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foundations of microeconomics

Questions and Answers of Foundations Of Microeconomics

where Ut is the act- edicted by the rt):.4ndard error (ji 4ed unemplc - . -•of persistent, .:Awes a long time 1..,t 3: The rise increase in long-t unemployed. 4, p. 575), ‘s, ilk developed
Figure 7.5. Unemployment in the United States, 1890-2000(1991, p. 77) obtain the following fit for the UK during the period 1900-1989:IJt = 0.0041 + 0.934 Ut_1, (7.1)(0.039)and for the US:(it =
Figure 7.4. Unemployment in the United Kingdom, 1855-2000 25.0 Es L 20.0 0TD_ 15.0 10.0 5.0 0.0 1900 1920 1 1940 1 1960 1980 1 2000 1890 1910 1930 1950 1970 1990
3 The data for the period until 1993 have been taken from Mitchell (1998a, pp. 163, 165, 168-169)for the United Kingdom and from Mitchell (1998b, pp. 112, 114) for the United States. The data for the
2 We focus on the figures for Sweden because it is a representative member of the European Free Trade Area (EFTA). Other member countries are Norway, Sweden, Finland, Austria, and Switzerland. Lack
if unemployment were purely a business-cycle phenomenon, one would expect a much more regular pattern than the one observed in these figures. To put the same argument slightly differently, the time
Fact 2: Unemployment fluctuates more between business cycles than within business cycles In Figures 7.4 and 7.5, we plot the unemployment rate for the US and the United Kingdom for extended periods
The unemployment experience in the US and the EC differs markedly from that in Japan and Sweden. 2 As is shown in Figure 7.2, until the early 1990s, the latter countries have had a stable and low
Figure 7.3. Unemployment in the United Kingdom and the Netherlands 1991 1997 ommunity and the
Chapter 7: A Closer Look at the Labour Market
The data for the period urn.111--r the United Kingdom and fr, -Sir period 1994-2000 have been t 160 European Community"♦`, United States as EC.12 —10 —8 —6 —4 —2 0United Kingdom
unemployment were pui, mulch more regular pattern __,.4ment slightly differ,...persistence, much more that:ssing unemployment 43 We focus on the figures for 5 , •—ea CFA). Other member cou:have
tact 2: Unemployment tia business cycles In Figur , and the United King,.. .truly deserves its name, e1/4 -longed period of time ‘:
17.8 million people out of work!). Unemployment in the US seems to be hovering around 6% during that same period, and in 1997 it stands at 4.9%.The unemployment exi Japan and Sweden. 2 As countries
Figure 7.2. Unemployment in Japan and Sweden up until the time of the first oil shock in 1973. After that, for about a decade, the employment rate followed a steady trend upward, peaking in 1985-1986
Figure 7.1. Unemployment in the European Community and the United States Figure 7.3. Unerr.Netherlands I
Sweden I 0 I I I I I I I I I I I I I I I I 1- I I I I I I I I I I I I I I I 1967 1973 1979 1985 1991 1997 10—4 —Japan
The Foundation of Modern Macroeconomics European Community 1967 1973 1979 1985 1991 1997 8 —E O6 C
Numb" follow from the theory.market rate of return do not sector resources and thus can ment consumptive spending) should be financed by means t display large fluctuations over inced with debt but
Unfortunately, as is often roximate validity of the RET is valid, this does not mean that ideed, according to the theory:bt to smooth its tax rates over'`- e behaviour of private agents, nizes the
The data are taken from various issues of the OECD Economic Outlook. Where possible we make use of standardized unemployment data.p on growth, informational prob-Dn), and the so-called "bird in that
Fact 1: The unemployment rates fluctuates over time In Figures 7.1-7.3, we plot the unemployment rate for a number of regions and countries since 1967. 1 As is evident from Figure 7.1, unemployment
7.1 Some Stylized Facts The stylized facts about the labour market in advanced capitalist countries can be subdivided into the two categories of time series evidence and cross-section information.The
4. What do we mean by efficiency wages and how do they lead to equilibrium unemployment?
3. How can we explain real wage rigidity as the outcome of an implicit contractual arrangement between risk-neutral firms and risk-averse workers?
