Macro midterm

Participation rate

Labor force/ adult population - the labor force includes individuals who have some form of attachment to the labor market, either because they have a job or because they do not have a job but they are searching for one

labor force participation rate

Labor force/ adult population - why is labor force participation increasing? - changing demographics: introduction of females into work force - structural changes in economy: decline in manufacturing and increase in services - age distribution of population: both young and older adults are less likely to work than middle aged people

The natural rate of unemployment is the _________ rate of unemployment

Steady state: it depends on the rate of job separation and the rate of job finding

The unemployment rate and the natural rate of unemployment in the US

There is always some unemployment. The natural rate of unemployment is the average level around which the unemployment rate fluctuates

International evidence on population growth and income per head

This figure shows that countries with high rates of population growth tend to have low levels of income per person, as the Solow model predicts.

The wage curve

W/P= F(u,z) 1. Workers base their wage request in the purchasing power of their wages (W/P) 2. Higher unemployment u reduces bargaining power and wages; higher unemployment reduces the efficiency wage 3. Structural factors z (UI, structural economic change) may increase wages at given unemployment- this is known as wage pressure

The equilibrium real wage

adjusts to equate labor demand with labor supply; downward sloping MPL curve and vertical labor supply curve

Disposable Personal Income (DPI)

personal income minus taxes Amount that households and no corporate businesses have available to spend after satisfying their tax obligations to the government

Unemployment is mostly a matter of high and rigid wages. If policy were able to get rid of wage rigidity, unemployment would be completely resolved. Do you agree?

Wage rigidity is only part of the story. If one could get rid of wage rigidities, wages would probably fall, but this would not be sufficient to completely eliminate unemployment in the presence of search fractions. Even with perfectly flexible wages, if it takes time to find a job, before all unemployed workers find jobs, some of the employees lose their jobs, and this provides a new inflow into unemployment. Thus unemployment cannot be completely eliminated

Simple model of the natural rate of unemployment has an important implication for public policy:

Any policy aimed at lowering the natural rate of unemployment must either reduce the rate of job separation or increase the rate of job finding. Similarly, any policy that affects the rate of job separation or job finding also changes the natural rate of unemployment - this model of unemployment rate assumes that job finding is not instantaneous, but it fails to explain why

Economists use many types of data to measure the performance of an economy. Three macroeconomic variables are especially important:

Real gross domestic product (GDP), the inflation rate, and the unemployment rate Macroeconomists study how these variables are determined, why they change over time, and how they interact with one another

Inflation Rate Formula

(Current year CPI ) - (Earlier Year CPI) / (Earlier Year CPI) x100

GDP growth rate formula

(GDP year 2 - GDP year 1 / GDP year 1 ) x 100 - if growth is constant: Yn= (1 + g)^nYo Given initial conditions Yo, small differences in g can translate into major differences in long run output Yn (and thus consumption, living standards, etc)

The national income accounts divide GDP into four broad categories of spending:

- consumption (c) - investment (I) - government purchases (G) - net exports (NX) Thus, letting Y stand for GDP, Y= C + I + G + NX

CPI Is a price index that may differ from the GDP deflator because of

- differences in the goods included - differences in the origin of the goods included - weights

Changes in investment demand

- might increase due to technological innovation - may change because the government encourages or discourages investment through the tax laws.

The costs of unexpected inflation

1. Arbitrary redistribution of purchasing power - many long term contracts are not indexed, but based on πe. - if π turns out to be different from πe, then some gain at others expense: the ex post real return that the debtor pad to the creditor differs from what both parties anticipated. If inflation turns out to be higher than expected, the debtor wins and the creditor loses because the debtor repays the loan with less valuable dollars. On the other hand, if inflation turns out to be higher than expected, the debtor wins and the creditor loses because the repayment is worth more than the two parties anticipated 2. Hurts individuals on fixed pensions: workers and firms often agree on fixed nominal pension when the worker retires. Because the pension is deferred earnings, the worker is essentially providing the firm a loan: the worker provides labor services to the firm while young but does not get fully paid until old age. The worker is hurt when inflation is higher than expected, and the firm is hurt when inflation is lower than expected 3. Increases uncertainty - when inflation is high, it's typically also more variable and less predictable - π turns out to be different from πe more often, and the differences tend to be larger - arbitrary redistribution's of wealth become more likely - this creates higher uncertainty, making risk averse people worse off

Three measures of the money stock for the US economy

1. C: currency 2. M1: currency plus demand deposits, travelers checks, and other checkable deposits 3. M2: M1 plus retail money market mutual fund balances, saving deposits (including money market deposit accounts), and small time deposits

Factors of growth

1. Capital accumulation (saving and investment) 2. Labor force growth Note: because of diminishing returns capital accumulation alone or labor force growth alone cannot sustain growth 3. Technological progress (shifts in the production function at given k)

The quantity theory of money implies

1. Countries with higher money growth rates should have higher inflation rates 2. The long run trend behavior of a country's inflation should be similar to the long run trend in the country's money growth

3 ways of measuring GDP

1. Expenditure on final goods and services 2. Income 3. Value added (production, value of output minus cost of inputs) - 3 ways of measuring GDP are equivalent

Three key differences between GDP deflator and CPI

1. GDP deflator measures the prices of all goods and services produced, whereas the CPI measures the prices of only the goods and services bought by consumers. Thus, an increase in the price of goods bought only by firms or the government will show up in the GDP deflator but not in the CPI 2. GDP deflator includes only those goods produced domestically. Imported goods are not part of GDP and do not show up in the GDP deflator. Hence, an increase in the price of Toyota's made in Japan and sold in this country affects the CPI, because the Toyota's are bought by consumers, but it does not affect the GDP deflator 3. Difference in the way the two measures aggregate the many prices in the economy. The CPI assigns foxes weights to the prices of different goods, whereas the GDP deflator assigns changing weights. In other words, the CPI is computed using a fixed basket of goods, whereas the GDP deflator allows the basket of goods to change over time as the composition of GDP changes.

An economy's output of goods and services- it's GDP- depends on:

1. It's quantity of inputs, called the factors of production 2. It's ability to turn inputs into output, as represented by the production function

Determinants of u: need to know determinants of s and f

1. Job separation rate - technological/ structural changes - competition from abroad - "idiosyncratic" factors - institutional factors (employment protection legislation) 2. Job finding rate - firms willingness to hire workers (labor demand; when there are frictions this is measured by job vacancies) - workers willingness to accept jobs, or search effectiveness - correspondence between job characteristics and worker characteristics (mismatch) - institutional factors (epl, unemployment insurance) Relatively dynamic labor markets tend to have both higher s and f

Facts about R&D

1. Much research is done by firms seeking profits 2. Firms profit from research: patents create a stream of monopoly profits, extra profit from being first on the market with a new product 3. Innovation produces externalities that reduce the cost of subsequent innovation Much do the new endogenous growth theory attempts to incorporate these facts into models to better understand technology progress Is private R&D enough? - the existence of positive externalities in the creation of knowledge suggests that the private sector is not doing enough R&D - but there is much duplication of R&D effort among competing firms - estimate: social return to R&D > 40% per year - thus, many believe govt should encourage R&D

Two ways of viewing GDP

1. The total income of everyone in the economy 2. The total expenditure on the economy's output of goods and services

Implications of existence and stability of steady state

1. There is no growth in the long run 2. If different countries have the same parameters s and δ, then they have the same steady state, so their capital per head and output per head levels will converge, i.e. the Solow model predicts conditional convergence. Along this convergence path, poorer countries grow faster

Efficiency wage theories

1. Wages influence nutrition because better paid workers can afford a more nutritious diet, and healthier workers are more productive 2. High wages reduce labor turnover- the more a firm pays its workers, the greater is their incentive to stay with the firm 3. Average quality of a firm's work force depends on the wage it pays its employees. If a firm reduces its wage, the best employees may take jobs elsewhere- adverse selection. By paying a wage above equilibrium, the firm may reduce adverse selection, improve quality of its workforce and increase productivity 4. High wage improves worker effort Because a firm operates more efficiently if it pays its workers a high wage, the firm may find it profitable to keep wages above the level that balances supply and demand. The result of this higher than equilibrium wage is a lower rate of job finding and greater unemployment

The wage is endogenous, we need a wage setting model. Two observations:

1. Workers wages exceed their reservation wages 2. Wages depend on labor market conditions

Real GDP

A better measure of economic well being- tallies the economy's output of goods and services without being influenced by changes in prices. Real GDP is the value of goods and services measured using a constant set of prices. That is, real GDP shows what would have happened to expenditure on output if quantities had changed but prices had not To see how real GDP is computed, imagine we want to compare output in 2014 with output in subsequent years for our apple- orange economy. We could begin by choosing a set of prices, called base year prices, such as the prices that prevailed in 2014. Goods and services are then added up using these base year prices to value the different goods in each year: Real GDP for 2014= (2014 price of apples x 2014 quantity of apples) + (2014 price of oranges x 2014 quantity of oranges) Real GDP for 2015= (2014 price of apples x 2015 quantity of apples) + (2014 price of oranges x 2015 quantity of oranges) Real GDP for 2016= (2014 price of apples x 2016 quantity of apples) + (2014 price of oranges x 2016 quantity of oranges) Notice that 2014 prices are used to compute real GDP for all three years. Because the prices are held constant, real GDP varies from year to year to year only if the quantities produced vary. Because a society's ability to provide economic satisfaction for its members ultimately depends on the quantities of goods and services produced, real GDP provides a better measure of economic well being than does nominal GDP

Inflation

A continuous rise in the price of goods and services Percentage change in the price level from one period to the next is called the inflation rate

The Solow growth model shows that in the long run,

A economy's rate of saving determines the size of its capital stock and thus its level of production. The higher the rate of saving, the higher the stock of capital and the higher the level of output

tech progress in Solow model

A new variable representing technology, denoted by A Y= F(K, L, A) Given K and L, an improvement in technology A leads to an increase in output Y - in particular: Y=F(K, AL) - given K: technological progress is labor augmenting; raises effective labor AL and reduces the number of workers (L) needed to achieve a given amount of output (Y) - assume a constant and exogenous rate of technological progress g= ΔA/A - assume CRS in K and AL, and diminishing marginal productivities of K and AL - assume: y= Y/AL: output per effective worker k= K/AL: capital per effective worker Production function per effective worker Y/AL= F(K/AL, 1) or y= f(k) Saving and investment per effective worker sy= sf(k) - (δ + n + g)k= breakeven investment: the amount of investment necessary to keep k constant - consists of: - δk to replace depreciating capital - nk to provide capital for new workers - gk to provide capital for the new "effective" workers created by technological progress

A reduction in saving (graph)

A reduction in saving, possibly the result of a change in fiscal policy, shifts the saving schedule to the left. The new equilibrium is the point at which the new saving schedule crosses the investment schedule. A reduction in saving lowers the amount of investment and raises the interest rate. Fiscal policy actions that reduce saving are said to crowd out investment

Stocks and flows

A stock is a quantity measured at a given point in time, whereas a flow is a quantity measured per unit of time - a person's wealth is a stock; his income and expenditure are flows - the number of unemployed people is a stock; the number of people losing their jobs is a flow - the amount of capital in the economy is a stock; the amount of investment is a flow - the government debt is a stock; the government budget deficit is a flow

Hyperinflation

A very rapid rise in the price level; an extremely high rate of inflation.

The Solow model shows that an economy's rate of population growth is another long run determinants of the standard of living:

According to the Solow model, the higher the rate of population growth, the lower the steady state levels of capital per worker and output per worker. Other theories highlight other effects of population growth.

GDP: housing services and other imputations

Although most goods and services are valued at their market prices when computing GDP, some are not sold in the marketplace and therefore do not have market prices. If GDP is to include the value of these goods and services, we must use an estimate of their value. Such an estimate is called an imputed value. Imputations are especially important for determining the value of housing. To take account of the housing services enjoyed by homeowners, GDP includes the "rent" that these homeowners "pay" to themselves. The department of commerce estimates what the market rent for a house would be if it were rented and includes that imputed rent as part of GDP. This imputed rent is included both in the homeowners expenditure and in the homeowners income. Imputations also arise in valuing government services: police officers, firefighters, and senators provide services to the public, but assigning a value to these services is difficult because they are not sold in a marketplace and therefore do not have a market price.

price

Amount of money required to buy a good

Impact of population growth

An increase in n causes an increase in break-even investment, leading to a lower steady state level of k. - higher n—> lower k* - and since y= f(k), lower k*—>lower y* - thus, the Solow model predicts that countries with higher population growth rates will have lower levels of capital and income per worker in the long run

An increase in the saving rate

An increase in the saving rate raises investment, causing k to grow toward a new steady state - the saving rate has no effect on the long run growth rate of capital per head and output per worker, this is equal to zero - the saving rate determines the level of capital per head and output per head in the long run - an increase in the saving rate will lead to a higher growth of capital per head and output per head for some time but not forever - higher s —> higher k* - and since y=f(k), higher k* —> higher y - thus, the Solow model predicts that countries with higher rates of saving and investment will have higher levels of capital and income per head in the long run

Population growth

Assume L(t+1)= Lt(1 + n) where n is the rate of population growth Then K(t+1)/L(t+1) x (1 + n) k(t+1) - kt= sf(kt)- (δ + n)kt - the growth rate in capital per head equals investment per head minus a term that now depends on both depreciation and population growth: (δ + n)kt - (δ + n)kt= "break even investment", the level of investment necessary to keep kt constant - break even investment includes δkt to replace capital as it wears out, nkt to equip new workers with capital

The flows into the financial markets (private and public saving) must _______ the flows out of the financial markets (investment)

Balance

If government purchases equal taxes minus transfers, then G = T, and the government has a _______ _______

Balanced budget If G exceeds T, the government runs a budget deficit, which it finds by issuing government debt- that is, by borrowing in the financial markets. If G is less than T, the government runs a budget surplus, which it can use to repay some of its outstanding debts We take government purchases and taxes as exogenous variables.

How is national income distributed to the factors of production

Based on the classical idea that prices adjust to balance supply and demand, applied here to the markets for the factors of production, together with the more recent idea that the demand for each factor of production depends on the marginal productivity of that factor. This theory, called the neoclassical theory of distribution, is accepted by most economists today as the best place to start in understanding how the economy's income is distributed from firms to households

Micro and macro

Because macroeconomic events arise from many microeconomic interactions, all macroeconomic models must be consistent with microeconomic foundations, even if those foundations are only implicit

GDP deflator

Can be computed from nominal GDP and real GDP. The GDP deflator, also called the implicit price deflator for GDP, is the ratio of nominal GDP to real GDP GDP deflator= nominal GDP/ real GDP The GDP deflator reflects what's happening to the overall level of prices in the economy. Consider an economy with only one good, bread. If P is the price of bread and Q is the quantity sold, then nominal GDP is the total number of dollars spent on bread in that year, P x Q. Real GDP is the number of loaves of bread produced in that year times the price of bread in some base year, Pbase x Q. The GDP deflator is the price of bread in that year relative to the price of bread in the base year.

