ADVANCED MACROECONOMICS

NOTES
Contents
1. SOLOW MODEL........................................................................................................ 3
1.2. Some Basic Facts about Economic Growth....................................................................3
1.2 Assumptions.......................................................................................................... 4
Derive Solow Model................................................................................................. 5
2. INFINITE-HORIZON AND OVERLAPPING-GENERATIONS MODELS..........................................13
2.1. The Ramsey--Cass--Koopmans Model....................................................................13
Assumption............................................................................................................... 13
Dynamics of the Economy in the Ramsey–Cass–Koopmans Model........................15
3. ENDOGENOUS GROWTH.................................................................................... 29
3.1. AK Model..................................................................................................... 29
Positive Technology shocks influencing production...............................................34
Effect of Technology on Investment and Income...................................................37
Effect of Technology Shocks on Labor Market.......................................................39
3. UNEMPLOYMENT............................................................................................ 42
The Shapiro-Stiglitz model.................................................................................... 44
Assumptions of the Shapiro-Stiglitz Model............................................................44
 1. SOLOW MODEL
1.2. Some Basic Facts about Economic Growth
1. Growth in Industrialized Countries:
o Incomes in countries like the U.S. and Western Europe are 5-20 times higher
than a century ago and 15-100 times higher than two centuries ago.
2. Long-Term Growth Trends:
o Growth rates have increased over modern history, with the 20th century seeing
higher growth than the 19th. Before the Industrial Revolution, incomes were
close to subsistence.
3. Slowdown in Growth:
o Since the 1970s, growth in industrialized countries has slowed by about 1%
annually, with a brief rebound in the 1990s.
4. Global Income Differences:
o Countries like the U.S. have incomes 15 times higher than nations like
Bangladesh and Kenya. Growth rates vary widely across countries.
5. Growth Miracles and Disasters:
o Miracles: Countries like Japan, South Korea, and China saw rapid growth.
o Disasters: Argentina and many sub-Saharan African countries have seen stagnant
or declining incomes.
6. Complicated Growth Patterns:
o Some countries like Côte d'Ivoire and Mexico experienced periods of high
growth, then stagnation.
7. Income Inequality:
o Income disparities between rich and poor countries have widened since the
Industrial Revolution.
8. Welfare Impact:
o Economic growth affects living standards, including nutrition, literacy, and life
expectancy. The U.S. income has dropped by 35% due to slow growth since the
1970s.
9. Focus of Growth Studies:
 o Research aims to raise growth in poor countries and reduce income gaps with
wealthier nations.

Solow Growth Model:

The Solow Growth Model is an economic framework that explains long-
term growth through capital accumulation, labor growth, and
technological progress. It highlights the role of savings, diminishing
returns, and steady-state equilibrium, with sustained per capita growth
driven by technological advancement.

Assumptions
Inputs and Output
In the Solow model, output (Y) is produced using three key inputs: capital (K), labor (L), and
labor effectiveness (A). The production function is:

 Time (t) affects output indirectly through changes in K, L, and A.

 Technological progress is captured by labor-augmenting progress (A), where effective
labor is the product of A and L.
 Capital-output ratio (K/Y) stabilizes over time, simplifying analysis, as it doesn’t trend
upward or downward in the long run.
The model assumes these inputs evolve over time, with technological progress playing a key
role in increasing output.
1. Production Function:
o Output is produced using a Cobb-Douglas production function:

o where capital (K), labor (L), and labor effectiveness (A) are the inputs.
2. Technological Progress:
o Technological progress is labor-augmenting (Harrod-neutral), meaning it
increases the effectiveness of labor (A), leading to higher productivity over time.
3. Capital Accumulation:
o Capital (K) grows through investment and depreciates over time. The model
assumes a fixed rate of depreciation.
4. Labor Growth:
 o The labor force (L) grows at a constant rate, usually denoted by n.
5. Constant Returns to Scale:
o The production function exhibits constant returns to scale in capital and
effective labor (i.e., doubling both capital and effective labor doubles output).
6. Closed Economy:
o The Solow model assumes a closed economy, meaning there is no international
trade or capital flows.
7. Savings and Investment:
o The savings rate (s) is constant, and a portion of output is invested to accumulate
capital.
8. No Government or External Shocks:
o The model assumes no government interventions (taxes, subsidies, etc.) or
external economic shocks affecting the economy.
These assumptions help simplify the model and make it easier to analyze how capital, labor,
and technology affect economic growth.
Derive Solow Model
The steady state is a key concept where the capital per worker (k) remains constant over time.
This happens when the amount of new capital added through investment exactly offsets the
capital lost due to depreciation and population growth.
Example 1
Given s, δ, and initial k, we can compute time paths for our variables as we approach the steady
state.
Let’s assume s=.4, δ=.09, and k=4.
Examples 2
 2. INFINITE-HORIZON AND OVERLAPPING-GENERATIONS MODELS
2.1. The Ramsey--Cass--Koopmans Model
Assumption
Technological Progress: Technology (A) grows at a constant rate g. This means that
technological progress is exogenous and grows at a steady rate over time, improving
productivity and the efficiency of labor.