2. How can we explain some of these stylized facts in the standard model of the labour market used so far? How do these theories fall short of providing a full explanation?
1. What are some of the most important stylized facts about the labour market in advanced capitalist economies?
3. To show how the fiscal stance of the government should be measured.
2. To explain the notion of tax smoothing and the golden financing rule, and
1. To explain and assess the validity of the Ricardian equivalence theorem, and to show how it operates in a simple two-period optimizing model of consumption behaviour;
These effects are intuitive. Note that, due to the Cobb-Douglas assumption, the notional labour supply equation is guaranteed to be upward sloping in the wage rate, i.e. the income effect is
where CD is the notional demand for goods, Ns is the notional supply of labour, and mD is the notional demand for real money balances. Equations (5.10)-(5.12)imply that consumption, leisure, and real
The Foundation of Modern Macroeconomics household budget restriction are very straightforward: 1 CD = CD(w,P,Mo + no)= a [CI° p+ 11° ) + Iv] , Ns = Ns(w,P,M0 + no) = 1 - ( 12) KM° n° ) + , Mop+
U = ( 1 - N)i6 m , (5.9)with 0
In words, the first condition states that the marginal rate of substitution between consumption and money should equal unity, and the second condition states that the marginal rate of substitution
where, of course, the final first-order condition, min. = 0, implies the household budget restriction (5.4). By substituting the Lagrange multiplier X, equations (5.6)-(5.8) can be summarized by two
The notional plans for the household are obtained by maximizing (5.2) subject to(5.4). The first-order conditions characterizing the notional plans are easily derived by using the Lagrange multiplier
a formal representation of- ice levels, the minimum n Figure 5.1.written in a more intuitive form:Cd-w(1-N)+m=m0+7ro+w, (5.4)where the right-hand side of (5.4) is the definition of full income, i.e.
where n-0 I10 /11 is real profit income received at the beginning of the period, mo MOP] is initial real money balances, and w W /P] is the real wage rate.Equation (5.3) says that the excess of
where Uc > 0, > 0, and Urn > 0. Real money balances appear in the utility function as a proxy for future consumption possibilities (see Muellbauer and Portes (1978) for an explicit two-period
We assume that there is a representative household that consumes goods (C), leisure(1— N), and real money balances (m M/P, where M is the nominal money supply and P is the price level). There are
The Foundation of Modern Macroeconomics I Figure 5.1. The minimum transaction rule iits. Re 6. I which equals Qs(P0) in the case depicted. Equation (5.1) is a formal representation of the minimum
A final element in the theories to be discussed is the minimum transaction rule, according to which the short side of the market determines the quantity that is actually traded. The idea can be
It is clear that we have to be very specific about the kind of restrictions that agents face when making their decisions. Glower (1965) formulated the dual decision hypothesis for this purpose.
