Limits of the permanent income model: precautionary savings and borrowing constraints
•Interest rates have ambiguous effects on current consumption.

•Investment: expenditure on structures, machines and equipment (durable goods used in production)
by private agents.
•Consumption is what people enjoy of GDP today but investment= determines the level of production
of tomorrow!
•Investment is an important component of GDP but not as big as consumption.

• The firm should buy capital if the profit of an additional unit (MPK × P) is bigger than the cost (r)
• It should stop when  MPK × P = r  MPK = r/P
• In equilibrium: the marginal product of capital equals the real interest rate!
• In the largest developed economies, corporations finance most of their investment through internal
resources  shareholders’ capital (e.g. stocks)
• When should a company increase the capital stock?
• Relevant trade-off:
value of capital vs replacement cost
• Replacement cost: the cost of buying the kind of capital the company currently uses and installing it
onsite.
Q = value of capital/replacement cost
•If q > 1 The stock market values a unit of capital more than its cost
 The company should invest!
•If q < 1  The company should disinvest

• Investment follows GDP but fluctuates more

• Companies invest comparing the cost of capital (interest rate) with its return (marginal profits)
• Savers provide capital to firms, offering more savings as the interest rate increases
• The market for capital: savers meet firms and the equilibrium interest rate makes demand and supply
compatible
• The q theory of investment: stock market valuation and level of investment should be closely related.

Lectures 13-14
Business cycles: s the fluctuations of output around its trend.
• Our production function: a long-run model of output
• In the short run, output varies a lot because
- firms do not work at full capacity
- they do not utilize labor at full efficiency
- …or the opposite!
• Output above trend: boom phase of business cycle
• Output significantly below trend: recession

• How do we define a recession?

• Simple definition (widely cited and used):
An economy is in recession if it experiences two consecutive quarters of negative growth.
• Take an economy that grows like this in three consecutive quarters: -0.5%  0.05%  -1%. Is this a
recession?

• Growth Recession: when the economy keeps growing, but growth is lower than the long-run trend
• Depression: no precise definition here. Used to refer to a particularly bad and long-lasting recession

• How do we measure how we are doing with respect to “normal times” (trend)?
• Different possible methods:
1. Estimate trend (normal times): use statistical techniques to define the trend and then define
 business cycle = actual GDP –trend (absolute measure)
 output gap = actual GDP / trend –1 (%-deviation)
2. Estimate a production function as in Chapter 3 and use it to generate estimates of potential output
3. Use business surveys on capacity utilization

Characterizing Business Cycles

1. Employment, Consumption and Investment are procyclical variables (they rise when GDP
rises and vice versa)
 2. Unemployment is countercyclical (it rises when GDP falls and vice versa)

Okun’s Law
• When output falls, unemployment rises
• Okun’s law: 2% output fall below trend  1% increase in unemployment

3. Expansions are longer than recessions. Recessions are sharper than expansion.
4. Cycles are correlated across sectors, regions and countries.

• Robert Lucas’ argument:

•gains from increasing long-run growth are enormous
•gains from stabilizing business cycles are relatively small
• Are gains from stabilizing cycles small?
• Fact: aggregate consumption does not change much in recessions  the motivation behind Lucas’
argument
• But: changes are very heterogeneous
•across households
•across sectors
• The economy does not suffer much – but somebody does!

• Recessions are mostly fine for the majority

• But a sizable group of the population is badly hurt:
 1% of population suffers more than 10% consumption loss
• Also, impact seems to be highest among the poorest!
• Some people lose income and are forced to reduce consumption
• Also: business cycle volatility may influence economic growth in the long run
 More uncertain environment = Less investment
But is this the whole story? Some potential good out of recessions
• In booms, firms do not want to reorganize or change productive processes – it’s too costly not to
produce
• Recessions can act as a “pit stop” to increase efficiency

• This question is crucial

 depending on the mechanism, the response to a business cycle changes completely!
• We look at two main competing viewpoints:
1) Real Business Cycle Theory
business cycles are the efficient response of markets to the shocks that affected the economy
2) Keynesian Theory
markets malfunction and the government should intervene to stabilize the economy

• The RBC theory: cycles are mainly due to shocks to technology

• Thus RBC explains growth and cycles with the same fundamental.
• The idea: profit-maximizing decisions of firms and consumers respond to changes in TFP
- Better tech  firms want to hire more K and L
 interest rates and wages rise
 people consume more
- Worse tech  the opposite: a recession
• Thus: the propagation mechanism is actually the efficient response of agents to mutated conditions
in the market!
• The punch-line: it’s not good to be in a recession – but it’s the best thing you can do given the
circumstances.