Changes in nominal GDP can be due to:______. Changes in real GDP can only be due to: _______

Changes in prices and changes in quantities of output produced; changes in quantities, because real GDP is constructed using constant base year prices

The federal reserve influences the money supply either by

Changing the monetary base or by changing the reserve ratio and thereby the money multiplier. It can change the monetary base through open market operations or by making loans to banks. It can influence the reserve ratio by altering reserve requirements or by changing the interest rate it pays back for reserves they hold

Job creation and wages

Close the model: need a condition that is playing the role of labor demand - job creation (or JC curve) And it gives the number of job vacancies that firms decide to post as a function of unemployment - to construct the JC curve, note that: the wage may not be equal to the marginal product of labor (labor market imperfections); assume that the speed at which firms want to expand employment positively depends on the gap between the marginal product of labor (MPL) and the real wage (W/P); thus the number of vacancies should positively depend on such gap

Golden Rule

Consider 2 scenarios: 1. S=0: capital eventually goes to 0, output goes to 0, and consumption goes to 0 2. S= 1: consumption is equal to 0, because 100% of output is saved - imagine to start from s=0 and initially raise s. The economy starts accumulating some capital, delivering positive output and consumption - raising s further will initially deliver higher consumption and then eventually lower consumption

Consumption

Consists of household expenditures on goods and services. Goods are tangible items, and they in turn are divided into durables and nondurables. Durable goods are goods that last a long time, such as cars and TVs. Nondurable goods are goods that last only a short time, such as food and clothing. Services include various intangible items that consumers buy, such as haircuts and doctor visits

Investment

Consists of items bought for future use. Investment is divided into three subcategories: business fixed investment, residential fixed investment, and inventory investment. Business fixed investment (nonresidential fixed investment) is the purchase by firms of new structures, equipment, and intellectual property products. Residential investment is the purchase of new housing by households and landlords. Inventory investment is the increase in firms inventories of goods (if inventories are falling, inventory investment is negative)

Properties of the Cobb-Douglas production function

Constant returns to scale; if labor and capital are increased by the same proportion, then output increases by that proportion as well Consider the marginal products for the Cobb Douglas production function. The marginal product of labor is MPL= (1 - α) A K^ α L^(-α) and the marginal product of capital is MPK= αAK^(α-1)L^(α-1) From these equations, recalling that α is between zero and one, we can see what causes the marginal products of the two factors to change. An increase in the amount of capital raises the MPL and reduces the MPK. Similarly, an increase in the amount of labor reduces the MPL and raises the MPK. A technological advance that increases the parameter A raises the marginal product of both factors proportionately

Components of demand for goods

Consumption, fixed investment, government spending, net exports, inventory investment - assuming closed economy, net exports=0 - thus Y= C + I + G

The economy's output is used for

Consumption, investment, and government purchases. Consumption depends positively on disposable income. Investment depends negatively on the real interest rate. Government purchases and taxes are the exogenous variables of fiscal policy

To start a bank, the owners must

Contribute some of their own financial resources, which become the banks capital. Because banks are highly leveraged, however, a small decline in the value of their assets can potentially have a major impact on the value of bank capital. Bank regulators require that banks hold sufficient capital to ensure that depositors can be repaid

At the equilibrium interest rate, the ______ for goods and services equals the ______

Demand, supply Interest rate must adjust to ensure that the demand for goods equals the supply. The higher the interest rate, the lower the level of investment, and thus the lower the demand for goods and services, C + I + G. If the interest rate is too high, then investment is too low and the demand for output falls short of the supply. If the interest rate is too low, then the investment is too high and the demand exceeds the supply

Model of supply and demand- price and quantity of pizza (example)

Develop a model that describes the behavior of pizza buyers, pizza sellers, and their interaction in the market for pizza The economist supposed that the quantity of pizza demanded by consumers Qd depends on the price of pizza P and on aggregate income Y. This relationship is expressed in the equation—> Qd= D(P, Y) where D() represents the demand function. Similarly, the economist supposed that the quantity of pizza supplied by pizzerias Qs depends on the price of pizza P and on the price of materials Pm, such as cheese, tomatoes, flour. This relationship is expressed as Qs= S(P,Pm), where S( ) represents the supply function. Finally, the economist assumes that the price of pizza adjusts to bring the quantity supplied and quantity demanded into balance: Qs= Qd These three equations compose a model of the market for pizza

Devoting a large share of national output to investments would help restore rapid productivity growth and rising living standards

Devoting a large share of national output to investment means raising the saving rate. Assuming that the economy is initially in steady state, this generates some positive growth during the transition path to the new steady state, and a higher steady state level of capital per head and income per head. So living standards will indeed be higher. But once the new steady state is reached, growth in capital per head is indeed zero, so this cannot sustain rapid growth in the long run

The Cobb Douglas production function

Douglas observed that as the economy grew more prosperous over time, the total income of workers and the total income of capital owners grew at almost exactly the same rate Douglas asked Cobb what production function would produce constant factor shares if factors always earned their marginal products. The production function would need to have the property that Capital income = MPK x K= αY where α is a constant between zero and one that measures capitals share of income. That is, α determines what share of income goes to capital and what share goes to labor. Cobb showed that the function with this property is F(K,L)= AK^ αL^(1-α) Where A is a parameter greater than zero that measures the productivity of the available technology. This function became known as the Cobb-Douglas production function

The system of fractional reserve banking creates money because

Each dollar of reserves generates many dollars of demand deposits

Encouraging tech progress

Encourage R&D, patent laws (encourage innovation by granting temporary monopolies to inventors of new products), tax incentives for R&D, grants to fund basic research at universities, industrial policy: encourages specific industries that are key for rapid tech progress

At the equilibrium interest rate, households desire to save balances firms desire to invest, and the quantity of loanable funds supplied ______ the quantity demanded

Equals

wage ridigity

Failure of wages to adjust to a level at which labor supply equals labor demand (another reason for unemployment) - in the equilibrium model, the real wage adjusts to equilibrate labor supply and labor demand. Yet wages are not always flexible. Sometimes the real wage is stuck above the market clearing level When the real wage is above the level that equilibrates supply and demand, the quantity of labor supplied exceeds the quantity demanded. Firms must in some way ration the scarce jobs among workers. Real wage rigidity reduces the rate of job finding and raises the level of unemployment

Sources of growth

Fast growth may come from two sources 1. A higher rate of technological progress. If g is higher, steady state output growth will also be higher. In this case, the rate of growth of output per head equals the rate of technological progress 2. Adjustment of capital per effective worker, K/AN, to a higher level. In this case, the growth rate of output exceeds the rate of technological progress - does source matter? In case 1 faster growth will last for as long as g lasts. In case 2 growth will eventually be eroded by diminishing returns to capital and return to steady state - understanding the Solow residual (technological progress) is crucial for understanding growth

Assumption of continuous market clearing is not entirely realistic

For markers to clear continuously, prices must adjust instantly to changes in supply and demand. In fact, many wages and prices adjust slowly. Although market clearing models assume that all wages and prices are flexible, in the real world some wages and prices are sticky The apparent stickiness of prices does not make market clearing models useless. After all, prices are not stuck forever; eventually, they adjust to changes in supply and demand. Market clearing models might not describe the economy at every instant, but they do describe the equilibrium toward which the economy gravitates. Therefore, most macroeconomists believe that price flexibility is a good assumption for studying long run issues.

A key feature of a macroeconomic model is whether it assumes that prices are ______ or _____

Flexible or sticky. According to most macroeconomists, models with flexible prices describe the economy in the long run, whereas models with sticky prices offer a better description of the economy in the short run

The Cobb Douglas case

From this, steady state: s(Kt /L)^a = δKt/L Therefore (K/L)*= (s/δ)^(1/1-a) (Y/L)*= (s/δ)^a/(1-a) These expressions can be used to evaluate the effect of parameters (s and δ) on the steady state levels of capital and output per head - what is the saving rate that would maximize steady state consumption in this example? In steady state: c*=(1-s)y* = (1-s)(s/δ)^a/(1-a) Is maximized when s= a

(GDP) Intermediate goods

GDP includes only the value of final goods. The reason is that the value of intermediate goods is already included as part of the market price of the final goods in which they are used. To add the intermediate goods to the final goods would be double counting. Hence, GDP is the total value of final goods and services produced One way to compute the value of all final goods and services is to sum the value added at each stage of production. The value added of a firm equals the value of the firms output less the value of the intermediate goods that the firm purchases. For the economy as a whole, the sum of all value added must equal the value of all final goods and services

GDP and used goods

GDP measures the value of currently produced goods and services. The sale of, for example, a collectors item, reflects the transfer of an asset, not an addition to the economy's income. Thus the sale of used goods is not included as part of GDP

Real economy definition of GDP

Gross domestic product (GDP) is the market value of all final goods and services produced within an economy in a given period of time.

The basic Solow model shows that capital accumulation, by itself, cannot explain sustained economic growth:

High rates of saving lead to high growth temporarily, but the economy eventually approaches a steady state in which capital and output are constant. To explain the sustained economic growth that we observe in most parts of the world, we must expand the Solow model to incorporate the other two sources of economic growth- population growth and technological progress.

What does the Solow model say about the relationship between saving and economic growth?

Higher saving leads to faster growth in the Solow model, but only temporarily. An increase in the rate of saving raises growth only until the economy reaches the new steady state. If the economy maintains a high saving rate, it will maintain a large capital stock and a high level of output, but it will not maintain a high growth rate forever. Policies that alter the steady state growth rate of income per person are said to have a growth effect; by contrast, a higher saving rate is said to have a level effect, because only the level of income per person- not its growth rate- is influenced by the saving rate in the steady state

household vs. establishment survey

Household survey: BLS obtains an estimate of the number of people who say they are working Establishment survey: obtains an estimate of the number of workers firms have on their payrolls Not identical- although they are positively correlated, these two measures can diverge. Maybe because the surveys measure different things, or that surveys are imperfect.

The investment function

I=I(r) Slopes downward because as the interest rate rises, the quantity of investment demanded falls The investment function relates the quantity of investment I to the real interest rate r. Investment depends on the real interest rate because the interest rate is the cost of borrowing. The investment function slopes downward: when the interest rate rises, fewer investment projects are profitable

Starting with too little capital

If k*<k*gold, then increasing c* requires an increase in s - future generations enjoy higher consumption, but the current one experiences an initial drop in consumption

How large is economic profit

If the production function has the property of constant returns to scale, as it is often thought to be the case, then economic profit must be zero. That is, nothing left after the factors of production are paid. This conclusion follows from a famous mathematical result called Euler's theorem, which states that if the production function has constant returns to scale, then F(K,L) = (MPK x K) + (MPL x L) If each factor of production is paid its marginal product, then the sum of these factor payments equals total output. In other words, constant returns to scale, profit maximization, and competition together imply that economic profit is zero.

Real-wage rigidity leads to job rationing

If the real wage is stuck above the equilibrium level, then the supply of labor exceeds the demand. The result is unemployment

The Solow model shows that the saving rate is a key determinant of the steady-state capital stock:

If the saving rate is high, the economy will have a large capital stock and a high level of output in the steady state. If the saving rate is low, the economy will have a small capital stock and a low level of output in the steady state - a government budget deficit can reduce national saving and crowd out investment. Now we see that the long un consequences of a reduced saving rate are a lower capital stock and lower national income. This is why many economists are critical of persistent budget deficits

The transitions between employment and unemployment

In every period, a fraction s of the employed lose their jobs, and a fraction f of the unemployed find jobs. The rates of job separation and job finding determine the rate of unemployment

The total output of an economy equals its total

Income; because the factors of production and the production function together determine the total output of goods and services, they also determine national income. This national income flows from firms to households through the markets for the factors of production

Growing gap between rich and poor

Increase in income inequality in US over the past several decades. The Gini coefficient is a measure of income dispersion: it is between zero and one, with zero representing perfect equality and one representing perfect inequality in income. The figure shows that the Gini coefficient fell from 0.38 to 0.35 from 1947 to 1968, a period when incomes were becoming slightly more equal. But the economy then entered a period of rising inequality. The Gini coefficient rose to 0.45 in 2012

The ratio of labor income to total income

Labor income has remained about two thirds of total income over a long period of time. This approximate constancy of factor shares is consistent with the Cobb-Douglas production function. Although the capital and labor shares are approximately constant, they are not exactly constant- in this figure, the labor share fell. The reason for this change in factor shares is not well understood. One possibility is that technological progress over the past several decades has not simply increased the parameter A but may have also changed the relative importance of capital and labor in the production process, thereby altering the parameter α as well. But it is also possible that there are important determinants of incomes that are not well captured by the Cobb Douglas production function together with the competitive model of factor markets

Laspeyres index vs Paasche index

Laspeyres index: fixed basket of goods Paasche index: changing basket of goods Economic theorists have studied the properties of these different types of price indexes to determine which is a better measure of the cost of living; neither is clearly superior. When prices of different goods are changing by different amounts, a Laspeyres index tends to overstate the increase in the cost of living because it does not take into account the fact that consumers have the opportunity to substitute less expensive goods for more expensive ones. By contrast, a Paasche index tends to understate the increase in the cost of living. Although it accounts for the substitution of alternative goods, it does not reflect the reduction in consumers welfare that may result from such substitutions.

Money, prices, and interest rates summady

Md and Ms determine P. Changes in P determine inflation. Given real interest rates, inflation determines nominal interest rates, which in turn affect Md

The unemployment rate in the us economy

Measures the percentage of people in the labor force who do not have jobs. There is always some unemployment in the economy, and although the unemployment rate has no long term trend, it varies substantially from year to year. Recessions and depressions are associated with unusually high unemployment.

If M denotes the money supply, C currency and D demand deposits, we can write

Money supply= currency + demand deposits M= C + D

GDP: underground economy

No imputation is made for the value of goods and services sold in the underground economy. The underground economy is the part of the economy that people hide from the government either because they wish to evade taxation or because the activity is illegal (ex domestic workers paid "off the books" and illegal drug trade).

Diminishing marginal product

Most production functions have this property; holding the amount of capital fixed, the marginal product of labor decreases as the amount of labor increases. The marginal product of labor is the slope of the production function. As the amount of labor increases, the production function becomes flatter, indicating diminishing marginal product

The definition of the GDP deflator allows us to separate nominal GDP into two parts:

One part measures quantities (real GDP) and the other measures prices (the GDP deflator): Nominal GDP= real GDP x GDP deflator Nominal GDP measures the current dollar value of the output of the economy. Real GDP measures output valued at constant prices. The GDP deflator measures the price of output relative to its price in the base year. We can also write this equation as Real GDP= nominal GDP/ GDP deflator

The factors of production and the production technology determine the economy's

Output of goods and services. An increase in one of the factors of production or a technological advance raises output

GDP: seasonal adjustment

Output of the economy rises during the year, reaching a peak in the fourth quarter (oct, nov, dec) and then falling in the first quarter (jan, feb, march). Real GDP follows a seasonal cycle. Attributable to changes in ability to produce, seasonal tastes. Most of the economic statistics reported are seasonally adjusted. This means that the data have been adjusted to remove the regular seasonal fluctuations. Therefore, when you observe a rise or fall in real GDP or any other data series, you must look beyond the seasonal cycle for explanation.

PCE deflator (personal consumption expenditure)

PCE deflator is calculated like the GDP deflator but, rather than being based on all of GDP, it is based on only the consumption component of GDP. That is, the PCE deflator is the ratio of nominal consumer spending to real consumer spending. The PCE deflator resembles the CPI in some ways and the GDP deflator in others. Like the CPI, the PCE deflator includes only the prices of goods and services that consumers buy; it excludes the prices of goods and services that are part of investment and government purchases. Also like the CPI, the PCE deflator includes the prices of imported goods. But like the GDP deflator, the PCE deflator allows the basket of goods to change over time as the composition of consumer spending changes.

constant returns to scale

Property of many production functions A production function has constant returns to scale of an increase of an equal percentage in all factors of production causes an increase in output of the same percentage. If the production function has constant returns to scale, then we get 10% more output when we increase both capital and labor by 10%. Mathematically, a production function has constant returns to scale if: zY= F(zK,zL) for any positive number z. This equation says that if we multiply both the amount of capital and the amount of labor by some number z, output is also multiplied by z.

A decrease in taxes

Reduction in taxes T. The immediate impact of the tax cut is to raise disposable income and thus to raise consumption. Disposable income rises by T, and consumption rises by an amount equal to T times the marginal propensity to consume MPC. The higher the MPC, the greater the impact of the tax cut on consumption. Because the economy's output is fixed by the factors of production and the level of government purchases is fixed by the government, the increase in consumption must be met by a decrease in investment. For investment to fall, the interest rate must rise. Hence, a reduction in taxes, like an increase in government purchases, crowds out investment and raises the interest rate

Changes in equilibrium

Rise in aggregate income causes the demand for a good to increase: at any given price, consumers now want to buy more of said good. This is represented by a rightward shift in the demand curve from D1 to D2. The market moves to the new intersection of supply and demand. The equilibrium price rises from P1 to P2, and the equilibrium quantity rises from Q1 to Q2. A rise in the price of materials decreases the supply of a food: at any given price, the food is less profitable and therefore less of it is produced. This is represented by a leftward shift in the supply curve.

Supply curve

Shows the relationship between quantity supplied and price - increase in price of inputs reduces the quantity of cars producers supply at each price, which increases the market price and reduces the quantity

Sabina and investment in terms of supply and demand

The "good" is loanable funds, and its "price" is the interest rate. Saving is the supply of loanable funds- households lend their saving to investors or deposit their saving in a bank that then loans the funds out. Investment is the demand for loanable funds- investors borrow from the public directly by selling bonds or indirectly by borrowing from banks. Because investment depends on the interest rate, the quantity of loanable funds demanded also depends on the interest rate. The interest rate adjusts until the amount that firms want to invest equals the amount that households want to save. If the interest rate is too low, investors want more of the economy's output than households want to save; the quantity of loanable funds demanded exceeds the quantity supplied. When this happens, the interest rate rises. Conversely, if the interest rate is too high, households want to save more than firms want to invest; because the quantity of loanable funds supplied is greater than the quantity demanded, the interest rate falls. The equilibrium interest rate is found where the two curves cross

Dimensions of technological progress

Technological progress can take several forms: - larger output from given quantities of capital and labor - better products - new products replacing old ones - a larger variety of products

Rules for computing GDP

The US economy produces many different goods and services, and GDP combines the value of these goods and services into a single measure. The diversity of products in the economy complicates the calculation of GDP because different products have different values To compute the total value of different goods and services, the national income accounts use market prices because these prices reflect how much people are willing to pay for a good or service: GDP= (price of good x quantity of good)

Marginal Propensity to Consume (MPC)

The amount by which consumption changes when disposable income increases by one dollar. The MPC is between zero and one: an extra dollar of income increases consumption, but by less than one dollar. Thus, if households obtain an extra dollar of income, they save a portion of it.

Factor prices

The amounts paid to each unit of factors of production. In an economy where the two factors of production are capital and labor, the two factor prices are the wage workers earn and the rent the owners of capital collect The price each factor of production receives for its services is in turn determined by the supply and demand for that factor. Because we have assumed that the economy's factors of production are fixed, the factor supply curve is vertical. Regardless of the factor price, the quantity of the factor supplied to the market is the same. The intersection of the downward sloping factor demand curve and the vertical supply curve determines the equilibrium factor price

The production function

The available production technology determines how much output is produced from given amounts of capital and labor. Economists express this relationship using a production function. Letting Y denote the amount of output, we write the production function as- Y= F(K,L) This equation states that output is a function of the amount of capital and amount of labor The production function reflects the available technology for turning capital and labor into output. If someone invents a better way to produce a good, the result is more output from the same amounts of capital and labor. Thus, technological change alters the production function

Equilibrium in the market for goods and services: the supply and demand for the economy's output

The demand for the economy's output comes from consumption, investment, and government purchases. Consumption depends on disposable income, investment depends on the real interest rate, and government purchases and taxes are the exogenous variables set by fiscal policymakers. The factors of production and the production function determine the quantity of output supplied to the economy: Y= F(K,L) Now let's combine these equations describing the supply and demand for output. If we substitute the consumption function and the investment function into the national income accounts identity, we obtain Y= C(Y- T) + I(r) + G G, T, and Y are all fixed. This equation states that the supply of output equals its demand, which is the sum of consumption, investment, and government purchases.