Not surprisingly, in view of Modigliani's interpretation of the Keynesian innovation, the crucial assumption that the neo-Keynesians use is the notion of comprehensive price and wage fixity (in the
Herschel Grossman (1971, r work by Robert Glower led at providing Keynesian-ever, that Barro "jumped,f the new classical school.sh to provide a selective Chapter 5: The Macroeconomics of Quantity
d a:, 1, - 7oblem that e menriume less). This is an e dear drat we L., Mt" Xle makin _ p"is. when formula plai,s that.74 ans. Pt: - is that'1111 element in the- Ade& -tile kit._ SU -rie pa..;44 QS,
Not surprisingly, a new research programme was launched by predominantly Keynesian macroeconomists such as Robert Barro (!) and Herschel Grossman (1971, 1976), and Edmond Malinvaud (1977), building
3. To ascertain the lasting contributions made by the quantity rationing approach.5.1 (Neo-) Keynesians go Micro Without any doubt, the Keynesian camp was in great disarray during the middle and late
2. To analyse the effects of fiscal and monetary policy in the different disequilibrium configurations,
1. To introduce the first attempt by (neo-) Keynesians to provide microeconomic foundations of Keynesian macroeconomics,
The Macroeconomics of Quantity Rationing The purpose of this chapter is to discuss the following issues:
Chapter 4: Anticipation Effects and Economic Policy and Eberly (1994), Abel et al. (1996), Dixit and Pindyck (1994), and Caballero and Leahy(1996). A good survey is Caballero (1999).Sargent (1987b)
The latter case allows for ployment, investment, and e effects of a policy shock or not. A policy shock is n coincides (postdates) the affects either the marginal-diate effect on investment re
The material on the investment subsidy is motivated in part by the analyses of Abel (1982)and Summers (1981). Abel (1981) shows how the investment model can be generalized by allowing for a variable
For example, with an anticipated increase in government consumption it is possible that output falls during the early phase of the transition. This is because the downward jump in Tobin's q causes a
model, the dynamic IS-LM model gives rise to a rich array of intertemporal effects.
Another attractive feature of Tobin's q theory is that it is easily incorporated in the IS-LM model. In doing so one of the objections raised against that model, namely that it contains only
larger impact effect on investment than a permanent subsidy does. Intuitively this happens because firms bring forward their intertemporal investment plans in order to "make hay while the sun
The model gives rise to some interesting policy implications. For example, an anticipated abolition (or reduction) of the investment subsidy leads to an investment boom at impact because firms rush
Graphically the model can be shown to be saddle-point stable, i.e. there is a unique trajectory towards the new equilibrium following a shock. At impact the capital stock is predetermined
Since the q-theory is inherently forward looking, the effects of a policy shock depend critically on whether the shock is anticipated or not. A policy shock is unanticipated (anticipated) if the time
The Foundation of Modern Macroeconomics the real wage rate and thus the marginal product of capital is constant. In a more complex setting we interpret the theory as pertaining to the economy as a
In order to understand the capital dynamics implied by Tobin's q theory, we study the effect of an investment subsidy in a number of different settings. In the simplest possible setting we interpret
it incorporates all the information that is of relevance to the firm. Under some conditions Tobin's marginal q coincides with average q, which can be measured in a relatively straightforward fashion
To illustrate this concept we develop Tobin's q theory of investment in continuous time. This theory, which was also discussed briefly in discrete time in Chapter 2, is quite attractive because it is
The key concept that is developed in this chapter is that of saddle-point stability.
)m B to E1 . Ultimately, lower value of q.n illustrated in the lower s implied by the path for a must satisfy (4.38). We nust rise (dRL = dRs > 0).e t4 since no anticipated jump down to a level(RL
I. Between tA and tI output collapsed due to the fall iot yet materialized). At tr on > Y), which leads
What happens to the other variables over time has been illustrated in the lower panel of Figure 4.11. The path of the short rate of interest is implied by the path for income Y and the LM curve
the fiscal impulse happens and demand exceeds production (YD > Y), which leads to a gradual increase in production along the saddle path from B to E l . Ultimately, the economy ends up with a higher
Agents know that output will expand in the future and as a result short interest rates will rise. Even though profits will rise also, the interest rate effect dominates in this case, so that the
Now consider what happens if the policy maker announces a permanent fiscal expansion to be implemented some time in the future (hence tI > tA). Using the heuristic solution principle used extensively
The model is saddle-point stable, and the initial equilibrium is at E 0, with output equal to Yo and Tobin's q equal to qo.
The dynamic behaviour of the model can once again be determined graphically with the aid of Figure 4.11 (the q = 0 line is drawn as a linear line for convenience).