• The idea is intuitive: in bad times, incentives to produce and work are low – so people produce and
work less.
• In order for the economy to allocate resources efficiently when things change, it needs to be flexible
• In particular, prices need to move fast.
• In reality we observe the following:
- Prices move little
- Quantities move much more
• Example: wages change very little during recessions …but hours worked move dramatically.
• How does the RBC theory reconcile this?
• A simple solution: labor supply is very elastic
 it reacts strongly to small wage changes in the short run
• Staying simple: two different types of shocks can trigger business cycle fluctuations
1. Aggregate Demand Shocks: shifts in the Aggregate Demand Curve
AD = C + I + G + X – M
For example: changes in r affect C and I, changes in G
2. Aggregate Supply Shocks: shifts in the Aggregate Supply Curve
AS = production function
For example: changes in TFP, in labor/capital utilization etc.

• When firms raise prices, they lose customers and possibly revenue
• If a firm has competitors and none of them has raised prices…
 doing so means losing market shares, revenue and profits.
• Changing prices is costly
 changing all the tags
 re-estimating demand for the product
 change all existing advertising
 real rigidities – what happens to the marginal cost?

GDP varies over time because of long-run growth (trend) and cyclical fluctuations around the trend
(business cycle)
• Business cycles share similar features all over the world
•employment, consumption and investment are procyclical
•unemployment is countercyclical
•recessions are shorter and sharper than expansions
•cycles are correlated across sectors, regions and countries
• Business cycles are especially bad for small fractions of the population – but not that bad for the
majority
+ they have some pros

• Two competing theories: Business Cycles mainly due to

•Supply shocks: Real Business Cycle theory
•Demand shocks: Keynesian viewpoint
• RBC highlights the role of technology and real determinants of output
• Keynesian models highlight the role of shifts in demand and price rigidities in the short run
• There is truth to both models – which one is quantitatively more important is still subject to lively
debate
• Keynesian models feature a role for governments in counteracting economic fluctuations – RBCs do
not because RBC cycles are optimal response to shocks.

• Aggregate Demand and Aggregate Supply shape business cycle fluctuations in the short run
• In the long run, prices are irrelevant –see chapters 3-7
• The effect of changes in AD and AS depends on
 the relative elasticity of the two curves
• A positive demand shock: prices go up, production goes up
• A positive supply shock: prices go down, production goes up
• Examples of demand shocks: changes in propensity to consume, invest, import, demographics etc.
• Examples of supply shocks: changes to technology and productivity

Lecture 15-16
• Our economies have a long-run trend…
• But also experience short-run fluctuations = Business Cycles
• Regularities: C, I& E procyclical, U countercyclical.
• Booms longer than busts, busts sharper than booms.
• Recessions on average have little impact on average welfare
– but some fractions of the population are hit hard.

• The Real Business Cycle Theory:

– The economy is perfectly competitive
– Recessions are caused by supply shocks
– As such, recessions are the optimal response of the economy to mutated conditions
• The Keynesian Theory:
– Markets can fail (e.g.sticky prices)
– Recessions are mainly caused by demand shocks
– They are not an efficient response and the government should dampen the business
cycle

Money and Prices

Inflation =growth in prices from one period to another
• Example:
– In 2012 we bought a basket of goods at 140€
– In 2013, the same basket of goods costs 150€
• Inflation in 2012 = 150/140 –1 = 0.0714 = 7.14%
• Inflation in t = ((Price in period t)/(Price in periodt-1) -1)*100
• Goods basket used to compute a consumer price index: Price Index in 2012 = 100Price Index in
2013= 107.14
• We are used to a mild inflation nowadays –has it always been like this?

• CPI: Consumer Price Index

−sometimes called also RPI (Retail Price Index)
−measure cost of living for consumers
−based on a representative basket of commodities
−includes goods and services
−stuff bought in shops, through mail order, on the internet, domestically and from abroad
• The CPI is the most important inflation measure
• Reported in the media and used often by central banks as their target.

