Final Exam Part 1Macroeconomic Theory, Final Exam Part 2 Macroeconomic Theory, Final: Macroeconomic Theory

Questions that are central to stimulating growth in poor countries

(1) What institutions in a country foster growth? Institutions mean things like infrastructure such as roads and bridges, law enforcement, or property rights. (2) Do policies designed to develop more efficient financial systems raise economic growth? (3) How does education affect economic growth? (4) How do policies to encourage research and development affect economic growth?

Supply shocks causes (things that causes change in A)

1.) Technology, increase in A causing a shift of A upward 2.)Environmental Shocks, can shift the curve down or up. 3.)Energy Shocks, shifts the curve downward

Private disposable income

Equals GDP plus net factor income plus transfer payments from the government plus interest payments on government debt minus taxes.

Net government income

Equals taxes minus transfers minus interest payments on government debt.

What is the appropriate role for stabilization policy?

Fiscal and monetary policymakers have the ability to implement policies to stabilize the economy, but a central question is how much (if at all) policymakers should intervene in the economy. For instance, during a recession it is typical for policymakers to pursue an activist policy to reduce unemployment and stimulate growth. However, some nonactivists observers believe that pursuing an activist policy may actually be destabilizing and do more harm than good.

Net Domestic Product

GDP - depreciation

Ways Government can increase savings rate

Governments can encourage higher saving through various tax policies. For instance, governments can lower taxes to households that put more of their income into saving or retirement accounts. Also, policymakers can devise taxes that discourage consumption, and therefore increase saving, such as a national sales tax. Finally, giving tax incentives to businesses that contribute to employee pension/retirement accounts can increase the saving rate.

flow

Refers to a measured amount of something over a specific time period, for instance GDP variables. These are usually reported quarterly or over a one year period. Flow is distinguished by stock in that stock adds the accumulation of a flow variable over time, such as the distinction between income (flow), and wealth (stock).

Total National Saving

S = Y - C - G (aka, Sp + Sg)

Government Saving formula

Sg = T - G

Should policy follow rules rather than discretion?

Should policy follow rules rather than discretion? If policymakers have full discretion on the type and size of policies implemented, this could lead to bad outcomes in the long run, for instance by pursuing excessive expansionary policies which create high long term inflation. One way to avoid this is to set up a rules-based policymaking system, effectively tying the hands of policymakers to pursue "their own" policies. Although a rules based policymaking authority can mitigate the bad outcomes from a discretionary regime, it also is less flexible to react to shocks to the economy.

What are two important attributes of real GDP per person over time in the US?

Since 1900, the two main features are (1) that real GDP per person has grown substantially over time, and (2), real GDP grows unevenly over time, fluctuating around a trend.

Private Saving formula

Sp = Y - T - C

CPI

The CPI is constructed by calculating the cost of a fixed basket of goods that a typical household would purchase, as such it is relevant considering that consumption is a large part of the U.S. economy. Captures the price of imported goods, which affects consumers. The major disadvantage to using the CPI is that several biases in its design overstate the actual 'cost of living' because of 'substitution bias' and the introduction of new goods.

GDP deflator

The GDP deflator can give a broad view of how overall prices are behaving in the economy. Includes a lot of prices of goods that people don't care about. The GDP deflator also ignores the costs of imported goods.

PCE deflator

The PCE deflator measures the prices of all domestically produced consumption goods. It does not contain substitution bias or introduction of new goods like the CPI does because it does not have a "fixed basket" of goods to base inflation on.

Do global trade imbalances cause harm?

The persistently high U.S. trade deficits are often pointed to as a symptom of a looming economic disaster, and threaten the autonomy of the U.S. that is so indebted to foreign countries. These large trade imbalances may have contributed to the recession of 2007-2009 by encouraging large capital flows into the U.S., pushing interest rates lower, and facilitating cheap access to credit which lead to unsustainable levels of consumption and a boom (and subsequent bust) in the housing market.

Fundamental identity of national income accounting

The principle that GDP can be determined and is equivalent to the three accounting approaches; total goods and services produced equals total expenditures on goods and services, which equals total income.

GDP approaches

The production, expenditure, and income approaches

Capital

The quantity of physical structures, equipment, plants, or machinery used in the production process, denoted by 'K'.

ex ante interest rate

The real interest rate anticipated when a loan is made; the nominal interest rate minus expected inflation.

Stock

The total amount of something that has been accumulated over time. Flow is distinguished by stock in that stock adds the accumulation of a flow variable over time, such as the distinction between income (flow), and wealth (stock).

Value added

The value of the firm's output, minus the value of intermediate goods purchased by the firm. The value added is the firm's contribution to total GDP. Always include the first value in the value added method.

How can poor countries grow rich?

This is a particularly difficult issue for policymakers to solve. Many poor countries lack the resources and infrastructure to allow for growth, which keeps them poor. If poor countries save more to invest in infrastructure for future growth, this necessarily reduces consumption today from already low levels, which may mean forgoing basic necessities, or even food to survive.

How can we avoid financial crises?

This is an important topic, especially considering the role financial markets played and the severity of the most recent recession. When financial markets and the banking sector cease to operate effectively (typical of financial crises), the economy can experience sudden, sharp downturns. These sharp downturns make it more difficult for policymakers to effectively implement policies to stabilize the economy.

endogenous variables

Variables that a model tries to explain

Cobb-Douglas Production formula

Y = F(K,L) = AK^0.3*L^0.7

10 year Treasury bond rate

a benchmark indicator of longer-term borrowing costs.

economic model

a simplified representation of the economic phenomenon that takes a mathematical or graphical form

Investment (for expenditure approach)

about 11% of U.S. GDP, and consists of business fixed investment, inventory investment, and residential investment.

Supply shocks

affect an economy's ability to produce output with a given amount of inputs (i.e. capital and labor), thus impacting the economy's long run output potential. Supply shocks can be either positive, in which production increases without any change in inputs, or negative, when production decreases holding inputs constant.

persistent (positive) net capital outflow represents

an accumulation of foreign assets by the domestic economy, thereby representing an increase in wealth.

as firms add more of the input...

as long as the extra revenue is greater than the extra cost, profit will always increase

National saving

can be split into two sources: saving generated from households in the form of private saving, and saving generated by the government in the form of government saving.

factors of production

capital and labor, which are preditermined in the long run

Decrease in labor productivity would cause a

decrease in real wages

Unemployed definition

does not currently have a job, but has been actively looking for work in the past 4 weeks.

Government purchases (for expenditure approach)

federal, state, and local level are about 20% of GDP

Stabilization policy

is macroeconomic policy that aims at minimizing business cycle fluctuations and stabilizing economic activity

Capital productivity

output per capital productivity (Y/K)

exogenous variables

variables that a model takes as a given

Equilibrium firms hire labor up to the point that

w = MPL

net capital outflow

which is invested abroad if there is leftover saving after satisfying domestic investment demands

federal funds rate

which is the overnight interest rate between banks and controlled closely by the Federal Reserve

For a representative (typical) firm in the economy, real profit (Π) for the firm is

Π = F(K,L) -r(c)K -wL r(c) = MPK w = MPL

inflation rate formula

(current price index - previous price index)/ (previous price index)

Net Exports (for expenditure approach)

(the difference between exports and imports) is about -3%, since imports are larger than exports in the U.S.

economic theory model steps

1.) Identify an interesting economic question 2. Specify the endogenous variables and the exogenous variables. 3. Posit a set of equations or graphical analysis to connect movements in the exogenous variables to the endogenous variables 4. Compare the conclusions of the model with what actually happens 5. Use the model to make further predictions

Price index for year x

100 x (value of goods and services in year x prices)/(value of goods and services in base year prices)

If a firm buys technology, it is always considered as

Business fixed investment

How costly is it to reduce inflation?

If inflation gets high enough, at some point it imposes costs to society in the form of inefficient allocation of resources and lost transactions. Thus, policymakers would like to have inflation generally at a low, manageable level. If inflation is currently higher than desirable, a deliberate policy to reduce inflation (by reducing economic activity) may be used. Monetary policy takes a central role in this process as will be seen later in the text. The amount of output that needs to be "sacrificed" to achieve lower inflation is debatable, and is dependent upon assumptions about firms' ability to adjust prices, and on ways in which people form expectations about and react to policy.

Is the saving rate too low?

In the U.S., the savings rate has been very low relative to most other countries. Over the last two decades, it has been at or below 5%. While a low saving rate signifies that individuals may enjoy more immediate consumption, it also translates into lower investment and dimmer prospects for long-term economic growth. Increasing saving today could enhance economic growth in the future, raising future incomes above what it otherwise would be and support higher future consumption. Creating policies that sacrifice lower current consumption today for higher future consumption is feasible, but can be politically contentious and difficult for the public to appreciate.

the demand for capital and labor is equal to

MPK and MPL in terms of w and rc instead of Y.

Chad owns a landscaping company, and is going to lay off several workers. What will happen to the marginal product of labor?

MPL will increase

How significant are budget deficits?

Many governments, including the United States, have run large budget deficits following the severe global recession that began in 2007. The central question in each case is how governments will pay for these deficits that will likely persist for many years. Raising taxes and/or lowering government spending will help the deficits, but could hinder current prospects for the economy. On the one hand, some economists and politicians argue that failing to address the large deficits could raise questions about the solvency of the government. On the other hand, some argue that budget deficits are not a problem and can be effectively managed.

Credit markets

Markets where households, businesses, and governments are able to access credit to borrow funds.

Labor

Measures the amount of workers or worker-hours that contribute to the production process.

RGDP

NGDP/price level

Labor productivity

Output per worker (Y/L)

Why would large amounts of capital flowing to the U.S from foreign countries in the 2000s be a danger to the global economy?

The capital flows helped to fuel a boom in the U.S. housing market. When housing prices crashed, this created a severe recession that spread globally.

Marginal product

The increased amount of output produced by a one unit increase in an input, holding all other inputs constant.

depriciation

The loss in value of capital over time due to wear and tear from ordinary use.

employment ratio

The number of workers employed, divided by the adult population.

Consumption (for expenditure approach)

comprises of approximately 2/3 of total GDP in the U.S., and is broken into consumer durables, nondurable goods, and service

Fiscal policy

deals with government spending and taxation

Government consumption

government purchases of short-lived goods and services at the federal, state, and local level, such as pay for teachers or firefighters.

Government Investment

government spending at the federal, state, and local level on capital goods such as schools, roads, and bridges.

Rent is considered as

housing services

fisher equation

i = r + πe.

diminishing marginal returns

implying that as the amount of inputs (K or L) increase, output increases, but at a decreasing rate.

financial crisis

is a large-scale disruption in financial markets characterized by sharp declines in the prices of assets (property that includes bonds, stocks, art, land) and business failures.

Monetary policy

is the management of the money supply and interest rates

Two other labor market indicators of interest

labor force participation rate, and the employment ratio

economic theory

logical framework to explain a particular economic phenomenon

Income approach

main sources of income are: Compensation of employees, including wages and salaries; corporate profits; self employment income, royalties, and rental income ('other income'); depreciation (this must be added into GDP to offset it being subtracted off from another subcategory of income); and net factor income.

MPK

marginal product of capital = change in Y/change in K (partial derivative of Cobb-Douglas Production function) MPK = 0.3(Y/K)

MPL

marginal product of labor = change in Y/change in L (partial derivative of Cobb-Douglas Production function) or MPL = 0.7(Y/L)

Interest rates

represent the cost of borrowing funds for a specified period of time

uses-of-saving identity

tells us that S = I + NX

constant returns to scale

the Cobb Douglas function exhibits this, meaning that if all inputs in the production process were doubled, output would exactly double in size (or similarly for any other scale factor)

Total factor productivity

the amount of output that can be achieved with a given amount of factor inputs... also A

Prime rate

the benchmark interest rate to which most corporate bank loans are tied

market value

the price a seller can expect to receive for a product in a competitive marketplace.

wL

total real cost of capital inputs used

r(c)K

total real cost of labor inputs used

Complicated aspects of accounting GDP

1. How to deal with nonmarket goods and the underground economy? Not counting these transactions could result in an underestimation of the actual size of the economy. 2. The value of some goods and services must be imputed, or estimated because there is not a clear market value for these services. 3. GDP does not include goods or services that were produced in a previous period. These have already been counted into GDP in the previous period. 4. Some goods and services are used as inputs to produce other goods and services. Because of this, we must count only final goods and services, or add up the value added of all the intermediategoods and services (but not both, since this would be counting some goods twice). 5. Goods that are produced in a particular period but not sold must be accounted for. We do this by adding inventory investment into the investment component of GDP. Essentially, firms 'buy' their own goods temporarily until they can be sold in the marketplace. 6. How do we interpret GDP over time? If GDP is expressed in nominal terms, it can give a misleading view of how much the economy has expanded over time, since a rise in nominal GDP could simply be a result of higher prices, even if production has remained constant. For this reason real GDP, which adjusts for changes in the price level over time, is more relevant than nominal GDP for understanding economic activity. To account for this, real GDP can be calculated as nominal GDP divided by the price level: RGDP = NGDP/Price level. In addition, changes in the size and composition of different sectors of the economy can complicate the interpretation of weighted average measures of the price level. For this reason, a chain-weightedmeasure of GDP is employed to fix this. 7. What does GDP tell us about overall well-being? Although GDP can be a reasonably good indicator of how well off people in an economy are, it necessarily does not take into account less quantifiable factors that people may care about. These may include things like a clean environment, lack of crime, literacy rate, life expectancy, or quality of health care and other social services.

Adverse supply function

A change in supply conditions leading to a decline in the economy's production of output from a given level of capital and labor. Can be policy induced, for instance by tax policy influencing work incentives, or can be unexpected, for instance through a natural disaster.

Capital good

A good that is produced in the current time period and that is used for future production. For instance, producing a lawnmower is a capital good when a landscaping company purchases it to produce lawn mowing services.

chain weighting

A methodology which averages the prices for goods and services over a two year period to construct a base year price level. This is done to eliminate a bias in the GDP deflator calculation which can arise when there is substantial variation in the prices of some goods over traditional base year periods. For instance, the prices for computing and technology goods have decreased dramatically over the last decade or so; at the same time the size of this sector has grown rapidly. These two factors have decreased the actual price level below what is indicated by traditional price level measures, initiating the use of chain-weighting to help correct for this.

variable A in Cobb-Douglas production formula

A represents the state of technology for the economy and how efficient the economy is at transforming capital and labor resources into output. This is referred to as total factor productivity (TFP)

seasonally adjusted

A statistical technique that adjusts economic variables to reflect typical, predictable changes in variables over the calendar year, to allow for easier comparisons over the year.

Bond

A type of debt instrument which pays a stream of income to the holder over a specified period of time.

imputed value

An estimated value of goods and services provided and counted into GDP that do not have a structured market to value the goods in the marketplace. For instance, the value of housing services for people who rent is valued at what the rent is. Likewise, the value of a judge in the judicial system is valued 'at cost' by the salary paid (even though the value to society may be higher than this)

Real rental price of capital

Denoted rc , this is the nominal rental price of capital (R) divided by the price level (P); rc = R/P. The rental price of capital represents the (opportunity) cost of obtaining capital to use in the production process. Note that this is factored into production cost even if firms use existing capital they own, since they could presumably receive revenue from 'renting out' that capital to other firms. This represents how much owners of capital earn when renting out, or firms pay to use, in terms of purchasing power

Real wage rate

Denoted w, this is the nominal wage rate (W) paid to labor divided by the price level (P); w = W/P. This represents how much workers earn, and firms pay, in terms of purchasing power for labor services

Economic profits

Different than accounting profits because it takes into account opportunity cost. P*F(K,L) - RK - WL, where the first term is the revenue for the firm, the second term is the nominal cost of capital, and the third term is the nominal cost of labor for producing the goods.

Policies governments can pursue to encourage higher savings

Discourage consumption by taxing it. This can be done, for instance, by implementing a value- added tax. Increase tax incentives for those who save, for instance by creating tax incentives to encourage households to put more income in retirement accounts. Increase the return on saving, for instance by reducing taxes on capital gains. Reduce budget deficits. Higher budget deficits (negative government saving) take away from the pool of funds available for investment by firms. Thus controlling deficits can be an important way to increase national saving.

Policy issues caused by overstatement of CPI

First, government payments and labor contracts that are indexed to increase automatically with the CPI would increase 'too much', presenting the possibility of substantial overpayments over time. Secondly, to the extent that the CPI suggests inflation is higher than it actually is, this may prompt monetary policymakers to create an unnecessarily 'tight' monetary policy by raising interest rates more than should be. Finally, if the CPI reflects a higher price level than actually exists, this would mean that real income looks lower than it actually is, i.e. the biased CPI would be indicating that families are doing worse than is actually the case. This could impact tax rates and the efforts of policymakers to redistribute income.

three main economic variables that macroeconomists look at when assessing the state of the economy

GDP, the inflation rate, and the unemployment rate

transfer payments

Government payments to support social programs such as social security, Medicare, or unemployment insurance. Note that transfers are not considered a part of government expenditures since they do not directly represent purchases of newly created goods or services. Transfers are simply a shift of income from one entity (the government) to another (households).