Intermediate Macroeconomic Theory Unit 1

Real GDP

The value of goods and services measured using a constant set of prices

As the interest rate rises, desired purchases of capital fall.

What is the logic of the slope of the investment curve?

= C(Y-T) + I(r) + G

The demand for goods is a function of:

Real Rental Price of Capital

(R/P) The rental price measured in units of goods rather than in dollars

Real Wage

(W/P) The payment to labor measured in unit of output rather than in dollars

Rose as the rate of educational attainment fell.

Income inequality in the US since 1970:

Seigniorage

The revenue raised by printing money

Labor's Share of Output

1 - Alpha

Nominal GDP/GDP Deflator

What is the Real GDP equation?

If labor and capital both rise by 5%, then output rises by 5%.

Which of the following best describes constant returns to scale?

V falls

As k rises:

V

Income velocity of money ; Average number of times a dollar enters someone's income

8 units of output per unit of labor

A business produces 80 units of output with 10 units of labor. It's productivity equals ______________.

GDP Deflator

A measure of the overall level of prices that shows the cost of the currently produced basket of goods relative to the cost of that basket in the base year.

A) Y = 320 B) The value of Y is in terms of goods because the variables K and L are expressed in real values which means they have been divided by the price of the good being produced. Thus, the dollar signs cancel out, and we are left with goods.

A simple example of the production function is Y = F(K,L) = 10K^1/2*L^1/2. A) Find the value of Y if K = 16 and L = 64. B) Is the value you found for Y given in terms of dollars or in terms of goods?

A) In this situation, there would be a surplus in the goods market. B) Since S>I, Y - C - G > I, so Y > C + I + G. So, more is produced than people desire to spend. C) Since S>I, the amount people want to lend exceeds the amount people want to borrow. This creates downward pressure on the interest rate. As the interest rate falls, desired investment spending rises until S = Desired Investment and the goods market is back in equilibrium at a lower interest rate.

A) Suppose that S>I. Is there a surplus or shortage in the goods market? B) Justify your answer. C) Given your answer what should happen to the interest rate?

Labor Productivity

According to the Cobb-Douglas production function, the real wage rate grows at the same rate as _______________.

The MPL will rise as the quantity of capital employed rises. Meaning, the labor demand curve (or MPL curve) will shift to the right.

According to the Cobb-Douglas production function, what happens to the marginal product of labor if the quantity of capital employed rises?

Capital's Share of Output

Alpha

The Fisher Effect

An increase in the rate of money growth of 1% causes a 1% increase in the rate of inflation. A 1% increase in the rate of inflation in turn causes a 1% increase in the nominal interest rate.

Constant Returns to Scale

An increase of an equal percentage in all factors of production causes an increase in output of the same percentage.

Falls ; Rises

As K rises the MPK ___________ and the MPL ___________.

Rises ; Decreasing ; Diminishing ; Product

As labor rises, output _________ at a _____________ rate. This is called _________ marginal __________.

The profitability of investment spending falls

As the interest rate increases:

A) At a given level of output an increase in T raises public saving by the change in T, and reduces private saving by -(1-MPC) * change in T. The change in national saving = MPC * Change in T which is positive but less than the increase in T. So the saving curve shifts to the right. B) As S shifts right the interest rate falls. Because the interest rate falls investment spending is higher. Because T is higher disposable income falls so consumption falls.

Assume that saving does not depend on the interest rate. A) If the government raises T which curve shifts and which direction does it shift? B) What does this increase in T do to the interest rate, investment spending, and consumption?

Manmade goods that produce other goods ; K

Capital is _____________. It is represented by the letter _____.

Alternative Equation for Private Saving

Change in Y - Change in T (1-MPC)

*Positive Slope (as L increases, Y increases) *Diminishing Slope (MPL diminishes as L increases) *Output increases but at a decreasing rate

Characteristics of a Marginal Product of Labor Schedule

Draw and Explain The Effects of a Change in Investment Demand

DONE

Draw and Explain The Effects of a Household Wanting to Save More

DONE

Draw and Explain The Long Run Effects of an Increase in G Financed by Deficit Spending

DONE

Draw and Explain The Long Run Effects of an Increase in G Financed by an Increase in T

DONE

Draw and Explain The Long Run Effects of an Increase in T

DONE

2/3 ; 1/3

Historically, labor's share of output has been about ______ and capital's share has been about ________.

r = i - E Inflation

Equation for the Real Interest Rate (r)

Welfare

Examples of transfer payments include:

Higher price level today

Expectations of higher money growth in the future lead to a:

An increase in taxes raises national saving. The change in public saving = Change in T - Change in G. Since G does not change, the change in public saving = Change in T, so a tax increase raises public saving by the amount of the tax increase. Since we assume Y is fixed, the change in private saving = - Change in T * (1-MPC). With higher taxes consumers have less to save, but also choose to reduce consumption which makes the decrease in private saving smaller than the increase in taxes. The Change in National Saving is the sum of changes in public and private saving. So, the national saving increases by the amount consumption decreases. So, if the saving curve is vertical, then in the long run if taxes raise by $100 saving rises by $100. With MPC = 0.60 consumption falls by $60 and private saving falls by $40. National saving rises by $60. Investment also rises by $60. If the saving curve were upward sloping, as saving shifted right the interest rate would fall by less, so I and S would rise by less. Since the drop in interest rate would also raise consumption (and reduce saving), consumption would fall by less.