The consumption function graph

The consumption function relates consumption C to disposable income Y - T. The marginal propensity to consume MPC is the amount by which consumption increases when disposable income increases by one dollar

Steady state consumption graph

The economy is output is used for consumption or investment. In the steady state, investment equals depreciation. Therefore, steady state consumption is the difference between output and depreciation. Steady state consumption is maximized at the golden rule steady state. The golden rule capital stock is denoted k*gold, and the golden rule level of consumption is denoted c*gold - at the Golden rule level of capital, the production function and the δk* line have the same slope, and consumption is at its greatest level - we can now derive a simple condition that characterizes the Golden Rule level of capital. Recall that the slope of the production function is the marginal product of capital MPK. The slope of the δk* line is δ. Because these two slopes are equal at k*gold, the golden rule is described by the equation MPK= δ At the Golden rule level of capital, the marginal product of capital equals the depreciation rate

In the steady state of the Solow model, the growth rate of income per person is determine solely by

The exogenous rate of technological progress

The marginal product of capital and capital demand

The firm decides how much capital to rent in the same way it decides how much labor to hire. The marginal product of capital (MPK) is the amount of extra output the firm gets from an extra unit of capital, holding the amount of labor constant: MPK= F(K + 1, L) - F(K, L) Thus, the marginal product of capital is the difference between the amount of output produced with K + 1 units of capital and that produced with only K units of capital.

Unemployment rate measures

The fraction of the labor force that is out of work

GDP and treatment of inventories

The general rule is that when a firm increases its inventory of goods, this investment in inventory is counted as an expenditure by the firm owners. Thus, production for inventory increases GDP just as much as does production for final sale. A sale out of inventory, however, is a combination of positive spending and negative spending, so it does not influence GDP. This treatment of inventories ensures that GDP reflects the economy's current production of goods and services

Profit

The goal of a firm is to maximize profit. Profit equals the revenue minus cost; it is what the owners of the firm keep after paying for the costs of production. Revenue equals P x Y, the selling price of the good multiplied by amount of the good the firm produces Y. Costs include labor and capital costs. Labor costs equal W x L, the wage W times the amount of labor L. Capital costs equal R x K, the rental price of capital R times the amount of capital K. We can write Profit= revenue - labor costs - capital costs = PY - WL - RK To see how profit depends on the factors of production, we use the production function Y=F(K,L) to substitute for Y to obtain Profit= PF(K,L) - WL - RK This equation shows that profit depends on the product price P, the factor prices W and R, and the factor quantities L and K. The competitive firm takes the product price and the factor prices as given and chooses the amounts of labor and capital that maximize profit

Illustrate the impact on the equilibrium interest rate and investment of an increase in public spending, accompanied by an equal increase in taxes. How does your answer depend on the marginal propensity to consume?

The higher the marginal propensity to consume, the lower the impact of this policy on total saving. The results in the interest and investment are qualitatively similar to point a, ie the interest rate rises and investment falls, but quantitatively smaller

Gross domestic product measures

The income of everyone in the economy and the total expenditure on the economy's output of goods and services

economic profit

The income that remains after the firms have paid the factors of production Economic profit= Y - (MPL x L) - (MPK x K) Note that income Y and economic profit are here being expressed in real terms- in units of output rather than in dollars. Because we want to examine the distribution of income, we rearrange the terms as follows: Y= (MPL x L) + (MPK x K) + economic profit Total income is divided among the return to labor, the return to capital, and economic profit

The inflation rate in the us economy

The inflation rate measures the percentage change in the average level of prices from the year before. When the inflation rate is above zero, prices are rising. When it is below zero, prices are falling. If the inflation rate declines but remains positive, prices are rising but at a slower rate. Inflation varies substantially over time. In the first half of the twentieth century, periods of falling prices, called deflation, were almost as common as periods of rising prices.

The marginal product of labor schedule

The marginal product of labor MPL depends on the amount of labor. The MPL curve slopes downward because the MPL declines as L increases. The firm hires labor up to a point where the real wage W/P equals the MPL. Hence, this schedule is also the firm's labor demand curve

Increase in revenue from an additional unit of labor depends on two variables:

The marginal product of labor and the price of the output. Because an extra unit of labor produces MPL units of output and each unit of output sells for P dollars, the extra revenue is P x MPL. The extra cost of hiring one more unit of labor is the wage W. Thus, the change in profit from hiring an additional unit of labor is Δprofit = Δrevenue - Δcost = (P x MPL) - W We can now answer the question of how much labor a firm hires. The firms manager knows that if the extra revenue P x MPL exceeds the wage W, an extra unit of labor increases profit. Therefore, the manager continues to hire labor until the next unit would no longer be profitable- that is, until the MPL falls to the point where the extra revenue equals the wage. The competitive firms demand for labor is determined by P x MPL = W We can also write this as MPL = W/P

The model of supply and demand

The most famous economic model is that of supply and demand for a good or service- for example, pizza. The demand curve is a downward sloping curve relating the price of pizza to the quantity of pizza that consumers demand. The supply curve is an upward sloping curve relating the price of pizza to the quantity of pizza that pizzerias supply. The price of pizza adjusts until the quantity supplied equals the quantity demanded. The point where the two curves cross is the market equilibrium, which shows the equilibrium price of pizza and the equilibrium quantity of pizza

The real interest rate is

The nominal interest rate corrected for the effects of inflation. The ex post real interest rate is based on actual inflation, while the ex ante real interest rate is based on expected inflation. The fisher effect says that the nominal interest rate moves one to one with expected inflation

The nominal interest rate is

The opportunity cost of holding money. Thus, one might expect the demand for money to depend on the nominal interest rate. If it does, then the price level depends on both the current quantity of money and the quantities of money expected in the future

labor force participation rate

The percentage of the adult population that is in the labor force Labor force participation rate= labor force/ adult population x 100

How a factor of production is compensated

The price paid to any factor of production depends on the supply and demand for that factors services. Because we have assumed that supply is fixed, the supply curve is vertical. The demand curve is downward sloping. The intersection of supply and demand determines the equilibrium factor price.

Open market operations

The primary way in which the Fed controls the supply of money- the purchase and sale of government bonds - when the fed wants to increase the money supply, it uses some of the dollars it has to buy government bonds from the public. Because these dollars leave the Fed and enter into the hands of the public, the purchase increases the quantity of money in circulation. Conversely, when the Fed wants to decrease the money supply, it sells some government bonds from its own portfolio - this open market sale of bonds takes some dollars out of the hands of the public and decreases the quantity of money in circulation

The production function graph

The production function shows how the amount of capital per worker k determines the amount of output per worker y= f(k). The slope of the production function is the marginal product of capital: if k increases by 1 unit, y increases by MPK units. The production function becomes flatter as k increase, indicating diminishing marginal product of capital

Seigniorage

The revenue raised by the government through the creation of money. In real terms/ seigniorage S= ΔM/P. By printing a new amount of money ΔM, the government can purchase ΔM/P units of goods and services

Seigniorage

The revenue raised by the printing of money

Investment, depreciation, and the steady state

The steady state level of capital k* is the level at which investment equals depreciation, indicating that the amount of capital will not change over time. Below k* investment exceeds depreciation, so the capital stock grows. Above k* investment is less than depreciation, so the capital stock shrinks - the higher the capital stock, the greater the amounts of output and investment. Yet the higher the capital stock, the greater also the amount of depreciation

money

The stock of assets that can be readily used to make transactions - the dollars in the hands of the public make up the nation's stock of money

Macroeconomics is

The study of the economy as a whole, including growth in incomes, changes in prices, and the rate of unemployment. Macroeconomists attempt both to explain economic events and to devise policies to improve economic performance

If economic profit is zero, how can we explain the existence of profit in the economy?

The term "profit" as normally used is different from economic profit. We have been assuming that there are three types of agents: workers, owners of capital, and owners of firms. Total income is divided among wages, return to capital, and economic profit. In the real world, however, most firms own rather than rent the capital they use. Because firm owners and capital owners are the same people, economic profit and the return to capital are often lumped together. If we call this alternative definition accounting profit, we can say that Accounting profit= economic profit + (MPK x K)

Private vs public saving

The term (Y - T - C) is disposable income minus consumption, which is private saving. The term (T - G) is government revenue minus government spending, which is public saving. If government spending exceeds government revenue, then the government runs a budget deficit and public saving is negative.

Real GDP measures

The total income of everyone in the economy (adjusted for the level of prices)

The household survey

The unemployment rate comes from a survey of about 60,000 households called the Current Population Survey. Based on the responses to survey questions, each adult in each household is placed into one of three categories: 1. Employed: this category includes those who at the time of the survey worked as paid employees, worked in their own business, or worked as unpaid workers in a family member's business. It also includes those who were not working but who had jobs from which they were temporarily absent. 2. Unemployed: this category includes those who were not employed, were available for work, and had tried to find employment during the previous four weeks. It also includes those waiting to be recalled to a job from which they had been laid off 3. Not in the labor force: this category includes those who fit neither of the first two categories, such as a full time student, homemaker, or retiree. A person who wants a job but has given up looking- a discouraged worker- is counted as not being in the labor force.

Exogenous variables

Those variables that a model takes as given

Over the long run, the rates of inflation and money growth move _______, as the quantity theory predicts

Together

Depreciation

To incorporate depreciation into the model, we assume that a certain fraction δ of the capital stock wears out each year. Here δ is called the depreciation rate. - the amount of capital that depreciates each year is δk - we can express the impact of investment and depreciation on the capital stock with this equation: Change in capital stock= investment - depreciation Δk= i - δk where delta k is the change in the capital stock between one year and the next. - because investment i equals sf(k), we can write this as Δk= sf(k) - δk

A two sector model

Two sectors: - manufacturing firms produce goods - research universities produce knowledge that increases labor efficiency in manufacturing - u= fraction of labor in research - in the steady state, manufacturing output per worker and the standard of living grow at rate ΔA/A=g(u) - key variables: - s: affects the level of income but not its growth rate - u: affects level and growth rate of income

Equilibrium unemployment

UV-JC model

Unemployment rate

Unemployed/ labor force - the unemployment rate is the fraction of the labor force who do not have jobs but are looking for jobs

Job creation and wage curve

Use wage curve W/P= F(u,z) Embodying this in the vacancy equation gives JC curve—> v= y[MPL - F(u,z)] - higher u lowers real wages (F) and thus raises the number of vacancies - thus the JC curve describes an upward sloping relationship between u and v

Money demand function: equilibrium

What determines what in the long run? - M: exogenous (central bank) - r: adjusts to ensure S=I - Y: Y= F(K,L) - P: adjusts to ensure M/P= L(Y, r + πe) for given Y, r, πe - a change in M causes P to change by the same percentage, just like in the quantity theory of money

What are the costs and benefits of a national money? Does the relative political stability of the small country and of the Euro Area play any role in this decision?

When a small country adopts the money of its neighbor instead of printing its own money it bears the cost of losing monetary policy as an independent policy instrument. But this has the advantage of important monetary discipline and in particular ruling out inappropriate use of seigniorage as a source of revenue- provides the ECB is independent and committed to low and stable inflation. The benefits from this practice decrease in the political stability of the small country.

A given rate of growth may be driven by a high rate of capital accumulation and/or a high rate of technological progress. Does the source of growth matter for assessing the growth prospects of an economy?

When growth is mostly driven by fast Capital accumulation, growth will eventually be eroded by diminishing returns to capital and return to study state. When growth is mostly driven by fast technological progress, the economy will display steady state growth and growth will last for as long as technological progress lasts.

An increase in investment demand when saving depends on the interest rate

When saving is positively related to the interest rate, a rightward shift in the investment schedule increases the interest rate and the amount of investment. The higher interest rate induces people to increase saving, which in turn allows investment to increase

Nominal interest rate vs real interest rate

When studying the role of interest rates in the economy, economists distinguish between the nominal interest rate and the real interest rate. This distinction is relevant when the overall level of prices is changing. The nominal interest rate is the interest rate as usually reported: it is the interest rate that investors pay to borrow money. The real interest rate is the nominal interest rate corrected for the effects of inflation. The real interest rate measures the true cost of borrowing, and thus determines the quantity of investment.

Increase in women's labor force participation rate, decrease in men's

Women's can be explained by: - new technologies such as washing machine and dishwasher that reduced the amount of time required to complete routine household tasks - improved birth control reducing number of children born to typical family - changing political and social attitudes Men's can be explained by: - longer education time - older men retire earlier and live longer - more stay at home dads

Disposable income

Y-T

National income accounts identity

Y=C+I+G

At the Golden rule level of capital, the marginal product of capital net of depreciation (MPK- δ) equals

Zero - a policymaker can use this condition to find the golden rule capital stock for an economy

fractional reserve banking

a banking system that keeps only a fraction of funds on hand and lends out the remainder

producer price index

a measure of the cost of a basket of goods and services bought by firms rather than consumers

Money demand function

an equation that shows the determinants of the quantity of real money balances people wish to hold - a simply money demand function is (M/P)^d=kY where k is a constant that tells us how much money people want to hold for every dollar of income. This equation states that the quantity of real money balances demanded is proportional to real income - the money demand function is like the demand function for a particular good. Here the good is the convenience of holding real money balances. Just as higher income leads to a greater demand for automobiles, higher income leads to a greater demand for real money balances - this money demand function offers another way to view the quantity equation—> condition that the demand for real money balances (M/P)^d must equal the supply M/P. Therefore, M/P= kY, M/k= PY, MV= PY where V=1/k. Show the link between the demand for money and the velocity of money When people want to hold a lot of money for each dollar of income (k is large), money changes hands infrequently (V is small). When people want to hold only a little money (k is small), money changes hands frequently (V is large) The money demand parameter k and the velocity of money V are opposite sides of the same coin

MPL and the demand for labor

as units of labor increase, units of output decrease

Sectoral shifts

changes in the composition of demand across industries or regions of the country - ex) technological change, more jobs repairing computers fewer jobs repairing typewriters - international trade: labor demand increases in export sectors, decreases in import competing sectors - result: frictional unemployment - workers are displaced from declining sectors (s increases) - greater mismatch between skills required by firms and skills supplied by workers, mm increases and f decreases - both shift out the UV curve, u increases

Four components of GDP

consumption, investment, government purchases, and net exports - the circular flow diagram contains only the first three components. We assume our economy is a closed economy- a country that does not trade with other countries. Thus, net exports are always zero - a closed economy has three uses for the goods and services it produces. These three components of GDP are expressed in the national income accounts identity: Y= C + I + G Households consume some of the economy's output, firms and households use some of the output for investment, and the government buys some of the output for public purposes. We want to see how GDP is allocated among these three uses

Reserves

deposits that banks have received but have not loaned out - mostly held at a central bank - in an economy where all deposits are held as reserves, this system is called 100-percent-reserve banking

The distribution of national income

determined by factor prices - the prices per unit that firms pay for the factors of production - wage (W)= price of L - rental rate (R)= price of K Real factor prices= nominal factor prices/ price of output (P) - real wage= W/P - real rental rate= R/P - factor prices are determined by supply and demand in factor markets

The golden rule capital stock

k*gold= the golden rule level of capital, the steady state value of k that maximizes consumption To find it, first express c* in terms of k* c*= y* + i* = f(k*) - i* = f(k*) - δk* - then, graph f(k*) and δk*, look for the point where the gap between them is biggest - formally: max[c* = f(k*) - δk*] - f'(k*)= δ - slope of production function= slope of depreciation line

minimum wage laws

laws specifying the lowest wage a firm can legally pay an employee - for some workers, especially the unskilled and inexperienced, the minimum wage raises their wage above its equilibrium level and therefore reduces the quantity of labor that firms demand - a 10% increase in the minimum wage reduces teenage employment by 1-3% - advocates of a higher minimum wage view it as a way to raise the income of the working poor. - opponents of a higher minimum wage claim that it is not the best way to help the working poor- the labor costs raise unemployment and the minimum wage is poorly targeted. - many economists and policy makers believe that tax credits are a better way to increase the incomes of the working poor. The earned income tax credit is an amount that poor working families are allowed to subtract from the taxes they owe. Unlike the minimum wage, the EITC does not raise labor costs to firms and does not reduce the quantity of labor that firms demand

financial intermediation

primary route for moving funds from lenders to borrowers

The steady stage level of capital per effective worker is defined by

sf(k*)= (𝛿 + n + g)k*

Demand curve

shows the relationship between the price of a product and the quantity of the product demanded - increase in income increases the quantity of cars consumers demand at each price, which increases the equilibrium price and quantity

neoclassical theory of distribution

states that each factor input is paid its marginal product - total labor income: W/P x L= MPL x L - total capital income: R/P x K = MPK x K - when Y displays constant returns to scale: Y= MPL x L + MPK x K

inflation rate

the percentage increase in the price level from one year to the next

Nominal GDP

the production of goods and services valued at current prices - can increase either because prices rise or because quantities rise - GDP computed this way is not a good gauge of economic well being. The measure does not accurately reflect how well the economy can satisfy the demands of households, firms, and the government. If all prices doubled without any change in quantities, nominal GDP would double. Yet it would be misleading to say that the economy's ability to satisfy demands has doubled because the quantity of every good produced remains the same

money supply

the quantity of money available in the economy - in a system of commodity money, the money supply is simply the quantity of that commodity. In an economy that uses fiat money, such as most economies today, the government controls the supply of money: legal restrictions give the government a monopoly on the printing of money

real rental price of capital

the rental price measured in units of goods rather than in dollars MPK= R/P The firm demands each factor of production until that factors marginal product falls to equal its real factor price

Microeconomics

the study of how households and firms make decisions and how they interact in markets A central principle of micro is that households and firms optimize- they do the best they can for themselves given their objectives and the constraints they face. Households choose their purchases to maximize their level of utility, and firms make production decisions to maximize their profits Because aggregate variables are the sum of the variables describing many individual decisions, macroeconomic theory rests on a microeconomic foundation

core inflation

the underlying increases in the CPI after volatile food and energy prices are removed. Because food and energy prices exhibit short run volatility, core inflation is sometimes viewed as a better gauge of ongoing inflation trends

Endogenous variables

those variables that a model tries to explain

GNP (Gross National Product)

total dollar value of goods & services produced by a nation at home or away To obtain GNP, we add to GDP receipts of factor income from the rest of the world and subtract payments of factor income to the rest of the world GNP= GDP + factor payments from abroad - factor payments to abroad Whereas GDP measures the total income produced domestically, GNP measures the total income earned by nationals (residents of a nation). For example, if a Japanese resident owns an apartment building in NY, the rental income he earns is part of US GDP because it is earned in the US. But because this rental income is a factor payment to abroad, it is not part of US GNP.

