EC303 Economic Policy Analysis

Lecture Notes (Michaelmas Term 2013)

Michael Peters

1 Introduction
These notes contain the basic models, we cover in this class. In particular, they
contain the standard 2-period version of the Real Business Cycles Model and
a 2-period version of the New Keynesian Model. These are the two workhorse
models, the economic profession uses to think about macroeconomic data and
we will use them for the remainder of the class. I hope that these notes will be
useful for you to study the material and the understand the derivations.
2 Real Business Cycles
We start out with the simplest set-up of the classical RBC model. The economy
lasts for 2 periods and we interpret the rst period as the present and the second
period as the future (which lasts a really long time). The economy is populated
by many consumers/individuals, which (a) decide on their consumption-saving
decision and (b) on their labor supply. For simplicity, there is no physical capital
in the economy and the unique nal good is produced solely through consumers
labor supply.
Without capital, there are no physical storage opportunities in the economy.
As I told you in class: this of the only good in this economy as ice-cream (and
there are no refrigerators). Hence: you cannot buy the good in period one
and then only consumer in period 2 - by then it will have melted. Hence, if
consumers want to save for the future, they have to rely on a nancial markets,
where they can trade riskless bonds among each other (or with a bank acting on
their behalf). Hence, a bond is simply a contract, which says I get one pound
today and I will pay you (1 + i) pounds tomorrow, where i is the nominal
interest rate. By assuming that such contracts are riskless, we implicitly assume
a high degree of enforcement power, i.e. we do not allow individuals to default
on their debt. Note that bonds are, what we call, in zero-net-supply, i.e. if one

m.peters1@lse.ac.uk
1
individuals wants to borrow, another individual has to lend (and vice versa).
The costs or borrowing is therefore determined as an equilibrium, where the
supply of savings (by some consumers) is equal to the demand for credit (by
some other consumers). We will see more details in this nancial arrangements
below.
Besides the nancial market there is also a labor market and a market for
the nal good and all these markets are perfectly competitive. The nal good
is produced by a representative rm, which hires workers.
To characterize the equilibrium, we obviously need to solve the consumers
problem to derive
the demand for goods
the demand and supply for nancial products (bonds)
the supply of labor
This is exactly the same problem, which you have already covered in your second
year classes.
2.1 Consumers
Consumers solve the standard 2-period utility maximization problem
max
[ct,nt,bt]
u(c
1
, n
1
) + u(c
2
.n
2
) (1)
s.t.
p
1
c
1
+ b = w
1
n
1
(2)
p
2
c
2
= (1 + i) b + w
2
n
2
, (3)
where n
t
denotes labor supply, c
t
consumption, b the amount of nancial bonds
(a positive number denotes savings and a negative number borrowing), p
t
is the
price of the nal good in terms of the numeraire (money), w
t
is the wage rate
and i is the interest rate. Note that consumers can borrow as much as they want,
i.e. b can be very negative - they just have to bear the consequences of having
to pay back a lot in period 2. The solution to this problem is straightforward.
Substituting for b yields the life-time budget constraint
p
1
c
1
+
p
2
c
2
1 + i
= w
1
n
1
+
w
2
n
2
1 + i
. .
NPV of income
, (4)
which simply says that the present value of consumption expenditures has to
be equal to the present value of future labor income. Hence, the consumers
maximize (1) subject to (4).
1
1
Note that we could have used the ow version of the budget constraint ((2) and (3))
instead of (4). These are equivalent. However, focusing directly (4) is easier, because we only
2
The consumers problem is characterized by a constrained maximization
problem, there constraint is an equality constraint. To solve these problems,
we set up the Lagrangian function
L = u(c
1
, n
1
) + u(c
2
.n
2
) +
_
w
1
n
1
+
w
2
n
2
1 + i
p
1
c
1

p
2
c
2
1 + i
_
,
where is the Lagrange multiplier. Remember that measures the increase
in the objective function when we increase the constraint by a small amount.
As the constraint is the consumers budget constraint, we sometimes call the
marginal utility of wealth, because it measures the increase in total utility if we
were to increase total wealth, i.e. the NPV of income, by a small unit. The
optimality conditions of this Lagrangian are given by
u
c
(c
1
, n
1
) = p
1
u
c
(c
2
, n
2
) =
p
2
1 + i
u
n
(c
1
, n
1
) = w
1
(5)
u
n
(c
2
, n
2
) =
w
2
1 + i
w
1
n
1
+
w
2
n
2
1 + i

