Economics 2 Formula Sheet

Lee Suddaby

April 2020

Contents
1 Microeconomics 2
1.1 Production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.2 Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.3 Perfect Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.4 Monopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.5 Imperfect Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.6 Factor Markets - Labour . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.7 Factor Markets - Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.8 General Equilibrium and Market Efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.9 Externalities, Property Rights & the Coase Theorem . . . . . . . . . . . . . . . . . . . . . 6
1.10 Government . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

2 Macroeconomics 7
2.0 List of Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2.1 Introduction to Macroeconomics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
2.2 Production, Prices and Distribution of Income . . . . . . . . . . . . . . . . . . . . . . . . 9
2.3 Interest Rates and Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
2.4 Consumption and the Natural Rate of Interest . . . . . . . . . . . . . . . . . . . . . . . . 11
2.5 Capital Accumulation and Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
2.6 Wage-Setting and Unemployment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
2.7 Money and Inflation in the Long Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
2.8 The Interest Rate and Production in the Short Run . . . . . . . . . . . . . . . . . . . . . 14
2.9 Economic Activity and Inflation in the Short Run . . . . . . . . . . . . . . . . . . . . . . 14
2.10 Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
2.11 Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
2.12 Exports, Imports and International Financial Markets . . . . . . . . . . . . . . . . . . . . 16
2.13 The Open Economy in the Long Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
2.14 The Open Economy in the Short Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
2.15 Exchange Rate Systems and Monetary Union . . . . . . . . . . . . . . . . . . . . . . . . . 18
2.16 Business Cycles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
2.17 Institutions and Economic Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
2.18 Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
2.19 Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

3 Mathematics 20
3.1 Total Differential and Total Derivative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
3.2 Constrained Optimisation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
3.3 Statistics Primer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
3.4 Matrix Algebra . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
3.5 Difference Equations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
3.6 Differential Equations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

1
1 Microeconomics
1.1 Production
We use the following production function

Q = F (K, L). (1.1.1)

Then the Marginal Product of Labour is,

∆Q ∆F (K, L) ∂F ∂Q
M PL = = = = . (1.1.2)
∆L ∆L ∂L ∂L
And similarly for Marginal Product of Capital

∆Q ∆F (K, L) ∂F ∂Q
M PK = = = = . (1.1.3)
∆K ∆K ∂K ∂K

The average product of labour/capital is

Q F (K, L) Q F (K, L)
APL = = , APK = = (1.1.4)
L L K K

We work with the Cobb-Douglas production function,

F (K, L) = mK α Lβ . (1.1.5)

Therefore
∂F
M PL = = βmK α Lβ−1 , (1.1.6)
∂L
and
∂F
M PK = = αmK α−1 Lβ . (1.1.7)
∂K

The Marginal Rate of Technical Substitution is (in the Cobb-Douglas case)

∆K ∆K M PL βK
M RT S = − = = = . (1.1.8)
∆L ∆L M PK αL

1.2 Costs
Total cost is given by the sum of fixed costs and variable costs

T C = F C + V C = rK + wL. (1.2.1)

Marginal cost is the (short-run) cost of producing an additional unit of output:

dT C dV C
M C(Q) = = . (1.2.2)
dQ dQ

Using the Cobb-Douglas production function in Equation (1.1.5), we have fixed capital in the short run,
and write
Q = κLβ , where κ = mK α . (1.2.3)
Rearranging for L gives
1 1
L = κ− β Q β . (1.2.4)

For long run cost minimisation, we create isocost lines,

w C
C = rK + wL =⇒ K = − L + , (1.2.5)
r r

2
then find where these are tangent to the isoquants, using the rule
M PL M PK
= . (1.2.6)
w r

In the long run, the main cost to consider is Long Run Total Cost (LTC). From this, we can find Long
Run Marginal Cost (LMC) and Long Run Average Cost (LAC):
dLT C
LM C = , (1.2.7)
dQ
and
LT C
LAC = . (1.2.8)
Q

1.3 Perfect Competition

The firm’s profit is given by
π = P Q −C(Q) (1.3.1)
|{z}
Revenue

To maximise profit (regardless of market structure), the firm produces until

M R = M C. (1.3.2)

In PC, the firm cannot influence market price, so M R = P and then Equation (1.3.2) is

P = M C. (1.3.3)

1.4 Monopoly
Here, the monopolist’s pricing decisions affect the market price, so revenue is now given by

π = P (Q)Q =⇒ M R = P 0 (Q)Q + P (Q), (1.4.1)

The profit maximising condition is still

M R = M C. (1.4.2)

If demand is linear, i.e.

P = a − bQ, (1.4.3)
then M R is twice as steep as the demand curve,

M R = a − 2bQ. (1.4.4)

1.5 Imperfect Competition

In the Cournot model of duopoly, we may have a demand function given by

P − a − bQ = a − b(Q1 + Q2 ), where Q = Q1 + Q2 . (1.5.1)

By considering the perspective of one firm and taking the other firm’s output as given, we find their
marginal revenue and equate to marginal cost

M R1 = (a − bQ2 ) − 2bQ1 = M C = c. (1.5.2)

This solves to give

a − bQ2 − c
Q∗1 = . (1.5.3)
2b
Similarly, firm 2 will have a reaction function of
a − bQ1 − c
Q∗2 = . (1.5.4)
2b

