Macroeconomics and Business -...

1

Executive Master in

Management and Banking

João César das Neves1

Macroeconomics and Business


João César das Neves

Winter 2012/13

Executive Master in




This Session

Economic policy: problems andissues• Questions of the national economy

• Types of economic policy• Aggregate problems• Reality and issues

Macroeconomics and BusinessSession 1

2

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João César das Neves• Mail: [email protected]• Home phone: 217214270• Mobile phone: non existent• Office: 5319, 3rd floor FCEE

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3

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Paul Krugman (1953-...) 2008 winner of the SverigesRiksbank Prize in Economic Sciences in Memory of Alfred Nobel

WND Books 2009

Los Libros del Lince, 2009

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-5

-4

-3

-2

-1

0

1

2

3

4

5

2004 2006 2008 2010 2012

GDP growth

Portugal

Euro zone

USA

Spain

2

4

6

8

10

12

14

16

18

20

22

2004 2006 2008 2010 2012

Unemployment rate

Portugal

Euro zone

USA

Spain

4

Executive Master in




Growth in 2009

-9

-7

-5

-3

-1

1

3

Slo

ven

ia

Fin

lan

d

Irela

nd

Ro

ma

nia

Hu

ng

ary

Jap

an

Ge

rma

ny

Italy

Bu

lga

ria

De

nm

ark

Sw

ed

en

Un

ited

Kin

gd

om

Slo

vakia

Cze

ch R

ep

ub

lic

EU

Eu

ro a

rea

Ne

the

rlan

ds

Sp

ain

Au

stria

Lu

xem

bo

urg

Be

lgiu

m

Po

rtug

al

US

A

Fra

nce

Gre

ece

Ma

lta

Cyp

rus

Po

lan

d

Esto

nia

Lith

ua

nia

La

tvia

14.1 15 18

Executive Master in




Unemployment in 2010

0

5

10

15

20

25

Ne

the

rlan

ds

Au

stria

Jap

an

Lu

xem

bo

urg

Cyp

rus

De

nm

ark

Slo

ven

ia

Ma

lta

Un

ited

Kin

gd

om

Ge

rma

ny

Bu

lga

ria

Cze

ch R

ep

ub

lic

Ro

ma

nia

Italy

Be

lgiu

m

Sw

ed

en

Po

lan

d

Fin

lan

d

US

A

EU

Po

rtug

al

Fra

nce

Eu

ro a

rea

Hu

ng

ary

Gre

ece

Irela

nd

Slo

vakia

Esto

nia

Lith

ua

nia

Sp

ain

La

tvia

5

Executive Master in




The «Great Recession»growth of world GDP (%)

-2

-1

0

1

2

3

4

5

6

7

8

1950 1960 1970 1980 1990 2000 2010

%

First oil shock

Second oil shock Gulf warFar-East crisis

September 11

2008 crisis

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Unemployment rate USA

0.00

5.00

10.00

15.00

20.00

25.00

1890 1910 1930 1950 1970 1990 2010

1893 panic

Great Depression

First oil shock

Volker recession

Great recession

6

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2009 2010IMF (WEO) forecasts

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2011 2012

IMF (WEO) forecasts

7

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2013

IMF (WEO) forecasts

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Portugal

IMF (WEO) forecasts

8

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Preliminary program

Executive Master Management and Banking


1. Aggregate problems and approaches2. The Low Frequencies: Development3. The High Frequencies: Business Cycle4. Money and monetary problems5. Policy issues6. Open economy issues

Final (open book) test

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Two aspects of method1 – University method

9

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Two aspects of method2- TV cooking method

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Some Basic References

Williamson, Stephen (2010) Macroeconomics, Addison Wesley, Boston USA, 4th edition.

Kydland, F. and E., Prescott (1990) “Business Cycles: Real facts and a Monetary Myth”, Federal Reserve Bank of Minneapolis

http://minneapolisfed.org/research/qr/qr1421.pdf

Lucas Jr., Robert E. (1977) “Understanding Business Cycles,” in Lucas (1981) Studies in Business Cycles Theory, MIT Press p.215-39.

Neves, J.C. (2012) As 10 questões da crise, 3ª ed., Dom Quixote, Lisboa

Neves, J. (2006) ) Dois milhões de Anos de Economia, Universidade Católica Editora, Lisboa 3rd edition.