_
p
1
c
1
+
p
2
c
2
1 + i
_
= 0.
The rst 4 equations are the optimality conditions with respect to the choice
variables (c
1
, c
2
, n
1
, n
2
) and the last equation is the budget constraint, i.e.
L

=
0. These are 5 equations in the 5 unknowns (c
1
, n
1
, c
2
, n
2
, ) and hence they
fully determine the solution as a function of (p, w, i) . Note in particular, that
agents demand for nancial assets is simply given by
b = w
1
n
1
p
1
c
1
,
i.e. is also determined given (n
1
, c
1
).
The two crucial optimality conditions are the intratemporal condition, which
balances consumers relative consumption of leisure and consumption goods
u
n
(c
t
, n
t
)
u
c
(c
t
, n
t
)
=
w
t
p
t
, (6)
and intertemporal condition, which equalizes the marginal utility of wealth
across periods
=
u
c
(c
1
, n
1
)
p
1
=
(1 + i) u
c
(c
2
, n
2
)
p
2
.
Note that this is simply the the Euler equation
u
c
(c
1
, n
1
) =
p
1
p
2
(1 + i) u
c
(c
2
, n
2
) , (7)
have one constraint. However, it is good practice to convince yourself that both problems
have the same solution.
3
which you should have seen in your second year.
It is useful to dene the real interest rate r, which is given by
1 + r
p
1
p
2
(1 + i) . (8)
The reason why r as dened in (8) is the real interest rate, is the following.
Suppose you have one unit of the nal good in period 1 (the real good). How
many goods do you get in period 2? By selling the good, you get p
1
units of
money (or rather unit of account), which you use to buy the bond. Hence,
you have (1 + i) p
1
units of account in period two, which you can exchange for
(1 + i)
p1
p2
unit of the nal good. Hence, instead of having one unit of the good in
period 1, you get (1 + i)
p1
p2
units of the good in period 2. Hence, (8) is exactly
the real interest rate.
Another important relationship is as follows. The ination rate is dened
1 +
p
2
p
1
,
as it is simply the change in the price level. (8) therefore implies that
1 + i = (1 + r) (1 + ) = 1 + r + + r 1 + r + ,
where we used that r 0. Hence,
r = i , (9)
which is the important Fisher equation, linking the real interest rate, the nomi-
nal interest rate and the ination rate. This implies that we can write the Euler
equation in the more familiar form
u
c
(c
1
, n
1
) = (1 + r) u
c
(c
2
, n
2
) .
The canonical case: u(c, n) =
c
1
1
n
1+
An important case, which we
will use quite often is the separable utility function
u(c, n) =
c
1
1
n
1+
. (10)
Here, 0 parameterizes the curvature of the utility function, i.e. the con-
sumers risk aversion, the disutility of labor eort and the curvature of the
labor eort function. We will see below that is related to the labor supply
elasticity. As for , consider Figure 1 below. In the right panel, I depict the
utility function for a high level of . This is the usual case of risk-aversion,
which you have seen in your micro classes: As the utility function is concave,
the consumers is risk-averse and hence strictly prefers a consumption level with
certainty over a fair lottery (i.e. a lottery, which delivers the same expected
value). Formally, u(E [x]) = E [(u(x))], where x is a random variable of con-
sumption allocations. In the left panel in contrast, we see the case where is
4
Figure 1: The curvature of the utility function as a function of
low, in particular equal to zero. Here, the consumer is risk-neutral. For our
case, the consumers risk-aversion is important, because it tells us consumers
attitudes towards consumption in dierent time periods. Intuitively: risk-averse
consumers ( high) do not like risk in consumption but would like to keep con-
sumption constant. Hence, across time, they really value an equalized level of
consumption across periods, i.e. the like consumption smoothing. Consumers
who are less averse to risk ( low) do not mind that much to have dierences
in their consumption levels across time. Hence: the higher to more we would
have to compensate a consumer to be willing to shift his or her consumption
level across time.
For this special case we get that the two marginal utilities are given by
u
c
(c, n) = c