3
Finally, we can solve to find the Cournot equilibrium:
a−c a + 2c
Q∗1 = Q∗2 = and P = . (1.5.5)
3b 3

Equilibrium in the Bertrand model is given by

P = P1∗ = P2∗ = c = M C. (1.5.6)

In the Stackelberg model, firm 2’s reaction function is

a − bQ1 − c
Q∗2 = . (1.5.7)
2b
Profit for firm 1 is given by

π1 = P1 Q1 − cQ1 (1.5.8)
= (a − b(Q1 + Q∗2 ))Q1 − cQ1 (1.5.9)
  
a − bQ1 − c
= a − b Q1 + Q1 − cQ1 . (1.5.10)
2b

The first order condition is

bQ21
 
dπ1 d a−c
= aQ1 − bQ21
− + Q1 − cQ1 (1.5.11)
dQ1 dQ1 2b 2b
a−c
= a − 2bQ1 − Q1 + − c = 0. (1.5.12)
2b

And solving this yields the Stackelberg equilibrium.

a−c a−c
Q∗1 = and Q∗2 = . (1.5.13)
2b 4b

1.6 Factor Markets - Labour

The Marginal Revenue Product of Labour is given by

M RPL = M R · M PL . (1.6.1)

In a competitive output market, M R = P , so this becomes

M RPL = P · M PL , (1.6.2)

also called Value of Marginal Product of Labour, V M PL .

Using the general rule M B = M C, the firm should hire more workers until

M RPL = w. (1.6.3)

In monopsony, the profit-maximising labour decision is very similar, only M C is now given by M F C,
relating to supply/AF C:
T F C = AF C · L = w(L) · L, (1.6.4)
then
dT F C
MFC = . (1.6.5)
dL

Finally, there may be a monopoly seller of labour, where marginal revenue (M R) is derived from the
demand curve as in the case of a monopoly in the goods market.

4
1.7 Factor Markets - Capital
Similar to the decision for labour, the firm chooses K so that

M P RK = M R · M PK = r. (1.7.1)

The present value of a payment £X in n years times is

X
P Vn = . (1.7.2)
(1 + i)n

For a certain piece of capital, we denote PK as the purchase price, R as additional revenue per period,
M as maintenance costs per period, and S as the scrap value of the capital as time t = N . Then the
present value is given by
R−M R−M R−M R−M
P VK = + + ··· + + , (1.7.3)
1+i (1 + i)2 (1 + i)N (1 + i)N

A firm should purchase capital is the present value is at least the price,

P VK ≥ PK . (1.7.4)

The present value of a perpetuity paying £X per year is

X
PV = . (1.7.5)
i

The effective yield is the interest rate (i) that solves the equation P V = P .
To summarise the demand for risky assets model, we have a portfolio with the expected return given
by
Rp = E(rp ) = bRm + (1 − b)rf . (1.7.6)

The variance (which gives a measure of risk) of this portfolio is

σp2 = b2 σm
2
=⇒ σp = bσm (1.7.7)

Then Equation (1.7.6) becomes the ‘budget constraint’, given as a linear function of risk, σp ,

Rm − rf
Rp = rf + σp . (1.7.8)
σm

Then the optimal portfolio is found where the indifference curve is tangent to this budget constraint.

1.8 General Equilibrium and Market Efficiency

In the two good/two consumer model, we have a Pareto efficient allocation of goods if the indifference
curves are tangent, i.e.
A B
M RSyx = M RSyx . (1.8.1)

When we introduce prices to the mix, we have the following budget constraint:

py ωyA + px ωxA = py y A + px xA . (1.8.2)

Then when utility is maximised a condition very similar to Equation (1.8.1) is satisfied:

A px B
M RSyx =− = M RSyx , (1.8.3)
py

5
On the production side, the Marginal Rate of Transformation (slope of the Production Possibilities
Frontier) is given by
M Cx
M RTyx = . (1.8.4)
M Cy

In order to get to the highest possible indifference curve, we require tangency between the IC and
PPF:
M RSyx = M RTyx . (1.8.5)

Bringing together the conditions for Pareto efficiency, the following holds:
M Cx px M Ux
M RTyx = = = = M RSyx . (1.8.6)
M Cy py M Uy

1.9 Externalities, Property Rights & the Coase Theorem

We make a distinction between private and social marginal costs and benefits: PMC, PMB, SMC and
SMB. Where consumption of a good imposes a Marginal External Cost (MEC), we have

SM C = P M C + M EC. (1.9.1)

The socially efficient level of consumption occurs when

SM C = P M B. (1.9.2)

Compare this to the privately efficient level of consumption that we are familiar with calculating, which
occurs when
P M C = P M B. (1.9.3)

1.10 Government
The Samuelson Conditions tells is that efficient provision of a public good Y requires

M RSYAx + M RSYBx = M RTY x , (1.10.1)

We compare this to the efficiency condition for two private goods x and z:
A B
M RSzx = M RSzx = M RTzx . (1.10.2)

Introducing Lindahl Prices/Lindahl Shares, the shares τ are set to that τ A + τ B = 1 (by definition of
shares) and then
M RSYAx + M RSYBx = τ A + τ B = 1. (1.10.3)

We consider Social Welfare Functions (SWF) of the form

W = W (U1 , U2 , . . . , UN ). (1.10.4)

The two most important examples are

PN
ˆ Utilitarian: W = i=1 Ui .
ˆ Rawlsian: W = min{U1 , U2 , · · · , UN }.