10

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Site of the coursewww.clsbe.lisboa.ucp.pt/docentes/url/jcn/MaBES

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Two guest stars

Alan Greenspan(New York, 1926-…)

Fed chairman 1987 – 2006

Edward Christian Prescott(Glenn Falls,1940-…)

Nobel prize winner 2004

11

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Kenneth S. Rogoff(Rochester, 1953-…) Harvard University

Carmen M. CastellanosReinhart (Havana, 1955-…)

Maryland University

Guest from the crisis

Raghuram G. Rajan(Bhopal, 1963- …)

University of Chicago

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One special guest star

Ben Bernanke(South Carolina, 1953-…)Fed chairman since 2006

12

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The rule of policy

«In reviewing a policy, I always asked myself the question, What are the costs to the economy if we are wrong? If there is no downside risk, you can try any policy you want. If the cost of failure is potentially very large, you should avoid the policy even if the probability of success is better than fifty-fifty, because you cannot accept the cost of failure»

Alan Greenspan (2007) The Age of Turbulence, Adventures in a new world, The Penguin Press, New York, p. 68.

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Three lessons

«There are at least three lessons here. First: Context matters. Take what you read in the paper with a many grains of historical salt. Second: Current data often provide poor guidance for effective policy making. To make forward-looking policies you have to understand the past. Finally: Establish good rules, change them infrequently and judiciously, and turn the people loose upon the economy. Booms will follow.»

(op. cit. p.3)

13

Executive Master in




1.Aggregate problems and approaches1.1. Types of aggregate problems

Neves, J. (2011) Introdução à Economia, Editorial Verbo, Lisboa 9th edition c. III B) 1

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Types of aggregate problems

• Economic development•Rise in welfare•Strong transformation of society

• Short-term fluctuations•Recessions and expansions•Unemployment• Inflation •Severe crises