Explain what happens to consumption, investment spending, and the interest rate when the government increases taxes.

MPK = R/P

Firms maximize profits by choosing the quantity of capital such that:

High and persistent money supply growth

High and persistent inflation is caused by:

The MPL schedule would rise so the production function would twist up, the labor demand curve would shift right, and the real wage would rise.

If A in the production function A*F(K,L) rose, then:

Do Not Hire More Labor

If MPL < W/P

Hire More Labor

If MPL > W/P

Consumption and Investment

If T and G rise by the same amount then which of the following falls?

Surplus

If Y > C + I + G then there is a _____________ in the goods market.

C = 7600

If Y were 10,000, taxes were 3,000, transfer payments were 1,000, the MPC was .70 and the part of consumption which didn't depend on income was 2,000 what would consumption be?

Surplus

If r is above its equilibrium level, there is a _________ in the goods market.

and investment spending would increase.

If technological progress raised the MPK schedule, then the interest rate:

The money supply rises. If this continues then money supply growth rises so inflation rises. Almost all hyperinflations have been associated with high government budget deficits that continued to be financed by money creation.

If the central bank buys bonds that the government sells to finance the deficit then:

There would initially be a surplus in the goods market, in equilibrium investment spending would be higher.

If the government cut expenditures and left taxes unchanged which of the following would happen?

Private saving falls by $200, national saving rises by $800.

If the government raises T by $1000 and the MPC is 0.80 what happens to private saving and to national saving?

Neither the goods market nor the market for loanable funds.

If the interest rate were above equilibrium, then there would be a shortage in:

Falls

If the real interest rate rises investment spending ___________.

A surplus in the goods market, in equilibrium the interest rate would be lower.

If the saving curve shifted to the right initially there would be:

a) An increase in A twists the production function up so MPL rises with an increase in technology. b) An increase in A twists the production function up so MPK goes up. c) As labor rises, Y rises but MPL falls and as K rises MPL rises. d) As capital rises, the MPK falls and as L rises MPK rises. e) Because the MPL is proportional to Y/L is equal to average labor productivity and since firms hire so that W/P = MPL real wages should grow at the same rate as labor productivity.

Implications of the Cobb-Douglas Production Function

Rise, so investment spending would fall.

In the saving-investment diagram if the saving curve shifted left, then the interest rate would:

Investment spending; the purchases of business equipment, business structures, residential construction, and changes in inventory, rises as the real interest rate falls. The changes in A leave the real interest rate unchanged. The changes in B reduce the real interest rate, so investment spending would rise.

In which case would companies decide to increase investment spending by buying more business equipment and business structures? A) The expected inflation rate falls by 2% points and the nominal interest rate falls by 2% points. B) The expected inflation rate rises by 2% points and the nominal interest rate rises by 1% point.

1) Money supply growth rises (A one point increase in money supply growth will increase inflation by 1% point.) 2) Money demand growth falls when % ^ V rises or if % ^ Y falls.

Inflation rises if:

Capital goods and residential construction

Investment spending includes the purchases of ________.

*The economy is closed. *Savings depends on the interest rate *The MPL diminishes as labor rises *The production function has constant returns to scale *The economy is in the long run *Investment spending falls as the interest rate rises *As disposable income rises people increase their consumption

List key assumptions of this chapter.

Y- T - C(Y-T)

Private Saving Equation

k falls or V rises

Money Demand Falls if:

Public Saving + Private Saving

National Saving Equation

1/3 and 2/3, but capital's share has risen some since 1970.

Over the last 50 years, capital and labor's share of income has been about:

Money Supply Rises, Money Demand Falls, or Y falls

P rises if:

Shoeleather Effect

People hold less cash and make smaller withdrawals due to a higher nominal interest rate.

T-G

Public Saving Equation

r = I - Einflation

Real Interest Rate Equation

*A reduction in competition (Government intervention or firms getting more market power) *Technological progress has favored capital (automation) *Global integration has possibly allowed outsourcing of labor intensive tasks

Reasons for Capital's Rising Share in Production

Prices paid rise but prices received also rise.

Rising prices are not a cost because

The firm should reduce the amount of capital it employs until the R/P is equal to the MPK.

Suppose that R/P is greater than a firm's MPK, what can the firm do to increase its profits?

The increase in consumption reduces private saving and so national saving. In the S-I diagram, the saving curve shifts left raising the interest rate which reduces investment spending.