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2 Macroeconomics
2.0 List of Variables
A Real asset holdings
C Real consumption
D Real government debt; D/Y is the government debt ratio
E Level of technology/efficiency
EN Effective number of workers
e Nominal exchange rate: price of domestic currency in terms of foreign currency
ee Expected future exchange rate
e⊗ Central bank (fixed) exchange rate target
f Job-finding rate for employed workers
G Real government purchases, G = C G + I G
g Growth rate of technology (E)
I Real investment
i Nominal interest rate
i∗ Foreign interest rate
IM Quantity of imports
K Real capital stock
Kd Desired real capital stock
K
k Capital stock per effective worker, k = EN
k∗ Steady state level of k
L Labour force, L = N + U
M Nominal money supply
MC Marginal cost
∂Y
MPK Marginal product of capital, ∂K
∂Y
MPL Marginal product of labour, ∂N
MR Marginal revenue
n Growth rate of production
N Employment
Nn Natural level of employment
NX Net exports, N X = X − IM
P Price level
P∗ Foreign price level
r Real interest rate, r ≈ i − π
ra ‘Autarky‘ (no trade) real interest rate
r∗ Foreign/ROW real interest rate
rn Natural rate of interest
s Share of employed workers who apply for other jobs and quit whether they find one or not
T rF Transfers from abroad
u Unemployment rate
U Number of unemployed workers
un Natural rate of unemployment
V Velocity of money
W Wage level
Wd Desired wage
W/P Real wage
Y Real production
Y∗ Foreign real production/income
Ye Expected future income
Yd Real disposable income; Y d = Y ` − T + r(D + F )
Y` Labour income
Yn Natural level of production
n
Ŷ Output gap, Ŷ = Y Y−Yn
YF Net primary income from abroad
X Exports
Z Share of employed workers who apply for other jobs and quit if they find one
α Importance of capital in production

7
 δ Depreciation rate
ε Real exchange rate: price of domestic goods in terms of foreign goods
η Elasticity of demand for a particular firm’s goods
λ Willingness and ability of unemployed workers to compete for jobs,
share of firms with flexible wages, and others
µ Mark-up on marginal cost
π Inflation rate
πe Expected inflation rate
π⊗ Central bank inflation target
ρ Subjective discount rate

2.1 Introduction to Macroeconomics

First, we have the formula for Gross Domestic Product (GDP):

Y = C + I + C G + I G + (X − IM ). (2.1.1)

Or, taking net exports as the difference between exports and imports (N X = X − IM ),

Y = C + I + C G + I G + N X. (2.1.2)

Some other values relating to the national accounts:

Gross value added at basic price = GDP − Taxes less subsidies (2.1.3)

Net domestic product at market price = GDP − Consumption of capital (2.1.4)

Gross national income at market prices = GDP + Net primary income from rest of world
(2.1.5)
=Y +YF

Net national income at market prices = GDP − Consumption of capital

+ Net primary income from rest of world (2.1.6)
F
= Y − δK + Y

Net national disposable income at market prices = GDP − Consumption of capital

+ Net primary income and
(2.1.7)
net transfers from rest of world
= Y − δK + Y F + T rF

In general, note that the difference between ”gross” and ”net” values is consumption of capital, and the
difference between market and basic prices is taxes less subsidies.

Current account = Net lending

= savings − real investment
= Y + Y F + T rF − C − C G − I − I G (2.1.8)
= net exports + net primary income + net transfers
= N X + Y F + T rF

8
Measuring real growth of production (for the case of two goods):

PtA Yt+1
A
+ PtB Yt+1
B
gt+1 = − 1. (2.1.9)
PtA YtA + PtB YtB

Measuring inflation - Consumer Price Index (CPI) (also for the case of two goods):
A
Pt+1 CtA + Pt+1
B
CtB
πt+1 = − 1. (2.1.10)
PtA CtA + PtB CtB

2.2 Production, Prices and Distribution of Income

Our generic production function:
Y = F (K, N ). (2.2.1)

In particular, the Cobb-Douglas production function:

Y = K α (EN )1−α , (0 ≤ α ≤ 1). (2.2.2)

Derivatives of the Cobb-Douglas production function:

Y
M P K = αK α−1 (EN )1−α = α , (2.2.3)
K

 α
α 1−α −α 1−α K Y
M P L = (1 − α)K E N = (1 − α)E = (1 − α) . (2.2.4)
N N

Price setting:
M R = M C. (2.2.5)

But revenue = Yi · P (Yi , P, Y ), so

d(revenue) dPi
MR = = Pi + Yi . (2.2.6)
dYi dYi

Applying elasticities yields  

1
MR = 1+ Pi = M C, (2.2.7)
η
1
and viewing mark-up µ as 1 + µ = 1+1/η ,

Pi = (1 + µ)M Ci . (2.2.8)

Price level for the whole economy (firms are symmetric):

W
P = (1 + µ) . (2.2.9)
MPL

In the Cobb-Douglas case:

 −α
1+µ W K
P = . (2.2.10)
1 − α E 1−α N

Written in terms of unit labour cost (W N/Y ):

1 + µ WN
P = . (2.2.11)
1−α Y

Natural rate of production occurs when unemployment u is at natural level un :

Y n = F (K, N n ) = F (K, E(1 − un )L). (2.2.12)

9
To find real wage, rearrange expression for price level:
W W MPL
P = (1 + µ) =⇒ = . (2.2.13)
MPL P 1+µ

If the production function is Cobb-Douglas:

