Lecture notes
, LECTURE 1: THE DEMAND SIDE
- When macroeconomists study an economy’s current state of health, they look at 3
variables:
- Output growth
- The unemployment rate
- The inflation rate
- But other metrics are increasingly important objects of policy debates and reforms:
- Business creation, financial stability
- Consumption, wealth and income inequality
- Mortality / fertility rates, educational attainment, access to health
Demand + Supply Side
Supply Side Demand Side
What firms make What agents buy
𝑦 𝑆 = 𝑎𝑓(𝑘, 𝑛) 𝑦 𝐷 = 𝑐 + 𝑖 + 𝑔 + (𝑥 − 𝑚)
a → technology c → consumption (goods and services)
f(.,.) → a production function i → investment (capital goods)
k → capital g → government spending (goods and
n → labour / hours of work services)
x - m → export - import / trade balance
Price and wage setting
yeq → equilibrium output
𝜋 → inflation
Supply-side policies: Demand-side policies:
Labour market reforms Monetary
Competition policy Fiscal
,The Three-Equations (IS-PC-MR) Model
IS: the demand side
1. Non-durable consumption of households
2. Investment by households (durables and housing) and firms
3. Government spending (exogenous)
WS / PS: the supply side
- Imperfectly competitive labour market
- Price setting by firms
- Wage setting by firms/ workers
PC: Phillips curve
- Summarising the supply side with nominal stickiness
MR: monetary rule
- Optimal monetary policy
Identity:
𝑎𝑑 = 𝑐 + 𝑖 + 𝑔
Market clearing:
𝑦 = 𝑎𝑑
y → goods and services produced
Behavioural models:
- Consumption:
𝑐𝑡 = 𝑐𝑡 (𝛬𝑐 ) = 𝑐0 (𝛬𝑐 ) + 𝑐𝑦 (𝛬𝑐 )𝑦𝑡 + 𝑐𝑟 (𝛬𝑐 )𝑟𝑡
- Investment:
𝑖𝑡 = 𝑖𝑡 (𝛬𝑖 ) = 𝑖0 (𝛬𝑖 ) + 𝑖𝑦 (𝛬𝑖 )𝑦𝑡 + 𝑖𝑟 (𝛬𝑖 )𝑟𝑡
The IS curve:
, IS: Households
Household spending consists of:
1 - Non-durable consumption
2
3 - Durable consumption
- Housing
The second two are counted as an
investment.
The demand side
Empirical Theoretical
1. Micro-level data + 𝑑𝑖𝑠𝑝
- “ad hoc” e.g. 𝑐𝑡 = 𝑐0 + 𝑐𝑦 𝑦𝑡
Macro-level with 𝑐0 and 𝑐𝑦 assumed constant
aggregation
𝑐𝑦 → the (marginal) propensity to consume, or the effect of an
extra £ of disposable income on consumption.
Natural restriction: 0 < 𝑐𝑦 < 1
𝑐0 → the intercept of the consumption function.
Natural restriction: 0 < 𝑐0
- Microfounded
Based on a description of the behaviour of individuals
Aggregated to get from individuals to aggregate
𝑐𝑡 = 𝑐𝑡 (𝛬𝑐 ) = 𝑐0 (𝛬𝑐 ) + 𝑐𝑦 (𝛬𝑐 )𝑦𝑡 + 𝑐𝑟 (𝛬𝑐 )𝑟𝑡
where 𝛬𝑐 may include: preferences; habits; expectations; credit
constraints…
Household’s consumption
Heterogeneity The Representative Agent
Let 𝑐ℎ,𝑡 be consumption of household h at time t. Assume that the decision of a single household
can be used to represent the aggregate
Then, if there are N households in the economy, behaviour of all households in the economy, i.e.
aggregate consumption at time t is given by: ignore heterogeneity.