• Producer Input Price Indexes used to measure changes in the prices of inputs used for production
• Producer Output Prices
used to measure changes in “factory gate prices,” excluding consumer taxes and distributors/retailers
markups
• Using different indexes can give different measures of inflation
• The basket of goods has to be changed in all indexes
 people did not buy computers 50 years ago.

Money neutrality
• An economist’s (simplified) perspective: price level is just a unit of measure
• Does it matter which unit of measure we use?
(meters vs kilometers etc.)
• That is: does it matter if prices go up and down?
• Economist’s view: money is a veil – what matters is relative prices, not absolute prices
• The real side of the economy does not change with the quantity of money or the level of prices
- especially true in the long

• Also, some prices (wages) may react slower to inflation

make consumers temporarily poorer (real income falls)
• Also, if inflation is high, it is often volatile
making predictions for the future becomes harder
uncertain environment
this can have redistributive effects
• An example: the elderly
– suppose you put your money in a retirement account expecting 2% inflation and
getting 4% interest rate
– in the end, inflation was 4%  you are not getting any interest out of your savings
you will be poorer in retirement

• So: inflation is bad

• What about falling prices (Deflation)?
1) Deflation increases the real interest rate
− deflation increases it and puts debtors in an awful position
− Default / bankruptcies
2) When real interest rates are high, there are incentives for saving and not for consuming
− demand goes down
− have to lower nominal interest rates (what if we are already at zero?)
− potentially vicious circle: prices fall in such a way that the increase in real interest rates cannot
be fought  Japan 1990s

• Banks have a reserve requirement  necessary to make them able to face demands for cash
• Suppose this reserve requirement is 5%
• Then they can take money from the central bank and lend it to people…
• …until their cash = money from central bank = 5% of loans!
• Result: Money Multiplier=1 / Reserve Requirement
• In our case: the money multiplier is 20
• 1 million additional money supply from the central bank results in 20 million additional loans to the
economy!

• Until now: a discussion of the nominal side of the economy

• Monetarism: the idea that money supply growth  inflation
“inflation is always and everywhere a monetary phenomenon”
Milton Friedman
• What does this mean? Inflation is related to the price of money
Is the price of an apple an appl-ishphenomenon?
• Deep meaning behind apparently vacuous statement

We start with a relationship that has to hold: the Quantity Equation

Consider the following:
− money is used to make transactions
− the same money can be used in many transactions,
− depending on how fast the same bill goes from hand to hand
M: the stock of money in the economy
P: the price level in the economy
T: the volume of transactions (related to GDP)
V: velocity of circulation (number of times the same bill is used in transactions)
M×V=P×T

% change in money supply + %change in velocity

≈ % change in prices + % change in GDP

• To go from this to a theory of inflation, we need a bit more

• Assume for the moment that %-change in velocity = 0
• Then,
%change in money = %-change in prices + %-change in GDP
• Also: if long-run output is not affected by money supply (money neutrality):
% change in money – % growth of GDP = inflation

• Money exists because it makes transactions easier

• Money also acts as a unit of measure and a store of value.
• Various money supply definitions – depending on the level of liquidity of included assets.
• Banks multiply money by lending more than the physical money existing, and keeping only reserves.
• Increasing money supply  Seigniorage  Inflation Tax
• Hyperinflation: extremely high inflation often originating in persistent fiscal deficits

• Monetarism closely links money supply and inflation

• Monetarism bases its view on the quantity theory of money
• Assuming that the velocity of money is constant and that money is neutral to output, excess changes
in money supply = changes in inflation
• Strong evidence for monetarism in the long-run
• Weak evidence for the short run

Lecture 17-18: Monetary Policy

• Banks have assets (loans) and liabilities (deposits), what about central banks?
• Note: in most countries, the central bank cannot purchase gov. debt directly from the government (an
action very similar to “former” money printing)
Assets: government debt, other domestic assets, foreign exchange reserves
Liabilities: currency, reserves, other debt and equity

• The goals of a Central Bank:

1. Stabilize (and lower) inflation
2. Stabilize output and promote growth
3. Lower unemployment
• This differs across countries:
•Europe: Only statutory goal of the ECB is to fight and stabilize inflation
•US: Besides inflation, explicit mention of GDP growth and unemployment is made in the statute of the
FED

The 3 aspects of monetary policy

 operational instruments of monetary policy, e.g. short-term interest rates, reserve requirement
 intermediate targets- indicators with a reliable connection with future inflation e.g. money
supply, exchange rate, inflation forecast
 ultimate policy target- normally inflation but could also include reference to output or
employment- what the central bank is really interested in