 α
W 1 − α 1−α K
= E . (2.2.14)
P 1+µ N

Labour share of income:

WN 1−α
= . (2.2.15)
PY 1+µ

Conversely, non-labour (capital) share of income:

1−α α+µ
=1− = . (2.2.16)
1+µ 1+µ

2.3 Interest Rates and Investment

Price of money today in terms of money tomorrow is

1 + it , (2.3.1)

and price of consumption today in terms of consumption tomorrow is

Pt 1 + it
= . (2.3.2)
Pt+1 /(1 + it ) Pt+1 /Pt

Inflation is given by:

Pt − Pt−1
πt = . (2.3.3)
Pt−1

The real interest rate is the price of consumption today in terms of consumption tomorrow:
1 + it
1 + rt+1 = . (2.3.4)
1 + πt+1

For small values of i and π,

rt+1 ≈ it − πt+1 . (2.3.5)

Capital stock changes over time according to:

Kt+1 − Kt = It − δKt . (2.3.6)

To reach desired capital stock next period:

d
It = Kt+1 − Kt + δKt . (2.3.7)

In the long run, capital stock is set so that

M P Kt+1 · M Rt+1 + (1 − δ)Pt+1 − (1 + it )Pt = 0 (2.3.8)

M P Kt+1
⇐⇒ − δ = rt+1 . (2.3.9)
1+µ

Using the Cobb-Douglas equation for M P K, we can derive desired capital stock explicitly as
 1
 1−α
d α α
K = EN = Y. (2.3.10)
(r + δ)(1 + µ) (r + δ)(1 + µ)

10
In the short run, we might set Y = Y e .
Returning to Equation (2.3.7) for desired investment:
α
I = K d − K + δK = Y e − (1 − δ)K. (2.3.11)
(r + δ)(1 + µ)

In sum, investment depends on three factors: r, Y e and K, so we write

I = I(r, Y e , K), (2.3.12)

where investment is increasing in Y e and decreasing in r and K.

2.4 Consumption and the Natural Rate of Interest

Lifetime budget constraint in a two-period model:
C2 Y2
C1 + = Y1 + . (2.4.1)
1+r 1+r

The Euler equation for optimal consumption in the two period model:
u0 (C1 )
=1+r (2.4.2)
u0 (C2 )/(1 + ρ)

u0 (C1 ) 1+r
⇐⇒ 0
= . (2.4.3)
u (C2 ) 1+ρ

Note that u(C) is a convex function (diminishing marginal utility), so higher u0 (C) implies smaller
C.
The Euler equation extends to the infinite horizon model:
u0 (Ct )
= 1 + rt+1 . (2.4.4)
u0 (Ct+1 )/(1 + ρ)

In the infinite horizon model, sustainable consumption is as follows:

Ct = Y ` + rAt . (2.4.5)

Our consumption function tells us that C relates to Y , Y e , r and A:

C = C(Y, Y e , r, A). (2.4.6)

The function is increasing in Y , Y e and A, but the effect of r may be ambiguous, depending on whether
the consumer is a borrower or a saver.
However, to simplify things, we assume in the infinite horizon case that r = ρ, in which case increasing
r always leads to lower consumption.
If we have the specific utility function u(Ct ) = ln(Ct ), then it is possible to derive a specific consumption
function: e
r̄(Yt + At ) + Yt+1
Ct = 1+rt+1 . (2.4.7)
1+ρ + r̄

Aggregate demand is the sum of consumption and investment:

Y = C(Y, Y e , r, A) + I(r, Y e , K). (2.4.8)

The natural rate of interest, rn , is the value of r so that the long-run equilibrium condition holds

Y n = C(Y n , Y e , rn , A) + I(rn , Y e , K). (2.4.9)

11
Alternatively, when examining a long-run equilibrium, we may define a savings function

S(Y, Y e , r, A) = Y − C(Y, Y e , r, A), (2.4.10)

and then the long-run equilibrium condition defining rn becomes

S(Y n , Y e , rn , A) = I(rn , Y e , K). (2.4.11)

Finally, the Fisher equation states that

i=r+π or r = i − π. (2.4.12)

2.5 Capital Accumulation and Growth

Production per effective worker is
 
Y K
=F , 1 = f (k). (2.5.1)
EN EN

Then f 0 (k) is the marginal product of capital. Letting k ∗ be the steady state capital stock per effective
worker. Then the condition for steady state capital stock is a reformulation of Equation (2.3.9):

f 0 (k ∗ )
− δ = r̄. (2.5.2)
1+µ

Then
K ∗ = k ∗ EN and Y ∗ = f (k ∗ )EN. (2.5.3)

Growth rates are defined as follows:

∆N ∆E
=n and = g. (2.5.4)
N E

So
∆K ∆Y
= = g + n. (2.5.5)
K Y
The real interest rate in steady state is
r̄ ≈ ρ + g, (2.5.6)

so Equation (2.5.2) is equivalent to

f 0 (k ∗ )
= ρ + g + δ. (2.5.7)
1+µ

We may use the Cobb-Douglas production function to find GDP per worker in the labour force:
 α
 1−α
Y α
= E(1 − u). (2.5.8)
L (1 + µ)(r̄ + δ)

The Golden Rule states that to maximise steady state consumption, the capital stock should be increased
until
f 0 (k) = n + g + δ. (2.5.9)

This is greater than the steady state capital stock from Equation (2.5.2), since consumers’ impatience
means they discount future utility.

