Lecture 1

Overview, Labor Demand and Supply

Macroeconomics EC2B1

Benjamin Moll

London School of Economics, Lent 2023

Who are we?
Who am I? Macroeconomist. When I don’t teach I work on:
1. Why are some countries so much poorer than others?
2. How does micro heterogeneity affect macro economy / policy?
• How does your professor tick? Look at current working papers
https://benjaminmoll.com/papers/
• Asset-Price Redistribution
• Present Bias Amplifies the Household Balance-Sheet Channels of Macroecon Policy
• What if? The Economic Effects for Germany of a Stop of Energy Imports from Russia
• The Great Lockdown and the Big Stimulus: Tracing the Pandemic Possibility Frontier
• also see https://benjaminmoll.com/research_agenda_2020/

Who is Yannick and the class teachers? You’ve already met...

Who are you? How many undergraduates, 2-year MSc? Econ background?
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This Course: Modern Macroeconomics

• Modern = as practiced in current academic research

• ̸= what’s in standard textbooks

• Macro with micro foundations

• utility and profit maximization just like in EC1A1
• ... but general equilibrium (= prices endogenous, clear markets)

• First time I’m teaching this course at LSE

• updated version of course at Princeton some years ago
• ... but everything is flexible, feedback very useful

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Admin
1. Lectures: Monday 9:00-11:00, Old Theatre
2. Office hours: Thursday 2:15-3:15, 32LIF 1.19 (my office)
3. Classes and class teacher office hours: see moodle
4. Problem sets (as before)
• one per week
• handed out after lecture, discussed in class a week later
• feedback on two: week 4 (PS #3) and week 10 (PS #9)

5. Assessment
• big exam at end of year
• project

6. Anything else? 3
What this course is about

• Wouter den Haan’s MT part: long-run issues

• growth, cross-country income differences etc

• This term: short-run issues

• business cycles
• economic crises: financial, energy, ...
• macroeconomic stabilization policies: monetary, fiscal, ...

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Special Notes: Lecture participation and attendance to classes are both strongly encouraged. Also see all the useful
Topics we will cover (subject to change)
tips on Wouter den Haan’s MT syllabus.

Course Outline
Topic
Section 1 Welcome and Overview, Labor Demand and Supply

Section 2 A Simple Macro Model, Equilibrium and Welfare Theorems

Section 3 The West without Russian Gas

Section 4 Consumption, Saving, Interest Rates

Section 5 Investment and Capital Accumulation

Section 6 Business Cycle Macro, Real Business Cycle Model

Section 7 New Keynesian Model I

Section 8 New Keynesian Model II

Section 9 The Financial Crisis, Asset Bubbles

Section 10 Unemployment (Pissarides), Inequality in Macro

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Tools

As just mentioned: macro with micro foundations

• utility and profit maximization just like in EC1A1

Reflected in tools:
• differential calculus
• heavy use of constrained optimization using Lagrangean methods
• Need to know how to solve
max u(c1 , c2 ) s.t. p1 c1 + p2 c2 ≤ m
c1 ,c2

using
L = u(c1 , c2 ) + λ [m − p1 c1 − p2 c2 ]
• If you don’t, refresh your memory using MA100, MA107 or EC1A1 notes
• Assignment 1 and class 1 will be about this
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One of my main goals: train you to read newspaper properly

• Train you to critically read and evaluate discussions of macroeconomic

policy in popular press, on TV, ...

• Help you understand where people come from

• what’s model in back of their minds (if any)?

• Help you evaluate quality of argument

• is argument internally consistent?
• what empirical evidence is there and is it credible?
• you will find that there’s huge variation in quality

• “Train your BS detector” so to speak

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Textbooks
Unfortunately, there exists no textbook with the proper level and focus for this
course. Instead, it will rely on lecture notes and research journal articles
That being said, the following textbooks may be useful as background reading
(given the extortionate prices of textbooks these days, I want to emphasize
that these are not required):
• Kurlat, Pablo, A Course in Modern Macroeconomics
https://sites.google.com/view/pkurlat/a-course-in-modern-macroeconomics
• if you do want to buy a book, buy this one ($ 27.95)
• but will also post relevant PDF excerpts on Moodle
• Jones, Chad, Macroeconomics – one of your books from EC1B1
• Williamson, Stephen, Macroeconomics
• Romer, David, Advanced Macroeconomics
• Abel, Andrew and Ben Bernanke and Dean Croushore, Macroeconomics 8
Finally, all of Wouter den Haan’s tips still apply

