June 2, 2010

Current Events

 As a result of the „mortgage crisis‟. the U.S. and many foreign

economies have recently experienced deep recessions
 GDP declined substantially, many countries still in recession

Intermediate Macroeconomics June 2, 2010 2

 Current Events

 U.S. unemployment rate reached its peak at 10.1% in October, 2009

 Still very high as of April 2010 (9. 5%)

Intermediate Macroeconomics June 2, 2010 3

 Current Events

 Stock-market prices declined 40% in 2008

 Stock-market prices have risen 45% since March

S&P 500 Index

1800
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1/3/1950

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1/3/2010
Intermediate Macroeconomics June 2, 2010 4
 Current Events

 Federal Reserve has lowered interest rates to virtually zero percent

 “Credit spreads” at their highest levels ever

Intermediate Macroeconomics June 2, 2010 5

 Current Events

 Federal Reserve has lowered interest rates to virtually zero percent

 “Credit spreads” at their highest levels ever

Intermediate Macroeconomics June 2, 2010 6

 Current Events

 Inflation level and wage rates declined substantially

Intermediate Macroeconomics June 2, 2010 7

 Theory

 Is “aggregate demand” weak?

 Is “aggregate supply” weak?
 IS/LM framework is not sufficient for in-depth analysis

AS
?
Price
Level

?
AD

GDP

Intermediate Macroeconomics June 2, 2010 8

 Theory

 Contemporaneous (within the same period) AND Dynamic (across periods)

interactions of variables
Employment

Production Wages

Consumption

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 Theory

Macroeconomic Outcomes:

1. GDP
MACROECONOMY 2. Inflation AGGREGATE
3. Unemployment OUTCOMES
4. Trade balances
5. Etc. etc...

PUBLIC
PRIVATE
Interact through policy: SECTOR
SECTOR
(GOVERNMENT)
1. Monetary policy (interest
rates)
2. Fiscal policy (taxes and
government spending)

Modern Macroeconomic Theory:

CONSUMERS FIRMS Build a theory of aggregate outcomes

by studying microeconomic decisions
and interactions between firms and
consumers
Interact through three types of
markets:

Microeconomic Foundation: 1. Goods markets Microeconomic Foundation:

Utility Maximization
2. Labor markets
3. Capital/asset markets
Profit Maximization Can we feasibly model the decisions of
every consumer and firm and every
interaction between them?...probably
not…

Intermediate Macroeconomics June 2, 2010 10

 Theory

 Consumer A: Consumed $50 in Year X No other consumers in the economy

 Consumer B: Consumed $75 in Year X

 Consumer C: Consumed $100 in Year X THE REPRESENTATIVE CONSUMER

 Consumer D: Consumed $125 in Year X

 Consumer E: Consumed $150 in Year X

 Aggregate (i.e., economy-wide) consumption = $500

 Average consumption = $100

 Macroeconomics is most concerned with aggregate outcomes

 If we want to take a micro-based approach to explaining aggregate

outcomes…
 …model Consumer C‟s behavior/decision-making

 A simplistic approach – turns out to yield surprisingly rich results, insights,

and predictions

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 Review of Consumer Theory

 Describe how much “happiness” or “satisfaction” an individual experiences

from “consuming” goods – the benefit of consumption

 Marginal Utility
 The extra total utility resulting from consumption of a small/incremental extra
unit of a good
 Mathematically, the (partial) slope of utility with respect to that good
Alternative notation: du/dc OR u‟(c) OR uc(c) OR u1(c)

 One-good case: u(c), with du/dc > 0 and d2u/dc2 < 0

 Recall interpretation: strictly increasing at a strictly decreasing rate
 Diminishing marginal utility

 Two-good case: u(c1, c2), with ui(c1, c2) > 0 and uii(c1, c2) < 0 for each of i =
1,2
 Utility strictly increasing in each good individually (partial)
 Diminishing marginal utility in each good individually

 Readily extendable to N-good case: u(c1, c2, c3, c4,…, cN)

Intermediate Macroeconomics June 2, 2010 12

 Review of Consumer Theory

 One-good case u(c)

Slope (marginal utility) asymptotes to (but never
reaches…) zero

Example: u(c) = ln c or u(c) = sqrt(c)

c
 Two-good case

Example: u(c1, c2) = ln c1 + ln c2 or u(c1,

c2) = sqrt(c1) + sqrt(c2)

u(c1,c2) u(c1,c2)

Viewed in
good-by-good
space

c1 c2

Intermediate Macroeconomics June 2, 2010 13

 Review of Consumer Theory

Alternative views

Emphasizing Viewing only

the contours Indifference Curve: the set the contours
of all consumption bundles
that deliver a particular level
of utility/happiness

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 Review of Consumer Theory

 Marginal Rate of Substitution (MRS)

 Maximum quantity of one good consumer is willing to give up to obtain one extra
unit of the other good

 Graphically, the (negative of the) slope of c2

an indifference curve

 MRS is itself a function of c1 and c2

(i.e., MRS(c1, c2))

c1
 MRS equals ratio of marginal utilities

u1 (c1 , c2 )
 MRS (c1 , c2 ) 
u2 (c1 , c2 )

 Using Implicit Function Theorem (see Practice Problem Set 1)

 Summary: whether graphically- or mathematically-formulated, utility

functions describe the benefit side of consumer optimization

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 The Graphics of Consumer Theory

 Describe the cost side of consumption

 One-good case (trivial): Pc = Y

 Assume income Y is taken as given by consumer for now…

 Two-good case (interesting): P1c1 + P2c2 = Y

 Assume income Y is taken as given by consumer for now…

Plotted in 3D-consumption-space Plotted in 2D-consumption-space

Slope = -P1/P2

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 The Graphics of Consumer Theory

 Consumer‟s decision problem: maximize utility subject to budget constraint

– bring together both cost side and benefit side
 One-good case u(c)

 Trivially, choose c = Y/P

 No decision to make here…

 Two-good case Y/P c

 How to optimally allocate Y across the two goods c1 and c2?

 A non-trivial decision problem…
OPTIMALITY CONDITION:
At the optimal choice,
c2 Utility increasing in
the northeast MRS = -slope of budget line
direction
Optimal choice
occurs at point of ratio of marginal utilities = price ratio
tangency between
budget line and an
indifference curve Highest attainable
indifference curve
c1

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 The Mathematics of Consumer Theory

 Consumer optimization a constrained optimization problem

 Maximize some function (utility function)…
 …taking into account some restriction on the objects to be maximized over
(budget constraint)

 Lagrange Method: mathematical tool to solve constrained optimization

problems

 General mathematical formulation

 Choose (x, y) to maximize a given objective function f(x,y)…
 …subject to the constraint g(x,y) = 0 (Note formulation of constraint)
 Step 1: Construct Lagrange function Lagrange multiplier

L( x, y,  )  f ( x, y)   g ( x, y)
 Step 2: Compute first-order conditions with respect to x, y, and λ
1) f x ( x, y )   g x ( x, y )  0 Rationale: setting first derivatives to zero isolates
maxima (or minima…technically, need to check
2) f y ( x, y )   g y ( x, y )  0 second-order condition…)
3) g ( x, y )  0

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 The Mathematics of Consumer Theory

 Step 3: Solve the system of first-order conditions for x, y, and λ

 Often most interested in simply eliminating the multiplier…

f x ( x, y )
 From eqn 1), isolate λ: 
g x ( x, y)
f x ( x, y )
 Insert expression for λ in eqn 2): f y ( x, y)  g y ( x, y)  0
g x ( x, y)
 Rearrange

 Optimality condition: at the optimum (x*, y*)

Graphical interpretation: at the constrained
f x ( x*, y*) g x ( x*, y*)
 optimum, the function f(.) is tangent to the
function g(.)
f y ( x*, y*) g y ( x*, y*)
y

f(x,y)
The constrained optimum (x*, y*)

g(x,y)

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 The Mathematics of Consumer Theory

 Apply Lagrange tools to consumer optimization

 Objective function: u(c1,c2)
 Constraint: g(c1,c2) = Y – P1c1 – P2c2 = 0

 Step 1: Construct Lagrange function

L(c1 , c2 ,  )  u(c1 , c2 )   Y  Pc
1 1  P2c2 

 Step 2: Compute first-order conditions with respect to c1, c2, λ

 Step 3: Solve (with focus on eliminating multiplier)

u1 (c1* , c2* ) P1
* *
 OPTIMALITY CONDITION
u2 (c1 , c2 ) P2
i.e., MRS = price ratio

Intermediate Macroeconomics June 2, 2010 20

 Next Time

 Read by end of the week

 Chapter -1 (mathematical refresher)
 Chapter 0 (introduction to representative-agent framework)
 Chapter 1 (consumer theory)

 Read for next week

 Chapter 2,3,4 (static consumption-leisure model)

 Practice Problem Set 1

 Practice with partial derivatives
 Reviews consumer theory

Intermediate Macroeconomics June 2, 2010 21