12
2.6 Wage-Setting and Unemployment
Unemployment rate is defined as
U L−N
u= = . (2.6.1)
L L
The job-finding rate depends on the level of unemployment and the share of workers quitting exoge-
nously:
Ns s
f= ≈ . (2.6.2)
U + Ns u+s

We model the share of workers in firm i searching on the job as a function of the firm’s relative wage:
 
Wi
Zi = Z . (2.6.3)
W

Then a firm’s cost per worker is

Wi + h · W (s + Z(Wi /W ) · f ). (2.6.4)

The wage-setting equation tells us the desired wage:

W d = (1 + a − bu)W. (2.6.5)

If unemployment is on its natural level, W d = W , and this rearranges to

a
un = . (2.6.6)
b

We also have an equation for desired wage increase:

∆Wtd ∆Wt
= − b(ut − un ). (2.6.7)
Wt−1 Wt−1

Natural level of employment is simply:

N n = (1 − un )L. (2.6.8)

If we introduce λ as the willingness and ability of unemployed workers to compete for jobs, then the
job-finding rate is λf for unemployed workers and
s
f= (2.6.9)
λu + s
for employed workers.
Finally, if the rate at which unemployed workers leave the labour force is ν, then the exit rate is

x = λf + ν, (2.6.10)

and expected duration of unemployment is

1 1 1
= = λs
. (2.6.11)
x λf + ν λu+s +ν

2.7 Money and Inflation in the Long Run

Money market equilibrium:
M V = P Y. (2.7.1)

Or, factoring in velocity as an increasing function of interest rate,

M Y
M V = P Y ⇐⇒ = . (2.7.2)
P V (i)

13
So price level is given by
MV
P = . (2.7.3)
Y

Inflation and growth rates:1

∆M ∆V ∆Y n
π= + − . (2.7.4)
M V Yn
Seigniorage:
∆M (π + g + n)
= . (2.7.5)
PY V

2.8 The Interest Rate and Production in the Short Run

1
Given a marginal propensity to consume c, the multiplier is 1−c , e.g.

1
∆Y = ∆I. (2.8.1)
1−c

The IS Curve shows the pairs of i and Y such that desired savings with desired investment (equilibrium
in the goods market):
Y − C(Y, Y e , i − π e , A) = I(i − π e , Y e , K). (2.8.2)

And the LM Curve shows points of equilibrium in the money market:

M Y
= . (2.8.3)
P V (i)

In the short run, we use r = i − π e so that i becomes explicitly endogenous.

The IS Curve has a negative slope and the LM Curve a positive slope when plotting i against Y .

2.9 Economic Activity and Inflation in the Short Run

We already have Equation (2.6.7) as an equation for desired wage increases.
If a proportion λ of firms set flexible wages (and proportion 1 − λ set rigid wages) then,

∆Wt ∆Wtx ∆Wtr

=λ + (1 − λ) (2.9.1)
Wt−1 Wt−1 Wt−1
e
∆Wt λb
= − b̂(ut − un ), where b̂ = . (2.9.2)
Wt−1 1−λ

The final relation is a version of the Phillips Curve. This curve is downward sloping and is steeper the
more responsive firms are to changes in unemployment (higher b) and the more forms set flexible wages
(higher λ).
To examine changes in wages and prices in the short run, we use a simplified production function

Y = EN. (2.9.3)

Marginal product of labour is nothing but E, so using Equation (2.2.9), P = (1 + µ) W

E . Using rule of
thumb for growth rates (Equation (2.19.2)),

∆W ∆E ∆W e ∆E e
π= − =⇒ π e = − . (2.9.4)
W E W E

We use this and Equation (2.9.1) to derive a second version of the Phillips Curve relating inflation to
unemployment,
π = π e − b̂(u − un ) + z, (2.9.5)
1 see Equation (2.19.2) for derivation.

14
where z is a cost-push shock.
Furthermore, we can define the output gap as
Y −Yn
Ŷ = , (2.9.6)
Yn

and find cyclical unemployment to be

Yn Y −Yn Yn
u = un = − = − Ŷ . (2.9.7)
EL Y n EL

This culminates in a Phillips Curve in terms of inflation and the output gap:
Yn λb Y n
π = π e + β Ŷ + z where β = b̂ = . (2.9.8)
EL 1 − λ EL

There are three assumptions we may make about expected inflation:

1. Price level is expected to remain constant: π e = 0.
2. Inflation is expected to be the same as last year: π e = π−1 .
3. Inflation is expected to be equal to the central bank’s inflation target: π e = π ⊗ .
If we assume πte = πt−1 , then we may produce an ‘accelerationist’ Phillips Curve:

∆π = β Ŷ + z (2.9.9)

2.10 Monetary Policy

No new formulas are introduced in the main part of this chapter, but we make use of the IS-LM model
from Section 2.8 and the Phillips curve from Section 2.9:

Y = C(Y, Y e , i − π e , A) + I(i − π e , Y e , K), (2.10.1)

M Y
= , (2.10.2)
P V (i)
Y −Yn
π = πe + β + z. (2.10.3)
Yn

These are equivalent to Equation (2.8.2), Equation (2.8.3) and Equation (2.9.8), respectively.