The Federal Reserve System

• Goal: “high employment consistent with stable prices”
• Organization:
•Board of Governors –7 members
•12 Federal Reserve District Banks
•Federal Open Market Committee (FOMC)
• Instruments:
•Federal short-term market interest rates
•Reserve Requirements
•Open Market Operations (“OMO”)
• Federal Funds Rate
•Rate charged on Interbank loans

The European Central Bank

• Goal: “Price stability with inflation close to but under 2%”
•Organization:
 •The European System of Central Banks (ESCB) –6 members of the executive board and 15 national
Central Banks of the European Union.
•interest rate decisions are made at fortnightly council meetings
• Instruments:
•repo rate –overnight interest rate
•Discount rate and Lombard rate (rates at which commercial banks acquire or deposit reserves)
•OMOs since Euro Crises
• Intermediate Targets: Inflation and M3

• Almost all central banks try to keep inflation low and stable, e.g. close to 2%
• Why not 0% if inflation is costly?
1) Deflation can be even worse than mild inflation – if goal is 0%, the risk of deflation is substantial
2) Individuals seem very reluctant to accept nominal wage cuts
- a nonzero rate of inflation allows real wage cuts though
3) Official price indices do not adequately abstract from quality improvements – this might overstate
inflation by as much as 2%

• Intermediate target: a variable that

1.reliably tracks future inflation
2.the central bank can control
• Why target future inflation?
 there is a lag between changing policy and effects
• Monetary policy must be preemptive and anticipate future outcomes
• Three main forms of intermediate targets currently in use:
1.Money Supply Targets
2.Exchange Rate Targets
3.Inflation forecasts
• Central banks can also use a combination of these

Money Supply Targeting- Problems

• While succeeding in lowering inflation, these policies did not prove very successful for several
reasons:
1) Which money supply should we control?
2) The velocity of money is highly unpredictable – what is our inflation target then?
3) Banks create money through the multiplier – what are they going to do in response to changes in
CB policy?
4) If the supply curve is vertical (recall Real Business Cycle Theory), then monetarism is a good idea
… but if it isn’t, nominal rigidities interact with monetary policy
 unintended short-run effects on output!
5) Even if monetarism is the way to go (RBC theory), supply shocks will make output fluctuate
long-run trend growth might not be the best forecast of GDP
adverse supply shocks will make prices rise and output fall at the same time –must be taken into
account
• In a nutshell: in the long run, monetarism had a great performance
• But it proved unreliable in the short run for controlling inflation

• Main problem with targeting money supply: inflexibility of target

• It is desirable to adopt a monetary policy based on a large amount of information and flexibly enough
to respond to different circumstances
• But should we write down a rule saying “what if” for every possibility?
• Trade-off between discretionary policy (flexibility) and strictness of rules (credibility)
• Solution: “constrained discretion”
• Inflation targeting: an attempt to achieve this

• The idea: the central bank is mainly concerned with inflation

• The CB dedicates monetary policy to achieve low inflation – and no other purpose
• Intermediate target: CB’s own inflation forecast
• If the forecast > target  the CB raises interest rates
• The forecast contains a huge amount of information
•how the economy is going to perform today
•and tomorrow
•which shocks are more likely etc.
• Any variable affecting inflation should be considered
• This seems to give the CB a lot of power and discretion
• Next step: build and preserve credibility
• Inflation targeting goes hand in hand with continuous communication to the public
• The CB has to explain its logic, its rules and its efforts to use monetary policy in order to achieve its
goal
• By doing that: the public will (hopefully) align its expectation forecasts with those of the CB and also
believe in its good will
• Why this? Strict rules will be broken sooner or later
– a flexible framework allows credibility (and vice versa).

• In practice: what does the central bank decide?

• It is first useful to review how our economic systems work:
1) Commercial banks
•take deposits from the private sector
•make loans
•help facilitate transactions by guaranteeing checks etc.
2) All banks have accounts with the central bank
•The CB allows to settle transactions of banks with each other
•and limits the ability of private banks to overdraw their accounts
3) Most of such transactions are thus cleared on the interbank market

• In order to alleviate fluctuations (example: on payday, banks receive a lot of money – but on other
days they need it just as much)…
…the CB provides reserves to all banks by buying short-term securities
in exchange for cash  at an interest rate
• In order to discourage banks to use this as standard lending
 CB discount interest rate > private market interest rate
• Thus the CB acts as a lender of last resort
• Main policy instrument: repo rate (repo = repurchase agreement)
•also called overnight interest rate
• Some central banks (such as the ECB) also offer
•a deposit rate (Lombard rate) for overnight deposits
•a discount rate for short-term overnight financing

If the central bank increases the interest rate:

In short: r ↑  Lower Aggregate Demand  GDP and Prices fall

Taylor Rules
• A Taylor rule specifies a link between
•short-term nominal interest rates
•Output
•Inflation
•the inflation target
• It’s a way of summarizing the behavior of a central bank in a simple equation
• Typical structure:
Nominal int. rate = Equilibrium nom. Int. rate + ( λ × Output Gap) + [ α × (Inflation – Inflation Target) ]
• Classic case: λ = 0.5, α = 1.5
Quantitative Easing
• Sometimes used to counter
•extremely low inflation
•high output gap
 Cases in which the interest rate should have been negative
• Negative interest rate is not possible  what can the CB do?
• In all these cases  the CB opted for quantitative easing (type of Mopo where the central bank
increases liquidity though purchasing long term government bonds and other assets)
• The idea: interest rates are close to zero
 the private sector is happy to hold higher quantities of money, because it’s a safe asset and has
similar return (zero) to other financial assets

• Why should this help at all?

1) Expectations: announcing quantitative easing might convince the private sector that the economy is
likely to recover and inflation is on the rise
 expectations produce growth in spending etc.
(motivation for Japan’s QE of 2001: unclear if this worked)
2) Excess Monetary Base: the idea is that when there is “too much” base money in the economy,
banks are more willing to give loans (however, most evidence suggests that commercial banks just
absorb excess money without lending it, see last financial crisis)
3) Purchases of Financial Assets: the excess money can be used to purchase government bonds,
thus increasing their price
 as a consequence, people who hold bonds might want to sell them and pursue more risky
investment  stimulus (again, it is unclear whether this works either)

• Central Banks today are very important players in modern economies

• They conduct monetary policy in several ways
•money supply targeting
•exchange rate targeting
•inflation targeting
• Main operational instruments: open market operations and short-term interest rates
• Increase in interest rates  decrease in demand
 decrease in prices and GDP
• Taylor rule: a summary of a CB’s behavior in a simple equation
• Quantitative Easing: increasing money supply in situations with low inflation and low interest rates
(however: unclear if this really helps much)

Lecture 19- Fiscal Policy

•General Government Spending: sum of
1. Government expenditure (G) =total government expenses in goods and services (including
investment) + compensation of government employees
2. Subsidies and other transfers include = subsidies to firms and households + pensions +
unemployment benefits
3. Interest Payments on Debt

The Growing Share of Government Spending

Fact 1: general government spending has increased substantially in most countries since 1870, and
even after WWII
Fact 2: government spending is a quantitatively important component of GDP but its size varies across
countries

Why do Governments play a role?

1. If any of these conditions is not satisfied  Market Allocation is not Pareto efficient: Market Failure -
 Allocation can be improved upon without hurting anyone
2. Even if all conditions are satisfied  What if we are not happy with the final allocation of resources?
(e.g. inequality)
• Some examples:
•there are no markets to insure against widespread changes in technology  what is a shoemaker
supposed to do to insure against machine-made shoes?
•If people are irrational, maybe a government knows better

Market Failures: Public Goods

• Public goods (and services) are provided inefficiently through markets
• Typical features of public goods:
•non excludability  you cannot exclude someone from the enjoyment of that good
•non rivalry in consumption  the fact that someone enjoys the good does not reduce other people’s
enjoyment of it
• Examples: police, national defense, legal system and enforcement of property rights (so-called
minimal state), clean air, street lights

• These features make market provision of public goods problematic

Typical problems with market provision of public goods:
1. Free Riding:
“since the good exists anyway, I won’t pay for it”
2. Inefficiently low provision:
“I don’t care about the positive effect it has on everybody else, so I will buy just enough for me”

• Production or consumption of a good or service can positively or negatively influence other parties
a. Positive externalities: planting a pretty flower, building a dam, education (?)
b. Negative externalities: smoking, coal plant
Typical problems with externalities in the market:
a. Production / consumption too low
b. Production / consumption too high