Equilibrium unemployment (beveridge curve)

u= s/(s + f(v, e, mm)); if v goes up, f goes up, u goes down - v= job vacancies - e= workers willingness to accept jobs, or search effectiveness - mm= mismatch

frictional unemployment

unemployment that results because it takes time for workers to search for the jobs that best suit their tastes and skills

The quantity equation in growth rates

ΔM/M + ΔV/V = ΔP/P + ΔY/Y - v constant means ΔV/V= 0 - ΔP/P= π (inflation rate) Thus: ΔM/M = π + ΔY/Y Rearranging: π= ΔM/M - ΔY/Y - inflation equals adjusted nominal money growth - real GDP growth requires a certain amount of money supply growth to facilitate growth transactions - money growth in excess of this amount leads to inflation - given ΔY/Y, quantity theory predicts a one for one relation between changes in the money growth rate and changes in the inflation rate - since ΔY/Y depends on growth in factors of production and technological progress, the primary cause for inflation is monetary growth

Money demand function

(M/P)d= real money demand, depends negatively on i (opportunity cost of holding money) and positively on Y (higher Y leads to more spending leads to increased need for money) - L is used for the money demand function because money is the most liquid asset - substituting i= r + πe (M/P)d= L(Y, r + πe) When people are deciding whether to hold money or bonds, they don't know what inflation will turn out to be. Hence, the nominal interest rate relevant for money demand is r + πe - expectations of higher money growth in the future lead to a higher price level today

Real GDP per capita and standard of living

- GDP is a good indicator of standard of living because it is correlated with many things that we care about - positive correlation between GDP per capita and life expectancy - positive correlation between GDP per capita and happiness - human development index: combines measures of life expectancy, education, and standard of living—> in general, as GDP per capita increases, so does human development - GDP per capita misses the distribution of income - over time, growth in GDP per capita usually does indicate growth in everyone's incomes: as average per capita income increases, also see increases in income of very poor

Nominal vs Real GDP

- GDP sums up the prices of all finished goods and services - 2 ways that GDP can increase: prices can increase (inflation drives higher GDP), quantities can increase (more valuable goods and services are produced) - second type of increase is what we want - real GDP measures growth in quantity (and value) of goods, controls for inflation by adding up all goods and services produced in an economy using the same set of prices over time - real GDP tells us how much GDP would increase or decrease if prices hadn't changed - if we want to compare our economy over time, we need to control for changes in prices - another difference in economy- a lot more people today - we can control for population size by using real GDP per capita by dividing real GDP by a country's population - good measure of average standard of living in country - real GDP per capita declines during recessions, also accompanied by increases in unemployment

Flow model of unemployment

- L= the labor force - E= the number of employed workers - U= the number of unemployed workers Because every worker is either employed or unemployed, the labor force is the sum of the employed and the unemployed: L= E + U - in this notation, the rate of unemployment is U/L - we assume that the labor force L is fixed and focus on the transition of individuals in the labor force between employment E and unemployment U. - let s denote the rate of job separation, the fraction of employed individuals who lose or leave their jobs each month - let f denote the rate of job finding, the fraction of unemployed individuals who find a job each month. - together, the rate of job separation s and the rate of job finding f determine the rate of unemployment - if the unemployment rate is neither rising nor falling- that is, if labor market is in a steady state- then the number of people finding jobs fU must equal the number of people losing jobs sE. We can write the steady state condition as fU= sE We can use this equation to find the steady state unemployment rate. From our definition of the labor force, we know that E= L-U; that is, the number of employed equals the labor force minus the number of unemployed. If we substitute (L-U) for E in the steady state condition, we find fU= s(L-U) Next, we divide both sides of this equation by L to obtain fU/L = s(1 - U/L) Now we can solve for the unemployment rate U/L to find U/L= s/(s + f) This can also be written as U/L= 1/(1 + f/s) This equation shows that the steady state rate of unemployment U/L depends on the rates of job separation s and job finding f. The higher the rate of job separation, the higher the unemployment rate. The higher the rate of job finding, the lower the unemployment rate

Why governments create hyperinflation

- when a government cannot raise taxes or sell bonds, it must finance spending increases by printing money - the revenue raised from printing money is called seigniorage - the inflation tax: printing money to raise revenue causes inflation. Inflation is like a tax on people who hold money

Quantity theory of money

- M: money supply (all the money in the economy) - V: the velocity of money (how many times a dollar is spent purchasing finished goods and services); number of times the average dollar is spent - Y: all finished goods and services sold in an economy; GDP - P: price level of all finished goods and services These are the variables in the quantity theory of money - Y is real GDP—> when you multiply Y by price level P, you get PY= nominal GDP - MV is also equal to nominal GDP So, MV= PY - how much money we have in total times how many times the money is spent covers the actions of buyers (MV) - the stuff we sell times the prices we charge covers the actions of sellers (PY) - core identity that MV= PY is a common tool

The solow model

- Robert Solow won the nobel prize in 1987 for contributions to the study of economic growth - his model represents a major paradigm: widely used in policy making, benchmark against which most recent theories are compared - looks at the determinants of economic growth and the standard of living in the long run - designed to show how growth in capital stock, growth in the labor force, and advances in technology interact in an economy as well as how they affect a nation's total output of goods and services

Growth as creative destruction

- Schumpeter coined the term "creative destruction" to describe displacements resulting from technological progress: the introduction of a new product is good for consumers, but often bad for incumbent producers, who may be forced out of the market

Endogenous Growth Theory

- Solow model - sustained growth in living standards is due to tech progress; the rate of tech progress is exogenous - endogenous growth theory - a set of models in which the growth rate of productivity and living standards is endogenous

Convergence

- Solow model predicts that, other things equal, poor countries (with lower Y/L and K/L) should grow faster than rich ones - if true, then the income gap between rich and poor countries would shrink over time, causing living standards to converge - in real world, many poor countries do not grow faster than rich ones - this doesn't mean a failure of the Solow model - Solow model predicts that OTHER THINGS EQUAL, poor countries should grow faster than rich ones - empirical evidence: - in samples of countries with similar savings and population growth rates, income gaps shrink about 2% per year - in larger samples, after controlling for differences in saving, pop growth and human capital, incomes converge by about 2% per year - what the Solow model really predicts is conditional convergence- countries converge to their own steady states, which are determined by saving, population growth, and education - this prediction comes largely true in the real world

Balanced growth

- Solow model's steady state exhibits "balanced growth"- many variables grow at the same rate - model predicts Y/L and K/L grow at the same rate g, so K/Y should be constant - this is true in the real world - Solow model predicts real wage grows at same rate as Y/L, while real rental price is constant - this is also true in the real world

The unemployment rate: dynamics

- a given unemployment rate may reflect two very different realities: a dynamic labor market, with many separations and many hires, or a sclerotic labor market, with few separations, few hires, and a stagnant unemployment pool - labor force surveys contain employment data, including the movements of workers - this is the information used to construct labor market flows

Unemployment: stocks and flows

- a high rate of unemployment can be driven by a high separation rate or a low hiring rate - most cross country differences in unemployment can be explained by differences in hiring rates, rather than differences in separation rates - hiring rates and unemployment duration are two sides of the same coin - countries with high unemployment also tend to have high unemployment duration - fluctuations in the aggregate unemployment rate affect the welfare of individual workers and wages - higher unemployment affects workers through a decrease in hires (higher unemployment makes it more difficult to find jobs) and through higher layoffs (higher unemployment may raise the risk of losing a job)

The market for loanable funds

- a simply supply demand model of the financial system - one asset: "loanable funds" - demand for funds: investment. Firms borrow to finance spending on plant and equipment, new office buildings, etc. Consumers borrow to buy new houses. Depends negatively on r, the price of loanable funds. Demand curve slopes downward (same as investment curve) - supply of funds: saving. Households use their saving to make bank deposits, purchase bonds and other assets. These funds become available to firms to borrow to finance investment spending. The government may also contribute to saving if it spends less than its tax revenue. National saving S is public plus private saving= (Y - T) - C + T - G —> Y - C - G Loanable funds supply curve is vertical because national saving does not depend on r - price of funds: real interest rate

Three purposes of money

- a store of value: money is a way to transfer purchasing power from the present to the future. Money is not a perfect store of value because if prices are rising, the amount you can buy with any given quantity of money is falling. Even so, people hold money because they can trade it for goods and services at some time in the future - a unit of account: money provides the terms in which prices are quoted and debts are recorded. Microeconomics teaches us that resources are allocated according to relative prices- the prices of goods relative to other goods- yet stores post their prices in dollars and cents. Similarly, most debts require the debtor to deliver a specified number of dollars in the future, not a specified amount of some commodity. Money is the yardstick with which we measure economic transactions - a medium of exchange: money is what we use to buy goods and services. The ease with which an asset can be converted into the medium of exchange and used to buy other things is sometimes called the assets liquidity. In a barter economy, trade requires the double coincidence of wants, permitting only simply transactions. Money makes more indirect transactions possible

The market for goods

- aggregate demand: C(Y-T) + I(r) + G - aggregate supply: Y= F(K,L) - equilibrium: Y= C(Y-T) + I(r) + G - the real interest rate adjusts to equate demand with supply

Technological progress: main results

- all steps followed for describing equilibrium in the simply Solow model can be repeated here to describe equilibrium in the Solow model augmented for technological progress - just need to think in terms of capital per effective worker K/AL as opposed to capital per worker K/L - capital per effective worker grows when investment per effective worker exceeds break even investment Steady state: k* such that: sf(k*)=(δ + n + g)k* - there is no steady state growth in capital per effective worker or output per effective worker - but this has new implications for growth in capital per worker or output per worker

The steady stage is significant for two reasons

- an economy at the steady state will stay there; an economy not at the steady state will go there. Regardless of the level of capital with which the economy begins, it ends up with the steady state level of capital. In this sense, the steady state represents the long run equilibrium of the economy - suppose that the economy starts with less than the steady state level of capital. In this case, investment exceeds the amount of depreciation. Over time, the capital stock will rise and will continue to rise- along with the output- until it approaches the steady state - if the economy starts with more than the steady state level of capital, investment is less than depreciation: capital is wearing out fasting than it is being replaced. The capital stock will fall, again approaching the steady state level. Once the capital stock reaches the steady state, investment equals depreciation, and there is no pressure for the capital stock to either increase or decrease

Why growth matters

- anything that affects the long run rate of economic growth- even by a tiny amount- will have huge effects on living standards in the long run - in general, g around 2% imply a doubling of y in 35 years (each generation can enjoy double living standards as their parents) - south Asian tigers g=8%. Y doubles in 10 years - China in the 1990s- g=13%. Y doubles in 7 years - but there are countries in which growth does not exist

Moving towards the steady state

- as long as k< k*, investment will exceed depreciation and k will continue to grow toward k*

Demand for Labor

- assume markets are competitive: each firm takes W, R, and P as given - basic idea: a firm hires each unit of labor if the cost does not exceed the benefit - cost= real wage - benefit= marginal product of labor - MPL: the extra output the firm can produce using an additional unit of labor - as a factor input is increased, its marginal product falls—> diminishing MPL

How quantity of money is measured

- because money is the stock of assets used for transactions, the quantity of money is the quantity of those assets. In simple economies, this quantity is easy to measure. - in more complex economies, no single asset is used for all transactions: people can use various assets, such as cash in their wallets or deposits in their checking accounts, to make transactions. - the most obvious asset to include in the quantity of money is currency, the sum of outstanding paper money and coins. Most day to day transactions use currency as the medium of exchange - second type of asset used for transactions is demand deposits, the funds people hold in their checking accounts. If most sellers accept personal checks or debit cards that access checking accounts balances, then assets in a checking account are almost as convenient as currency. Assets are in a form that can easily facilitate transaction

The Solow model and the steady state

- capital depreciates - depreciation increases at a constant rate as the capital stock increases; the more capital, the more capital depreciation -the money for capital accumulation comes from saving and investment - when we create economic output we can either consume it or save it; what we don't consume can be saved and invested in new capital - suppose we invest a constant fraction of our output- we can now add an investment curve to the graph - it will mimic the shape of the output line, since investment is just a constant fraction of output - first units of capital and very productive and so they create a lot of output and investment- but with more and more units of capital come less output and investment: diminishing returns - depreciation is growing at the same rate the capital stock grows; each new unit of capital creates an equal amount of depreciation - when investment is greater than depreciation, the capital stock must be growing; we're adding more units of capital than are depreciating. But as capital stock grows, investment and depreciation intersect- when they do, they have reached the steady state level of capital - the steady state is the key to understanding the Solow model. At the steady state, an investment is equal to depreciation- all investment is being used to repair and replace existing capital stock. If capital stock isn't growing, then nothing is growing; when we reach the steady state level of capital, we've also reached the steady state level of output - other side of steady state point: depreciation is greater than investment- meaning some capital stock needs repair, but not enough investment to do repairs so the capital stock shrinks, pushing back towards steady state - we always end up moving towards the steady state - what if we decide to save more out output? Higher savings rate shifts the investment curve up- now investment is higher than depreciation- adding to capital stock - same logic of diminishing returns- will again revert back to steady state level of capital - the higher savings rate spurs growth for s time and it does increase steady state level of output. But, at the new steady state, investment = depreciation and zero economic growth - accumulating of physical capital can only generate temporary growth

Demographics

- changes in demographic structure of the population may have an effect on unemployment insofar different demographic groups have different labor market behavior

Wage bargaining

- collective or individual bargaining between firms and workers - union wage bargaining: unions have monopoly power in supply of labor - bargaining between union leaders and firms management often raises the wage about the competitive level (level at which labor demand= labor supply and there is no involuntary unemployment) - the result is a reduction in the number of workers hired, a lower rate of job finding, and an increase in structural unemployment - unions can also influence the wages paid by firms whose workforce's are not unionized because the threat of unionization can keep wages above equilibrium level. A firm may choose to pay its workers high wages to keep them happy and discourage them from forming a union - important distinction: - insiders: employed union workers whose interest is to keep wages high - outsiders: unemployed non-union workers who prefer competitive wages, so there would be enough jobs for them - bargaining power depends on: - how easily a firm can replace a worker - how easily a worker can find another job - these depend on: specificity if skills required, labor market conditions (unemployment)

Establishing the right institutions

- creating the right institutions is important for ensuring that resources are allocated to their best use: - legal institutions to protect property rights, transparent capital markets to help financial capital flow to the best investment projects, a corruption free government to promote competition and enforce contracts, very active line of research these days

Does capital have diminishing returns or not?

