## Macroeconomics Study Guides

Keep the following two comprehensive study guides handy throughout your macroeconomics course study. They provide brief oulines for many of the major macroeconomics topics studied in this course and can help prepare you for your final economics exams.

### Principles of Macroeconomics Lecture Notes

#### Part I: Labor Demand

• In a competitive market, a firm can sell as much Y as it wants at the going
• price p, and can hire as much N as it wants at the going wage w.
• Facing w and p, a profit maximizing firm hires N to the point where
$\text{MPN = w/p}$ (the benefit from an additional worker, in terms of additional output, must equal the cost of hiring him). <<This is straight from micro>>

Why? MPN is decreasing in N, hence:

• If MPN> w/p then the firm can increase profits by increasing N.
• If MPN< w/p then the firm can increase profits by decreasing N.

• With Cobb-Douglas: $\text{MPN =.7 Y/N =.7 A (K/N).3}$
• If firms maximize profits: $\text{w/p =.7 Y/N =.7 A (K/N).3}$

#### Notes on the Labor Demand Curve

• For the moment keep A and K constant.
• $N_{d}$ slopes downward: $N_{d} =\text{ MPN =.7 A * (K/N)}^{3}$
• $N_{d}$shifts up with $A$ and $K$ (complementarity)
• Caveat: Who says that there is a demand for more Y?
• Need to look at the demand side of economy (next lectures).

#### Part II: Labor Supply

• Labor Supply Ns Results from Individual Optimization Decisions
• Households compare benefits of working (additional lifetime resources) with cost of working (forgone leisure + effort)
• How much labor an household will choose to supply as the real wage (before taxes) wp varies?
• 2 effects:
1. Substitution effect: higher real wage means higher reward to working, hence you want to work more!
2. Income effect: higher real wage means you are richer, hence you need to work less to consume the same goods!

#### Refresh your memory from Micro!

• Think of an agent who gets utility from consuming apples and bananas
• From the utility maximization problem you get

$\text{MU(apples)/ MU(bananas) = P(apples)/P(bananas)}$

• If P(apples) increases:
1. Substitution effect: you want to increase MU(apples)/ MU(bananas). By the law of diminishing marginal utility you need to consume less apples and more bananas! You subsitute away from apples towards bananas
2. Income effect: you spend more for the apples that you buy, so you are poorer. You will consume less apples AND bananas!

#### From Micro to Macro

• The two goods that the household can consume are now consumption (C) and leisure (L)
• The household can spend 1 unit of time either working (N) or having fun (L), that is $\text{N + L = 1}$
• The budget constraint is $\text{WN = PC (and P(C)=P}$ for simplicity) with $\text{N=1-L}$. Then we can write a static version of the maximization problem as:

$\text{Max U(C,L)}$

$\text{s.t. W = PC + WL}$

• The price of leisure is the foregone wages, that is $P(L) = W$. Then

$\text{MU(L)/ MU(C) = W/ P}$

• If W/P increases:
1. Substitution effect: you want to increase $\text{MU(L)/ MU(C)}$. By the law of diminishing marginal utility you need to subsitute away from leisure towards consumption goods. Then you need to work more!
2. Income effect: you have higher wages, so you are richer. You will consume more C and L. To consume more L, you need to work less!

#### Back to the Labor Supply

• In reality the household problem is not static. Define $\text{PVLR = present value of life time resources}$, that determines the household income. life time resources, that determines the household income.
• For simplicity to graph the Labor Supply we separate income and substitution effects by separating PVLR from the current real wage w/p effects by separating PVLR from the current real wage w/p.
• PVLR represents the income effect and w/p the substitution effect.
• SHORTCUT: if w/p increases permanently PVLR increases as well, BUT if w/p increases temporarily only, then PVLR increases just a tiny bit so that we assume that $PVLR$ does not change!

#### The Labor Supply Curve

• Factors Affecting Labor Supply
• The Real Wage (w/p)
• The Household's Present Value of Lifetime Resources (PVLR)
• The Marginal Tax Rate on Labor Income(tn)
• The Marginal Tax Rate on Consumption (tc)
• Value of Leisure (reservation wage) - non-'work' status (VL)
• The Working Age Population (pop)
• Labor Supply (Ns) shows the relationship between real wages and hours worked holding everything else constant (included (PVLR)!)

#### The Labor Supply Curve: Income effect

$\text{PVLR → PVLR'(< PVLR) = income effect}!$

#### What affects the Labor Supply?

• The Real Wage - HOLDING PVLR fixed: A higher w/p encourages individuals to substitute away from leisure toward work (leisure becomes more expensive). This is a substitution effect.  <<This is why the labor supply curve slopes upwards>>
• Estimating this substitution effect is difficult since PVLR is not easily held constant. Estimates range from 0 - 2 (For a 1% increase in after-tax w/p holding PVLR fixed, labor supply either increases between 0% and 2%). Very Wide Range – little consensus.
• $\text{PVLR = initial wealth + present discounted value of earnings}$
• A higher PVLR induces individuals to work less (lower Ns ) for a given after-tax wage, allowing them to enjoy more leisure (If leisure is preferred to work – as I get richer, I can afford to work less). <<This is represented by a shift of the supply curve >>
• PVLR is net of taxes and non-work governmental transfers and inclusive of all other transfers.
• Marginal tax rate on labor income- Should have same substitution effect as the before tax real wage. Studies of the 1986 U.S. Tax Reform found that only high-earning married women worked more in response to lower marginal income tax rates. income tax rates.
• Marginal tax rate on consumption - see above
• Value of Leisure - If leisure/no-work becomes more/less attractive, households will work less/more (think about welfare programs, child care,…)
• Working Age Population: Usually defined as 16-64 (includes changes in Labor Force Participation Rates)

#### Recap on Labor Supply

• Substitution Effect:

– For a given PVLR, a higher after tax wage increases $NS$.