u
n
(c, n) = (1 + ) n

,
so that (6) and (7) are given by
_
c
2
c
1
_

= (1 + r) (11)
c

t
(1 + ) n

t
=
w
t
p
t
. (12)
Labor supply elasticities An import quantity in macroeconomics is the
elasticity of labor supply, in particular the Frisch elasticity, which is dened as
the elasticity of hours worked with respect to the wage holding the marginal
utility of wealth () xed. Intuitively: It is the short-run elasticity, where we do
not take income eects into account. Remember the denition of an elasticity.
For any function f (x), the elasticity of f at point x is simply given by

f
(x)
f (x)
x
x
f (x)
=
f(x)
f(x)
x
x
. (13)
5
Hence,
f
(x) measures the relative increase in f (x) due to a relative increase
in x, i.e. by how many percent does f increase if x increases by one percent.
Another way to see this, is as follow. Recall the derivate of the log-function. It
is simply given by
ln(f (x))
x
=
1
f (x)
f (x)
x
.
Hence, (13) can also be written as

f
(x) =
ln(f (x))
ln(x)
.
In the case of (10) we get from (5) that
w
1
= u
n
(c
1
, n
1
) = (1 + ) n

1
.
Hence, we can take logs and rearrange terms to arrive at
ln(n
1
) =
1

ln
_

1 +
1

_
+
1

ln(w
1
) .
The labor supply elasticity is then simply given by
ln(n)
ln(w
1
)
=
n
1
w
1
w
1
n
1
=
1

,
so that is the exactly the (inverse of) of the Frisch elasticity. This is an
important parameter, because it parametrizes the slope of the labor supply
function. If is very high, the labor supply elasticity is very low. Intuitively:
the marginal disutility of labor is very convex (see (10)) so that the workers
does not want to expand his labor supply very much as the wage increases. If
is very low however, the labor supply elasticity is very high and the consumers
labor supply response with respect to an increase in the wage is very high. These
dierent cases are seen in Figure 2 below, where I depict the consumers labor
supply function for dierent values of . It is clearly seen how a given change
of the wage induces a larger supply response of the consumers when is low.
2.2 Firms
Production is done by a representative rm with production function
Y = An,
where A denotes total factor productivity and n the labor input. Taking prices
and wages as given, the prots of the rm are given by

t
= p
t
A
t
n
t
w
t
n
t
= p
t
_
A
t

w
t
p
t
_
n
t
.
6
Real
wage
(w/p)
Laborsupply
(n)
d(w/p)
dn
low

dn
high

Lowelas7city(
high
)
Highelas7city(
low
)
Figure 2: The Labor Supply Function for dierent values of
low
<
high
Optimal labor demand by the rm is then given by
n
d
t
=
_

_
0 if A
t
<
wt
pt
[0, ] if A
t
=
wt
pt
if A
t
>
wt
pt
.
This at labor demand function is a consequence of the assumption that rms
production function is linear. Each employed worker generates a prot of p
t
A
t