- depends on the definition of capital - if capital is narrowly defined then yes - advocates of endogenous growth theory argue that knowledge is a type of capital - if so, then constant returns to capital is more plausible, and this model may be a good description of economic growth

The classical dichotomy

- dichotomy between real and nominal variables - real variables: measured in physical units, for example: quantity of output produced, real wage (output earned per hour of work), real interest rate (output earned in the future by lending one unit of output today) - nominal variables: measured in money units, for example: nominal GDP (the money value of output produced), nominal wage (money value per hour of work), nominal interest rate (money earned in future my lending one dollar today), price level (the amount of money needed to buy a representative basket of goods) - theoretical separation of real and nominal variables in the classical model, which implies that nominal variables do not affect real variables - classical dichotomy stems from the neutrality of money: Changes in the money supply do not affect real variables - this implies that we can study determination of real variables without reference to nominal variables - most economists believe that the economy works this way in the long run - but important departures from classical dichotomy and money neutrality in the short run

Differences in output per head

- differences in output per head across countries can be due to differences in 1. Capital per worker K/L 2. Efficiency of production A - empirically evidence - both factors are important - the two factors are correlated: countries with higher physical or human capital per worker also tend to have higher production efficiency - possible explanations for the correlation between capital per worker and production efficiency: - production efficiency encourages capital accumulation - capital accumulation has externalities that raise efficiency - a third, unknown variable causes capital accumulation and efficiency to be higher in some countries than others

The golden rule: introduction

- different values of s lead to different steady states. How do we know which is the best steady state? - the best steady state has the highest possible consumption per person: c*= (1-s)f(k*) - an increase in s: leads to higher k* and y*, which raises c*; reduces consumption's share of income (1-s), which lowers c* - so how do we find the s and k* that maximize c*

Employment protection

- employment protection legislation (EPL) includes costs and restrictions that firms bear when firing workers - severance payments, firing litigation, advance notice - in our model, higher EPL means that firms are less likely to both fire and hire - the effects on unemployment are ambiguous - cross county evidence shows that countries with higher EPL have less intense labor market flows - but no clear effects of ELP on overall level of unemployment

The most famous hyperinflation case: interwar Germany

- end of WW1: allies demanded that Germany pay substantial reparations - fiscal deficits eventually financed by money creation - hyperinflation followed: price of newspaper rose from .3 DM in 1921 to 1,000 DM in 1923 to 20,000 DM in oct 1924, to 70 DM in November - by December 1923 money supply and prices abruptly stabilized - just as fiscal problems caused hyperinflation, a fiscal reform ended it - massive restructuring of public administration, reparations payments suspended - new central bank appointed, committed to not financing government by printing money

Types of money

- fiat money: money that is established by government decree with no intrinsic value - commodity money: money with intrinsic value, line gold - when people use gold as money, the economy is said to be on a gold standard. Gold is a form of commodity money because it can be used for various purposes as well as for transactions

Convergence

- finding out about convergence would make economists feel optimistic long term living standard prospects of the world population - caveat: could the finding of convergence be influenced by the way the countries are selected? - there is in general conditional convergence but not absolute convergence - absolute convergence: poor countries grow faster than rich countries - conditional convergence: among similar countries (conditional on country characteristics) poor countries grow faster than rich countries - cross country growth: OECD and Asian countries are not converging, African countries are not converging, international growth experiences are very heterogenous

Frictional unemployment vs structural unemployment

- frictional unemployment: short term unemployment caused by the ordinary difficulties of matching employee to employer - always present because US economy is very dynamic - every month, millions of people quit their jobs: to get a new job, to go back to school, to retire; other people start new jobs after graduating or finding new opportunities (frictional unemployment) - when firms compete, some will naturally do better than others - short term frictional unemployment is inherent in a growing and changing economy - structural unemployment: persistent, long term unemployment -large share of the unemployed have been unemployed for a long time, and this has been true for many years - one cause is large, quick hitting shocks that change the number, location, and types of jobs - why is structural unemployment a worse problem in Europe? European labor regulations have increased structural unemployment by making it more difficult to respond to shocks. Because it's difficult to fire workers in these countries, employers are reluctant to hire. Also more difficult when every job requires long term commitment from employer. Also, European unemployment benefits are much more generous than in the US; gives workers time to find better jobs, but also creates higher and more persistent unemployment rates

Digression: functional notation

- general (implicit) functional notation shows only that the variables are related—> Qd=D(P,Y) - an explicit functional form shows the precise quantitative relationship—> D(P,Y)= 60-10P+2Y

A number of government programs may affect unemployment

- government employment agencies: disseminate information about job openings to better match workers and jobs - active labor market policies: job search assistance, public job training schemes, help workers displaced from declining industries get skills needed for jobs in growing industries - very little evidence that these programs actually work

Cobb-Douglas production function

- has constant factor shares - a= capitals share of total income: Capital income= MPK x K = aY Labor income= MPL x L = (1-a)Y - the Cobb Douglas production function is Y= AK^a x L^(1-a) where A represents the level of technology - each factors marginal product is proportional to its average product: MPK= aAK^(a-1)L^(1-a) = aY/K MPL= (1-a)AK^aL^-a = (1-a)Y/L

Hyperinflation: remedies

- in theory, the solution to hyperinflation is simply: stop printing money - in the real world, this requires drastic fiscal restraint, and an independent central bank - this has painful effects on real economy if nominal wages are rigid and/ or if the change in monetary policy may not be fully and instantaneously credible

The economics of innovation, patents and subsidies

- ideas grow in good institutions - institutions and incentives - American institutions create good incentives to pursue technological progress: people who can help you start your business, laws that protect your idea, culture that idealizes innovation, markets that will reward you - in the US, ideas are produced for profit - we want institutions that create incentives to create new ideas - ideas are non rivalrous- but if no one is ever excluded from using a new idea, there will be no incentive to create new ideas - inventors are given patents to resolve this- temporary monopoly so they can profit before innovators steal their idea - goods that create positive externalities are undersupplied- might be able to increase production of these goods with subsidies - another idea is to offer a large prize for output of solving a problem; leave it open how a goal is to be accomplished

The duration of unemployment

- if most unemployment is short term, one might argue that it is frictional and perhaps unavoidable. Unemployed workers may need some time to search for the job that is best suited to their skills and tastes. - long term unemployment cannot easily be attributed to the time it takes to match jobs and workers: we would not expect this matching process to take many months. Long term unemployment is more likely to be structural unemployment, representing a mismatch between the number of jobs available and the number of people who want to work The data shows that many spells of unemployment are short but that most weeks of unemployment are attributable to the long term unemployed Depending on whether we look at spells of unemployment or months of unemployment, most unemployment can appear to be either short term or long term - the evidence on the duration of unemployment has an important implication for public policy. If the goal is to substantially lower the natural rate of unemployment, policies must aim at the long term unemployed, because these individuals account for a large amount of unemployment. Yet policies must be carefully targeted because the long term unemployed constitute a small minority of those who become unemployed

Capital accumulation

- in each period, the capital stock is given by the non depreciated part of the capital stock of the previous period, plus investment K(t+1)= (1 - δ)Kt + It - δ: constant rate of depreciation, the fraction of the capital stock that wears out every period - we have K(t+1)= (1 - δ)Kt + It Given It= sYt, K(t+1)= (1 - δ)Kt + sYt In per capita terms, assuming constant labor force, K(t+1)/L= (1 - δ)Kt/L + sYt/L Rearranging: K(t+1)/L - Kt/L = sYt/L - δKt/L Left: change in capital per head Right: investment per head- depreciation per head Result: the change in the capital stock per head is given by investment minus depreciation - capital accumulation depends on output (via investment) and output depends on capital (via production function) k(t+1) - kt = sf(kt) - δkt - this is the key dynamic equation for capital accumulation - given the current capital stock, it gives capital accumulation in the next period - the change in capital per head between time t and time t+1 equals the difference between investment per head and depreciation per head - capital per head increases if investment per head is greater than depreciation per head - capital per head decreases if investment per head is lower than depreciation per head - capital per head stays constant if investment per head is equal to depreciation per head - this is the steady state

A summary of population growth

- in the Solow model with population growth, there is a unique, stable steady state in capital per head and output per head - in steady state growth of capital per head or output per head is zero - but the total capital stock and total output grow at rate n (population growth) - there is conditional convergence

Allocating the economy's investment

- in the Solow model, there's one rule of capital - in the real world, there are many types, which we can divide into three categories: private capital stock, public infrastructure, human capital (the knowledge and skills that workers acquire through education) - how should we allocate investment among these types Two viewpoints: 1. Equalize tax treatment of all types of capital in all industries, then let the market allocate investment to the type with the highest marginal product 2. Industrial policy: govt should actively encourage investment in capital of certain types of in certain industries, because they may have positive externalities that private investors don't consider - potential problems with industrial policy - the govt may not have the ability to pick winners (choose industries with the highest return to capital or biggest externalities) - politics rather than economics may influence which industries get preferential treatment

Human capital and conditional convergence

- in the long run we always end up in the steady state where all of investment is used to make up for depreciation - what about human capital eL (e= education level, L= labor force) - higher levels of education correlate with higher levels of economic output- but human capital is subject to diminishing returns - it's possible for a country to invest too much in education - it's a good investment to teach people basic life skills - education is subject to diminishing returns - depreciation: human capital wears out. - takes a lot of investment, time, and effort to build human capital - accumulation of capital, both physical and human, can only get us so far - conditional convergence: poor countries should grow faster than rich countries, and all countries should approach similar levels of steady state output - over the last century, we've seen divergence instead of convergence - factors of production are only one aspect of this- when it comes to explaining prosperity, we also need to remember the importance of institutions that create the incentives to accumulate and use the factors of production in socially beneficial ways - two countries with very different institutions won't converge- but focusing on countries with similar institutions, the Solow model predicts that the poorer countries should grow faster, and all countries with similar institutions should converge to similar levels of output (conditional convergence) - Solow model also predicts zero growth in the steady state: growth weights for wealthy countries is slower, but not zero - two types of growth: 1. Catching up - this is when the Solow model predicts that you grow quickly as capital accumulates before slowing down before the steady state - this model of capital accumulation fails to explain how you keep growing 2. Cutting edge - ideas (A)

Summary of Solow Model

- in the simple Solow model without population growth or technological progress, there is a unique, stable steady state in capital per head and output per head - in steady state growth of capital per head or output per head is zero - growth in the total capital stock or total output is also zero - there is conditional convergence

The Solow model and ideas

- increasing productivity - ex) Henry ford and the assembly line - sparked a dramatic increase in productivity - in all industries, increasing output per worker across economies - better ideas multiply the output from the same capital stock (multiplier A on output curve) - when output doubles, so does investment - better ideas spur more output, which leads to more investment, which leads to capital accumulation - better ideas lead to growth in two ways: the increase of capital stock, the increase of productivity

Measuring inflation

- inflation is when the average prices are going up - measures using a price index- average price from a large and representative "basket" of goods - CPI: based on a basket of thousands of goods and services bought by consumers in the US. Weighted average. - inflation rate can be measured as percentage change in index over a period of time - inflation has gone up, but wages have also gone up during this period

Why bother with the long run?

- long run analysis tells us where the economy is on average. Short run analysis tells us about the deviation from that average - for social welfare, the average level is usually more important than deviations from the average - in the UK, GDP dropped by 2-3% during the 1979-1981 recession, and by 6% during the 2008-09 recession. The average annual rate of GDP growth in the UK is 2-2.5% - unemployment changes in response to the business cycle by about 3-4 percentage points over a period of 4-5 years. The rise in the average unemployment rate from the 1970s to the 1980s was about 8 percentage points - internationally, growth over fairly short periods of time has made enormous difference to the national incomes

Growth over a very long time

- looking across two millennia - from the end of the Roman Empire to 1500, no output per capita growth in Europe - 1500-1700- small growth in output per capita - 1820-1950- modest growth - the high growth of the 1950s and 1960s is unusual - 1st millennium to the 15th century, China had the highest output per capita - leaders in output per capita change frequently: Italy, Netherlands, UK - growth is not historically necessary - convergence of OECD countries to the US may be the prelude to leapfrogging - the rapid post WWII growth was spectacular and atypical

The productivity slowdown: 1948-72 vs 1972-95

- measurement problems: productivity increases not fully measured (but why would measurement problems be worse after 1972 than before) - oil prices: oil shocks occurred about when productivity slowdown began (but then why didn't productivity speed up when oil prices fell in the mid-1980s?) - structural transformation; the scope of technological progress is more limited in services (but the slowdown has affected nearly all sectors. The decline has been roughly the same in manufacturing as in service sectors) - worker quality: 1970s large influx of new entrants to labor force. New workers tend to be less productive than experienced workers - the depletion of ideas: perhaps the slow growth of 1972-1995 is normal, and the rapid growth during 1948-1972 is the anomaly - several explanations plausible but difficult to prove that any one of them is guilty

Tools: economic models

- models are stylized representation of the economy. Help to abstract from irrelevant details and focus on essential features of interest - are used to: show relationships between variables, explain the economy's behavior, devise policies to improve macroeconomic performance - models are means to an end: understand how the economy works

The fisher effect

- nominal interest rate is the sum of the real interest rate and the inflation rate: i= r + π - the equation written in this way is called the Fisher equation. It shows that the nominal interest rate can change for two reasons: because the real interest rate changes or because the inflation rate changes - the real interest rate adjusts to equilibrate saving and investment. The quantity theory of money shows that the rate of money growth determines the rate of inflation - the Fisher equation then tells us to add the real interest rate and the inflation rate together to determine the nominal interest rate - the quantity theory and the Fisher equation together tell us how money growth affects the nominal interest rate. According to the quantity theory, an increase in the rate of money growth of 1% causes a 1% increase in the rate of inflation. According to the Fisher equation, a 1% increase in the rate of inflation in turn causes a 1% increase in the nominal interest rate

Inflation and interest rates

- nominal interest rate, i, not adjusted for inflation - real interest rate, r, adjusted for inflation: r= i - π - equilibrium in goods market (S=I) determines r - hence, an increase in π causes an equal increase in i - this one for one relationship is called the Fisher effect

One benefit of inflation

- nominal wages are rarely reduced, even when the equilibrium real wage falls- this hinders labor market clearing - inflation allows the real wages to reach equilibrium levels without nominal wage cuts - therefore, moderate inflation improves the functioning of labor markets - inflation greases the wheel of the economy - if nominal wages can't be cut, then the only way to cut real wages is to allow inflation to do this job. Without inflation, the real wage will be stuck above the equilibrium level, resulting in higher unemployment

The production function

- notation Y= F(K, L) - shows how much output (Y) the economy can produce from K units of capital and L units of labor - reflects the economy's level of technology - exhibits constant returns to scale

GDP

- often considered the best measure of how well an economy is performing - in the US, GDP is computed every three months from a large number of primary data sources, including administrative data (byproducts of government functions such as tax collection, education programs, defense, and regulation) and statistical data (come from government surveys of retail establishments, manufacturing firms, farms, etc) - the purpose of GDP is to summarize all these data with a single number representing the dollar value of economic activity in a given period of time

Income and other indicators

- other main indicators of living standards are associated with growth - infant mortality: 20% in the poorest 1/5 of all countries, 0.4% in the richest 5 - one fourth of the poorest countries have had famines during the past 3 decades - poverty is associated with oppression of women and minorities

Expected inflation

- over the long run, people don't consistently over or under forecast inflation, so π= πe on average - in the short run, πe may change when people get new information - ex) CB announces it will increase M next year. People will expect next years P to be higher, so πe rises. This affects P now, even though M hasn't changed yet

Causes of inflation

- primary cause of inflation explained using quantity theory of money MV=PY - divide both sides by Y—> MV/Y= P - this tells us that if prices are changing, there are three possible causes— changes in M, V, or Y - P can change quite a bit in a short period of time; V and Y, however, are pretty stable. - Y is real GDP- real GDP doesn't vary that much in a single year - changes in real GDP can't really explain large and sustained changes in prices - V: velocity of money. V has been about seven in the US economy in recent years; and it's determined by the same kinds of factors that might determine personal V (how often you are paid, how long it takes to clear a check). V can change in the short run but usually not much more than 1 unit up or down. Can't change enough to explain large and sustained changes in prices - if Y and V are relatively stable, then it follows immediately that the only thing that can cause an increase in P is an increase in M: increases in prices are caused by an increase in the money supply - it's changes in the money supply that are driving the speed and height of our inflation elevator - when more money chases the same amount of goods and services, prices must rise - how well does the theory hold up? - pretty well empirically - we can also write the quantity theory in terms of growth rates: M + V= P + Y - what the growth form of the quantity theory tells us is that if V and Y aren't growing too much, then the growth rate of M should be equal to the growth rate of P - the growth rate of prices is the inflation rate - as the growth rate of money supply increases, so does inflation rate Three principles: 1. In the long run, money is neutral. A doubling of the money supply will in the long run lead to a doubling of prices. 2. Inflation is always and everywhere a monetary phenomena 3. Since central banks often have significant control over a nation's money supply, they also often have significant control over a nation's inflation rate

A basic model

- production function Y= AK where A is the amount of output for each unit of capital - key difference between this model and Solow: MPK is constant here, diminishes in Solow - investment: sY - depreciation: δK - equation of motion for total capital: ΔK= sY - δK - divide through by K and use Y=AK to get ΔY/Y = ΔK/K = sA - δ - if sA > δ, then income will grow forever and investment is the engine of growth - here, the permanent growth rate depends on s. In Solow model, it does not

Cost of inflation: price confusion and money illusion

- question: inflation increases all prices, including wages. If all prices are going up, what's the problem? - often the case that no one knows what the inflation rate will be in future years - high rates of inflation do create some problems, but volatile and high inflation rates are really costly - price confusion and money illusion - price signals become more difficult to interpret- price system becomes a less effective way of coordinating economic action - money illusion: people mistake changes in nominal prices for changes in real prices - inflation makes long term contracting riskier - real interest rate= nominal rate I - inflation rate; inflation reduces the real return on a loan, so inflation redistributes wealth from the lender to the borrower - if lenders expect a change in inflation rate, they'll adjust the interest rate they charge; nominal interest rates will rise with expected inflation rates (Fisher effect) - same thing happens when inflation falls, or is lower than expected- transfers wealth from borrower to lender - neither lenders nor borrowers want to act when inflation is difficult to predict - the economy becomes less able to coordinate savings with investment

How to increase the saving rate

- reduce the government budget surplus deficit - increase incentives for private saving: reduce capital gains tax, corporate income tax, estate tax as they discourage saving; replace federal income tax with a consumption tax; expand tax incentives for retirement savings accounts

A common currency can

- reduce uncertainties associated with the relative price of currencies - contribute to economic growth, especially when accompanied by the removal of other obstacles to trade between European countries - create difficulties for some countries associated with the move to a common monetary policy

Aggregate demand curve

- shows us all combinations of inflation and real growth that are consistent with a specified rate of spending growth - M + V= inflation + real growth - left: spending growth - MV: growth rate of nominal GDP - increase in growth rate of nominal GDP shifts demand curve outward

Steady state: graphically

- steady state value of capital per worker: k* such that sf(k*)= δk* - steady state value of output per worker: y*= sf(k*)

2 long run relationships between output and capital

- the amount of capital determines the amount of output being produced (production function) - the amount of output determines the amount of savings and investment and thus, the amount of capital

Growth in the capital stock and the steady state

- the capital stock can change over time, and those changes can lead to economic growth. In particular, two forced influence the capital stock: investment and depreciation. - investment is expenditure on new plant and equipment, and it causes the capital stock to rise - depreciation is the wearing out of old capital due to aging and use, and it causes the capital stock to fall - investment per worker i equals sy. By substituting the production function for y, we can express investment per worker as a function of the capital stock per worker: i= sf(k) - this equation relates the existing stock of capital k to the accumulation of new capital i - for any value of k, the amount of output is determined by the production function f(k), and the allocation of that output between consumption and investment is determined by the saving rate s

Money demand and the quantity equation

- the concept of velocity was emphasized in one of the earliest theories of money demand, the quantity theory of money, which asserts that money demand is proportional to nominal income, or: Md= kPY - k= how much money people wish to hold for each unit of transactions - k exogenous and constant - money demand: Md= kPY - quantity equation: MV= PY - combine them: k=1/V - when people hold lots of money relative to their incomes (k is high), money changes hands infrequently (V is low)

The real interest rate is

- the cost of borrowing - the opportunity cost of using ones own funds to finance investment spending - so increase in r —> decrease in I

Measuring growth

- we care about growth because we care about standards of living - growth in output per head gives us an idea of standards of life - output per head: yt = GDP/population - to compare yt across countries, use common set of prices - finally compute growth rate g= yt- y(t-1)/y(t-1) - we are also interested in growth in output per worker, which gives an idea about productivity

The demand for goods and the consumption function

- the demand for goods in the Solow model comes from consumption and investment. In other words, output per worker y is divided between consumption per worker c and investment per worker i: y= c + i - this equation is the PER WORKER version of the national income accounts identity for an economy. It omits government purchases and net exports (because we are assuming a closed economy) - the Solow model assumes that each year people save a fraction s of their income and consume a fraction (1-s). We can express this idea with the following consumption function: c= (1-s)y where s, the saving rate, is a number between zero and one. We take the saving rate s as given for now - to see what this consumption function implies for investment, substitute (1-s)y for c in the national income accounts identity: y= (1-s)y + i Rearrange the terms to obtain i=sy - this equations shows that investment equals savings. Thus, the rate of saving s is also the fraction of output devoted to investment

The transition to the golden rule steady state

- the economy does not have a tendency to move toward the Golden Rule steady state - achieving the golden rule requires that policymakers adjust s - this adjustment leads to a new steady state with higher consumption - but what happens to consumption during the transition to the golden rule?