Paternalism, Income Distribution and the Welfare State

• Some goods are provided by the government because it is felt (paternalistically) that, if left to
themselves, people will not produce enough
 examples: education, pensions
• Also, the distribution of income produced by the market might be undesirable
•people might not like inequality (ethics)
•risk-averse individuals might want to reduce inequality
•inequality carries increased risks  crime, delinquency, diseases  lowering quality of life for
everybody
• Given all this: How big a role should governments play?
• Government resources mainly come out of taxation
 which carries economic costs
• When discussing how large governments should be, we have to balance benefits
(correction/alternative to market failures) with costs (distortions, inefficiency)

The Costs of Taxation

• Taxation does not have costs per se
• These have to do with the form of taxation and the particular distortion to individual behavior it
induces
• Take the case of a competitive market in which all previous conditions for its efficiency are satisfied
 the allocation is efficient
• Taxes create a wedge (gap) between what sellers receive and what buyers pay
• Typical example: labor income. If labor is taxed, probably people will work less than they would
without taxes!

1) There is a limit at how much government revenue can raise

2) The marginal cost of taxation (distortion) increases with revenue
3) Distortions approach infinity close to the maximum revenue (government cannot tax at the
maximum)

The Laffer Curve

Revenue = tax rate ×wage ×hours worked
• Laffer’s idea: there is a point after which raising a tax rate will cause a decrease in revenue
 because further increases over-proportionally deter the supply of the good (example: deter more
workers from supplying hours)
• This means that
 two different tax rates can generate the same revenue
• But the lower tax rate entails less distortions.
• If taxes depress economic activity, we should expect income levels and growth to be negatively
related to government size
• But if bigger governments spend well in education and health, maybe they can have even higher
growth

Deficits and Taxes

• High average government spending = high average taxes
…but this does not have to hold from year to year
• Temporarily, governments can run deficits
… and build up debt
• Current debt will be repaid with future taxation
• Governments can borrow more at lower costs compared to companies or individuals

Maastricht criteria: set of rules to ensure convergence across EU, include limits for government deficits
and government debt: Deficit / GDP <= 3% ; Debt / GDP <= 60%

Optimal Budget Deficits

• Budget deficits: a problem or a blessing?
• In principle, they can be very useful to smooth shocks
…but they should be sustainable (i.e. not lead to exploding debt)
• Equity argument (Fairness): spread costs across generations
• Efficiency argument: distortions increase with taxes
 it is efficient to distribute taxes over many periods
 Deficits & Debt allow for this

• Governments are central actors in modern economies

• If markets worked perfectly, there would be no need for them besides preferences for redistribution
( inequality)
• But markets fail  the government can improve the allocation
• There is a cost to intervention: distortionary taxation
• The optimal size of a government balances distortions with benefits from intervention
• Additional instrument: Fiscal Deficit
• Keeping tax rates smooth avoids excessive distortions
 shocks should be absorbed by surpluses/deficits

Lectures 20/21- Stabilization Policy

Recap: Monetary and Fiscal Policy in a Nutshell
1. Central Banks
• print money
• influence inflation and output
2. Governments
• collect taxes
 • issue debt
• purchase goods and services (G)
All policies are subject to trade-offs
• more money  more economic activity + higher inflation
• more expenditures  more economic activity + higher taxes

Stabilization and Policy: RBC vs. Keynes

• If the world is RBC (remember, according to RBC, business cycles are mostly due to shocks to
technology, and cycles are the efficient response of markets to these shocks)
 stabilization policy is totally ineffective and can only influence the price level – also, it’s
suboptimal
• If the world is Keynesian (markets can malfunction)
 stabilization policy is effective and can influence output levels and price levels in the short run
• In what follows, we will take the standpoint that the Keynesian view is (at least partially) correct and
discuss the criticisms to this viewpoint later

Putting it together: the IS-LM model

• IS-LM is made of two building blocks:
1) IS curve: relation between interest rate and output on the real side (Investment – Saving)
IS represents the goods market
2) LM curve: relation between interest rate and output on the nominal side (Liquidity preference –
Money Supply): LM represents the money market

Aggregate Demand
AD = C + I + G
• Recall that, according to our theories (standard investment theory and intertemporal consumption
choice):
C(r) is decreasing in r
I(r) is decreasing in r
• This means that Aggregate Demand ↓ if r ↑
↓ AD = C ↓ + I ↓ + G if r ↑

In equilibrium: Y = AD, So Y is high, AD needs to be high, and thus r needs to be low.