HOW TO STUDY
EFFICIENTLY
• The slides are the most important. Then required readings.
• It is very beneficial if you keep up with the course. A lot of the material is new
and will need some reflection time to sink in. Moreover, material taught later
builds on material covered earlier.
• Thus, spending a bit of time every week will mean (i) you will absorb and
understand the material spending less hours than when you try to catch up at a
later date, (ii) you’ll enjoy the lectures more since you understand more, and (iii)
it may also lead to less stress.
• MAKE SURE TO MAKE GOOD NOTES. Revision before the exam will be easier.
• Come to classes prepared, having studied course material and the assignment.
• BE AN ACTIVE LEARNER BY DOING THE FOLLOWING:
o Don’t just go over the material line by line and be happy when you can follow
the argument. Put all the material away and see whether you can rebuild the
whole argument from scratch. On the exam (and in real life) you will be
expected to do more than having memorized stuff.
o Summarise to your boy/girlfriend, younger sibling, grandparents, stranger on
the tube, and/or an imaginary friend what you have just learned.
o Study with other students and challenge each other.
o When you get lost, do NOT try to find more literature online or in the library.
The struggle to figure things out yourself is part of studying effectively.

IF YOU NEED HELP 9

Some thoughts on methodology:
what economists do and why

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The interplay of models and data
• Like in your previous courses, will make use of models and look at data
• Example of model: firms choose labor demand to maximize profits
max f (n) − w n
n
where n is labor, f (n) is output (f is production function), w is the wage
• Example of data:

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The interplay of models and data

How to think about interplay of model and data?

• why not only data?

• why not only models?

Here: quick, superficial treatment of important methodological issues

• part of much broader methodological debates (see references)

• my main goal here: get you thinking about these issues

• disclaimer: no single “right” approach here, reflects my personal opinion

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The interplay of models and data

Macroeconomics needs interplay of both theory and data

1. Theory without data
• “smart kids playing in sandbox”

2. Data without theory

• flying blind
• “Let the data speak” is fiction / wishful thinking
• there is no paper in economics without a (implicit) model
• policy questions are questions about counterfactuals (“what happens
in world with policy relative to world without policy?”)
• ... requires a model (either explicit or implicit)
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Further reading for the interested (not required)

Some relevant references (discussion in many much deeper than here):

• Nakamura-Steinsson “Identification in Macroeconomics”

• Reis “Is something really wrong with macroeconomics?”

• JEP Symposium “Con out of Economics” https://www.aeaweb.org/issues/126

• Heckman-Urzua “Comparing IV With Structural Models: What Simple IV

Can and Cannot Identify”
• Card “Model‐Based or Design‐Based? Competing Approaches in
‘Empirical Micro’” https://davidcard.berkeley.edu/lectures/woytinsky.pdf
https://www.youtube.com/watch?v=S6xSEiB6E2s

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Modeling in (Macro)economics

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Modeling in (Macro)economics
Objective is not to build one big model we use to address all issues
• descriptive realism is not the objective
• instead make modeling choices that are dependent on the issue
• whether a model is “good” is context dependent
Approach to modeling in (macro)economics well summarized by
• “All models are false; some are useful”
https://en.wikipedia.org/wiki/All_models_are_wrong

• “If you want a model of the real world, look out the window” (kidding, but
only half kidding)
• “The map is not the territory” https://en.wikipedia.org/wiki/Map-territory_relation
• Literary version of this: Borges “On Exactitude in Science”
• Point in case: geographically accurate London tube map
https://kottke.org/plus/misc/images/tubegeo.gif

https://www.ifs.org.uk/publications/10282 by Bandiera, Machin,... 16

London tube map (https://kottke.org/plus/misc/images/tubegeo.gif)

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My own version (same ideas)
https://economicsobservatory.com/how-are-economic-models-adapting-to-rising-inequality-and-the-pandemic

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Crucial or Critical Assumptions

Source: Solow (1956) “A Contribution to the Theory of Economic Growth” 19

Modeling in (Macro)economics
Ten commandments for non-economists

1. Economics is a collection of models with no predetermined conclusions; do not let anyone tell
you otherwise.
2. Do not criticize an economist’s model because of its assumptions; ask how the results would
be changed if the assumptions that seem problematic were more realistic.
3. Analysis requires simplicity; beware of incoherence that passes itself off as complexity.

4. Do not be put off by the math; remember economists use math not because they are smart,
but because they are not smart enough.
5. When an economist makes a recommendation, ask what makes him/her sure the underlying
model applies to the case at hand.
6. When an economists uses the term “economic welfare,” ask what s/he means by it.

7. Do not assume what an economist says in public is the same as what he says in the seminar
room.
8. Economists don’t (all) worship markets; if they seem like they do, it’s probably because they
know better how they work than you do.
9. If you think all economists think alike, do attend one of their seminars.