𝑁
𝑐𝑡 = ∑ 𝑐ℎ,𝑡
ℎ=1
, LECTURE 1: THE DEMAND SIDE
- When macroeconomists study an economy’s current state of health, they look at 3
variables:
- Output growth
- The unemployment rate
- The inflation rate
- But other metrics are increasingly important objects of policy debates and reforms:
- Business creation, financial stability
- Consumption, wealth and income inequality
- Mortality / fertility rates, educational attainment, access to health
Demand + Supply Side
Supply Side Demand Side
What firms make What agents buy
𝑦 𝑆 = 𝑎𝑓(𝑘, 𝑛) 𝑦 𝐷 = 𝑐 + 𝑖 + 𝑔 + (𝑥 − 𝑚)
a → technology c → consumption (goods and services)
f(.,.) → a production function i → investment (capital goods)
k → capital g → government spending (goods and
n → labour / hours of work services)
x - m → export - import / trade balance
Price and wage setting
yeq → equilibrium output
𝜋 → inflation
Supply-side policies: Demand-side policies:
Labour market reforms Monetary
Competition policy Fiscal
,The Three-Equations (IS-PC-MR) Model
IS: the demand side
1. Non-durable consumption of households
2. Investment by households (durables and housing) and firms
3. Government spending (exogenous)
WS / PS: the supply side
- Imperfectly competitive labour market
- Price setting by firms
- Wage setting by firms/ workers
PC: Phillips curve
- Summarising the supply side with nominal stickiness
MR: monetary rule
- Optimal monetary policy
Identity:
𝑎𝑑 = 𝑐 + 𝑖 + 𝑔
Market clearing:
𝑦 = 𝑎𝑑
y → goods and services produced
Behavioural models:
- Consumption:
𝑐𝑡 = 𝑐𝑡 (𝛬𝑐 ) = 𝑐0 (𝛬𝑐 ) + 𝑐𝑦 (𝛬𝑐 )𝑦𝑡 + 𝑐𝑟 (𝛬𝑐 )𝑟𝑡
- Investment:
𝑖𝑡 = 𝑖𝑡 (𝛬𝑖 ) = 𝑖0 (𝛬𝑖 ) + 𝑖𝑦 (𝛬𝑖 )𝑦𝑡 + 𝑖𝑟 (𝛬𝑖 )𝑟𝑡
The IS curve:
, IS: Households
Household spending consists of:
1 - Non-durable consumption
2
3 - Durable consumption
- Housing
The second two are counted as an
investment.
The demand side
Empirical Theoretical
1. Micro-level data + 𝑑𝑖𝑠𝑝
- “ad hoc” e.g. 𝑐𝑡 = 𝑐0 + 𝑐𝑦 𝑦𝑡
Macro-level with 𝑐0 and 𝑐𝑦 assumed constant
aggregation
𝑐𝑦 → the (marginal) propensity to consume, or the effect of an
extra £ of disposable income on consumption.
Natural restriction: 0 < 𝑐𝑦 < 1
𝑐0 → the intercept of the consumption function.
Natural restriction: 0 < 𝑐0
- Microfounded
Based on a description of the behaviour of individuals
Aggregated to get from individuals to aggregate
𝑐𝑡 = 𝑐𝑡 (𝛬𝑐 ) = 𝑐0 (𝛬𝑐 ) + 𝑐𝑦 (𝛬𝑐 )𝑦𝑡 + 𝑐𝑟 (𝛬𝑐 )𝑟𝑡
where 𝛬𝑐 may include: preferences; habits; expectations; credit
constraints…
Household’s consumption
Heterogeneity The Representative Agent
Let 𝑐ℎ,𝑡 be consumption of household h at time t. Assume that the decision of a single household
can be used to represent the aggregate
Then, if there are N households in the economy, behaviour of all households in the economy, i.e.
aggregate consumption at time t is given by: ignore heterogeneity.
𝑁
𝑐𝑡 = ∑ 𝑐ℎ,𝑡
ℎ=1