The Firm,
Identical Firms: There are many identical firms in the economy.
Production Function: Firms use the production function Y=F(K,AL) where:
 K = Capital
 A = Technology (total factor productivity)
 L = Labor
Factor and Output Markets:
 Firms hire labor and rent capital in competitive factor markets.
 They sell output in a competitive output market.
Free Access to Technology: The A input (technology) is freely available to all firms.
Profit Maximization: Firms maximize profits.
Ownership: Firms are owned by households, so profits are distributed to them.
Constant Returns to Scale: With identical firms, constant returns to scale, and common factor
prices, the aggregate output of all firms is the same as the output of a single firm using total
capital K and total labor L.
Total Output: Total output is given by Y(t)=F(K(t), A(t)L(t)).

Household Characteristics
 Household Structure:
o Households are identical.
o Each household grows at a rate of n.
 o Each household member always supplies 1 unit of labor.
Capital and Income:

 Households own initial capital K(0)/H where:

o K(0)): Initial capital in the economy.
o H: Number of households.
 Income sources include:
o Labor supply.
o Rented capital.
o Potential profits from firms.
 Income is divided between consumption and saving to maximize lifetime utility.
Dynamics of the Economy in the Ramsey–Cass–Koopmans Model
The dynamics of the economy can be analysed in terms of two variables: consumption per
capita (c) and capital per capita (k).
1. Axes and Variables
 The horizontal axis (k): Represents the capital stock per worker.
 The vertical axis (c): Represents consumption per worker.

 The critical point k∗: Represents the steady-state level of capital per worker.
This diagram combines the dynamics of consumption per worker (ccc) and capital per worker
(k) in the Ramsey–Cass–Koopmans model, providing a phase diagram for the system. It
integrates the loci c˙=0 and k˙=0to show how the economy evolves over time toward the steady
state.
This figure illustrates the trajectories of capital per worker (k) and
consumption per worker (c) for different initial conditions in the Ramsey–
Cass–Koopmans model. It demonstrates how the economy converges toward
the steady state (E) depending on its starting position.
The saddle path in the Ramsey-Cass-Koopmans (RCK) model is a stable trajectory that leads the
economy toward its steady-state equilibrium
 3. ENDOGENOUS GROWTH
Endogenous growth theories that address the limitations of earlier
models like the Solow model and the Ramsey–Cass–Koopmans framework.
Key Insights from Earlier Models
1. Limitations of Capital Accumulation:
o Capital accumulation alone cannot explain long-term growth or
the significant income differences between countries.
o The contribution of capital diminishes due to decreasing returns,
meaning it plays a smaller role in sustaining growth.
2. The "Effectiveness of Labor" (A):
o This variable is treated as exogenous in previous models.
o Its meaning (often interpreted as technological progress or
knowledge) and its behavior are not explained in those
frameworks.
Moving Forward: Endogenous Growth
To address these gaps, the chapter emphasizes:
1. Knowledge as a Driver of Growth:
o The "effectiveness of labor" is explicitly interpreted as
knowledge or technology.
o Technological progress explains why economies can produce
more output with the same capital and labor over time.
2. Accumulation of Knowledge:
o The focus shifts to understanding how knowledge evolves and
contributes to growth.
o This involves modeling how inputs (e.g., capital, labor) are
allocated between producing goods and accumulating
knowledge.
3.1. AK Model
The AK Model is a simple form of endogenous growth theory,
emphasizing the role of capital and constant returns to scale in driving long-
term economic growth.
Endogenous Growth Theory: Unlike exogenous models (e.g., Solow Model),
where growth is driven by external factors like technological progress, the AK
model explains growth because of internal factors like capital accumulation
and policy variables.
It eliminates diminishing returns to capital, which is a key assumption in the
Solow Model, making sustained growth possible without relying on
exogenous technological progress.
Graph
AK MODEL GRAPHICAL PRESENTATION
Positive Technology shocks influencing production
Effect of Technology on Investment and Income
6. Conclusion:
The graph illustrates how technological advancements initially increase
income and later stimulate investment. This progression is a critical element
of business cycle theory, demonstrating how economies adjust to
innovations over time.
Effect of Technology Shocks on Labor Market
 3. UNEMPLOYMENT