2.11 Fiscal Policy

The stock of real net government debt changes over time according to

∆Dt+1 = Gt − Tt + rDt (2.11.1)

We define the debt ratio, dt as

Dt
dt = , (2.11.2)
Yt
and the change in the debt ratio is given by
 
1 G−T
dt+1 − dt = + (r − g)dt . (2.11.3)
1+g Y

Therefore if the debt ratio is to remain constant, the government must have a primary surplus equal
to
T −G D
= (r − g) . (2.11.4)
Y Y

15
Note that
G−T
(2.11.5)
Y
gives the primary balance/deficit, while the formula
G − T + iD
(2.11.6)
Y
gives the fiscal balance, which includes net interest payments.
Introducing taxes into the budget constraint of the two-period consumption model (Equation (2.4.1)),
C2 Y ` − T2
C1 + = Y1` − T1 + 2 . (2.11.7)
1+r 1+r
Since the government sets period 2 taxes to cover its period 2 spending and repayment of the deficit,
T2 = G2 + (1 + r)(G1 − T1 ), and the budget constraint becomes
C2 Y ` − G2
C1 + = Y1` − G1 + 2 , (2.11.8)
1+r 1+r
which is independent in T1 and T2 , proving the Ricardian equivalence.

2.12 Exports, Imports and International Financial Markets

The real exchange rate is the price of domestic goods in terms of foreign goods,

eP
ε= . (2.12.1)
P∗
The IS equation for a small open economy is
IM Cf
Y + = Cd + + I + G + X, (2.12.2)
ε ε
or, equivalently,
IM
Y = C + I + G + N X, where NX = X − (2.12.3)
ε
The Marshall-Lerner Condition says that, when trade is initially balanced, dN X
dε < 0 if the sum of absolute
values of the elasticities of exports and imports with respect to ε is greater than 1, i.e.
dX ε dIM ε
− + > 1. (2.12.4)
dε X dε IM
Net exports is a function of the real interest rate (ε), domestic income (Y ) and foreign income (Y ∗ ),
N X = N X(ε, Y, Y ∗ ). (2.12.5)
∗
This function is increasing in Y and Y , and decreasing in ε when the Marshall-Lerner Condition is
satisfied.
Therefore the IS equation may be written in full as,
Y = C(Y d , Y e − T e , r, A) + I(r, Y e , K) + G + N X(ε, Y, Y ∗ ), (2.12.6)
and in the long run, ε adjusts to make this hold.
The current account gives the change in net claims on foreign households,
∆F = Y + rF − C − G − I = N X + rF. (2.12.7)

The interest parity condition is

eet+1 ∆eet+1
1 + i∗t = (1 + it ) , or approximately, it − i∗t ≈ − . (2.12.8)
et et

Rearranging the interest parity condition, we find an equation for the current (floating) exchange rate
given interest rates set by respective central banks,
1 + it e
et = e . (2.12.9)
1 + i∗t t+1

16
2.13 The Open Economy in the Long Run
Beginning with the definition of the real exchange rate (Equation (2.12.1)), we first rearrange for e,

P∗
e=ε . (2.13.1)
P
Then, assuming ε is constant in the long run, and applying the rule of thumb for growth rates (Equa-
tion (2.19.2)), we find
∆et+1 ∗
≈ πt+1 − πt+1 . (2.13.2)
et

Combining this with Equation (2.12.8), we see that the real interest rate in the open economy must be
the same as abroad,
rt ≈ rt∗ . (2.13.3)

However, we usually write Equations (2.13.2) and (2.13.3) as equalities (=) instead of approximations
(≈).
Based on the IS curve in the open economy (Equation (2.12.6)), for production to be at natural level,
Y = Y n , we must have

N X(ε, Y n , Y ∗ ) = Y n − C(Y d , Y e − T e , r∗ , A) − I(r∗ , Y e , K) − G. (2.13.4)

In a closed economy, the steady state capital stock is determined by Equation (2.5.2). In the open
economy, the equation is very similar,
f (k ∗ )
− δ = r∗ . (2.13.5)
1+µ

In a large open economy, the country’s net lending/saving (∆F ) can influence the world real interest rate
(r∗ ), and we the intersection
∆F (r∗ ) = Y n − C(r∗ ) − I(r∗ ) − G (2.13.6)
in (∆F, r∗ ) space to determine r∗ and ∆F .

2.14 The Open Economy in the Short Run

The Mundell-Fleming Model consists of three equations:
 
eP
Y = C(Y − T, Y e − T e , i − π e , A) + I(i − π e , Y e , K) + G + N X , Y ∗, Y , (IS)
P∗

M Y
= , (LM)
P V (i)
ee
1 + i∗ = (1 + i) . (IP)
e
If we have a floating exchange rate regime, we combine the IS equation and the IP equation to get the
IS ∗ equation, which incorporates the effect of an interest rate rise via the exchange rate channel:

1 + i ee P
 
e e e e e ∗
Y = C(Y − T, Y − T , i − π , A) + I(i − π , Y , K) + G + N X ,Y ,Y . (2.14.1)
1 + i∗ P ∗

When analysing the effects of exogenous changes, it is useful to have specific functional forms:

C = c0 + c1 [(1 − τ )Y + T r] 0 < c1 < 1

∗
I = b0 − b1 i b1 > 1
(2.14.2)
IM = εqY 0<q<1
X = dε−σ Y ∗ d > 0, σ > 0

17
2.15 Exchange Rate Systems and Monetary Union
There are no new formulas introduced in this section. Useful equations are those in the Mundell-Fleming
model (see Section 2.14.)