10. If you think economists are especially rude to non-economists, do attend one of their
seminars.

Source: Rodrik (2015) “Economics Rules” 20

http://www.centreformacroeconomics.ac.uk/pdf/Events/Slides/1510-RodrikD.pdf
Navigating Among Models
• Chapter 3 “Navigating Among Models” of “Economics Rules”
• Responses to this tweet
https://twitter.com/ben_moll/status/1312042597876142081

• ... especially Beatrice Cherrier and Gianluca Violante’s replies

https://twitter.com/Undercoverhist/status/1312053154515693568

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Toward a Simple Macro Model:
Labor Supply and Demand

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Toward a simple macro model
• Next lecture: your first modern macro model
• Model will be extremely (ridiculously) simple, a baby version
• a single “representative” consumer
• a single “representative” firm
• only one time period, i.e. model is static not dynamic
• only one good
• only one factor of production (labor)
• no frictions, “market imperfections”
• model is sometimes called “Robinson Crusoe economy”
• ... but it will have key features of most modern macro models
1. micro foundations
2. general equilibrium
• Rest of course: build much richer, more satisfactory models 23
Sketch of simple macro model (Robinson Crusoe economy)
• Preferences (i.e. utility function):
U(c, h)
• c : consumption of coconuts, U is increasing in c
• h: hours worked, U is decreasing in h
• Technology (i.e. production function):
y = f (n)
• y : output, i.e. production of coconuts
• n: hours employed, f is increasing in n
• Resource constraints:
c = y, n=h
• Next lecture: different ways of organizing this economy
• One of them: Robinson Crusoe is alone on an island, lives off coconuts,
harvesting coconuts takes time. Hence the name. 24
Some thoughts on the representative agent assumption
• Model assumes “representative consumer” and “representative firm”
(jointly = “representative agent”)
• When is this justified? Here: sketch, more in supplement (not examinable)
• Firms: if at least one of following 3 conditions is satisfied
1. all firms in economy are identical
2. particular assumptions on production functions (“homogeneity”)
3. perfect factor markets (capital, labor) ⇒ equalize marginal products
• see supplement
• Consumers (even harder): if one of following 2 conditions is satisfied
1. all consumers in economy are identical
2. particular assumptions on preferences (“Gorman aggregation”)
• see supplement
• Do we believe these conditions are satisfied? No, but...
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Toward a simple macro model
Today: study key building blocks of simple macro model

1. labor demand
2. labor supply

This should largely be a refresher of material you’ve already seen in EC1A1

• probably with different notation
• good point to mention: you need to be able to handle changing notation
• economists change notation all the time
• notation varies across textbooks, courses, even within lectures
• extreme example: rather than writing production as nα , write αn

• my experience: if you can’t handle changing notation, you probably don’t

understand the economics
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Vocabulary: “partial equilibrium” and “general equilibrium”
Will frequently hear macroeconomists use following two words
• “general equilibrium” = all prices endogenously determined in equilibrium
• “partial equilibrium” = problem of individual household or firm in isolation
taking as given prices

Let’s apply vocabulary:

• Today: labor demand and supply in partial equilibrium
• Next lecture: labor demand and supply in general equilibrium

Note: “partial equilibrium” = misnomer

• Nothing “partial” about it, should really be “no equilibrium”
• This is specific to macro. Other fields use “partial equilibrium” differently:
equilibrium in a single market.
• But very common language in macro ⇒ will adopt even though misnomer 27
Labor demand
• Representative firm has production function
y = f (n)
• Assumptions: f ′ (n) > 0 and f ′′ (n) < 0 for all n

• Example: f (n) = Anα with 0 < α < 1, A > 0 28

Labor demand

• Representative firm maximizes profits

Π = max f (n) − w n
n

• Solution: labor demand function

n∗ = nd (w )

• Optimality condition
f ′ (n) = w

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Labor demand: graphical representation

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Labor demand: more minimal graphical representation

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Labor demand: alternative graphical representation

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Labor demand: parametric example

• Example: f (n) = Anα with 0 < α < 1, A > 0

• Representative firm maximizes profits

Π = max f (n) − w n
n

• ⇒ optimal labor demand is

  1
∗ d αA 1−α
n = n (w ) =
w
which is
• decreasing in wage w (as a demand curve typically is)
• increasing in productivity A
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Labor supply

• Derive labor supply from utility maximization of representative household

• Good treatment in Kurlat, chapter 7.2 (see moodle)

• Two equivalent formulations

1. in terms of hours worked h

2. in terms of leisure ℓ

• My guess: you’ve probably seen the latter ⇒ start with that one

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Derivation of labor supply in terms of leisure ℓ

• Preferences (role of ̃ will become clear momentarily)

u(c) + ṽ (ℓ)
where c = consumption, ℓ = leisure, ṽ (ℓ) = utility from leisure
• Assumptions
• u ′ (c) > 0 and ṽ ′ (ℓ) > 0
• u ′′ (c) < 0 and ṽ ′′ (ℓ) < 0