14

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RC F AS

Br

Ba

Ec

Executive Master in




RC F AS

Br 2

Ba 4

Ec 2

15

Executive Master in




RC F AS

Br 2 8

Ba 4 2

Ec 2 8

Executive Master in




RC F AS

Br 2 8 6

Ba 4 2 12

Ec 2 8 0

16

Executive Master in




RC F AS

Br 2 8 6 16

Ba 4 2 12 18

Ec 2 8 0 10

Executive Master in




PBr=PBa=PEc=

RC F AS

Br 2 8 6 16

Ba 4 2 12 18

Ec 2 8 0 10

17

Executive Master in




PBr=1PBa=2PEc=3

RC F AS

Br 2 8 6 16

Ba 4 2 12 18

Ec 2 8 0 10

RC F AS

Br 2 8 6 16

Ba 8

Ec

Executive Master in




PBr=1PBa=2PEc=3

RC F AS

Br 2 8 6 16

Ba 4 2 12 18

Ec 2 8 0 10

RC F AS

Br 2 8 6 16

Ba 8 4 24 36

Ec 6 24 0 30

18

Executive Master in




PBr=1PBa=2PEc=3

RC F AS

Br 2 8 6 16

Ba 4 2 12 18

Ec 2 8 0 10

RC F AS

Br 2 8 6 16

Ba 8 4 24 36

Ec 6 24 0 30

16 36 30 82

Executive Master in




Jean-Baptiste SAY

Lyon 1776 – Paris 18321803 - Traité de Économie Politique

19

Executive Master in




PBr=1PBa=2PEc=3

RC F AS JBS

Br 2 8 6 6 22

Ba 8 4 24 24 60

Ec 6 24 0 0 30

16 36 30 30 112S D

Br

Ba

Ec

Executive Master in




PBr=1PBa=2PEc=3

RC F AS JBS

Br 2 8 6 6 22

Ba 8 4 24 24 60

Ec 6 24 0 0 30

16 36 30 30 112S D

Br 16

Ba 36

Ec 60

20

Executive Master in




PBr=1PBa=2PEc=3

RC F AS JBS

Br 2 8 6 6 22

Ba 8 4 24 24 60

Ec 6 24 0 0 30

16 36 30 30 112S D

Br 16 22

Ba 36 60

Ec 60 30

Executive Master in




PBr=1PBa=2PEc=3

RC F AS JBS

Br 2 8 6 6 22

Ba 8 4 24 24 60

Ec 6 24 0 0 30

16 36 30 30 112S D ExS

Br 16 22

Ba 36 60

Ec 60 30

21

Executive Master in




PBr=1PBa=2PEc=3

RC F AS JBS

Br 2 8 6 6 22

Ba 8 4 24 24 60

Ec 6 24 0 0 30

16 36 30 30 112S D ExS

Br 16 22 -6

Ba 36 60 -24

Ec 60 30 30

Executive Master in




PBr=1PBa=2PEc=3

RC F AS JBS

Br 2 8 6 6 22

Ba 8 4 24 24 60

Ec 6 24 0 0 30

16 36 30 30 112S D ExS

Br 16 22 -6

Ba 36 60 -24

Ec 60 30 30

112 112 0

Say’s Law

22

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PBr=1PBa=2PEc=3

RC F AS

Br 2 8 6 16

Ba 8 4 24 36

Ec 6 24 0 30

16 36 30 82

PBr=0.5

PBa=1

PEc=1.5

Executive Master in




PBr=0.5PBa=1PEc=1.5

RC F AS

Br

Ba

Ec

RC F AS

Br 2 8 6 16

Ba 8 4 24 36

Ec 6 24 0 30

16 36 30 82

23

Executive Master in




PBr=0.5PBa=1PEc=1.5

RC F AS

Br -

Ba -

Ec -

RC F AS

Br 2 8 6 16

Ba 8 4 24 36

Ec 6 24 0 30

16 36 30 82

Executive Master in




PBr=0.5PBa=1PEc=1.5

RC F AS

Br - 4 3 7

Ba 4 - 12 16

Ec 3 12 - 15

7 16 15 38

RC F AS

Br 2 8 6 16

Ba 8 4 24 36

Ec 6 24 0 30

16 36 30 82

24

Executive Master in




PBr=0.5PBa=1PEc=1.5

RC F AS

Br - 4 3 7

Ba 4 - 12 16

Ec 3 12 - 15

7 16 15 38

RC= 7

F= 16

AS= 15

Executive Master in




PBr=0.5PBa=1PEc=1.5

RC F AS

Br - 4 3 7

Ba 4 - 12 16

Ec 3 12 - 15

7 16 15 38

+ 4 + 3 14

12

12

+ 4 + 12

10

28

0 + 3 + 12

7

16

15

RC= 7

F= 16

AS= 15

25

Executive Master in




RC F AS

Br - 4 3 7

Ba 4 - 12 16

Ec 3 12 - 15

7 16 15 38

RC F AS

Br - 4 1 5

Ba 1 - 10 11

Ec 3 12 - 15

4 16 11 31

RC: 3Ba = 3MAS: 4Br+2Ba=4M

S D ExS

Br 7 5 2

Ba 16 11 5

Ec 15 15 0

38 31 7

Executive Master in




Marie-Ésprit LÉON WALRAS

Evreux (França) 1834 - Clarens (Suíça) 19101874-77 - Élements d'Économie Politique Pure

[2ªed. 1889, 3ªed. 1896, 4ªed. 1900, 5ªed. 1926]

26

Executive Master in




RC F AS

Br - 4 1 5

Ba 1 - 10 11

Ec 3 12 - 15

4 16 11 31

S D ExS

Br 7 5 2

Ba 16 11 5

Ec 15 15 0

38 31 7

RC: 3Ba = 3MAS: 4Br+2Ba=4M

7M

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Walras’ Law

D

S

27

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Gross Domestic Product per capita Portugal 1833-2011