w
t
. Hence, only when the real wage is equal to productivity A
t
will the rm be
satised to hire the workers available on the market. More precisely: the only
wage that is consistent with equilibrium is given by
A
t
=
w
t
p
t
.
If A
t
<
wt
pt
the rm would not be willing to hire anyone. If A
t
>
wt
pt
, the
m would want to hire an innite amount of workers, which is of course not
possible. Hence, equilibrium wages in this economy are fully determined from
the production side. This is in fact a special result. Whenever rms production
function is not linear (or has constant returns to scale), the equilibrium wage
will depend on both labor supply and labor demand characteristics.
7
2.3 Equilibrium
Remember the denition of an equilibrium. It is a set of prices such that all mar-
kets clear and consumers and rms behave optimally. Formally, the denition
of an equilibrium is as follows.
Denition 1. A competitive equilibrium in this economy is a set of prices
(p
1
, p
2
, w
1
, w
2
, i), consumption allocations (c
1
, c
2
), labor supply and labor de-
mand decisions
_
n
1
, n
2
, n
d
1
, n
d
2
_
, production levels (y
1
, y
2
) and nancial positions
(b
1
, b
2
) such that
1. Consumers maximize utility
2. Firms maximize prots
3. Markets clear, i.e.
n
t
= n
d
t
for all t
c
t
= y
t
for all t
b
t
= 0 for all t (remember: zero net supply)
Hence, we have ve prices (p
1
, p
2
, i, w
1
, w
2
) and three markets - the market
for goods, labor and nancial bonds. The market clearing conditions for the
rst two are
c
t
= y
t
(14)
n
d
t
= n
s
t
. (15)
The market clearing condition for the nancial market is
b = 0, (16)
because nancial assets are in zero-net supply. Hence: in the aggregate, there
has to be exactly as much savings as borrowing. This is crucial. With nancial
assets, each transaction has two parties - one lender one borrower. In the
aggregate, these two sides of the trades have to add up. In this particular
model, (16) then directly implies that each consumer individually does neither
borrow or save, even they could. But: the equilibrium price will be such that
everyone is happy not to. The reason is the absence of heterogeneity. If everyone
is alike it cannot be the case that some people want to borrow and some want to
save. Hence, for there to be savers and borrowers in the aggregate, market prices
- in particular the interest rate -will adjust so that all individuals are satised to
not be active on the nancial market. We will see below and in the remainder
of the class what types of heterogeneity will enable us to meaningfully speak of
borrowing and lending.
Using (14) and (15) we can now solve for the equilibrium quantities. In
particular, (6) implies that
w
t
p
t
= A
t
= c

t
(1 + ) n

t
= A

t
n

t
(1 + ) n

t
,
8
Real
wage
(w/p)
n
Laborsupply
Labordemand
A
t

n
*
=n
d
=n
s

Figure 3: Equilibrium on the labor market

where the last inequality uses c
t
= y
t
= A
t
n
t
. Graphically, this equilibrium
relationship is depicted in Figure 3 below Hence, equilibrium employment is
given by
n
t
=
_
1
(1 + )
A
1
t
_ 1
+
so that - in logs -
ln(n
t
) =
1
+
ln(A
t
) +
1
+
ln
_
1
(1 + )
_
=
nA
ln(A
t
) +
n
, (17)
where