• This is why Labor Supply Curve Slopes Upward
• Income Effect

– For a given after-tax wage, higher PVLR decreases (Ns).

• Evidence:

– Weak Consensus is that, with equal (%) increase in PVLR and after-tax wage, (Ns)falls (income effect dominates)

#### Permanent Increase in A

N* < N" → Here income effect is dominated!

#### Can Technological Progress destroy jobs?

Facts:

A N w/p are trending up over time A, N, w/p are trending up over time.

N/pop is trending down (except in U.S. since 1980).

Higher A countries have higher w/p and lower N/pop.

Implications:

Adjusting for pop, higher A goes with lower N.

Higher A reduces Nd and destroys jobs? - NO! Labor Demand Increases.

Higher A increases PVLR and reduces Ns.It is Labor Supply that falls

#### Temporary Increase in Taxes (tc or tn)

After tax wage SHIFTS the supply curve!!

#### Permanent Increase in Taxes (tc or tn)

Income effect can dominate or not! Try the other case

#### Labor Market Equilibrium (Long Run)

• We define Long Run Equilibrium in macroeconomics as occurring when the labor market clears.
• By definition, long run macro equilibrium exists when $\text{N = N*}$.
• At N*, labor demand = labor supply. So, by definition, all workers who want a job (the suppliers) are able to find a firm looking for a worker (the demanders).
Long run equilibrium is characterized by zero cyclical unemployment!
• It is an equilibrium such that there is no incentive for real wages to change at N*
Real wages have 2 components: nominal wages (w) and the price level (p).
• Define Y* as the long run equilibrium level of output (output when labor market is in equilibrium):
$\text{Y* = A K.3(N*).7}$

#### Long Run Aggregate Supply

• Suppose prices (p) increase. What happens in the labor market?
• In terms of equilibrium, nothing happens!
• Increasing prices have no effect on labor demand (A and K do not change).
• Increasing prices have no effect on labor supply (taxes, population, etc. do not change).
• You may ask "Doesn't PVLR change when prices increase???" No!
• As long as nominal wages adjust, real wages will be unchanged when p increases.
• The % change in prices will be matched exactly by the % change in nominal wages – real wages will not change (so PVLR will not change).
• No effect on labor supply.
• Key: Because real wages will not change, changes in prices will have NO effect on the labor market (.e., it will have no effect on N).*
• Conclusion: Changing prices will have NO effect on Y* (since N* is constant).

#### Long Run Aggregate Supply curve

• If labor market clears, changes in prices will lead to equal changes in nominal wages.
As a result, there will be no change in N* and hence no change in Y*.
• Leads to a vertical LRAS curve. Prices do not affect production in the long run!

#### What shifts Y*? (the LRAS)

• Anything that affects the labor market will affect Y*!
• If N* increases, Y* will shift to the right.
• If N* decreases, Y* will shift to the left.
• Summary: Y* will shift right if:
• A increases
• K increases
• population increases
• labor income taxes fall (and income effect is small relative to substitution effect)
• labor income taxes rise (and income effect is large relative to substitution effect)

#### Take out

• In the long run – when labor markets clear.
– Supply side of economy (labor market, K, A, other inputs like oil) determines output.
– Demand side of economy (C+I+G+NX) will determine prices.
• In the short run – when labor markets do not clear:
– Demand and Supply jointly determine prices and output.
– Three outstanding issues (we will get to them soon):
• What determines demand?
• When is the labor market NOT in equilibrium?
• What does the supply curve look like when labor market doesn't clear?

#### Preview: Disequilibrium in Labor Markets

• When do we get cyclical unemployment in our models? So far NO unemployment! We need some frictions  in the labor market to get cyclical unemployment.
• Cyclical unemployment occurs when labor demand is smaller than labor supply at current wages (one story: nominal wages do not adjust to clear the labor market).
• Cyclical unemployment occurs only in disequilibrium!

#### Trends in Actual (Standardized) Unemployment Rates

 1994 1996 1998 2000 2001 2002 2004 2007 200802 Britain 9.6 8.2 6.3 5.5 5 5.1 4.7 5.3 5.4 Japan 2.9 3.4 4.1 4.7 5 5.4 4.7 3.9 4 USA 6.1 5.4 4.5 4.0 4.8 6 5.5 4.6 5.3 France 12.3 12.4 11.7 9.5 8.5 8.9 9.6 8.3 7.7 Germany 8.4 8.9 9.4 7.9 7.7 8.7 9.5 8.4 7.4 Spain 24.1 22.1 18.3 14.1 10.6 11.3 10.9 8.3 10.6 Poland 18.5 19.8 18.8 9.6 7.3

#### Why is Unemployment So High In Europe?

1. High labor income tax rates (tn)
2. Firing restrictions
3. Centralized wage setting
4. High minimum wages
5. Powerful unions and insiders
6. Generous unemployment benefits