0

2000

4000

6000

8000

10000

12000

14000

16000

18000

1833 1883 1933 1983

€, p

.20

10

Executive Master in




GDP per capita1800-2012

0

5000

10000

15000

20000

25000

30000

35000

1800 1850 1900 1950 2000

USA

Portugal

Brazil

Spain

Angola

28

Executive Master in




Business Cycles (real GDP growth)1833-2011

-30

-20

-10

0

10

20

30

40

1833 1853 1873 1893 1913 1933 1953 1973 1993

%

Executive Master in




Business Cycles(av. 3-years GDP gr.) 1953-2012

-2

-1

0

1

2

3

4

5

6

1953 1963 1973 1983 1993 2003

Port

Spain

EUA

Brazil

29

Executive Master in




Business Cycles (av. 3-years GDP gr.) 1953-2012

-9

-7

-5

-3

-1

1

3

5

7

9

1953 1963 1973 1983 1993 2003

Port

Spain

EUA

Brazil

Angola

Executive Master in




Inflation rate Portugal, 1833-2011

-30

-20

-10

0

10

20

30

40

50

60

70

1833 1853 1873 1893 1913 1933 1953 1973 1993

%

30

Executive Master in




Inflation rate 1960-2012

0

5

10

15

20

25

30

1960 1970 1980 1990 2000 2010

Portugal

Spain

US

EU-12

Executive Master in





-20

0

20

40

60

80

100

1960 1970 1980 1990 2000 2010

Portugal

Spain

US

EU-12

Brazil

Angola

31

Executive Master in





-800

200

1200

2200

3200

4200

5200

1960 1970 1980 1990 2000

Brazil

Angola

Executive Master in




Unemployment rate Portugal, 1952-2013

0

2

4

6

8

10

12

14

16

18

1952 1962 1972 1982 1992 2002 2012

MF

OCDE

UE

UCP

IMF

32

Executive Master in




Unemployment rate1960-2012

0

2

4

6

8

10

12

14

16

18

20

1960 1970 1980 1990 2000 2010

Spain

Port

EU-12

US

Brazil

Executive Master in




This Session

Economic policy: problems andissues• The macroeconomic approach

• The problems identified• The models to assess them

Macroeconomics and BusinessSession 2

33

Executive Master in




1.Aggregate problems and approaches1.2. Structures of aggregate problems

Williamson, Stephen (2010) Macroeconomics, Addison Wesley, Boston USA, 4th edition, c.1

Lucas, R.(1988) «What do economists do?» The 411th convocation address at the University of Chicago (December 9, 1988)

Executive Master in




Problems of the aggregate economy

1. Spectral band• Low frequency problems - long-term

growth• High frequency problems - business cycle

2. Types of value• Real issues• Nominal issues

3. Economic sectors• Private agents• Policy interventions

34

Executive Master in




Portugal: GDP (log) and HPtrend

9

9.5

10

10.5

11

11.5

12

1953 1963 1973 1983 1993 2003

Executive Master in




Portugal: GDPcycle

-0.1

-0.08

-0.06

-0.04

-0.02

0

0.02

0.04

0.06

0.08

0.1

1953 1963 1973 1983 1993 2003

35

Executive Master in




Relative importance of growth and cycles

Lucas calculationsLets suppose consumption evolves with a growth

component and cycle component, with the rule:

where m is the long term rate of growth and s is the volatility of the cycle component (which has average 1)

In the USA output trend, m = 3% and s = 1,3%.Lucas asks what is the increase in consumption today

that would compensate for a variation of long term growth rate and for a elimination of fluctuations.

21.

2(1 ). 0,1,2,...,s

t tc m e z t−

= + =

Executive Master in




Variation in long term growth

m Compensation

1% 45%

2% 20%

3% 0

4% - 17%

5% - 31%

6% - 42%

Lucas Jr., Robert E. (1987) Models of Business Cycles, Basil Blackwell, chapter III

Interpretation

• The consumers would require an increase of 20% to be compensated

from a reduction of growth rate from 3% to 2%

• They would accept a reduction of 42% of current consumption if growth rate increased to 6%.

36

Executive Master in




Variation in volatility

CRA\s 1,3% 3,9% 12%

1 0,008% 0,072% 0,65%

5 0,042% 0,38% 3,4%

10 0,084% 0,76% 6,8%

20 0,17% 1,5% 13,6%

Lucas Jr., Robert E. (1987) op. cit.

Interpretation• If the volatility of American GDP (1,3%) was eliminated, consumers would gain the

equivalent of much less than 0,2% of consumption

(depending of their relative risk aversion, CRA)

• If volatility was 10 times larger, the benefit of its

elimination would still be much smaller than anything related to

growth

Executive Master in




Economic structure of the issues

Changes of Output per Worker

Secular growth Business cycle

Due to changes in capital 1/3 0

Due to changes in labour 0 2/3

Due to changes in productivity 2/3 1/3

Source: Cooley, Thomas (ed) (1995) Frontiers of Business Cycle Research, Princeton University Press, p.11

37

Executive Master in




“Understanding Business Cycles”

“One exhibits understanding of business cycles by constructing a model in the most literal sense: a fully articulated artificial economy which behaves through time so as to imitate closely the time series behaviour of actual economics”

Lucas, R. (1977) "Understanding Business Cycles"

Executive Master in




Model 1 - Five Monkeys and a banana

• How will five monkeys that have not been fed for a day react to one banana being thrown into their cage?• Let us take our banana, cut it into five pieces,

give each to of the five monkeys one piece, and impose on them the rule they may interact only by exchanging banana pieces for minutes of backscratching, at some fixed rate (I confess to having no idea how this imposition might be effected in practice).

• We can predict the outcome of this interaction (equilibrium price and quantities exchanged), at least given sufficient computational ability.

in Lucas, R. (1980) “Methods and Problems in Business Cycle Theory”

38

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Model 2 – Recession in a park

• The location I have in mind is an old-fashioned amusement park (...) At the gate, visitors use U.S. dollars to purchase tickets and than enter the park and spend the tickets.• “GNP” in the park (total tickets spent) and employment

(the number of man hours worked) will fluctuate from one day to the next due to fluctuations in demand.

• Then, with no advance warning to anyone inside the park, and no communication to them as to what is going on, the cashiers are instructed for this one day to give 8 tickets per dollar instead of 10. What will happen?

• What I have done, in short, is to engineer a depression in the park.

Lucas, R.(1988) «What do economists do?» The 411th convocation address at the University of Chicago (December 9, 1988)

Executive Master in




Models and the crisis

«One thing we are not going to have, now or ever, is a set of models that forecasts sudden falls in the value of financial assets, like the declines that followed the failure of Lehman Brothers in September [2008]. This is nothing new. It has been known for more than 40 years and is one of the main implications of Eugene Fama’s “efficient-market hypothesis” (EMH), which states that the price of a financial asset reflects all relevant, generally available information. If an economist had a formula that could reliably forecast crises a week in advance, say, then that formula would become part of generally available information and prices would fall a week earlier.»

Lucas, Robert E. (2009) “In defence of the dismal science”, in The Economist, August 6th, 2009

39

Executive Master in




1.Aggregate problems and approaches1.3. Walrasian Equilibrium Models

Williamson, Stephen (2010) Macroeconomics, Addison Wesley, Boston USA, 4th edition, c. 2 and 4

Executive Master in




Marie-Ésprit LÉON WALRAS

Evreux (França) 1834 - Clarens (Suíça) 1910

1874-77 - Élements d'Économie Politique Pure[2ªed. 1889, 3ªed. 1896, 4ªed. 1900, 5ªed. 1926]

40

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Economic circuit

Families Firms

GOODS Market

RESOURCESMarketResources

GoodsExpenditure

Income

Executive Master in




BEHAVIOUR OF FAMILIES

Max U(Goods, Leisure)

BUDGET CONSTRAINT OF THE FAMILIES (F)sources: wages + interests + transfers (Pub., For.) -

taxes =

usages: consumption + investment + bond purchases(net) + increase in money holdings (net)

w/p.L + ρ.K + r.(B+B*)/p + (TrF + Tr*F) - TF = C + IF+ (∆B+∆B*)/p + (∆M+∆M*)/p

Families

41

Executive Master in




BEHAVIOUR OF FIRMS

Max Profits

BUDGET CONSTRAINT OF THE FIRMS (E)sources: production =usages: wages + interests + profits of the firms

Y = w/p.L + (1+r).K - (1-δ).K + profits- Including the transfers in the firm’s profits

profits + TrE + Tr*E = TE + IE

Y - TrE - Tr*E = (w/p.L + (r+δ).K) + TE + IE

Note: ρ = r+δ

Firms

Executive Master in




Families (F) Firms (E)

GOODS Market

RESOURCES MarketResources

GoodsExpenditure

Income

Public St (G)

Foreign St*

Economic circuit

42

Executive Master in




BUDGET CONSTRAINT OF THE PUBLICSECTOR (G)

(National Budget)sources: taxes + loans issued + new money

issues

usages: current consumption+ transfers + debtinterests + public investiment

T + ∆B/p + ∆M/p = G + Tr + r.B/p + IG

Budget constraint: Public sector

Executive Master in




Portugal, public balance/GDP 1947-2011

-14.0

-12.0

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

1945 1955 1965 1975 1985 1995 2005

43

Executive Master in




Public Balance/GDP 1995-2012

-12

-10

-8

-6

-4

-2

01995 2000 2005 2010

%

Tot.Balance

exc.temp.meas.

adj.cic+med.