n,A
=
1
+

n
=
1
+
ln
_
1
(1 + )
_
.
9
Equilibrium output (in logs) is given by
ln(y
t
) = ln(A
t
) + ln(n
t
)
= (1 +
nA
) ln(A
t
) +
n
=
_
1 +
+
_
ln(A
t
) +
n
=
yA
ln(A
t
) +
n
. (18)
The (log of) the real wage is trivially given by
ln
_
w
t
p
t
_
= ln(A
t
) . (19)
Similarly, Finally the Euler equation (7) can be used to solve the real interest
rate as
ln(1 + r) = ln
_
c
2
c
1
_
ln() = [ln(y
2
) ln(y
1
)] ln()
r =
yA
[ln(A
2
) ln(A
1
)] + (20)
where the discount factor is related to the discount rate via
1
1+
so that
ln() = ln(1 + ) .
Equations (17), (19), (18) and (20) determine the real variables in this econ-
omy. However, an equilibrium consists of a set prices (here ve as mentioned
above). How many of these prices are determined? The remarkable answer is:
none. This economy is a real economy (hence the name Real Business Cycle
Theory) so that the nominal variables p
t
, w
t
and i are not determined - any
combination of p
t
, w
t
and i that are consistent with the real wage
w
p
(19) and
the real interest rate r (20) will be an equilibrium in this economy.
2.4 Nominal variables and Monetary policy
We are now more specic about these nominal indeterminacies. In particular we
are going explicitly introduce a Central Bank, which can freely chose the nominal
interest rate i. Remember, there are ve nominal prices (p
1
, p
2
, w
1
, w
2
, i) in this
economy. As you know from your rst year classes, we can normalize one of these
prices, say p
1
= 1. As (19) determines the real wage
wt
pt
, w
1
is then determined.
Similarly, w
2
follows directly for a given p
2
. Hence, we are left with (i, p
2
). Now,
i is controlled by the Central Bank and hence now exogenous. And p
2
can then
be solved from the denition of real interest rates (see (8)) as
p
2
= p
1
_
1 + i
1 + r
_
=
1 + i
1 + r
.
Hence, an interest rule by the central bank (like i = 2%) is enough to get
rid of the nominal indeterminacies in the system. This is quite intuitive: In
10
equilibrium, individuals have to receive a particular real interest rate r, say for
example r = 1%. If r was dierent, the good market could now clear - if r
was higher, individuals would save too much and hence demand in the second
period was too high. If r was lower, individuals would borrow from the future
and demand in the rst period was too high. If the central bank were to set the
nominal interest rate to 2%, individuals would get a real return of 1% as long as
the ination rate was 1% - see (9), which states that r = i . Similarly, if the
Central Bank were to set a lower interest rate, say i = 1%, the required ination
rate was 0%, i.e. there would be price stability. The key insight of the RBC
model is that these are all equivalent equilibria as far as real allocations are
concerned. In particular, policy by the central bank, like a reduction in interest
rates, does not have any eect, because the price level will adjust to ensure
that real interest rates are given by its equilibrium value. To make monetary
policy eects, we there have to have some nominal rigidities, where prices do not
adjust right away. If prices were sticky and hence the ination rate constant,
the central bank could aect the real interest rate by changing the nominal
interest rates. This will be the essence of the New Keynesian model, which we
will study below. Note also that at this point there is no right or correct
nominal interest rate, which the central bank might want to target - they all
lead to the same real allocations. Hence, to sensibly talk about good (or bad)
monetary policy we have to argue that nominal interest rates in fact do aect
real allocations - again, the New Keynesian model will deliver that for us.
2.5 Fluctuations in RBC
This simple model is remarkable in that it gives us a very transparent theory of
uctuations in economic activity. In particular, uctuations in output and em-
ployment are entirely driven by uctuations in productivity A
t
. In particular,
there is no relation between real variables and say the ination rate . Fur-
thermore, the sensitivity of the dierent variables with respect to productivity
shocks depends on the underlying parameters, in particular the intertemporal
elasticity of substitution . As seen from (17), the theory implies that equilib-
rium employment n
t
is increasing in productivity A
t
if < 1 but decreasing in
A
t
if > 1. Hence, even though rms productivity is high, they will employ
less people in equilibrium. While this result seems really couterintutive, it is
simply a consequence of the income and substitution eects, which you have
seen in your second year classes. To see this, consider again the consumers
intratermporal condition given in (6)
c

t
(1 + ) n

t
=
w
t
p
t
. (21)
Optimal labor supply is then given by
n
t
=
_
w
t
p
t
1
c

t
(1 + )
_
1/
. (22)
11
Real
wage
(w/p)
n
Laborsupply(c
low
)
Labordemand(A
low
)
A
low