What is the fisher effect?

- the fisher effect describes the relationship between the inflation rate and the nominal interest rate - real interest rate= nominal rate - inflation rate - inflation reduces the real return on a loan - the fisher effect observes that nominal interest rates will rise with expected inflation rates; described how interest rates and expected inflation rates move in tandem

Comparing steady states

- the policymakers goal is to maximize the well being of the individuals who make up the society. Individuals themselves do not care about the amount of capital in the economy or even the amount of output. They care about the amount of goods and services they can consume. Thus, a benevolent policymakers would want to choose the steady state with the highest level of consumption - the steady state value of k that maximizes consumption is called the golden rule level of capital and is demoted k*gold - how can we tell whether an economy is at the Golden rule level? To answer this question, we must first determine steady state consumption per worker: c*= f(k*) - δk* - according to this equation, steady state consumption is what's left of steady state output after paying for steady state depreciation. This equation shows that an increase in steady state capital has two opposing effects on steady state consumption. On the one hand, more capital means more output. On the other hand, more capital also means that more output must be used to replace capital that is wearing out

The rise in European unemployment

- the rate of unemployment in France, Germany, the UK, and Italy has risen substantially from 1960 to 2012 - what is the cause of rising European unemployment? No one knows for sure, but there is a leading theory. Many economists believe that the problem can be traced to the interaction between a long standing policy and a more recent shock. The long standing policy is generous benefits for unemployed workers. The recent shock is a technologically driven fall in the demand for unskilled workers relative to skilled workers - many countries allow the unemployed to collect benefits for years, rather than for only a short period of time as in the US. In some sense, people living off benefits are really out of the labor force: given the employment opportunities available, taking a job is less attractive than remaining without work, yet these people are often counted as unemployed in government statistics - change in demand for skilled workers is probably due to changes in technology

Velocity

- the speed at which money circulates - definition: the number of times the average unit of money changes hands in a given time period - V= total value of transactions/ nominal money stock= T/M - using nominal GDP as a proxy for total transactions, V= PY/M

The supply of goods and the production function

- the supply of goods in the solow model is based on the production function, which states that output depends on the capital stock and the labor force: Y= F(K,L) - the solow growth model assumes that the production function has constant returns to scale: zY= F(zK,zL) - production functions with constant returns to scale allow us to analyze all quantities in the economy relative to the size of the labor force. To see that this is true, set z= 1/L in the preceding equation to obtain: Y/L= F(K/L, 1) - this equation shows that the amount of output per worker Y/L is a function of the amount of capital per worker K/L. The assumption of constant returns to scale implies that the size of the economy- as measured by the number of workers- does not affect the relationship between output per worker and capital per worker - because the size of the economy does not matter, it will prove convenient to denote all quantities in per worker terms. We designate quantities per worker with lowercase letters, so y=Y/L is output per worker, and k=K/L is capital per worker. We can then write the production function as y= f(k) where we define f(k)= F(k,1) - the slope of this production function shows how much extra output a worker produces when given an extra unit of capital. This amount is the marginal product of capital MPK—> MPK= f(k+ 1) - f(k) - as the amount of capital increases, he production function becomes flatter, indicating that the production function exhibits diminishing marginal product of capital. When k is low, the average worker has only a little capital to work with, so an extra unit of capital is very useful and produces a lot of additional output. When k is high, the average worker has a lot of capital already, so an extra unit increases production only slightly

Two real interest rates

- when a borrower and a lender agree on a nominal interest rate, they do not know what the inflation rate over the term of the loan will be. Therefore, we must distinguish between two concepts of the real interest rate: the real interest rate that the borrower and lender expect when the loan is made, called the ex ante real interest rate, and the real interest rate that is actually realized, called the ex post real interest rate. - π= actual inflation rate (not known until after it has occurred) - πe= expected inflation rate - i - πe= ex ante real interest rate; the real interest rate people expect at the time they buy a bond or take out a loan - i - π= ex post real interest rate: the real interest rate actually realized

The rise of European leisure

- the typical American works many more hours than the typical resident of Germany or France - over time, many Europeans have substantially reduced the number of hours they work, while typical Americans have not - the difference in hours worked reflects two facts: the average employed person in the US works more hours per year than the average employed person in Europe, and more potential workers are employed in the US- that is, employment to population ratio is higher in the US - it has been proposed that all of the large differences between US labor supply and those of Germany and France are due to differences in tax systems: Europeans face higher tax rates than Americans, and European tax rates have risen significantly over the past several decades - another hypothesis is that the difference in observed work effort may be attributable to the underground economy - role of unions could have an impact - possibility of different preferences

Unemployment variation within Europe

- the unemployment rate varies substantially from country to country - much of the variation in unemployment rates is attributable to the long term unemployed. The unemployment rate can be separated into two pieces- the percentage of the labor force that has been unemployed for less than a year and the percentage of the labor force that has been unemployed for more than a year. The long term unemployment rate exhibits more variability from country to country than does the short term unemployment rate - unemployment rates are higher in nations with more generous unemployment insurance - nations tend to have higher unemployment if benefits can be collected for longer periods of time - spending on "active" labor market policies appear to decrease unemployment, such as job training, assistance with job search, and subsidized employment - national unemployment rates are positively correlated with the percentage of the labor force whose wages are set by collective bargaining with unions

Mastering the loanable funds model

- things that shift the saving curve: public saving, fiscal policy changes in G or T, private saving (preferences, tax laws that affect saving, replace income tax with consumption tax) - things that shift the investment curve: some technological innovations (to take advantage of the innovation firms must buy new investment goods), tax laws that affect investment (investment tax credit) - an increase in investment demand raises the interest rate. But the equilibrium level of investment cannot increase because the supply of loanable funds is fixed

natural rate of unemployment

- unemployment fluctuations have both a short term and a long term component - natural rate of unemployment (NRU): the average rate of unemployment around which the economy fluctuates - in a recession, the actual unemployment rate rises above the natural rate - in a boom, the actual unemployment rate falls below the natural rate - we will model unemployment by modeling directly the flows in and out of unemployment and then the resulting equilibrium rate of unemployment - this approach is well grounded empirically

Defining the unemployment rate

- unemployment rate fluctuates - increases during recessions - unemployment rate is never 0 - in the official definition, not everyone without a job is unemployed - a person is counted as unemployed only if they're an adult non-institutionalized civilian without a job and actively looking for work - they must have taken some action to find a job in the last four weeks - unemployment rate: number of people who are unemployed/ number of people in the labor force (employed + unemployed) - reasonable to define someone as unemployed only if they don't have a job and they're actively seeking a job - discouraged workers: although they haven't looked for work in the past four weeks, they have looked in the past year

Evaluating the rate of saving

- use the golden rule to determine whether a country's saving rate and capital stock are too high, too low, or about right - if (MPK - δ)>(n + g), the dining is below the golden rule steady state and should increase s - if (MPK - δ)<(n + g>, the economy is above the golden rule steady state and should reduce s - the US is below the golden rule steady state: increasing the US saving rate would increase consumption per head in the long run

Physical capital and diminishing returns

- variables in Solow model: L, K, e, A - hold human capital and ideas constant so we can focus on K - y= f(K) - more K increases output - while more capital produces more output, it should do so at a diminishing rate - marginal product of capital describes how much additional output is produced with each additional unit of capital (slope of production function)

Efficiency wages

- wages above the market clearing level increase effort, productivity, and reduce the turnover rate - the influence of wages on worker efficiency may explain the failure of firms to cut wages despite an excess supply of labor. Even though a wage reduction would lower a firms wage bill, it would also lower worker productivity and the firms profits - efficiency wage considerations also depend on labor market conditions: when unemployment is high, workers become more attached to their jobs because finding an alternative job is hard; in order to motivate and retain workers, firms can pay relatively lower wages than in a low unemployment scenario

Sticky wages

- wages get stuck and failure to adjust downwards, forestalling the recovery process during a recession - firm often doesn't want to lower nominal wages because of worker morale- wages fall only slowly in a recession, even though falling wages would end the recession more quickly - some price inflation can do some good in a recession because it makes it easier for real wages to fall- fall in labor cost improves employment - sticky wages happen because employers are worried about worker morale

Rates of change and derivatives

- we can show how the output changes as the input changes visually using something called a tangent (which is the slope of a function at a particular point) - the instantaneous rate of change can be different at different points along a function - if we want to find the instantaneous rate of change at every point, we need to specify the rate of change of a function as its own separate function- deriving - if f(x) is the name of some function then the derivative functions name is f'(x) or df(x)/dx - in this unit let's use the common notation of df(x)/dx - power rule: if f(x)= ax^n, then the derivative function is df(x)/dx= n • ax^(n-1) - if we have a function that is made up of the sum or difference of two or more terms, then we derive them each separately: if f(x)= x^2 + x^3, then df(x)/dx= 2x + 3x^2 - the product rule says that for function f(x)= g(x)h(x), df(x)/dx= g'(x)h(x) + g(x)h'(x) - if the function has an additive constant it will disappear, if it has a multiplicative constant it is preserved - function inside another function: chain rule- multiply derivative of outside function by derivative of inside function - log rule: f(x) = ln(x); df(x)/dx= 1/x - exponential rule: f(x)= e^x; df(x)/dx= e^x

How saving affects growth

- when the saving rate increases from s1 to s2, the sf(k) curve shifts upward. At the initial saving rate s1 and the initial capital stock k*1, the amount of investment just offset the amount of depreciation. Immediately after the saving rate rises, investment is higher, but he capital stock and depreciation are unchanged. Therefore, investment exceeds depreciation. The capital stock gradually rises until the economy reaches the new steady state

Unemployment: key questions

- why unemployment varies so much across countries and over time? - why has EU unemployment risen so much during the past three decades - several explanations have been put forward, but not definitive answer - adverse economic shocks? These could probably explain the rise in unemployment during the 1970s and possible the 1980s, but why didn't EU unemployment go back to pre shock level afterwards? - rigidities? Eu labor market regulations in unemployment insurance, employment protection, tax wedge. Rigidities were largely in place in the early 1970s, when EU unemployment was even lower than US unemployment - a combination of the two? The interaction of roughly unchanged institutions with adverse economic shocks may explain the EU unemployment experience. EU rigidities could cope well with favorable labor market conditions of the 1960s, but were not capable to face the adverse shocks that hit most OECD countries since the 1970s - still no definite answer

Hyperinflation

- π > 50% per month - moderate inflation has relatively small costs, but hyperinflation has huge costs - money ceases to function as a store of value, and may not serve its other functions (unit of account, medium of exchange) - people may conduct transactions with barter or a stable foreign currency - hyperinflation is caused by excessive money supply growth - when the central bank prints money, the price level rises - if it prints money rapidly enough, the result is hyperinflation

The national income accounts divide national income into six components, depending on who earns the income. The six categories, and the percentage of national income paid in each category, are the following:

1. Compensation of employees (61%): the wages and fringe benefits earned by workers 2. Proprietors income (9%): the income of non corporate businesses 3. Rental income (4%): the income that landlords receive, including the imputed rent that homeowners pay to themselves, less expenses 4. Corporate profits (15%): the income of corporations after payments to their workers and creditors 5. Net interest (3%): the interest domestic businesses pay minus the interest they receive, plus interest earned from foreigners 6. Taxes on production and imports (8%): certain taxes on businesses, such as sales taxes, less offsetting business subsidies.

Cost of expected inflation

1. Shoe leather costs - distorting effect of the inflation tax on the amount of money people hold. A higher inflation rate leads to a higher nominal interest rate, which in turn leads to lower real money balances. - increase in πe, increase in i, decrease in real money balances - If people hold lower money balances on average, they must make more frequent trips to the bank to withdraw money. The inconvenience of reducing money holding is metaphorically called the shoe leather cost of inflation - same monthly spending but lower average money holdings means more frequent trips to the bank to withdraw smaller amounts of cash 2. menu costs - cost of printing new menus, cost of printing and mailing new catalogues - the higher inflation is, the more frequently firms must change their prices and incur these costs - both shoe leather costs and menu costs have fallen greatly with recent technological advances 3. relative price distortions: because firms facing menu costs change prices infrequently, the higher the rate of inflation, the greater the variability in relative prices. Different firms change their prices at different times, leading to relative price distortions, causing microeconomic inefficiencies in the allocation of resources - same argument applies to wage setting. Wages negotiated infrequently, so real wages may fall between negotiations- but only in short run 4. Unfair tax treatment - some taxes are not adjusted to account for inflation, such as capital gains tax - ex. you buy 10,000 dollars of stock at the beginning of the year. At the end of the year you sell the stock for 11,000, so your nominal gain is 1,000 (10%). Suppose π=10% during the year. Your real capital gain is zero, but the government requires you to pay taxes on your nominal gain anyway. 5. General inconvenience: inflation makes it harder to compare nominal values from different time periods. This complicates long range financial planning

Three warnings of Quantity theory

1. Short run vs medium run: although over long periods of time and on average the correlation between the rate of money growth and inflation is good, over short periods of time they can deviate quite a lot. So the claim is not a good short term guide to inflation 2. Constant velocity: velocity might vary, even over long periods of time 3. Endogeneity of money growth: there may be periods in which some other monetary target is used, and money growth becomes endogenous, accommodating inflation

Properties of steady state

1. Steady state exists and is unique as the investment and depreciation curves cross once and only once 2. The economy always converges to the steady state from either lower or higher initial capital per head, because the investment curve is above the depreciation curve for k<k* and is below the depreciation curve for k>k* 3. The key intuition for this is diminishing marginal product of capital

Quantity theory of money building blocks

1. The factors of production and the production function determine the level of output Y 2. The money supply M set by the central bank determines the nominal value of output PY. This conclusion follows from the quantity equation and the assumption that the velocity of money is fixed 3. The price level P is then the ratio of the nominal value of output PY to the level of output Y - the productive capability of the economy determines real GDP, the quantity of money determines nominal GDP, and the GDP deflator is the ratio of nominal GDP to real GDP

Net exports

Accounts for trade with other countries. Net exports are the value of goods and services sold to other countries minus the value of goods and services that foreigners sell us (exports minus imports). Net exports are positive when the value of our exports is greater than the value of our imports and negative when the value of our imports is greater than the value of our exports. Net exports represent the net expenditure from abroad on our goods and services, which provides income for domestic producers

Effects of an increase in investment demand

At any given interest rate, the demand for investment goods is higher. This increase in demand is represented by a shift in the investment schedule to the right. Equilibrium amount of investment is unchanged because the fixed level of saving determines the amount of investment; there is a fixed supply of loanable funds. An increase in investment merely raises the equilibrium interest rate.