Pact

Executive Master in




Public balance/GDP 1970-2012

-20

-15

-10

-5

0

5

1970 1980 1990 2000 2010

Spain

Portugal

US

EU-15

Brazil

Angola

44

Executive Master in




BUDGET CONSTRAINT OF THE FOREIGNSECTOR (X)

(BALANCE OF PAYMENTS)sources: Exports - Imports + Inflows of transfers

and factor income (net)

usages: Inflow of assets (net) – ForeignInvestiment + Inflows of reserves of foreigncurrency

Ex - Im + Tr* + r.B*/p = ∆B*/p - IX + ∆M*/p

Budget constraint : Foreign sector

Executive Master in




Current Balance (BC + BK)

-15

-10

-5

0

5

10

1970 1980 1990 2000 2010

%

45

Executive Master in




Current Account(%GDP)

-15

-12

-9

-6

-3

0

3

6

1960 1970 1980 1990 2000 2010Spain

Portugal

Brazil

US

Executive Master in




Current Account(%GDP)

-15

-12

-9

-6

-3

0

3

6

9

12

15

1960 1970 1980 1990 2000 2010

Spain

Portugal

Angola

Brazil

US

46

Executive Master in




FAMILIES w/p.L + (r+δ).K + r.(B+B*)/p + (TrF + Tr*F ) - TF - C

= SF = IF + (∆B+∆B*)/p + (∆M+∆M*)/pFIRMS ( as Y = F(K,L) )Y + TrE + Tr*E - (w/p.L + (r+δ).K) - TE = IE =

Retained earnings = SE

PUBLIC SECTOR[ T- G - Tr - r.B/p] = - Budget Deficit = SG = IG - ∆B/p

- ∆M/pFOREIGN SECTOR [Im - Ex - Tr* - r.B*/p] = CA Deficit = SX = IX - ∆B*/p

- ∆M*/p

Walras’ law 1/4

Executive Master in




Adding all constraints

IF + (∆B+∆B*)/p + (∆M+∆M*)/p + IE + IG - ∆B/p -∆M/p + IX - ∆B*/p - ∆M*/p =

= [w/p.L + (r+δ).K + r.(B+B*)/p + (TrF + Tr*F ) - TF - C] + [Y + TrE + Tr*E - (w/p.L + (r+δ).K) - TE] + [ T- G - Tr - r.B/p] + [Im - Ex - Tr* - r.B*/p]

(A)

Walras’ law 2/4

47

Executive Master in




From equation (A) we may obtain:A) Savings = Investment

Cancelling ∆B, ∆B*,∆M,∆M* and using the definition of S:IF + IE + IG + IX = SF + SE + SG + SX � I = S

where I = ∆K + δK <=> Kt+1 = I + (1-δ) K B) Product = Expenditure

Cancelling similar terms:I = - C + Y - G + Im - Ex �Y = C + G + I + Ex –Im

C) Product = Income

Directly form the firms constraintY = w.L + (r+ δ)K + Lu

Walras’ law 3/4

Executive Master in




D) Walras’ Law

Defining D = C + G + I + Ex - Im and noting that families demand (D) and State and Foreign sectors supply (S) bonds and money

Y + ∆BS/p+∆B*S/p + ∆MS/p+∆M*S/p = D + ∆BD/p + ∆B*D/p + ∆MD/p + ∆MD*/p

Total supply = Total demand[Y - D] + [∆BS/p -∆BD/p] + [∆B*S/p -∆B*D/p] + [∆MS/p

-∆MD/p] + [∆M*S/p - ∆MD*/p] = 0If all markets but one are in equilibrium, the last is

also in equilibrium

Walras’ law 4/4

48

Executive Master in




Portugal, savings by sector (%)

-10

0

10

20

30

40

50

1953 1963 1973 1983 1993 2003

Families

FirmsFor.

Pub.

Executive Master in




Portugal, lending/borrowing requirements by sector (%)

-15

-10

-5

0

5

10

15

1999.75 2001.75 2003.75 2005.75 2007.75 2009.75 2011.75

Firms

Banks

Public S.

Families

Foreign S.

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Executive Master in




Keynes (1936 p.25-26) criticized what he called «Say’s law»: «supply creates its own demand», from which he deduced that «there are no obstacles to full employment».

In his book, Keynes manipulated the theories of his predecessors, who never defended the positions he attributed to them. The meaning of this «law» is, thus, much debated among specialists.

One simple interpretation of Say’s Law consists in the application of Walras’ Law to the case of barter. In this case total demand of goods equals total supply of goods and the there can never be

global underemployment.

Jean Baptiste Say

(1776-1832)

Say’s Law and Walras’ law

Executive Master in




Economic decisions

• Global movements of the economy will be understood as the aggregation of individual decisions by families and firms, in response to economic shocks and policies.

• The model, unlike its predecessors of the 1950s and 1960s, will have «microeconomic foundations», thus avoiding the schizophrenia caused by the division between Microeconomics and Macroeconomics.

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Executive Master in




Families• Intra-temporal decisions:

• Choice between labour and consumption• Change in income - income effect• Change in wage rate - income and substitution effects

• Inter-temporal decisions• Choice between consuming today or tomorrow

• Change in wealth - wealth effect• Change in interest rate - wealth and inter-temporal

effects

Firms• Intra-temporal decisions:

• Production choice• Technological shock

Executive Master in




Families: intratemporal decision

C = w/p.(H - D) + (r+δ).K - T

C Consumption

H D Leisure

w/p.H + (r+δ).K - T

Max U(C, D)

MRSC,D = U’C/U’D= p/w

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Executive Master in




Solution of utility maximization

Max U(C, D)

s.t. C = w/p.(H - D) + (r+δ).K - T

L = U(C,D) + λ.[C - w/p.(H - D) - (r+δ).K + T]

Rest one hour = U’D

Work that hour and get w/p units of consumption, with utility w/p U’C

U’D = w/p U’C � U’C /U’D = p/w

Executive Master in




Families: Income effectchange in (r+δ).K

H D

w/p.H + (r+δ).K - T

Income effect: Being richer, increases consumption and

leisure, reducing labour

C

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Executive Master in




Families: Income and substitution effects – change in w

C

H Leisure D

w/p.H + (r+δ).K - T

Substitution effect:Labour being better rewarded,

consumption is cheaper. This reduces leisure and increases consumption

Income effect:Being richer

increases leisure and consumption

Executive Master in




1650

1700

1750

1800

1850

1900

1950

2000

2050

200 220 240 260 280 300 320

Ave

rage

hou

rs w

orke

d pe

r pe

rson

Real Wage (index 1953=100)

Hours worked vs Real wagePortugal

Source: OECD

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Executive Master in




Families: intertemporal decision

• Another decision has to do with the passage of time. Every year, the consumer faces the restriction

(where Ydi= w/p.Li + ρ.Ki - T)Ydt + (1+r).B0/p = Ct + Bt/p

Ydt+1 + (1+r).Bt/p = Ct+1 + Bt+1/p Solving the system by eliminating B1:

1 1 10

/p/p.(1 )

1 1 1t t t

t t

Yd B CB r Yd C

r r r+ + ++ + + − = +

+ + +

W

Executive Master in




Families: intertemporal decision

Ct+1 Future Consumption

W Ct Present Consumption

W.(1+r)

1

1t

t

CW C

r+= +

+

IMRS = UCt+1/UC = 1/(1+r)

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Executive Master in




Solution of utility maximization

Max U(Ct+1, Ct)

s.t. W = Ct + Ct+1/(1+r)

L = U(Ct+1, Ct) + λ.[W - Ct - Ct+1/(1+r)]

Consume one unit = U’Ct

Save that unit, get the interest (1+r) and consume it next year, with utility (1+r) U’C+1

U’Ct = (1+r) U’Ct+1

� U’Ct+1 /U’Ct = 1/(1+r)

Executive Master in




Fisher separability theorem 1/2


W.(1+r)

consumption

production

savings

(1+r). savings


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Executive Master in





W.(1+r)

consumption

production

debt

(1+r). debt


Fisher separability theorem 2/2

Executive Master in




Families: Wealth effect –change in W


W.(1+r)

Wealth effect: An increase in disposable

income in any period is spread throughout the

timeline


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Executive Master in




Families: Wealth and substitution effects – change in r


W.(1+r)

Substitution effect:the increase in the interest rate will increase savings and future consumption, by

reducing present consumption

Wealth effect:Being richer increases all

consumptions


Executive Master in




Economic Agents: Families

DECISIONS OF THE FAMILIES

- Labour Supply:• intratemporal substitution effect wt ⇒ Lt

• intertemporal substitution effect wt+1 ⇒Lt

- Consumption Decision:• Intertemporal income effect

Ydt ⇒ Ct , Ct+1 , Ct+2 ...• Intertemporal substitution effect

r (Ydt ) ⇒ Ct , Ct+i

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Executive Master in




Firms: intratemporal decision

Y Output

L* Labor L

profits = Y – w/p.L - (r+ δ).K

Y = F(K,L)

MPL

w/p

L* L

F’L= w/p

Executive Master in




Firms: Technological improvementY

Labor L

MPL

w/p

L* L

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Executive Master in




DECISIONS OF THE FIRMS

Demand for Labour w = p.PML

Demand for Capital ρ = p.PMK

cost of the rent of capital ρ = r+δ

Economic Agents: Firms

Executive Master in




The theorem of «Invisible Hand»1- Pareto’s optimum

«An optimum is defined as an attainable state such that, within the limitations imposed by the consumption sets, the production sets, and the total resources of the economy, one cannot satisfy better the preferences of any consumer without satisfying less well those of

another»G. Debreu (1959) Theory of Value – An axiomatic Analysis of

Economic Equilibrium, cap.6, p.90

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Executive Master in




VILFREDO PARETOParis 1848 – Geneve 1923

1906 - Manuel d’Économie Politique

Executive Master in




«It is shown, under certain weak assumptions, that, if an attainable state of an economy is an equilibrium relative to a price system, that state is an optimum (...) A converse assertion is proved under somewhat different assumptions: if an attainable state of an economy is an optimum, there is a price system relative to which that state is an equilibrium. To sum up briefly, an attainable state is an optimum if and only if there is a price system to which all the agents are adapted in the way described above. These two essential theorems of the theory of value thus explain the role of prices in an economy»

G. Debreu op. cit., cap.6, p.90

The theorem of «Invisible Hand»2- Fundamental theorems of welfare

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Executive Master in




1952 – Arrow,K and G. Debreu 'Existence of an equilibrium for a competitive economy‘, Econometrica, vol. XXII, 265-90

1959 – Debreu, G. Theory of Value, New York: Wiley.

The theorem of «Invisible Hand»

KENNETH J. ARROW

New York 1921- ...

GERARD DEBREU

Calais (França) 1921- 2004

Executive Master in




General equilibrium

Output

Y

Labor L

C

D

Families

FirmsY

L

F’L= w/p

U’C/U’D= p/w

MRS = w/p = MRT

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Executive Master in




The crucial element

«How much has America’s political system –its protection of individual rights, especially property rights, and its relative low degree of regulation and low incidence of corruption– contributed to the gap between standards of living of U.S. residents and those of developing countries? I suspect a great deal.»

Alan Greenspan (2007) op. cit. p. 388.

Executive Master in




Not a little delicate machine

«The sky is not falling. No need to panic and start playing around with all sorts of policy responses. Despite the impression created by some economic pundits, the U.S. economy is not a delicate little machine that needs to be fine-tuned with exact precision by benevolent policymakers to keep from breaking down. Rather, it is large and complex, with millions of people making billions of decisions every day to improve their lives, the lives of their families and the health of their businesses.

On the one hand, it’s difficult to screw up all these well-intentioned people by crafting bad policy, but, on the other hand, it is of course entirely possible to do so. And once things are broken, they are much harder to fix. (…). This economy is fundamentally sound.»

(op. cit. p.1)

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