UNEMPLOYMENT
There are theories about unemployment, including:
1. Classical Theory
It states that the government should leave the economy alone and
allow market forces to determine the best level of the economy. It also
states that unemployment occurs when real wages are set above the
market-clearing level.
2. Keynesian Model
Based on the idea of a dynamic economy.
It states that unemployment can occur when money wages are rigid
downwards, and workers are unwilling to work for a lower real wage if
prices rise.
3. Search Unemployment
It states that unemployment can occur when workers have limited
information about wages & conditions in other jobs.
Wages
 Why are developing countries being short-changed?
 China did
 Globalization
Employers have limited knowledge of workers' abilities.
Unemployment Benefit Theory
They state that unemployment benefits can reduce the incentives for people
to find new employment quickly.
Stiglitz Model
This is a model of the labor market which considers the case where the firm
is unable to perfectly monitor the workers it employs. This means it allows
for a situation where workers are able to slack off on the job and get away
with it.
Formally, the model tells a story regarding the welfare of workers exiting and
moving between 3 different states:
1. Being unemployed
2. Being employed and doing their job
 3. Being employed but shirking (going to work but not working)
The shirking theory states that when workers are paid higher than the
efficiency wage, workers tend to be more productive. It assumes that the
labor market is in perfect competition and all workers earn the same wage
rate and have the same production level.
The Model Set-Up
 It consists of many infinitely workers III and many firms NNN.
 Workers maximize their expected discounted utility, and firms
maximize their expected discounted profit.
 It consists of 4 main equations.

The Value in Each State

 The main decision that has to be made in this model is the worker who is employed
deciding whether they shirk or not.
 This decision depends on how much a given worker values being employed,
unemployed, and shirking.
  To solve for these values, we use dynamic programming, where we consider the
solution for small intervals and extend the solution for all other periods.
 We will be assuming that time can be divided into intervals, and if a worker loses their
job, they cannot search for a job until the beginning of another interval.

9. Unemployed workers find work at a rate of a, which acts in place of the job break-up
rate B. Compared to unemployed workers, this will be important when we analyze how
our workers value being employed.

The Shapiro-Stiglitz model

The Shapiro-Stiglitz model is an economic theory that explains the

persistence of involuntary unemployment due to the presence of worker
shirking and the need for employers to incentivize effort. It is a key model
in the field of labor economics.

1. The Problem of Shirking

 Workers may choose to "shirk" (not work hard) if they feel the benefits
of shirking outweigh the risks of being caught and fired.
 Employers cannot perfectly monitor employees’ effort all the time (this
is known as imperfect information).
Example: A worker at a factory might spend time on their phone instead of
working if they think the supervisor isn’t watching.

2. Employers’ Solution: The Efficiency Wage

 To prevent shirking, employers pay workers a wage higher than the
market-clearing wage. This is called the efficiency wage.
 A higher wage increases the cost of job loss for workers, making
shirking less attractive because getting fired means losing a job with
above-market wages.
Example: If the market-clearing wage is $15/hour, an employer might pay
$20/hour to discourage workers from shirking

Assumptions of the Shapiro-Stiglitz Model

The Shapiro-Stiglitz model relies on several key assumptions to explain
involuntary unemployment and the role of efficiency wages in deterring
worker shirking. Below, I provide an exhaustive explanation of these
assumptions, breaking them down with detailed examples:
1. Workers are Rational and Utility-Maximizing
 Workers aim to maximize their utility by weighing the benefits of
shirking (less effort, more leisure) against the costs (risk of being
caught and fired).
 If the perceived benefits of shirking outweigh the costs, workers will
shirk.
Example: A worker might decide to scroll through social media during work
hours if they believe the probability of being caught is low and the
consequences are mild.
2. Imperfect Monitoring
 Employers cannot perfectly monitor workers at all times due to
information asymmetry.
 There is always a probability (pp) that a shirking worker will go
undetected.
 This creates an incentive for workers to shirk unless countermeasures,
such as efficiency wages, are implemented.
Example: In a large warehouse, a supervisor cannot constantly monitor all
employees, making it possible for some workers to idle without being caught.

3. Firing is the Only Punishment

 If a worker is caught shirking, the employer fires them.
 The threat of job loss is the primary mechanism to deter shirking.
 This implies that workers only value their jobs if the wage offered is
significantly higher than what they could earn elsewhere (e.g.,
unemployment benefits).
Example: A factory worker earning $20/hour may avoid shirking because
losing the job would mean living on unemployment benefits of $10/hour.

4. Wages are Set Above the Market-Clearing Level (Efficiency Wage)

 Employers pay wages higher than the equilibrium wage to incentivize
workers not to shirk.
  This creates a gap between labor supply and demand, resulting in
involuntary unemployment.
Example: The market-clearing wage for a cashier might be $15/hour, but a
supermarket offers $18/hour to ensure that employees work diligently and
avoid shirking.