Suppose that an increase in consumer confidence raises consumers' expectations about their future income and thus increases the amount they want to consume today. This might be interpreted as an upward shift in the consumption function. How does this shift affect investment and the interest rate?

If consumption fell as the interest rate rose, then the saving curve would be upward sloping. An increase in G would shift the saving curve to the left. Interest rates would rise, but the increase in the interest rate would cause saving to rise. The increase in saving created by higher interest rates means that saving falls by less than if the saving curve is vertical, so the increase in the interest rate and decrease in investment spending are smaller than otherwise.

Suppose that consumption depends on the interest rate. How, if at all, does this alter the conclusions reached in the chapter about the impact of an increase in government purchases on investment, consumption, national saving, and the interest rate.

If taxes and government expenditures increase by equal amounts there is no change in public saving which equals T - G. The change in private saving = - Change in T (1-MPC) because we assume Y is fixed in the long run. Provided that MPC < 1 private saving falls so national saving falls. The increase in taxes reduces disposable income which reduces private saving. The decrease in national saving means the saving curve shifts to the left increasing interest rates and so reducing investment.

Suppose the government increases taxes and government purchases by equal amounts. What happens to the interest rate and investment in response to this balanced-budget change? Explain how your answer depends on the marginal propensity to consume.

*Requires adjustment to make comparisons across time *Menu costs *Increased Relative Price Variability *Inflation Tax *Shoeleather Costs *Increased Tax Distortions *Uncertain inflation complicates planning for the future *Unexpected inflation reallocates wealth

The Costs of Inflation

k

The amount of money people want to hold per dollar of output.

Menu Costs

The cost of adjusting prices (higher inflation requires more frequent adjustments)

Substitution Effect of an Increase in the Real Interest Rate

The higher interest rate increases the amount of future consumption for each dollar saved so people would save more

Constant Returns to Scale

The production function is assumed to have:

Rises at a decreasing rate.

The production function shows that other things the same as labor rises, output:

Monetary Neutrality

The proposition that changes in the money supply do not affect real variables

Investment Spending

The purchase of business equipment and structures (capital goods), and changes in inventory, and residential construction.

GDP

The total income earned domestically, including the income earned by foreign owned factors of production; the total expenditure on domestically produced goods and services

% ^ P = % ^ M + % ^ V - % ^ Y

What is the equation for the percent change in price?

MPL = W/P

To maximize profits firms will hire workers until:

The Real Wage

To maximize profits, a firm should hire labor such that the marginal product of labor equals:

A) L rises so the MPL falls and the MPK rises. So, the real wage falls and the real rent rises. B) K falls so the MPK rises and real wage falls. So, the real rent rises and real wage falls. C) A rises so MPL and MPK rise. So, the real wage and rent rise. D) Since the price level doubles and the nominal wage and rent double, the real wage and rent are unchanged.

Use the neoclassical theory of distribution to predict the impact on the real wage and the real rental price of capital of each of the following events: A) A wave of immigration increases the labor force. B) An earthquake destroys some of the capital stock. C) A technological advance improves the production function. D) High inflation doubles the prices of all factors and outputs in the economy.

1) Output Rises 2) The amount that output rises by as we add one more worker = F(L+1,K) - F(L,K) FALLS.

We assume that as labor rises:

P = Price Y = Output w = Nominal Wage L = Labor r = Rental Rate K = Capital

What do the variables stand for in the equation: Profit = PY - (wL + rK)

Y = Output (GDP is a way to measure Y) K = Capital (Machinery, Tools, Building) L = Labor

What do they variables stand for in the equation: Y = F(K,L)

Consumption = C(Y-T) Y-T = Disposable Income T= Taxes Net of Transfer Payments If Y-T rises, then C rises by: Change in C = MPC * Change in (Y-T)

What is consumption a function of?

Budget Deficit = G - T

What is the equation for a budget deficit?

Nominal GDP/Real GDP

What is the equation for the GDP Deflator?

The interest rate adjusts. For example, if I>S, there is a shortage in the goods market and the market for loanable funds. The interest rate will rise making I fall and so moving the economy towards equilibrium.

What makes the demand for the economy's output of goods and services equal the supply?

A construction company buys new tools.

Which of the following is an example of investment spending?

It has constant returns to scale, the MPL is proportional to labor productivity, implies constant output shares for labor and capital, and if labor rises, the MPK rises.

Which of the following is true concerning a given Cobb-Douglas production function?

Y = A*L^3/4*K^1/4

Write a Cobb-Douglas production function for which capital earns 1/4 of total income.

Private Saving = T - G Private Saving = Y- T - C National Saving = Public Saving + Private Saving OR = Y - G - C

Write the definitions of public saving, private saving, and national saving assuming a closed economy.

National Saving Equation

Y - C - G

Real GDP

Y stands for real output. It is measured by: