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A Dynamic Macroeconomic Model Notes

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A Dynamic Macroeconomic Model Summary
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Key Points

The Dynamic Macroeconomic Model The Representative Household The Representative Firm Government

The Dynamic Macroeconomic Model

* Putting together household consumption behaviour and firm behaviour to build a complete macroeconomic model

* Study the economy in general equilibrium

* General Equilibrium = Equilibrium in all markets

* We use the model as a benchmark for studying the effects of shocks

* We place an emphasis on expectations about the future

* Two time periods: the present and future
* The length of time in each period may depend on the context
? For business cycles, the current period will be the current year or quarter
? For longer term issues, the current period may be the current decade or longer
# i.e. productivity trends

* Closed economy = No international trade

* 3 agents in the economy: a. A representative household
? Makes a consumption vs. leisure decision, and a consumption now vs. saving decision b. A representative firm
? Makes a labour hiring decision, and an investment decision c. The government
? Consumes resources, levies taxes and issues debt

* 3 markets in the economy: a. Goods market
? Supply: output produced by firms
? Demand: consumption by households, investment (accumulation of capital) by firms, government spending b. Labour market
? Supply: work done by households
? Demand: hiring by firms c. Bond market
? Supply: debt issued by government
? Demand: household savings

The Representative Household

* Preferences over consumption and leisure, now and in the future
* Assume that consumption and leisure are normal goods

* Income:
* Labour income
* Dividends (the representative household owns the firms)
* Interest from bonds

* Must pay taxes to government

Household Preferences
* Moving to a higher indifference curve but holding constant the slope (the MRS) implies that both consumption and leisure rise

Graph showing household preferences for consumption and leisure

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* Consumption in the current period and the future period are also assumed to be normal goods
? Same for leisure
* Moving to a higher indifference curve (holding constant MRS)
? Implies more current and future consumption Graph showing household preferences for current and future consumption

Course Notes Page 14

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Agents in the economy Markets in the economy Household preferences Household budget constraint Consumption/saving decision Consumption/leisure decision Intertemporal substitution: Labour Income and substitution effects Income effects in the closed economy Wealth effects Effects of changes in lifetime after-tax income Marginal propensity to consume

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Household Budget Constraint
? Current Period:
? Future Period:
? Combined: Consumption/Saving Decision
? The optimality condition:
? Giving up one unit of consumption today yields an extra 1+r units in the future
? Households must be indifferent between doing this or not to maximize utility
? MRS is diminishing
# [?] higher interest rate encourages saving (substitution effect)

Graph of the consumption/saving decisionConsumption/Leisure Decision
? Optimality condition:
? Giving up an hour of leisure yields an extra w units of consumption now
? Households must be indifferent between doing this or not to maximize utility
? MRS is diminishing:
# [?] higher wage needed to work more (substitution effect) Graph of the consumption/leisure decision? Where N = h - l = hours used for work Intertemporal Substitution: Labour
? There is also an intertemporal dimension to the labour supply decision
? Taking one more hour of leisure in the current period implies a reduction in income of w
? If consumption plans (now and in the future) are not to change, this income must be made up by working more in the future
? Each hour of future work pays wage
? So the household must work

in present value terms more hours in the future

? Optimality requires the household to be indifferent between working an hour now or in the future:
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This can also be derived from the following 3 conditions:

Course Notes Page 15

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