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Chapter 1: Simple Frameworks of Macroeconomics

Kornkarun Kungpanidchakul, Ph.D.Macroeconomics

MS FinanceChulalongkorn University, Spring 2008

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Reading lists

• Any undergraduate macroeconomic textbooks.

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National Income Account

• Gross Domestic Product (GDP)The total value of the current production of final

goods and service within the national territory during a given period of time.

GDP = C + I + G + X – M

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National Income Account

• Gross National Product (GNP)The total value of income that domestic

residents receive in a given of time.

GNP = GDP – NFD

where NFD is net factor income (payments) received from abroad.

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Real vs Nominal Variables

• Consumer price index

Denote Pct as a weighted average of all prices of the consumption goods at time t.

wi as athe weights of each good

Then,

Pct = w1 (P1t/p10)+…+ wN (PNt/pN0)

Pct is called the consumer price index (CPI) or the consumption price deflator.

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Real vs Nominal Variables

• Real GDP

Given P = GDP price deflator

Q = real GDP

GDP = P.Q

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Flows vs Stocks

• A flow is an economic magnitude measured as a rate per unit of time.

• A stock is a magnitude measured at a point of time.

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The static AS-AD model

• Aggregate supply (AS)

The total amount of output that firms and household choose to provide given wages and prices

The demand for laborSuppose that the capital stock is fixed, the

production function can be written as:

Q = F(L,K)

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The static AS-AD model

We consider the nicely convex technology in which:

1. MPL >0 and MPK > 0

2. and

3. CRS technology

Profit maximization problem:

Max pf(K,L) – wL

FOC : MPL = w/p

Therefore, MPL is the demand for labor.

LD = LD(w/p,K)

02

2

L

f0

2

2

K

f

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The static AD-AS model

The supply of labor

Suppose that C = set of consumption goods

R = 1-Ls = leisure

Household’s maximization problem is:

Max U(C, 1-Ls)

s.t. C = (w/p) Ls

FOC : MRS = w/p

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The static AD-AS model

• Is the supply of labor curve is always upward sloping?

We can decompose the price effect into:

1. Substitution effect: The higher wage makes people substitute leisure for consumption goods.

2. Income effect: The higher wage makes people richer and increase the consumption of leisure (which is a normal good).

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The static AD-AS model

• If SE > IE, supply curve has positive slope.

• If SE < IE, supply curve has negative slope (normally when wage is really high).

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The static AD-AS model

• The classical approach to aggregate supply

Assumptions :

1. nominal wage is fully flexible.

2. The expectation is perfect foresight.

3. Labor is always fully employed.

AS is always the vertical line at the full employment level.

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The static AD-AS model

• The Classical Aggregate Supply

Q

P

AS

Qf

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The static AD-AS model

• The Keynesian approach to aggregate supply

Assumption:

The nominal wages and prices do not adjust quickly.

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The static AD-AS model

• Suppose that the nominal wage is fixed by a labor contract. The real wage then varies inversely with price level. As price increases, the demand for labor increases so as the output supply. Therefore AS curve is upward sloping until the full employment level.

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The static AD-AS model

• Keynesian Aggregate Supply

Qs = Qs(w/p, K)

Q

P

AS

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The static AD-AS model

• Extreme Keynesian

When MPL is constant and the nominal wage is fixed, AS is horizontal.

P

Q

AS

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The static AD-AS model

• Aggregate Demand (AD)

QD =C + I + GP

QAD

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The static AD-AS model

• Classical approach : Upward shift in AD leads to a change in price only.

PAS

Qf

AD’

AD

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The static AD-AS model

• Keynesian Approach : An increase in AD raise both price and output.

P

QAD

AS

AD’