n
*
(A
low
)
A
high

Labordemand(A
high
)
<1
=1
>1
Laborsupply(c
high
)
Figure 4: Equilibrium on the labor market: Income and substitution eects
An increase in productivity A
t
has two eects. First of all, it will increase
the real wage
wt
pt
. This makes work attractive and will increase labor supply.
However, consumers will also be richer and consume more! This income eect
will reduce their incentive to work - according to (22), n
t
is decreasing in c
t
holding
wt
pt
xed. The relative strength of these eect is governed by . If
is small, the substituion eect dominates and n
t
increases. If is high, the
opposite is true and the income eect dominates and n
t
declines. Graphically,
these possibilities are depicted in Figure 4 below. For the case of > 1, there
are strong income eects and the labor supply function shifts to the right -
Intuitively: if you know that you are going to be rich anyway, you want to
consume more consumption and more leisure so your labor supply is low for
any given wage. For the case of < 1, the opposite is true: the shifts in
the labor supply function are not very pronounced and the equilibrium level of
employment increases if productivity is high.
For the special case of = 1, i.e. a utility function
u(c, n) = ln(c) n
1+
, (23)
12
we get that
ln(n
t
) =
1
1 +
ln
_
1
(1 + )
_
(24)
ln
_
w
t
p
t
_
= ln(A
t
)
ln(y
t
) = ln(A
t
) +
1
1 +
ln
_
1
(1 + )
_
r = ln(A
2
) ln(A
1
) + . (25)
Hence,
1. Employment is constant in this economy even though productivity uc-
tuates.
2. Output and the real wage is increasing in productivity A
t
3. The real interest rate is low whenever future productivity falls short of
current productivity.
Clearly, this result is special - it depends on the particular utility function,
especially the parametric restriction = 1. However, it is a case, which is a
very useful benchmark for us, because it stresses the crucial role of prices, i.e.
the real wage and the real interest rate, to serve as adjustment mechanism. This
is especially true for employment, which - again - is constant. Note that this is
very surprising! Firms demand for labor is clearly low, whenever productivity
A is low. So why do they end up hiring the same amount of workers? The key is
of course the equilibrium wage. Precisely because low productivity also reduces
the wage, labor is cheap whenever productivity is low and hence employment is
constant.
One crucial mechanism for this result is the responsiveness of the real interest
rate r. According to (25), the real interest rate is low whenever A
2
is low.
This positive correlation between the interest rate and future productivity is at
the heart of the neoclassical adjustment mechanism. Intuitively: if A
2
is low,
there are only few resources around in period 2. As markets have to clear
in equilibrium, consumers have to be willing to not consume too much in the
second period. In particular, they should be enticed to move their consumption
to the present, i.e. period 1. The price, that sends this signal, is the interest
rate. For the special case of log utility, the Euler equation (7) is given by
(1 + r) =
u
c
(c
1
, n
1
)
u
c
(c
2
, n
2
)
=
c
2
c
1
,
because u
c
(c
1
, n
1
) =
ln(c1)
c1
=
1
c1
. Hence, for the consumer to be willing to
have c
2
< c
1
, the interest rate has to be low.
A similar intuition holds in the case of negative demand shocks. Let us for
simplicity think of a negative demand shock as reduction in the discount rate
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- i.e. consumers do not want to consume today but rather want to consume in
the future. Hence, we want to study this economy as increases or equivalently
falls. For the case of (23), the equilibrium is still given by (24)-(25). Clearly,
the only variable, which is aected by the discount rate is the real interest rate
in (25). In particular, a negative demand shock, modeled as a decrease in the
discount rate , will reduce the interest rate. This is - again - the neoclassical
adjustment mechanism. If consumers do not want to consume in period 1, they
will shift their consumption expenditures to the future. But in equilibrium this
cannot happen, because markets have to clear, i.e. we have to have
y
1
= c
1
regardless of consumers preferences. Hence, if consumers are luke-warm about
consuming in period 1, the price of period 1 consumption has to fall. This is of
course simply the interest rate.
In particular, there is nothing in this economy, which requires the real inter-
est rate to be positive. Using (25), it is clear that
r < 0 ln(A
2
) ln(A
1
) + < 0,
i.e. as long as the discount rate is low, current productivity A
1
is relatively high
and future productivity A
2
is low, the real interest rate can clearly be negative
- there is nothing wrong that. As a simple example, consider the following
situation: Suppose you know that you get one serving of ice-cream each day
of the weekend. Now you wake up on saturday and you have a tooth ache
and you really do not feel like ice-cream. Hence, if possible you want to save
the ice-cream tomorrow. Unfortunately you do not have a freezer - but you
neighbor has one. He tells you Sure, you can put your ice-cream in my freezer
... however, for my services I will keep half of it and return the other half.
You will happily accept this deal, because it is the only way you can transfer
your ice-cream to Th. future. Hence, you will hand over your ice-cream for a
negative real interest rate simply to have access to it in the future. But this
is exactly, what the nancial market is doing in this model (and also the real
world, by the way). Hence, there is no reason why r should be close to any
particular value, for example zero.
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