2.16 Business Cycles

If yt is the log of real GDP, we can decompose it into a trend component, ytT , and a cyclical component,
ytC :
yt = ytT + ytC (2.16.1)

Some of the ways to model the trend are:

ˆ Linear: ytT = a + bt.
ˆ Quadratic: ytT = a + gt + bt2 .
ˆ Hodrick-Prescott filter.
ˆ Stochastic random walk: ytT = g + yt−1
T
+ εTt .
Since GDP is given by (as in Equation (2.1.1)),

Y = C + I + G + X − IM, (2.16.2)

we have

∆Y = ∆C + ∆I + ∆G + ∆X − ∆IM (2.16.3)
∆Y ∆C ∆I ∆G ∆X ∆IM
=⇒ = + + + − . (2.16.4)
Y Y Y Y Y Y

In fact,
∆Y ∆C C ∆I I ∆G G ∆X X ∆IM IM
= + + + − . (2.16.5)
Y C Y I Y G Y X Y IM Y

2.17 Institutions and Economic Policy

We remind ourselves of several equations from previous sections, for example the Phillips Curve (Equa-
tion (2.9.5))
λb
π = π e − b̂(u − un ) + z, where b̂ = , (2.17.1)
1−λ
and also the formula for change in the debt ratio, as given in Equation (2.11.3),

D G−T D
∆ = + (r − g) . (2.17.2)
Y Y Y

We also rearrange Equation (2.11.4) to find the level of taxation as a fraction of GDP when the debt
ratio is constant,
T G D
= + (r − g) . (2.17.3)
Y Y Y
The long-run steady state debt ratio is given by

D (G − T + iD)/Y deficit / GDP

= = . (2.17.4)
Y π+g growth rate of nominal GDP

The loss function that a policymaker tries to minimise will be, for example,

L(πt , ut ) = πt2 + λu2t . (2.17.5)

18
2.18 Financial Markets
For a firm, it must be the case that

Assets = Liabilities + Equity (2.18.1)

Value of a share is the present value of expected future dividends:

det+1 det+2 det+3
St = + 2
+ + ··· (2.18.2)
1 + r (1 + r) (1 + r)3

If dividends are expected to be d in the next period and increase at a rate g from period t + 1 onwards,
this becomes
d (1 + g)d (1 + g)2 d d
St = + + + ··· = . (2.18.3)
1+r (1 + r)2 (1 + r)3 r−g

When the firm is entirely financed by equity, Tobin’s q is

S
q= . (2.18.4)
K

When the firm finances a share θ of its investments by borrowing, Tobin’s q becomes2
S + θK
q= . (2.18.5)
K

π
Assuming the real value of shares is r, and taking a Cobb-Douglas production function so that π =
αY − δK, this formula becomes
αY /K − δ
q= . (2.18.6)
r
Investment is determined by the ratio of the marginal product less depreciation and the real interest
rate,  
MPK − δ
I=I , (2.18.7)
r
and in the Cobb-Douglas case, M P K = αY /K, so investment is a function of Tobin’s q.

2.19 Other
Suppose Z is defined as
X ·Y
Z= . (2.19.1)
Q

Then the growth rate of Z may be approximated as

∆Z ∆X ∆Y ∆Q
≈ + − . (2.19.2)
Z X Y Q

This approximation is better the smaller the values of X, Y and Q.

2 Note that Equation (2.18.4) is just a special case of Equation (2.18.5), taking θ = 0.

19
3 Mathematics
3.1 Total Differential and Total Derivative
For a function of two variables, z = f (x, y), the total differential dz is defined as
∂z ∂z
dz = dx + dy = fx dx + fy dy. (3.1.1)
∂x ∂y

More generally, for f = (x1 , x2 , · · · , xn ), the total differential is

∂z ∂z ∂z
dz = dx1 + dx2 + · · · + dxn . (3.1.2)
∂x1 ∂x2 ∂xn

The chain rule for z = f (x, y), where y = g(x) is

dz ∂z ∂z dy
= + . (3.1.3)
dx ∂x ∂y dx

When finding the derivative of implicit functions, we have

dy fx
=− , (3.1.4)
dx fy
or
∂y fx
=− . (3.1.5)
∂x fy

3.2 Constrained Optimisation

For objective function z = f (x, y) and constraint g(x, y) = c, the Lagrangian is defined as

L = f (x, y) + λ(c − g(x, y)) (3.2.1)

Then we use the following first order conditions to find where f is maximised subject to x and y:
∂L
= fx − λgx = 0
∂x
∂L
= fy − λgy = 0 (3.2.2)
∂y
∂L
= c − g(x, y) = 0
∂λ

It is quite easy to generalise to n variables, i.e. with an objective function z = f (x1 , x2 , · · · , xn ) and
constraint g(x1 , x2 , · · · , xn ):

L = (x1 , x2 , · · · , xn ) + λ(c − g(x1 , x2 , · · · , xn )). (3.2.3)

The first order conditions are therefore

∂L
= fx1 − λgx1 = 0
∂x1
............
∂L (3.2.4)
= fxn − λgxn = 0
∂xn
∂L
= c − g(x1 , x2 , · · · , xn ) = 0.
∂λ

For multiple constraints, as an example, the case of two variables and two constraints would be

L = f (x, y) + λ(c − g(x, y)) + µ(d − h(x, y)). (3.2.5)

20
In general, with n variables and m constraints, we might write this as
m
X
L = f (x1 , x2 , · · · , xn ) + λi (ci − gi (x1 , x2 , · · · , xn )). (3.2.6)
i=1

Then, the first order conditions will consist of the derivatives with respect to x1 , · · · , xn , and a restatement
of the m constraints, i.e. a total of m + n equations.