• Example
u(c) = log c, ṽ (ℓ) = θ log ℓ, θ>0
• More general version would feature non-separable utility function
Ũ(c, ℓ)
but this doesn’t add very much so work with simpler separable version
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Derivation of labor supply in terms of leisure ℓ
Representative household solves
max u(c) + ṽ (ℓ) s.t. c = w (1 − ℓ) + Π
c,ℓ
Explanation:
• household’s time endowment = 1
• hours worked h = 1 − ℓ
• note: 1 is just a normalization to save on notation, could equally have
assumed time endowment = 24 hours or some abstract parameter ℓ̄
• w (1 − ℓ) = w h = is labor income
• Π = other unearned income, e.g. dividend income from owning stocks

Solution: labor supply function

h∗ = hs (w ) = 1 − ℓ∗ 36
Labor supply in terms of leisure ℓ: graphical representation

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Derivation of optimality condition

You should already know this but I will do derivation once (and never again)

Two equivalent strategies:

1. Direct substitution (brute force)

max u(w (1 − ℓ) + Π) + ṽ (ℓ) ⇒ −u ′ (c)w + ṽ ′ (ℓ) = 0

ℓ | {z }
c

2. Lagrangean
L = u(c) + ṽ (ℓ) + λ [w (1 − ℓ) + Π − c]
)
c: u ′ (c) = λ ṽ ′ (ℓ)
′ ⇒ =w
ℓ: ṽ (ℓ) = λw u ′ (c)

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Derivation of labor supply in terms of hours worked h
• Preferences
u(c) − v (h)
where c = consumption, h = hours worked, v (h) = disutility from work
• Assumptions
• u ′ (c) > 0 and v ′ (h) > 0
• u ′′ (c) < 0 and v ′′ (h) > 0, i.e. disutility is convex

• Link to leisure formulation: set v (h) = −ṽ (1 − h) ⇒ the two are equivalent
• Example 1: u(c) = log c, v (h) = −θ log(1 − h), θ > 0
• Example 2:
h1+1/ε  
u(c) = log c, v (h) = θ , θ, ε > 0 note: v ′ (h) = θh1/ε
1 + 1/ε
• As before, could also work with non-separable U(c, h) 39
Derivation of labor supply in terms of hours worked h

Representative household solves

max u(c) − v (h) s.t. c = wh + Π

c,h

• w h = is labor income

• Π = other unearned income, e.g. dividend income from owning stocks

Solution: labor supply function

h∗ = hs (w )

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Graphical representation in terms of hours worked h

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Graphical representation in terms of hours worked h

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Note: same graph as before but with flipped x -axis

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Two exercises and a question

• Exercise 1: derive optimality condition in terms of hours worked

• Exercise 2: derive optimal labor supply in example 2

h1+1/ε
u(c) = log c, v (h) = θ , θ, ε > 0
1 + 1/ε
• Question: suppose w increases, what will happen to labor supply? Why?

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Next time

• Combine labor supply and labor demand

• ⇒ your first (baby, ridiculously simple) modern macro model

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 Appendix on
Income and Substitution Effects

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A way of thinking about income and substitution effects
• Note: only some people find this useful (those who “think in equations”)
• If you don’t, please just ignore. The standard graphical analysis is just fine.
• This definition of income and substitution effects is also non-standard
(compared to textbook definition) but it’s helpful nevertheless
• on my to-do list: work out exact relation to standard definition

• Recall: representative household solves

max u(c) − v (h) s.t. c = wh + Π
c,h
• Optimal h∗ (w ) solves optimality condition and budget constraint
v ′ (h)
=w
u ′ (c)
c = wh + Π
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A way of thinking about income and substitution effects

• Let’s do something funny: separate notation for w in the two equations

v ′ (h)
= wS
u ′ (c)
c = wIh + Π
where S stands for “substitution” and I for “income” (explain momentarily)
• Obviously when w S = w I = w ⇒ obtain h∗ (w ) again
• But can still solve system even when w S ̸= w I ⇒ solution h∗ (w S , w I )
• Key observation:
• Substitution effect = change in h∗ from changing w S but not w I , i.e.
effect of price change working through first-order condition
• Income effect = change in h∗ from changing w I but not w S , i.e. effect
of price change working through budget constraint
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This is much more general

• Example: intertemporal choice (Lecture 4 and EC1A1)

c2 y2
max u(c1 ) + βu(c2 ) s.t. c1 + = y1 +
c1 ,c2 1+r 1+r

• Following logic of previous slide, write first-order condition and budget

constraint as
u ′ (c1 ) = β(1 + r S )u ′ (c2 )
c2 y2
c1 + I
= y1 +
1+r 1 + rI
• Substitution effect = change in (c1∗ , c2∗ ) from changing r S but not r I , i.e.
effect of price change working through first-order condition
• Income effect = change in (c1∗ , c2∗ ) from changing r I but not r S , i.e. effect
of price change working through budget constraint
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