Macro Midterm 2 - Chapters 9 and 10

Formula for changes over short periods of time (perhaps a few years):

% change in nominal GDP = % change in real GDP + % change in prices

Growth rates

% change in quantity = growth rate QTY - QLY / QLY Trick: GR NGDP = GR RGDP + GR price level

Calculate growth in real GDP

% change in real GDP = % change in nominal GDP - % Change in prices

Diminishing returns to capital

(Notes from a graph of GDP per worker on Y and Physical capital per worker on X and the line being production function) A: A given change in physical capital... B: ...causes a large change in GDP per worker when the capital stock is low C: ...causes a small change in GDP per worker when the capital stock is high

Limitation one: prices are not values

- GDP effectively assigns each good and service a value equal to its market price - Price is not a good indicator of value when either consumer surplus or a market failure is present -Remember: water example

Limitation three: The shadow economy is missing

- The shadow economy includes economic activity purposely conducted out of view of the government. - these activities are unmeasured and therefore are excluded from GDP

characteristics of capital

- physical capital is a complement to labor - investment depends on the savings rate - foreign investment builds the capital stock

GDP is the market value...

-$20.5 trillion is the market value of everything produced in 2018 -Add up the value of everything produce from armchairs to zippers -The value of each item is its market price times the quantity produced

total income, total output and total spending are all equal

-All output that's produced gets sold at some market price ---> the market value of total output must be equal to spending -Every dollar that someone spends is a dollar of income for someone else ---> total spending must be equal to total income

why does economic growth matter?

-Before modern civilization, there was little to no economic growth -Each generation lived exactly the same as its ancestors, largely hand-to-mouth -With advancements in agriculture, fewer people needed to work on farms -This led to the Industrial Revolution, which resulted in levels of economic growth never before experienced -Health (mortality and longevity) improved dramatically -Small differences in economic growth amplify over time, resulting in "rich" countries.

How do you calculate GDP using total income?

-Bennet Lumber started with raw materials that cost $0. Bennet paid $300 in wages and sold lumber for $400. --> $300 wages $100 profit -McCreary Modern bought the lumber for $400 and paid $500 in wages. It sold the couch for $1,000 --> $500 wages $100 profit -Crate & barrel bought the couch for $1,000 and paid $200 in wages. It sold the couch for $1,500. --> $200 wages $300 profit $1,500 total income

A production function describes how a business transforms inputs into outputs

-Describes the management techniques your company uses to transforms inputs into outputs -managers must acquire the right ingredients and mix them in appropriate proportions

Insight three: Poor countries can enjoy catch-up growth.

-Diminishing returns implies poor countries can catch-up to wealthier ones -Investment in capital will have a large return for a relatively poor country

Limitation two: Nonmarket activities are excluded

-GDP does not measure all productive activity -Nonmarket activities are omitted from GDP

Limitation five: Leisure doesn't count

-GDP includes the benefit of work, which is more income -GDP does not include the cost of work, which is less leisure

GDP measures total income

-GDP is the sum of all incomes in the economy -Total income = total wages + total profits -capital gains and losses are not counted as new income (your earnings or losses from selling an existing asset)

...produced... (GDP)

-GDP measures production, so it does not count the resale of existing goods and services (ex. sale of a used car) -Second-hand sales change only the ownership of the product

Limitation four: Environmental degradation isn't counted.

-GDP treats natural resources as if they have no value until they are transformed into something else -The cost of environmental degradation is ignored

The role of incentives

-Institutions (ex. government) can provide incentives for people to invent new ideas and invest in human or physical capital -Key examples are 1. property rights 2. government stability 3. efficiency of regulation 4. policy to encourage innovation

Net Exports (NX)

-NX = exports - imports -Exports: the value of goods and services sold to other countries -Imports: the value of goods and services purchased from other countries -Hence, NX equals net spending from abroad on our goods and services -Net exports: spending on exports minus spending on imports; also referred to as the trade balance

Nominal GDP versus real GDP

-Nominal GDP measures the value of GDP right now, based on current prices -Real GDP excludes the effect of price changes -Real GDP measures changes in the quantity of output produced -Real GDP is used to measure economic growth

Depreciation

-The amount of capital that wears out each period -Often viewed as approximately 10 percent

The Solow Model

-The capital stock will grow as long as investment outpaces depreciation -Because of diminishing returns, the difference between investment and depreciation decreases as (K/L) increases -Growth in (K/L) and (Y/L) will eventually stop growing -Therefore, GDP per person will eventually stop growing as well