5. Involuntary Unemployment Exists

 Not all workers who are willing to work at the efficiency wage will find
jobs, as employers hire fewer workers at higher wages.
 This unemployment is not due to workers refusing jobs but is a
necessary outcome to maintain the no-shirking condition.
Example: A town has 200 unemployed individuals, but a factory paying
efficiency wages only hires 100 workers because the higher wage increases
its costs.

6. Workers Have Alternative Income Sources

 Unemployed workers can earn a small income (bb), such as
unemployment benefits, but this income is lower than the efficiency
wage.
 The difference between the efficiency wage and alternative income
increases the cost of being fired.
Example: A worker earning $25/hour will hesitate to shirk if unemployment
benefits are $10/hour, as the gap between the two is substantial.

7. Job Loss is Costly to Workers

 Losing a job means:
1. Transitioning to unemployment and earning less (bb).
2. Searching for a new job, which takes time and effort.
 The longer it takes to find a new job (low qq, the job-finding rate), the
higher the cost of losing a job.
Example: If it takes 3 months to find a new job and unemployment benefits
are much lower than the efficiency wage, workers will avoid shirking to keep
their current jobs.
8. Labor Supply is Greater than Labor Demand
 Due to the efficiency wage, the number of people willing to work at the
higher wage exceeds the number of jobs available.
 This ensures there is always a pool of unemployed workers ready to
replace any shirking workers.
Example: In a company paying $30/hour while the equilibrium wage is
$20/hour, more applicants apply than there are positions, maintaining
pressure on current employees to perform.

9. The Probability of Being Caught Shirking

 There is a known probability (pp) that a worker shirking their
responsibilities will be caught and fired.
 The higher this probability, the less likely workers are to shirk.
Example: If a factory installs cameras that increase the likelihood of
detecting shirking, workers are more likely to work diligently.

10. Job-Finding Rate (qq) is Finite

 It is not guaranteed that a worker who is fired will find a new job
quickly.
 A lower job-finding rate makes the threat of being fired more severe.
Example: In a recession, when jobs are scarce, the job-finding rate (qq) is
low. Workers will be even less likely to shirk since losing a job might mean
prolonged unemployment.

11. Firms Minimize Costs and Maximize Productivity

 Employers balance the cost of paying higher wages against the
productivity they gain by deterring shirking.
 The efficiency wage is set such that the cost of monitoring and firing
workers is minimized.
Example: A retail store might decide it is cheaper to pay workers $22/hour
to prevent shirking than to hire additional supervisors for strict monitoring.
12. Workers Have a Discount Rate (rr)
 Workers value current income more than future income, which
influences their decision-making about whether to shirk.
 If the cost of being fired is spread over a long period, workers may
discount its importance and be more likely to shirk.
Example: A worker might shirk if they think it will take a long time for the
employer to notice and fire them, especially if they plan to leave the job soon
anyway.

Conclusion:
The assumptions of the Shapiro-Stiglitz model reflect a labor market where:
 Imperfect information leads to shirking behavior.
 Efficiency wages are used to deter shirking.
 Involuntary unemployment exists as a natural byproduct of this
system.
These assumptions provide a framework to understand real-world labor
market phenomena, such as why some firms pay above-market wages, why
unemployment persists, and how worker behavior is shaped by incentives.
CONSUMPTION
Importance of Consumption and Investment:
1. Role in Growth and Standards of Living:
o The division of resources between consumption and
investment (in physical capital, human capital, and R&D)
affects long-term living standards.
o This division is shaped by:
 Households’ allocation of income between consumption
and saving, influenced by rates of return and constraints.
 Firms’ investment demand, influenced by interest rates
and other factors.
2. Role in Economic Fluctuations:
o Consumption and investment constitute most of the demand
for goods.
o Understanding their determinants is essential to analyzing how
factors like government spending, technology, and monetary
policy impact aggregate output.
Relevance to Macroeconomic Analysis:
3. Empirical Focus:
o Consumption and investment have been the subject of
significant empirical research in macroeconomics.
4. Connection to Financial Markets:
o Households’ saving and borrowing decisions in financial
markets influence their consumption choices.
o Firms’ investment decisions depend on how financial markets
value output under different conditions.
Analytical Framework:
5. Case Studies:
o The analysis examines consumption and investment in scenarios
with perfectly functioning financial markets and with
imperfect financial markets.
6. Financial Market Interaction:
 o Chapter 10 (referenced in the text) delves into how consumption
and investment decisions intersect in financial markets and their
broader macroeconomic implications.
Overall Focus:
The chapters aim to integrate theoretical and empirical insights into
consumption, investment, and their interaction with financial markets to
explain their roles in growth, economic fluctuations, and macroeconomic
policy.