In this section, we begin to develop a micro-founded model of the macroeconomy. We examine how utility maximizing consumers make optimal choices for for consumption and leisure. We consider a single consumer, but imagine he or she is a representative consumer, so that his or her consumption decisions coincide with aggregate consumption (i.e. total consumption in the macroeconomy). Aggregate consumption is part of aggregate demand, and a major expenditure component of real GDP. Leisure decisions determine labor supply decisions, which coincides with the aggregate level of labor supply.
In the last section (consumption and leisure choices), we developed a model of consumer optimal behavior that led to a labor supply curve. The goal of this section is to develop a model of optimal producer behavior to determine labor demand. By optimal producer behavior, we mean that businesses choose how much labor to hire to maximize profits. We begin this section with the production function, which is a mathematical and graphical function which shows how different quantities of labor and capital determine the level of output for the producer. Also similar to the previous section, we consider a single producer, but imagine it is a representative producer, so that its production decisions coincide with the aggregate level of production.
We return to the utility maximizing representative consumer and examine how consumers make optimal choices for consumption and saving when they consider having enough income and saving to support future consumption. We build an intertemporal two-period model, with periods associated with the present and the future. For simplicity, we focus on an endowment model where consumers' incomes are predetermined, and given these income levels we derive consumers' budget constraints for each period and combine these into a lifetime budget constraint. We derive consumers' utility maximizing choices for present consumption, future consumption, and saving. We also introduce a government that collects taxes and uses it for government spending, and look at some of the effects that fiscal policy has on optimal consumer choices.
Here we look at the investment decision from the point of view of a profit maximizing producer in a multi-period model that considers the present cost of investment and the return earned in the future. We build on the producers' profit maximization decision from the Production and Labor Market Section to include two periods and an investment decision. Investment is purchases of capital which includes machines, buildings, factories, and any other manufactured good used in the production of goods and services. Understanding the behavior of investment is important for both short-run and long-run macroeconomic considerations. In the short-run, investment is one component of demand for all final goods and services, so fluctuations in investment demand can have consequences for the business cycle. In the long-run, investment leads contributes to a nation's capital stock which influences their long-run production possibilities, and therefore their long-run standard of living.
Here we expand the intertemporal model of consumer and saving decisions (Section 3) to include consumers' decisions for work versus leisure and bring that together with the production side of the economy. Consumers' income is no longer predetermined, but rather determined by their choices for work versus leisure and equilibrium wages. We use consumers' utility maximization rule to derive a theory for labor supply, use producers' profit maximization rule to derive a theory for labor demand, and bring these together to describe equilibrium in the labor market. Supply in the market for final goods and services is determined by the production function and equilibrium in the labor market. On the demand side, we derive output demand by combining consumers' utility maximizing consumption decisions with producers' profit maximizing investment decisions (Section 4). The final Pencasts in this section use the entire general equilibrium model to describe and illustrate the equilibrium consequences deriving from a number of potential changes in the economy.
Here we present two models to explain long-run trends in economic growth. The first model is the Malthusian growth model, which is based on Thomas Malthus's 1798 book, An Essay on the Principle of Population, which advances a theory that population growth depends positively on economic well-being. In these Pencasts, we present a formalization of the theory in which production depends positively on land availability and population (labor). The theory suggests that improvements in technology lead only to temporary improvements in economic well-being and permanent increases in population size. The second model is the Solow growth model, a theory advanced in the 1950s by Robert Solow, and which won him the Nobel Prize in economics in 1987. In this theory, production depends positively on labor and capital. This theory suggests that improvements in technology lead to permanent improvements in economic well being, with increases in capital stock per person and output per person.
We begin with a model of money demand based on consumer utility maximizing decisions in an environment that includes cash goods and credit goods. We use optimal decisions for cash versus credit goods to derive a theory of money demand. We combine this with the money supply determined by the central bank to describe and illustrate equilibrium outcomes in the market for money.
In this section we incorporate the market for money (Section 7)into the dynamic general equilibrium model (Section 5). The result is a dynamic general equilibrium model that includes equilibrium outcomes for the aggregate price level and introduces the a limited role for monetary policy. We describe and illustrate the some of the economic conditions which cause monetary policy to have real effects on the economy versus only nominal effects (affecting only the aggregate price level, but no real variable such as employment or real GDP).
The IS/LM model is a macroeconomic model that explains short-run fluctuations in real GDP and the interest rate. The model helps explain how recessions occur and it is conducive to exploring monetary policy prescriptions to remedy such short-run problems. The IS curve is a graphical relationship explaining how aggregate demand fluctuations impact interest rates and real GDP when the market for goods and services is in equilibrium. The LM curve is graphical relationship showing how monetary policy and the market for money affects interest rates and real GDP. Together, they show how the equilibria in market for money and the market for goods and services together to determine interest rates and production levels in the macroeconomy.
In this section, we combine the idea of aggregate demand for goods and services with aggregate supply. We discuss how both the aggregate demand and the aggregate supply for all final goods and services depend on the aggregate price level. We develop a graphical model of aggregate demand and aggregate supply that shows how real GDP and aggregate price level are determined in equilibrium. We also discuss what other factors (besides aggregate price level) can influence demand and supply decisions, and demonstrate the effect that it has on the economy in the short-run and the long-run. We combine this model with the market for money to show how monetary policy can influence real GDP and price level. The last Pencasts in this series demonstrate how macroeconomic problems may be remedied with monetary policy actions.
Here we introduce the Phillips curve and the Taylor rule, which together form an alternative framework to examine the short-run trade-off between unemployment and inflation and the role for monetary policy. The Phillips rule describes the relationship between inflation and unemployment. We derive a Phillips rule for the short-run and long-run, and consider a modern innovation called the New Keynesian Phillips curve which considers the role inflation expectations has on this trade-off. The Taylor rule is prescription for monetary policy in which the central bank influences the interest rate in response to targets for inflation and unemployment.