Transfer payments

payments that transfer income from one entity (the government) to another (an individual) - because they involve no new production of goods or services, they are not counted in GDP

technological progress

new methods for using existing resources to produce more valuable output

production function

the methods by which inputs are transformed into output which determines the total production that's possible with a given set of ingredients -it's like a cookbook for economic growth

Production function

the methods for transforming labor input, human capital and physical capital into goods and services (outputs)

Dependency ratio

the number of people too young or too old to work per 100 people of working age -rose sharply due to the post-WWII baby boom -women entered the labor force in large numbers during WWII -women were responsible for a large share of the growth in GDP per person

labor productivity

the quantity of goods and services that each person produces per hour of work

Catch-up growth

the rapid growth that occurs when a relatively poor country (with low capital stock) invests in its physical capital

Physical capital

the total amount of tools, machinery, and structures that can be used in the production of goods and services

capital stock

the total quantity of physical capital used in the production of goods and services at a point in time

If C = $1,000, I = $500, G = $800, X = $400, and M = $600, what is the value of GDP?

$2,100 (subtract materials)

...within a country... (GDP)

-U.S. GDP measures what is collectively produced domestically (within the U.S.) -This includes products made in the U.S. by foreign-owned businesses -U.S. GDP does not include products made in foreign countries by American-owned businesses

...of all... (GDP)

-as a comprehensive measure, GDP includes everything produced and sold in markets -non-market goods and services are not included

The definition of economic growth

-growth of real GDP per person - the exact rate of change per capita RGDP or income per person -A percent change - the change between two periods divided by the value of the variable in the initial period (a period is typically a year but could also be a quarter, a month,...)

...final goods and services... (GDP)

-intermediate goods and services are not included (ex. lumber used to make a couch) -only final goods and services are included (ex. couch) -if intermediate goods were counted, their value would be double-counted -- as lumber and inside the couch

Investment vs. capital

-investment is spending on new capital -example (assumes no depreciation): -1/1/2021 - economy has $10 trillion worth the capital -During 2021 - investment = $2 trillion -1/1/2022 - economy will have $12 trillion worth of capital

Labor's share of GDP is declining

-labor share describes the share of total income going to workers -capital share describes the share of total income going to owners of capital

Characteristics of Capital

-physical capital is a complement to labor -investment depends on the savings rate -foreign investment builds the capital stock

Technological progress

-refers to new methods for using existing resources. -makes it possible to produce more from given resources. -is embodied by computers.

...in a year. (GDP)

-we need a time frame for GDP -A year is typically used, although measures are also reported quarterly

GDP is a key measure of economic acitivity

1. ....market value... 2. ...of all... 3. ....final goods and services... 4. ...produced... 5. ...within a country.. 6. ...in a year

Three ways to calculate GDP

1. Add up every dollar's worth of output produced 2. Add up every dollar of spending 3. Add up every dollar of income earned

Technological progress relies on new ideas. Ideas can generate unlimited growth because they:

1. can be freely shared 2. don't depreciate with use 3. may promote other ideas

government strategies to encourage innovation include:

1. create incentives through intellectual property laws (e.g. patents etc.) 2. subsidize research and development

Limitations of GDP

1. prices are not values 2. nonmarket activities are excluded 3. the shadow economy is missing 4. environmental degradation isn't counted 5. Leisure doesn't count 6. GDP ignores distribution

Calculating Nominal GDP

= P x Q (P) = actual price (Q) = quantity sold

What does the aggregate production function tell us about economic growth?

A country will produce more output if 1. it employs more workers 2. its workers become more highly skilled 3. it accumulates more physical capital Improving the recipe can also lead to more output

Limitation six: GDP ignores distribution

Average income has risen, but not for the bottom half (poorest half of adults)

key take-away of the Solow model

Capital accumulation alone can't sustain long-run economic growth

Insight one: Constant returns to scale means doubling inputs will double outputs

Constant returns to scale refers to the situation when all inputs are increased by some proportion and output increases by the same proportion

Rule of 70

Divide 70 by the annual growth rate to get the number of years until the original amount double

Is economic growth unlimited?

Economic growth is limited only by our imagination

Suppose that GDP is $50 million in 2015 but falls to $48 million in 2016. No changes in personal consumption expenditures, gross private domestic investment, and government spending are recorded. What must have happened to net exports to cause this change?

From 2015 to 2016, the difference between exports and imports must have risen by $2 million.

the key macroeconomic variable most macroeconomic analysis resolves around is

GDP

GDP measures total spending

GDP is the sum of the following: Consumption (C) Investment (I) Government purchases (G) Net Exports (NX) Y (GDP) = C + I + G + NX

Real GDP:

GDP measured in constant prices

Nominal GDP:

GDP measured in today's prices

intermediate goods and services

Goods or services used as inputs in the production of other products

Government Purchases (Government spending)

Government purchases of goods and services (including investment) This excludes transfer payments (e.g. unemployment insurance payments) because they do not represent spending on goods and services

Consumption

Household spending on final goods and services -includes: -durable goods: last a long time (e.g. cars, home appliances) -nondurable goods: last a short time (e.g. food, clothing) -services: are intangible items purchased by consumers (e.g. dry cleaning, air travel)

Labor input

Number of workers to transform raw materials into products and services that people want to buy

Ingredient Two: Human Capital

Output reflects the quantity of hours worked and the productivity of people at work -labor productivity is the quantity of goods and services that each person produces per hour of work -your productivity depends in part on your human capital

Value Added vs Income

Profits = values of sales - cost of intermediate inputs -wage payments -interest payments -rent payments Profits + Wages + Interest payments + Rent = value of sales - cost of intermediate inputs = value added

How to calculate growth rate

Take the current value and subtract that from the previous value, divide this difference by the previous value, and multiply by 100.

Ingredient Three: Capital Accumulation

The equipment you work with also determines how much you can produce per hour -Capital stock is the total quantity of physical capital used in the production of goods and services -You are more productive when you have the right equipment

impact of technological progress

The key sustained economic growth is technology -technology shifts the production function -the shifts yield more output for a given capital-labor ration

Insight two: there are diminishing returns to capital

The law of diminishing returns states that when one input is held constant, increases in other inputs will, at some point, begin to yield smaller and smaller increases in output

Human capital

The skills and knowledge of people developed through education, practice and training

macroeconomics

The study of the economy as a whole

Why institutions matter for economic growth

They provide the framework that creates the right incentives for people to invest in physical and human capital and generate new ideas and products

GDP per person

Total GDP divided by the population

Diminishing returns and depreciation mean that investment in physical capital is

a limited source of growth

Percent change

calculate "percent change in value" Percent change = new value - old value / old value

Molly Maids house cleaning services are considered:

consumption

government stability

corruption and political instability discourage investment and innovation by reducing the potential benefits from such investments

efficiency of regulation

excessive red tape can make it hard to invest or innovate

final goods and services

finished goods or services

government policy to encourage innovation

government policy can support development of new ideas by: 1. increasing the marginal benefit through intellectual property laws 2. decreasing the marginal cost by subsidizing research and development

the cost-benefit principle provides a useful reminder of the importance of incentives

incentives

Economic growth

increased production of goods and services, leading to rising living standards

McDonald's hires 20 new workers to staff a new restaurant: Where does this transaction take place?

input market

Gross domestic product (GDP)

is the market value of all final goods and services produced within a country in a year

Ingredient One: Labor and Total Hours Worked

labor input is measured as the total number of hours worked across the whole economy -the more labor that workers do, the more output gets produced -population boosts total GDP but not GDP per personx

The more labor that workers do, the more output gets produced

population boosts total GDP but not GDP per person

the aggregate production function

relates total output (GDP) to the quantity of inputs employed L - labor (time that workers spend on the job) H - human capital (skills that workers bring to the jobs) K - physical capital (tools, machinery, and structures) Y = f(L, H, K)

Investment

spending on new capital assets that increase the economy's productive capacity includes: -business fixed investment: spending on plant, equipment, and intellectual property -residential fixed investment: spending by consumers, and landlords on housing units -inventory investment: the change in the value of all firms' inventories

Replication argument

states that to double output in your business you can replicate everything you are already doing

Value added

the amount by which the value of an item is increased at each stage of production; value added = total sales - cost of intermediate input

the circular flow

the circular flow diagram illustrates the interdependence of the macroeconomy. It is a great example of the interdependence principle at work, providing a conceptual framework for analyzing macroeconomic independence.

macroeconomics income

total income in the whole country

macroeconomics output

total output produced by all businesses in a country

GDP is three things at once

total output, total spending and total income

macroeconomics spending

total spending across all people, business and the government in a country

technological progress shifts the production function

what picture says

Diminishing returns

when one input (labor input, human capital or physical capital) is held constant, increases in other inputs will, at some point, begin to yield smaller and smaller increases in output

law of diminishing returns

when one input is held constant, increases in the other inputs will, at some point, begin to yield smaller and smaller increases in output

property rights

without property rights and a trusted enforcement system, no one creates wealth.

Base Year

year at which prices are held fixed (constant) in Real GDP calculation