Hence, the "bad news" case holds if al < qk/l, which is likely if the LM curve is relatively steep (as the monetarists would have it). Equation (4.48) also implies that an increase in the money
e tio ea lains isillimart,-.)elr 10 q = Rsq — ao — aiI'd4 = [qk/1 — ai ] dY + Rs dq — q d(M /P1).From (4.48) we can derive that the slope of q = 0 is:aq = ai — qk/l a Y ) 4=o Rs
h I coescm,-
1. The demand for real money•t and positively on income.e of interest on single-period they mature after a single the rate of interest on a bond are no capital gains/losses in short bonds and
The 4 = 0 line is slightly more complicated due to its non-linearity. Its slope depends on the relative strength of two effects: if Y increases, both profits and the short rate of interest rise. As a
The Y = 0 line is linear and upward sloping. Increasing government spending shifts the Y = 0 line down and to the right, and the dynamic forces operating on points off the Y = 0 line are stabilizing,
The model can be condensed to three equations by means of simple substitutions:bEE 1 0
Since shares and the other financial instruments are perfect substitutes, the rate of return on shares must be the same as the short rate of interest. This is what (4.39)says. Finally, equation
Equation (4.39) is another arbitrage equation. Since q measures the value of shares, the rate of return on shares is the sum of the periodic dividend payment (7r) plus the expected capital gain (4)
Equation (4.42) is known as the term structure of interest rates.
where we have used PB 1/RL and PB = (- 1/RDIZI, to arrive at the final expression.This rate of return on consols must be the same as the short rate of interest:Rd& = RL — Rs. (4.42)
ar mot a pd illimusaasa 44°, 100 aY aY = —ab < (4.47)101 Chapter 4: Anticipation Effects and Economic Policy gain (PB) expressed in terms of the price of the consol (PB):return on consol - PB
Equation (4.38) is the arbitrage equation between short bonds and consols (see Chapter 2). We assume that the two types of financial instruments are perfect substitutes, so that their respective
Furthermore, spending depends on an index of fiscal policy G.Equation (4.36) shows the dynamic behaviour of output. If demand exceeds production(YD > Y) then inventories are run down and output is
Equations (4.35)—(4.36) together describe a dynamic IS curve. Equation (4.35)shows that spending depends on Tobin's average q, both because of its positive effect on investment and (potentially)
This allows us to study the macroeconomic effects of traditional fiscal policy in an explicit forward-looking framework. The model that is used is described by the following equations:YD = aq pi/ +
The Foundation of Modern Macroeconomics process, and gives predictions that are not grossly contradicted by empirical evidence.In this section we discuss Blanchard's (1981) IS-LM model which
if a permanent unanticipated in Figure 4.9. As the labour ivels of the capital stock) and jumps from E0 to A, and the a very good business climate'esting. The economy moves ation in the labour market
No to N' . This is not the end of the story, however. Due to the fact that more capital is put in place (factories are expanded) labour becomes more productive as well. In terms of Figure 4.10, the
The immediate, transitional, and long-run effects of a permanent unanticipated reduction in the labour income tax have been illustrated in Figure 4.9. As the labour tax falls, the marginal product of
This expression is particularly important. It says that the marginal product of capital increases if the tax on labour is reduced. The reason is that a decrease in the labour tax stimulates
(4.34)oKN + ( 1 — 04,)Es
By substituting (4.33) into (4.30), the expression for PK is obtained:(0/, [k + ESid r K = ,
The Foundation of Modern Macroeconomics Combining (c) and (b) yields (4.29). Note that we have used (P1) and (c) to derive that FKK/17 = 1 — FNN IY 1 -- wN IY =-- 1 — col,. The derivation of
It remains to be shown that FNKK/N can be written in terms of an income share and the substitution elasticity defined in (P4):(b)FNKK (FKK) (FNK IT )FN Y F FK 97

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