The leads to a negative relationship between Y(r) and r  the IS curve

Fiscal Policy and the IS Curve

• The government can influence Aggregate Demand through fiscal policy:
Y = C(r) + I(r) + G
• If government expenditures increase (or, equivalently, taxes decrease):
G↑  Y is higher for any level of r

From Real Side to Monetary Side

• IS-Curve: combinations of interest rates and levels of equilibrium output that make the plans of
households (demand) and firms (supply) compatible
 the goods market is in equilibrium
• But: who controls interest rates (in the short run)? The central bank!
• Either directly, by using a Taylor rule
• Or indirectly, by controlling money supply
• Conclusion: we need to add monetary policy to the picture

The Monetary Side: the LM Curve

Quantity equation: M^d × V = P × Y
• In equilibrium, money demand = money supply.
Plug in M^s = M^d
M^s × V = P × Y
• It makes sense to assume V(r) rises in r. If r ↑…
 Individuals do not want to hold money because it’s costly
Velocity increases

LM Curve under a Taylor Rule

• If the CB follows a Taylor rule, it sets r as a function of Y (more precisely: the output gap)
• We obtain a function r(Y) increasing in Y, the so-called LM curve
Money Supply is Residual
• Under a Taylor rule, the CB decides on an interest rate (r) for every level of output (Y)
• The CB then supplies as much money as the public demands for any Y to achieve their targeted r
• In Quantity Equation:
M^s×V(r) = P ×Y
…M^s is determined as the residual

• Money supply stays fixed (because it is directly targeted by CB)

• Now suppose income goes up: what happens?
•If the CB changes nothing, people want more money
 r ↑ such that M^d =M^s still holds
 money market is still in equilibrium

Interest rate is residual

• Under money supply targeting, the LM curve looks the same as with a Taylor rule
Mathematically, now the interest rate r is the residual:
If income goes up (Y ↑) for a fixed money supply (M = const)
Velocity has to increase (V(r) ↑)
This happens if interest rates rise (r ↑)

Monetary Policy and the LM curve

• Suppose that Central Bank decides to increase money supply, Ms↑
• What happens?
 For money demand to increase, interest rates must go down opportunity cost of holding money go
down  individuals hold more money
1) If r↓, then V↓
2) For the same income (Y), M^d↑ to match M^s↑
3) LM shifts down and right

• IS: r and Y combinations for equilibrium in goods market

• LM: r and Y combinations for equilibrium in money market (can come both from a Taylor rule, or from
money supply targeting)
• IS-LM: Diagram to find simultaneous equilibrium in both markets
• Intersection: Single r*-Y*-combination for which goods market and money market are in equilibrium

Both Interest Rate and Output move a bit if there is a demand shock.  positive demand shock
Higher Government Expenditures: Income increases and the interest rate increases.  expansionary
fiscal policy
Higher Money Supply (or laxer Taylor rule): Income increases and the interest rate decreases!

From IS-LM to AS-AD

• IS-LM model shows that monetary and fiscal policy can be used to offset demand shocks
• However, we ignored the price level so far (in IS-LM prices are fixed, so we are only looking at the
short run)
• We can incorporate price level by using the AS-AD model, which expands the IS-LM model to
include the supply side of the economy (i.e. the production function)
• AS-AD model talks about
– Output & price movement over the business cycle
– Long run equilibrium output
Deriving the AD curve
• Find all equilibrium r*-Y*-combinations in the IS-LM model for different price levels P.
• If P↑
– Under money supply targeting: M = const.so V↑ and thus r↑(Recall: M x V(r) = P x Y)
– Under a Taylor rule: the central bank raises r↑(because higher prices = inflation)
LM curve shifts left/upwards
Demand ↓
• From the IS-LM model, we therefore obtain a negative relationship between Y and P
1. Long run (“LRAS“)
– Supply depends only on fundamentals like technology and capital stock (remember
what we did before the midterm?)
– Supply independent of prices
– Vertical supply curve in the long run
2. Short run (“AS”)
– Keynesian view: menu cost, etc.
– Output increases in prices
– Upwards sloping supply curve in the short-run

•Decrease G (= increase T)
•Decrease M (= increase r)

The economy is hit by a positive demand shock  To stabilize output, tighten monetary policy
The economy is hit by a negative demand shock  To stabilize output, loosen monetary policy