To grasp the effects of an increase in government purchases, consider the impact on the market for loanable funds

Because the increase in government purchases is not accompanied by an increase in taxes, the government finances the additional spending by borrowing- reducing public saving. With private saving unchanged, this government borrowing reduces national saving. A reduction in national saving is represented by a leftward shift in the supply of loanable funds available for investment. At the initial interest rate, the demand for loanable funds exceeds the supply. The equilibrium interest rate rises to the point where the investment schedule crosses the new saving schedule. Thus, an increase in government purchases causes the interest rate to rise firm r1 to r2

Equilibrium in the financial markets: the supply and demand for loanable funds

Because the interest rate is the cost of borrowing and the return to lending in financial markets, we can better understand the role of interest rate in the economy by thinking about financial markets. Rewrite the national income accounts identity as Y - C - G= I The term Y - C - G is the output that remains after the demands of consumers and the government have been satisfied; it is called national saving or simply saving (S). In this form, the national income accounts identity shows that saving equals investment We can split national saving into two parts- one part representing the saving of the private sector and the other representing the saving of the government: S= (Y - T - C) + (T - G) = I National saving is the sum of private and public saving.

An increase in government purchases

Because the total output is fixed by the factors of production, an increase in government purchases must be met by a decrease in some other category of demand than G. Disposable income Y - T is unchanged, so consumption C is unchanged as well. Therefore, the increase in government purchases must be met by an equal decrease in investment. To induce investment to fall, the interest rate must rise. Hence, the increase in government purchases causes the interest rate to increase and investment to decrease. Government purchases are said to crowd out investment

What happens when the central bank changes the supply of money?

Because velocity V is fixed, any change in the money supply M must lead to a proportionate change in the nominal value of output PY. Because the factors of production and the production function have already determined output Y, the nominal value of output PY can adjust only if the price level P changes. Hence the quantity theory implies that the price level is proportional to the money supply - the quantity theory of money states that the central bank, which controls the money supply, has ultimate control over the rate of inflation. If the central bank keeps the money supply stable, the price level will be stable. If the central bank increases the money supply rapidly, the price level will rise rapidly

Nominal GDP values goods and services at their ________ prices, while real GDP values goods and services at ______ prices

Current, constant Real GDP rises only when the amount of goods and services has increased, whereas nominal GDP can rise either because output has increased or because prices have increased. The GDP deflator is the ratio of nominal to real GDP and measures the overall level of prices

How the income of the economy is distributed from firms to households

Each factor of production is paid its marginal product, and these factor payments exhaust total output. Total output is divided between the payments to capital and the payments to labor, depending on their marginal productivities.

Prices: flexible vs sticky

Economists normally presume that the price of a good or service moves quickly to bring quantity supplied and quantity demanded into balance. In other words, they assume that markets are normally in equilibrium, so the price of any good or service is found where the supply and demand curves intersect. This assumption is called market clearing.

Theory as model building

Economists use models made of symbols and equations to understand the world. Economists build their "toy economies" to help explain economic variables, such as GDP, inflation, and unemployment. Economic models illustrate, often in mathematical terms, the relationships among variables. Models are useful because they help us dispense with irrelevant details and focus on underlying connections.

Models have two kinds of variables:

Endogenous variables and exogenous variables The purpose of a model is to show how the exogenous variables affect the endogenous variables. Exogenous variables come from outside the model and serve as the model's input, and endogenous variables are determined within the model and are the model's output.

In the Solow model with population growth and technological progress, the Golden Rule steady state is characterized by

Equality between the net marginal product of capital (MPK- δ) and the the steady state growth rate of total income (n + g). In the US economy, the net marginal product of capital is well in excess of the growth rate, indicating that the US economy has a lower saving rate and less capital than it would have in the Golden Rule steady state

The real interest rate adjust to

Equilibrate supply and demand for the economy's output- or the supply of loanable funds (saving) and the demand for loanable funds (investment). A decrease in national saving decreases the supply of loanable funds, reduces equilibrium amount of investment, and raises interest rate. An increase in investment demand increases demand for loanable funds, and also raises the interest rate. An increase in investment demand increases the quantity of investment only if a higher interest rate stimulates additional saving

The supply of goods and services

Factors of production and the production function together determine the quantity of goods and services supplied, which in turn equals the economy's output. To express this mathematically, we write Y= F(K-bar, L-bar)—> Y-bar We assume that because the supplies of capital and labor and the technology are fixed, output is also fixed.

National income —> personal income

Four adjustments 1. Subtract taxes on production and imports because those taxes never enter anyone's income 2. Reduce national income by the amount that corporations earn but do not pay out, either because the corporations are retaining earnings or because their are paying taxes to the government 3. Increase national income by the net amount the government pays out in transfer payments 4. Adjust national income to include the interest that households earn rather than the interest that businesses pay. Thus, Personal income= national income - indirect business taxes - corporate profits - social insurance contributions - net interest + dividends + government transfers to individuals + personal interest income

Using functions to express relationships among variables

Functional notation allows us to express the general idea that variables are related, even when we do not have enough information to indicate the precise numerical relationship. As long as we know that a relationship among the variables exists, we can express that relationship using functional notation

consumption

Households receive income from their labor and their ownership of capital, pay taxes to the government, and then decide how much of their after tax income to consume and how much to save. The income that households receive equals the output of the economy Y. The government then taxes households an amount T. We define income after the payment of all taxes, Y-T, to be disposable income. Households divide their disposable income between consumption and saving.

Inflation rate measures

How fast prices are rising

If factors earn their marginal products, then the parameter α indeed tells us

How much income goes to labor and how much goes to capital. The total amount paid to labor, which we have seen is MPL x L, equals (1-α)Y. Therefore, (1-α) is labors shade of output. Similarly, the total amount paid to capital, MPK x K, equals αY, and α is capitals share of output. The ratio of labor income to capital income is a constant, (1-α)/α. The favor shares depend only on the parameter α, not on the amounts of capital or labor or on the state of technology as measured by the parameter A.

For any given capital stock k, the production function y=f(k) determines

How much output the economy produces, and the saving rate s determines the allocation of that output between consumption and investment.

The division of national income

If all firms in the economy are competitive and profit maximizing, then each factor of production is paid its marginal contribution to the production process. The real wage paid to each worker equals the MPL, and the real rental price paid to each owner of capital equals the MPK. The total real wages paid to labor are therefore MPL x L, and the total real return paid to capital owners is MPK x K

The level of capital that maximizes steady state consumption is called the Golden Rule level:

If an economy has more capital than in the Golden rule steady state, then reducing saving will increase consumption at all points in time. By contrast, if the economy has less capital than in the Golden rule steady state, then reaching the golden rule requires increased investment and thus lower consumption for current generations

Three economists are debating whether an increase in the number of immigrants will increase, decrease, or have no effect on the growth rate of the domestic economy. Use the Solow model to justify each of their arguments

If immigrants enter the country with an endowment of capital per head that is lower than that of natives, then more intensive migration reduces the capital to labor ratio in the economy, so growth becomes positive in the short run, until capital per worker goes back to the pre-existing steady state level. If immigrants enter the country with an endowment of capital per head that is higher than that of the natives, more intensive migration raises the capital to labor ratio, so growth goes negative in the short run, again until capital per worker goes back to the pre-existing steady state level. If immigrants enter the country with an endowment of capital per head that is the same as that of the natives, the capital to labor ratio does not change, nor the short term growth rate of the economy. In the long run, growth is unchanged

Starting with too much capital

If k*>k*gold, then increasing c* requires a fall in s. In the transition to the Golden Rule, consumption is higher at all points in time

GDP: imputation in practice

In many cases, an imputation is called for in principle but is not made in practice. One might expect GDP to include the imputed rent on cars, lawn mowers, jewelry, and other durable goods owned by households. Yet the value of these rental services is left out of GDP. In addition, some of the output of the economy is produced and consumed at home and never enters the marketplace. For example, meals cooked at home are similar to meals cooked at a restaurant, yet the value added when a person prepares a meal at home is left out of GDP.

Motivation

In the Solow model we have seen: the production technology is held constant, income per capita stays constant in steady state Neither point is true in the real world - 1904-2004: US real GDP per person grew by a factor of 7.6, or 2% per year - from 1950 to 2000, US farm sector productivity nearly tripled - the real price of computer power has fallen an average of 30% per year over the past three decades

Describe the effects of an increase in the saving rate on growth in the Solow model

In the Solow model, an increase in the saving rate raises growth in the short run, but not in the long run, once the economy has again reached the new steady state. In the AK model, an increase in the saving rate permanently increases growth.

Returns to scale: a review

Initially Y= F(K,L) Scale all inputs by the same factor: z K2= zK, L2= zL What happens to output - if constant returns to scale, Y2= zY - if increasing returns to scale, Y2 > zY - if decreasing returns to scale, Y2< zY

A mode for the NRU

Intuition for presence of unemployment: - finding a job (or matching unemployed workers with available job vacancies) requires time and resources due to search frictions - sources of frictions: the unemployed have imperfect information about job opportunities and firms have imperfect information about job seekers, its hard to meet a labor market partner; when jobs and workers are heterogenous, one an unemployed finds a vacancy she may not be suitable for the job; imperfect mobility of workers When job finding is not instantaneous, before all unemployed workers and vacant jobs are matched, a fraction of the employed lose their jobs, providing a new inflow into unemployment - in equilibrium there will always exist some unemployed workers

The quantity theory is based on a simple money demand function:

It assumes that the demand for real money balances is proportional to income. Another determinant of money demand is the nominal interest rate, i. - the money you hold in your wallet does not earn interest. If, instead of holding that money, you used it to buy government bonds or deposited it in a savings account, you would earn the nominal interest rate. Therefore, the nominal interest rate is the opportunity cost of holding money: it is what you give up by holding money rather than bonds - hence: increase in nominal interest rate, decrease in money demand

Can we blame trade unions for the increase in European unemployment since the 1970s?

It would be hard to blame the increase in European unemployment since the 1970s on this kind of mechanism, because union power has been falling instead of rising since the late 1970s

Monetary policy

Just as the level of taxation and the level of government purchases are policy instruments of the government, so is the quantity of money. The government's control over the money supply is called monetary policy - in the US, monetary policy is delegates to a partially independent institution called the central bank - the central bank of the US is the federal reserve- often called the Fed. - decisions about monetary policy are made by the Fed's federal open market committee consisting of two groups: members of the federal reserve board, who are appointed by the president and confirmed by congress, and the presidents of the regional federal reserve banks, who are chosen by these banks boards of directors

Factors of production

K= capital; tools, machines, and structures used in production L= labor; the physical and mental efforts of workers

Labor force and unemployment rate

Labor force is the sum of the employed and unemployed, and the unemployment rate is the percentage of the labor force that is unemployed Labor force= number of employed + number of unemployed and Unemployment rate= number of unemployed/ labor force x 100 Labor force= 155.4 million Unemployment rate= 6.2% Labor force participation rate= 62.8%

In the Solow model, an increase in the rate of saving has a ______ effect on income per person

Level: it causes a period of rapid growth, but eventually that growth slows as the new steady state is reached. Thus, although a high saving rate yields a high steady state level of output, saving by itself cannot generate persistent economic growth

Diminishing marginal product with capital

Like labor, capital is subject to diminishing marginal product. The increase in profit from renting an additional machine is the extra revenue from selling the output of that machine minus the machines rental price: Δprofit = Δrevenue - Δcost = (P x MPK) - R To maximize profit, the firm continues to rent more capital until the MPK falls to equal the real rental price MPK= R/P

What policies might a less developed country pursue to raise the level of income?

Lowering the growth rate of population, raising the saving rate

A fall in consumer confidence shifts the saving function to the right, and thus

Lowers interest rate and raises investment. The mechanism works through saving: the fall in consumption implies an increase in saving, and to restore equilibrium in the loanable funds market a lower interest rate is needed - increase in public spending: savings/ investment decrease and interest rates increase

How P responds to Δ πe

M/P= L(Y, r + πe) for given Y, r, M: Increase in πe: increase in i (Fisher effect), decrease in M/Pd, increase in P to make (M/P)d fall and re-establish equilibrium

The marginal products for the Cobb Douglas production function can also be written as

MPL= (1- α)Y/L MPK= αY/K The MPL is proportional to output per worker, and the MPK is proportional to output per unit of capital. Y/L is called average labor productivity, and Y/K is called average capital productivity. If the production function is Cobb Douglas, then the marginal productivity of a factor is proportional to its average productivity

Real wage

MPL= W/P Real wage= the payment to labor measured in units of output rather than in dollars. To maximize profit, the firm hires up to the point at which the marginal product of labor equals the real wage

Determining the rental rate

MPL= W/P The same logic shows that MPK= R/P - diminishing returns to capital - the MPK curve is the firms demand curve for renting capital - firms maximize profits by choosing K such that MPK= R/P - the real rental rate adjusts to equate demand for capital with supply; vertical supply of capital line and downward sloping MPK

The quantity equation

MV=PY - follows from the preceding definition of velocity - it is an identity: it holds by the definition of the variables

Does CPI overstate inflation?

Many economists believe that, for a number of reasons, the CPI tends to overstate inflation. One problem is the substitution bias. Because the CPI measures the price of a fixed basket of goods, it does not reflect the ability of consumers to substitute toward goods whose relative prices have fallen. Thus, when relative prices change, the true cost of living rises less rapidly than does the CPI. A second problem is the introduction of new goods. When a new good is introduced into the marketplace, consumers are better off because they have more products from which to choose. In effect, the introduction of new goods increases the real value of the dollar. Yet this increase in the purchasing power of the dollar is not reflected in a lower CPI. A third problem is unmeasured changes in quality. When a firm changes the quality of a good it sells, not all of the goods price change reflects a change in the cost of living.

Real GDP per person in the US economy

Real GDP measures the total income of everyone in the economy, and real GDP per person measures the income of the average person in the economy. Real GDP per person tends to grow over time and this normal growth is sometimes interrupted by periods of declining income, called recessions or depressions; although real GDP rises in most years, this growth is not steady. Real GDP per person today is about eight times higher than it was in 1900. This growth in average income allows us to enjoy a much higher standard of living than previous generations.

Model explaining the production, distribution, and allocation of the economy's output of goods and services

Relies on the classical assumption that prices adjust to equilibrate supply and demand. Factor prices equilibrate factor markets, and the interest rate equilibrates the supply and demand for goods and services. Because the model incorporates all the interactions illustrated in the circular flow diagram, it is sometimes called a general equilibrium model. The model can explain how income is divided among the factors of production, and how factor prices depend on factor supplies.

Voluntary unemployment

Resulting from labor supply behavior. More workers choosing to work when wages are higher - useful labor supply theory. Not very useful theory of unemployment, as unemployment is largely involuntary

Involuntary unemployment

Resulting from some sort of labor market imperfection, such that unemployed workers would be willing to work at the ongoing wage but they cannot get a job at that wage

_________ is a necessary part of building a useful model

Simplification: any model constructed to be completely realistic would be too complicated for anyone to understand. Yet if models assume away features of the economy that are crucial to the issue that hand, they may lead us to conclusions that do not hold in the real world

competitive firm

Small relative to the markets in which it trades, so it has little influence on market prices; a firm can produce as much of a good as it wants without causing the price of the good to fall or it can stop selling altogether without causing the price of the good to rise. Similarly, the firm cannot influence the wages of the workers it employs because many other local firms also employ workers. Therefore, the competitive firm takes the prices of its output and its inputs as a given by market conditions To make its product, a firm needs two factors of production, capital and labor. As we did for the aggregate economy, we represent the firms production technology with the production function Y= F(K,L) where Y is the number of units produced (output), K is the number of capital used, and L is the amount of labor. Holding constant the technology as expressed in the production function, the firm produces more output only if it uses more machines or if its employees work more hours. The firm sells its output at price P, hires workers at a wage W, and rents capital from households at a rate R.

Revising laws to reduce degree of indexation

Social security benefits could be indexed to CPI inflation minus 1 percent. Such a change would provide a rough way of offsetting these measurement problems. At the same time, it would automatically slow the growth in government spending

How does interest rate bring financial markets into equilibrium

Substitute the consumption function and the investment unction into the national income accounts identity Y - C(Y - T) - G = I(r) G and T are fixed by policy and Y is fixed by the factors of production and the production function The right hand side of this equation shows that national saving depends on income Y and the fiscal policy variables G and T. For fixed values of Y, G, and T, national saving S is also fixed. The right hand side of the equation shows that investment depends on the interest rate

NNP (net national product)

Subtract from GNP the depreciation of capital- the amount of the economy's stock of plants, equipment, and residential structures that wears out during the year: NNP= GNP - depreciation In the national income accounts, depreciation is called the consumption of fixed capital. It equals about 16% of GNP. Because the depreciation of capital is a cost of producing the output of the economy, subtracting depreciation shows the net result of economic activity. Net national product is approximately equal to another measure called national income. The two differ by a small correction called the statistical discrepancy, which arises because different data sources may not be completely consistent National Income= NNP - statistical discrepancy National income measures how much everyone in the country has earned.

A closed economy, market clearing model

Supply side - factor markets (supply, demand, price) - determination of output/income Demand side - sources of demand: C, I, and G Equilibrium - goods market - financial market

Population growth: alternative views

The Malthusian model (1798) - main factor of production is land (agricultural society), which is in fixed supply - population growth will outstrip the Earth's ability to produce food, leading to the impoverishment of humanity - since Malthus, world population has increased sixfold, yet living standards are higher than ever - Malthus omitted the effects of capital accumulation and technological progress The Kremerian model (1993) - posits that population growth contributes to economic growth - more people= more geniuses, scientists and engineers, so faster technological progress - evidence: as world pop growth rate increases, so did rate of growth in living standards - historically, regions with larger populations have enjoyed faster growth

What explains increasing inequality in family incomes?