3.3 Statistics Primer

Expected value is given by
n
X
E(X) = xi p i , (3.3.1)
i=1

Rules of the expected value:

E(bX) = bE(X) (3.3.2)

E(X + Y ) = E(X) + E(Y ) (3.3.3)
E(b) = b. (3.3.4)

2
The variance σX is a measure of how far X can deviate from its mean µX ,
n
X
2
Var(X) = σX = (xi − µX )2 pi = E(X 2 ) − µ2X . (3.3.5)
i=1

Then, standard deviation is nothing but the positive square root of the variance:
q
σX = σX 2 (3.3.6)

Rules for variances:

Var(bX) = b2 Var(X) (3.3.7)

Var(b) = 0 (3.3.8)
Var(X + b) = Var(X) (3.3.9)
2 2
Var(aX + bY ) = a Var(X) + b Var(Y ) + 2abCov(X, Y ). (3.3.10)

Covariance is defined as

Cov(X, Y ) = σXY = E[(X − µX )(Y − µY )] = E(XY ) − µX µY . (3.3.11)

Covariance rules, for random variables W , X, Y , and Z, and constant c:

ˆ If Y = W + X, then Cov(Y, Z) = Cov(W, Z) + Cov(X, Z).
ˆ If Y = bZ, then Cov(X, Y ) − bCov(X, Z).
ˆ Cov(X, b) = 0.
ˆ Cov(X, Y ) = Cov(Y, X).
ˆ Cov(X, X) = Var(X).
Correlation is always between −1 (perfect negative linear relationship) and +1 (perfect positive linear
relationship):
Cov(X, Y )
ρ = Corr(X, Y ) = . (3.3.12)
σX σY

21
3.4 Matrix Algebra
The inverse of a matrix A is defined as the matrix A−1 such that

AA−1 = A−1 A = I. (3.4.1)

 
a b
For a 2 × 2 matrix, A = , the determinant is given by
c d

|A| = det(A) = ad − bc. (3.4.2)

If the determinant of A is non-zero, then A has an inverse, and this inverse is given by
 
1 d −b
A−1 = . (3.4.3)
det(A) −c a

The determinant of a 3 × 3 matrix A is given in terms of minors:

|A| = a11 |M11 | − a12 |M12 | + a13 |M13 |. (3.4.4)

These sign-adjusted minors are called cofactors:

Cij = (−1)i+j |Mij |. (3.4.5)

In finding the inverse of a matrix, we form a matrix of cofactors,

 
C11 C12 C13
C = C21 C22 C23  . (3.4.6)
C31 C32 C33

The adjoint matrix is the transpose of this matrix of cofactors:

 
C11 C21 C31
adj(A) = C12 C22 C32  . (3.4.7)
C13 C23 C33

Finally, the inverse is given by

adj(A)
A−1 = . (3.4.8)
|A|

We often aim to solve a general system of n equations in n unknowns, which may be written as Ax = b,
where      
a11 a12 · · · a1n x1 b1
 .. .
.. . .. .
..  , x =  ..  , b =  ... 
.
A= . . (3.4.9)
   

an1 an2 · · · ann xn bn

Cramer’s Rule states that, for find the solution for x1 , find a derived matrix A1 by replacing the first
column in A with the vector b:  
b1 a12 · · · a1n
A1 =  ... .. .. ..  (3.4.10)

. . . 
bn an2 · · · ann

Then
|A1 |
x1 = , (3.4.11)
|A|
and this applies similarly for finding x2 etc.

22
When conducting input-output analysis, we form a matrix of production input coefficients:
 
a11 · · · a1n
A =  ... .. ..  (3.4.12)

. . 
an1 · · · ann

We then define the production vector x, where xi represents the value of commodity i produced in the
economy, and a vector of final demand c, where ci gives the value of quantity demanded by final consumers
of commodity i.    
x1 c1
 ..   .. 
x =  . , and c =  . . (3.4.13)
xn cn

If demand is satisfied in all industries,

x = Ax + c
(3.4.14)
=⇒ x = (I − A)−1 c,

assuming (I − A)−1 exists. The matrix I − A is called the Leontief Matrix.

The Hawkins-Simon Condition gives the requirements for non-negative solutions: the leading principle
minors of the Leontief Matrix (I − A) must all be positive. For the matrix
 
a11 a12 a13
A = a21 a22 a23  , (3.4.15)
a31 a32 a33

a11 a12 a13

a11 a12
the leading principle minors are |a11 |, , and a21 a22 a23 .
a21 a22
a31 a32 a33

3.5 Difference Equations

We consider difference equations of the form
yt = byt−1 + c. (3.5.1)

For a particular initial value y0 , this solves for yt in terms of just t:

 
t c c
yt = b y0 − + . (3.5.2)
1−b 1−b
 
c
Or, if y0 is not known, we replace y0 − 1−b with an arbitrary constant A:
c
yt = Abt + . (3.5.3)
1−b

3.6 Differential Equations

We consider differential equations of the form
dy
= by + c. (3.6.1)
dt

The general solution to this equation is

c
y = Aebt − . (3.6.2)
b
If we know the initial value of y at time t = 0 (written y(0)), this becomes
 c  bt c
y = y(0) + e − . (3.6.3)
b b

23