General Arguments against Stabilization Policy

1) Automatic Stabilizers
by construction, a lot of government spending and taxation responds automatically to business
cycles  and already stabilizes the economy to an extent
Examples: tax collection is lower when GDP is lower, unemployment benefits are higher when GDP is
lower
2) Uncertainty
We supposed until now that we know what kind of shock hit the economy – what if we don’t? And
what if these shocks are permanent and not temporary?
3) Policy-making Lags
Worldwide experience: from the time a policy is needed to when it is actually approved lots of time
passes.
Identifying the problem is just a first step
•Then there is a discussion
•and political bargaining
•finally some kind of compromise law is passed…
It takes around 2 years before impact of changes peaks  uncertainty of policy and ineffectiveness
4) Problems with Fiscal Policy
Not a water tap – it cannot be turned on and off easily
There is a tension between long-run planning and short-run demand regulation
Also, the same instrument (fiscal policy) has many aims (reduce inequality, stabilize demand, growth,
etc.)
… Here are 3 more specific channels reducing its effectiveness:

Problems with Fiscal Policy

1) Ricardian Equivalence
by David Ricardo (1772-1823), who argued that financing expenditure by raising taxes or issuing
debt is the same thing!
• Why is that? Consider a government’s budget constraint in a simple two period model: (this is easily
extendable to many periods)
G1 = T1 + D1
G2 + D1(1 + r) = T2
• Rewrite:
T1 = G1 – D1
T2 = G2 + D1 (1 + r)
 C1(1+r) + C2 = (Y1 – G1)(1+r) + (Y2 – G2)
• Debt and Taxes are not important
 a household cares for planned government spending!
In a nutshell: it does not matter whether the government finances itself through taxes or debt
 households anticipate that more debt today = more taxes tomorrow
• Ricardian equivalence is unlikely to hold in this pure form
−many households are constrained
−sometimes govt. expenditures are not perfectly anticipated
−taxes are distortive
• But: its underlying mechanism still has a strong dampening influence on the impact that policy has on
aggregate demand

2) Consumer Expectations
Consumers’ response to tax cuts depends on whether the cut is perceived to be
−temporary: small response of aggregate demand
−permanent: large response of aggregate demand

3) Crowding Out
Essential mechanism: if a fiscal deficit leads to higher interest rates, demand can fall because higher r
lower C and I
• The intuition:
→if the government issues debt, someone who wants to save buys it
→this reduces the amount of resources available to private borrowers
→Private borrowers must pay higher r
→More expensive resources for investors and consumers
• In a liquidity trap (interest rates are at the zero lower bound):
−Little crowding out because interest rate is extremely low
• In a big recession:
−more people are constrained and Ricardian equivalence becomes less of an issue
If demand management (more spending, more money supply) raises prices, the anticipation of higher
prices may reduce spending of private agents today
• In this case, the spending policy may be self-defeating
• A famous example for this is the Phillips curve

• Intuitively: if unemployment is low, workers have higher ability to demand wage raises
 wage inflation  price inflation
• The opposite happens if unemployment is high
Inflation (π) = Expected Inflation + A ×(Nat. Rate Unemp. –Actual Unemp.)
• Recall: the Phillips Curve is
Inflation (π) = Expected Inflation + A ×(Nat. Rate Unemp. –Actual Unemp.)
• If Expected Inflation would not change
change inflation
Achieve any level of unemployment (and output!)
• If the Phillips curve was stable, governments could just choose between inflation and unemployment
• However: people are not stupid
eventually, their expectations catch up
 if they live in a world with higher π, they expect higher π!
• Fixed rules might be good vs discretion. Why?
1) Are authorities up-to-date when taking decisions? If not, maybe a simple rule will avoid mistakes
2) Can governments really control demand?
3) Time-inconsistency: if the government commits to a rule, it can improve the outcome vs without
commitment
• The IS-LM Model: a joint model of equilibrium in goods and money markets
a powerful representation of how monetary and fiscal policy can influence the business cycle
• The AS-AD Model: Introduce production side to IS-LM model
incorporates changes in price level (=inflation) and the long run
• For a number of reasons, governments and central banks might be more constrained than IS-LM
suggests:
−Uncertainty
−Lags
−Ricardian Equivalence
−Expectations and the Phillips Curve
−Time Inconsistency
• A way to partially solve this problem: rules instead of discretion