The change in factor shares. Because capital income tends to be more concentrated in higher income households than is labor income, a fall in the labor share and rise in the capital share tends to increase inequality. More important, if we look within labor income, we find the gap between the earnings of high wage workers and the earnings of low wage workers has grown substantially since the 1970s. - "the sharp rise in inequality was largely due to an educational slowdown": for the past century technological progress has been a steady economic force, not only increasing average living standards but also increasing the demand for skilled workers relative to unskilled workers. By itself, this skill-biased technological hand tends to raise the wages of skilled workers relative to the wages of unskilled workers, thereby increasing inequality. This didn't pan out for much of the 20th century because education of skilled workers grew just as fast as technological progress. In the past decades, technological progress kept its pace but educational advancement slowed down. Because growth in the supply of skilled workers has slowed, their wages have grown relative to those of the unskilled - in response to these economic developments, some policy makers advocate a more redistributive system of taxes and transfers, to take from those higher on the economic ladder and give to those on the lower rungs

1995-2004: IT and the new economy

The computer revolution strongly affected productivity, but only not until the mid-1990s Two reasons: 1. Computer industry's share of GDP much bigger in late 1990s than earlier 2. Takes time for firms to determine how to utilize new technology most effectively The big open question - how long will IT remain an engine of growth?

The model of the pizza market has two exogenous variables and two endogenous variables

The exogenous variables are aggregate income and the price of materials. The model does not attempt to explain them but instead takes them as given. The endogenous variables are the price of pizza and the quantity of pizza exchanged. These are the variables that the model attempts to explain The model can be used to show how a change in one of the exogenous variables affects both endogenous variables. If aggregate income increases, then the demand for pizza increases. The model shows that both the equilibrium price and the equilibrium quantity of pizza rise. Similarly, if the price of materials increases, then the supply of pizza decreases. The model shows that in this case the equilibrium price of pizza and the equilibrium quantity of pizza falls. Thus, the model shows how changes either in aggregate income or in the price of materials affect price and quantity in the market for pizza The art in economics lies in judging when a simplifying assumption clarifies our thinking and when it misleads us

factors of production

The inputs used to produce goods and services. The two most important factors of production are capital and labor. Capital is the set of tools that workers use, while labor is the time people spend working. We use the symbol K to denote the amount of capital and the symbol L to denote the amount of labor In this chapter we take the economy's factors of production as given; we assume that the economy has a fixed amount of capital and a fixed amount of labor. We write: K = K-bar, L=L-bar. The bar means that each variable is fixed at some level. We also assume here that the factors of production are fully utilized.

Competitive, profit maximizing firms hire labor until

The marginal product of labor equals the real wage. Similarly, these firms rent capital until the marginal product of capital equals the real rental price. Therefore, each factor of production is paid its marginal product. If the production function has constant returns to scale, then according to Euler's theorem, all output is used to compensate the inputs

Gross domestic product

The market value of all finished goods and services produced within a country in a year - finished goods: one that will not be sold again as part of some other good - capital goods: goods that are used to make other goods but are still considered finished - produced goods: GDP only counts production. If an old house is sold this year, that doesn't add to GDP, since the House wasn't produced this year - within a country: GDP only counts goods and services produced within the country - market value: if a good isn't bought and sold in a market, its not typically counted in GDP. Market prices are observable- without market prices, there's no easy way to determine the worth of something

Many empirical studies have examined the extent to which the Solow model can help explain long run economic growth:

The model can explain much of what we see in the data, such as balanced growth and conditional convergence. Recent studies have also found that international variation in standards of living is attributable to a combination of capital accumulation and the efficiency with which capital is used

The supply of money depends on

The monetary base, the reserve deposit ratio, and the currency deposit ratio. An increase in the monetary base leads to a proportional increase in the money supply. A decrease in the reserve deposit ratio or in the currency deposit ratio increases the money multiplier and thus the money supply

The marginal product of labor

The more labor the firm employs, the more output it produces. The marginal product of labor (MPL) is the extra amount of output the firm gets from one extra unit of labor, holding the amount of capital fixed. We can express this using the production function: MPL= F(K, L + 1) - F(K,L) The first term on the right hand side is the amount of output produced with K units of capital and L + 1 units of labor; the second term is the amount of output produced with K units of capital and L units of labor. This equation states that the marginal product of labor is the difference between the amount of output produced with L + 1 units of labor and the amount produced with only L units of labor

CPI (Consumer Price Index)

The most commonly used measure of the level of prices - computed by collecting the prices of thousands of goods and services. Just as GDP turns the quantities of many goods and services into a single number measuring the value of production, CPI turns the prices of many goods and services into a single index measuring the overall level of prices - can't compute an average of all prices because this approach would treat all goods and services equally. BLS weights different items by computing the price of a basket of goods and services purchased by a typical consumer. The CPI is the price of this basket of goods and services relative to the price of the same basket in some base year For example, suppose that the typical consumer buys five apples and two oranges every month. Then the basket of goods consists of five apples and two oranges, and the CPI is CPI= (5 x current price of apples) + (2 x current price of oranges)/ (5 x 2014 price of apples) + (2 x 2014 price of oranges) The index tells us how much it costs now to buy 5 apples and 2 oranges relative to how much it cost to buy the same basket of fruit in 2014

Quantity theory of money

The quantity equation can be viewed as a definition: it defines velocity V as the ratio of nominal GDP, PY, to the quantity of money M. Yet if we make the additional assumption that the velocity of money is constant, then the quantity equation becomes a useful theory about the effects of money - like many assumptions in economics, the assumption of constant velocity is only a simplification of reality. Velocity does change if the money demand function changes. Nonetheless, experience shows that the assumption of constant velocity is a useful one in many situations - with this assumption included, the quantity equation can be seen as a theory or what determines nominal GDP. The quantity equation says MV= PY, with a fixed velocity. Therefore, a change in the quantity of money must cause a proportionate change in nominal GDP (PY). - that is, if velocity is fixed, the quantity of money determines the dollar value of the economy's output

Interest rate

The quantity of investment goods demanded depends on interest rate, which measures the cost of the funds used to finance investment. For an investment project to be profitable, it's return (the revenue from increased future production of goods and services) must exceed its cost (the payments for borrowed funds). If the interest rate rises, fewer investment projects are profitable, and the quantity of investment goods demanded falls.

real money balances

The quantity of money expressed in terms of the quantity of goods and services it can buy; the quantity of money divided by the price level (M/P) - real money balances measure the purchasing power of the stock of money

Variation in the unemployment rate across demographic groups

The rate of unemployment varies substantially across different groups within the population. Younger workers have much higher unemployment rates than older ones. To explain this difference, recall our model of the natural rate of unemployment. The model isolates two possible causes for a high rate of unemployment: a low rate of job finding and a high rate of job separation. When economists study data on the transition of individuals between employment and unemployment, they find that those groups with high unemployment tend to have higher rates of job separation. They find less variation across groups in the rate of job finding. - these findings help explain the higher unemployment rates for younger workers. Younger workers have only recently entered the labor market, and they are often uncertain about their career plans. It may be best for them to try different types of jobs before making a long term commitment to a specific occupation- if they do so, we should expect a higher rate of job separation and a higher rate of frictional unemployment - unemployment rates are much higher for blacks than for whites. This phenomenon is not well understood. Possible reasons for the lower rates of job finding include less access to informational job finding networks and discrimination by employers

The neoclassical theory of distribution tells us that

The real wage W/P equals the marginal product of labor. The Cobb Douglas production function tells us that the marginal product of labor is proportional to average labor productivity Y/L. Theory and history confirm the close link between labor productivity and real wages. This lesson is the key to understanding why workers today are better off than workers in previous generations

Structural unemployment results when

The real wage remains above the level that equilibrates labor supply and labor demand. Minimum wage legislation is one cause of wage rigidity. Unions and the threat of unionization are another. Finally, efficiency wage theories suggest that firms may find it profitable to keep wages high despite an excess supply of labor

Seigniorage is

The revenue that the government raises by printing money. It is a tax on money holding. Although seigniorage is quantitatively small in most economies, it is often a major source of government revenue in economies experiencing hyperinflation

Saving and investment as a function of interest rate

The saving function is a vertical line because in this model saving does not depend on the interest rate. The investment function slopes downward: as interest rate decreases, more investment projects become profitable. The interest rate adjusts to bring saving and investment into balance.

Output, consumption, and investment

The saving rate s determines the allocation of output between consumption and investment. For any level of capital k, output is f(k), investment is sf(k), and consumption is f(k)- sf(k)

Transitions into and out of the labor force

The sole reason for unemployment is job separation, and the sole reason for leaving unemployment is job finding - movements into and out of the labor force are important. About 1/3 of the employed have only recently entered the labor force. Some of these entrants are young workers still looking for their first jobs; others have worked before but had temporarily left the labor force. In addition, not all unemployment ends with job finding: almost half of all spells of unemployment and in the unemployed persons withdrawal from the labor market - individuals entering and leaving the labor force make unemployment statistics more difficult to interpret. On one hand, some individuals calling themselves employed may not be seriously looking for jobs and perhaps should best be viewed as out of the labor force. Their unemployment may not represent a social problem. On the other hand, some individuals may want jobs but, after unsuccessful searches, have given up looking. These "discourages workers" are counted as being out of the labor force and do not show up in unemployment statistics. Even though their jobless is unmeasured, it may nonetheless be a social problem

The predictions of the Solow growth model lead us to be optimistic about the prospects of poorer countries to reach the standard of living of richer countries in the very long run. What element in the Solow model of growth drives this result? Is this result confirmed in the data?

The solow growth model predicts conditional convergence: if two countries have the same economic structure and the share the same parameters, the country with the lower initial capital stock will grow faster than the country with a higher initial capital stock, and eventually the two countries will converge to the same study state level of capital per head and output per head. The element that drives this result in the model is diminishing marginal product of capital: in the country with lower capital stock, capital is more productive and thus fosters higher growth. The day's show presence of convergence among rich countries since WW2, but no strong signs of convergence between rich and poor countries. This may be due to the fact that convergence would only happen if the underlying parameters were identical across countries, and to the fact that the returns to capital are not really diminishing

quantity theory of money

The starting point of the quantity theory of money is the insight that people hold money to buy goods and services. The more money they need for such transactions, the more money they hold. Thus, the quantity of money in the economy is related to the number of dollars exchanged in transactions - the link between transactions and money is expressed in the following equation, called the quantity equations: Money x velocity = price x transactions M x V = P x T The right hand side of the quantity equation tells us about transactions. T represents the total number of transactions during some period of time, say, a year. In other words, T is the number of times in a year that goods or services are exchanged for money. P is the price of a typical transaction - the number of dollars exchanged. The product of the price of a transaction and the number of transactions, PT, equals the number of dollars exchanged in a year The left hand side of the quantity equation tells us about the money used to make the transactions. M is the quantity of money. V, called the transactions velocity of money, measures the rate at which money circulated in the economy. In other words, velocity tells us the number of times a dollar bill changes hands in a given period of time. The quantity equation is an identity: the definitions of the four variables make it true.. this type of equation is useful because it shows that if one of the variables changes, one or more of the others must also change to maintain the equality. For example, if the quantity of money increases and the velocity of money remains unchanged, then either the price or the number of transactions must rise

The quantity theory of money assumes that

The velocity of money is stable and concludes that nominal GDP is proportional to the stock of money. Because the factors of production and the production function determine real GDP, the quantity theory implies that the price level is proportional to the quantity of money. Therefore, the rate of growth in the quantity of money determines the inflation rate

To understand the economy, economists use models:

Theories that simplify reality in order to reveal how exogenous variables influence endogenous variables. Because no single model can answer all questions, macroeconomists use different models to look at different issues

The saving rate and the golden rule

There is only one saving rate that produces the golden rule level of capital k*gold. Any change in the saving rate would shift the sf(k) curve and would move the economy to a steady state with a lower level of consumption

How can GDP measure both the economy's income and its expenditure on output?

These two quantities are really the same: for the economy as a whole, income must equal expenditure. That fact follows from an even more fundamental one: because every transaction has a buyer and a seller, every dollar of expenditure by a buyer must become a dollar of income to a seller.

Government purchases

Third component of demand for goods and services. The federal and local government buys guns, missiles, services of government employees, library books, builds schools, hire teachers. These purchases are one type of government spending- the other is transfer payments to households, such as public assistance for the poor and social security payments for the elderly. Transfer payments are not made in exchange for some of the economy's output of goods and services. Therefore, they are not included in the variable G. Transfer payments are the opposite of taxes: they increase households disposable income just as taxes reduce it. Thus, an increase in transfer payments financed by an increase in taxes leaves disposable income unchanged. We can now revise our definition of T to equal taxes minus transfer payments. Disposable income Y - T includes both the negative impacts of taxes and the positive impacts of transfer payments

Production function graph

This curve shows how output depends on labor input, holding the amount of capital constant. The marginal product of labor MPL is the change in output when the labor input is increased by 1 unit. As the amount of labor increases, the production function becomes flatter, indicating diminishing marginal product

The circular flow

This figure illustrates the flows between firms and households in an economy that produces one good, bread, from one input, labor. The inner loop represents the flows of labor and bread: households sell their labor to firms, and the firms sell the bread they produce to households. The outer loop represents the corresponding flows of dollars: households pay the firms for the bread, and the firms pay wages and profit to the households. In this economy, GDP is both the total expenditure on bread and the total income from the production of bread GDP measures the flow of dollars in this economy. We can compute it in two ways. GDP is the total income from the production of bread, which equals the sum of wages and profit. GDP is also the total expenditure on purchases of bread. To compute GDP, we can look at either the flow of dollars from firms to households or the flow of dollars from households to firms. These two ways of computing GDP must be equal because, by the rules of accounting, the expenditure of buyers on products is income to the sellers of those products.

The circular flow diagram of dollars through the economy

This figure is a more realistic version of the circular flow diagram found in chapter 2. Each yellow box represents an economic actor- households, firms, and the government. Each blue box represents a type of market- the markets for goods and services, the markets for the factors of production, and financial markets. The green arrows show the flow of dollars among the economic actors through the three types of markets.

consumption function

We assume that the level of consumption depends directly on the level of disposable income. A higher level of disposable income leads to greater consumption. Thus C= C(Y - T) This equation states that consumption is a function of disposable income. The relationship between consumption and disposable income is called the consumption function

From transactions to income

When studying the role of money in the economy, economists usually use a slightly different version of the quantity equation. The problem with the first equation is that the number of transactions is difficult to measure. To solve this problem, the number of transactions T is replaced by the total output of the economy Y. Transactions and output are related because the more the economy produces the more goods are bought and sold. They are not the same, however. When one person sells a used car to another person, they make a transaction using money, even though the used car is not part of current output. Nonetheless, the dollar value of transactions is roughly proportional to the dollar value of output. Quantity equation becomes: MV = PY - because Y is also total income, V in this version of the quantity equation is called the income velocity of money

Does the increase in saving that leads to the Golden Rule steady state raise economic welfare?

When the economy begins above the Golden Rule, reaching the Golden Rule produces higher consumption at all points in time. When the economy begins below the Golden Rule, reaching the Golden Rule requires initially reducing consumption to increase consumption in the future - reaching the golden rule achieves the highest steady state level of consumption and thus benefits future generations. But when the economy is initially below the golden rule, reaching the golden rule requires raising investment and thus lowering the consumption of current generations. Thus, when choosing whether to increase capital accumulation, the policymaker faces a trade off among the welfare of different generations

Aggregate production function

Y=F(K,L) - K is no longer fixed: investment causes it to grow, depreciation causes it to shrink - L is no longer fixed: population growth causes it to grow - marginal products MPK and MPL are positive and diminishing: MPK falls in K and MPL falls in L - MPK goes to 0 when K goes to infinity - MPK goes to infinity when K goes to 0 - similar for MPL - output per worker only depends on capital per worker

GDP is the sum of

consumption, investment, government purchases, and net exports Each dollar of GDP falls into one of these categories. This equation is an identity- an equation that must hold because of the way the variables are defined. It is called the national income accounts identity

Government purchases

goods and services bought by federal, state, and local governments - includes such items as military equipment, highways, and the services provided by government workers. It does not include transfer payments to individuals, such as social security and welfare. Because transfer payments reallocate existing income and are not made in exchange for goods and services, they are not part of GDP.

causes of frictional unemployment

job search, sectoral shifts, unemployment insurance - sectoral shift: a change in composition of demand among industries or regions. As the demand for goods shifts, so does the demand for the labor that produces those goods. Because sectoral shifts are always occurring, and because it takes time for workers to change sectors, there is always frictional unemployment - workers find themselves unexpectedly out of work when their firms fail, when their job performance is deemed unacceptable, or when their particular skills are no longer needed. Workers may also quit their jobs to change careers or to move to different parts of the country. Regardless of the cause of job separation, it will take time and effort for the worker to find a new job. As long as the supply and demand for labor among firms is changing, frictional unemployment is unavoidable - unemployment insurance: under this program, unemployed workers can collect a fraction of their wages for a certain period after losing their jobs. By softening the economic hardship of unemployment, unemployment insurance increases the amount of frictional unemployment and raises the natural rate. The unemployed who receive unemployment insurance benefits are less pressed to search for new employment and are more likely to turn down unattractive job offers. Both of these changes in behavior reduce the rate of job finding

structural unemployment

unemployment that results because the number of jobs available in some labor markets is insufficient to provide a job for everyone who wants one - resulting from wage rigidity and job rationing - workers are unemployed not because they are actively searching for the jobs that best suit their individual skills but because there is a fundamental mismatch between the number of people who want to work and the number of jobs that are available. At the going wage, the quantity of labor supplied exceeds the quantity of labor demanded; many workers are simply waiting for jobs to open up