Econ 2 Midterm #2

Average tax rate vs. marginal tax rate

average: Total income tax (=rate x taxable income)/total income marginal: tax paid on additional dollar of income

Inflation

% ∆ in price index P(t)-P(t-1)/P(t-1) x100 Matters bc of redistribution, psychology, efficiency If a good's quality increases and price increases, we try and take out the part of the price increase due to quality improvement and count only the remainder when calculating inflation.

Private and public saving

(Y*-T*-C*)+(T*-G*) where the first expression is private saving and the second expression is public saying. public saving is sometimes negative

Wages in low/high skilled workers and inequality

Changes in relative wages of low and high skilled workers parallel trends in rising income inequality

How to reach aggregate production function

1. Y*/POP=Y*/N*xN*/POP 2. Y*/N*=f(K*/N*,t) 3. Y*/POP=f(K*/N*,T)xN*/POP Increases in N*/POP will raise Y*/POP (there have been periods where rises in N*/POP had a noticeable impact on growth). But contributions are limited by diminishing returns. When N*/POP increases, K*/* tends to fall, so Y*/POP rises less than proportionately with N*/POP Increase in K*/N* will raise Y*/POP, but diminishing returns means doubling K*/N* less than doubles Y*/POP Tech ∆ is key determinant of economic growth, namely by new production techniques, methods of organization, products. Especially relevant to poor countries as a form of tech progress

Potential output per person (Y*/POP)

=(Y*/N*)x(N*/POP) where Y* is potential output, POP is population, N* is normal employment. N*/POP is the normal employment to population ratio, Y*/N* is normal average labor productivity

Normal saving supply (S*)

=Y*-C*-G*. Y* C* and G* are all income for someone. So, S*=I* (only thing not income)

Y*/N*

=f(K*/N*,T) where K*/N* is normal capital per worker, T is technology Capital=aids the production process created in the past, including physical and human capital Technology=methods for producing things

Capital

Accumulated stock of aids to the production process that were created in the past

Union negotiated wage above equilibrium level

Acts as a price floor. Raises wage of workers who remain employed, but bc of profit maximization, firms cut back employment (won't pay workers more than the MRP(L) of the last worker hired), causing unemployment to increase Increased minimum wages decrease demand for low skill workers

Potential output (Y*)

Amount of output the economy produces when using resources at nominal rates Determined by labor, capital, technology Level of potential output per person indicates standards of living Per person output differs greatly across countries and in many countries has increased a lot over time Small ∆ in growth rate of potential output can have large impacts on standards of living over time

Nordhaus "Do Real Output and Real Wage Measures Capture Reality"

Argues growth of real GDP in the US over the past two centuries may have been faster than conventionally measured; related to mismeasurement in price indexes Typical price measures do not account for quality changes, new goods Uses lighting to illustrate importance of these problems If the growth of price indexes from one year to the next is overstated, the growth of real GDP is understated; same argument applies for the growth of real wages (true bc Real GDP (year t2/t1)=nominal GDP(t2/t1)/GDP price index (t1/2)

Assumptions about world supply and demand

Assumed that world relative price is perfectly elastic With rising opportunity cost (for supply and demand with trade) we get incomplete specialization, showing where we come to rest in CPC

Impact of a tax cut

Assuming that government spending remains constant, (take G* as given; doesn't respond to other variables). Households will devote some money to saving, some to consumption; T*-G* falls by full amount of tax cut Y*-T*-C* rises by less than the full amount of tax cut bc C* increase so savings (S*) decrease So, the savings curve shifts left

Effects of increased income inequality

Bad for social cohesion, democracy, etc. Often correlated with poverty Income inequality has increased in the US in the past few decades

Determining long-run output

Based on economy's available resources

Fall in purchase price of capital impact on investment demand curve

Because capital becomes less expensive, investment becomes more attractive so the investment curve shifts out

Impact of pessimism about future MRPKs on investment demand

Causes firms to buy less capital because firms assume that MRPk is decreasing (only buy up to the point where the PV(stream of MRPks)=purchase price)

Investment

Changes in capital stock; construction/purchase of new machines in structures, additions to capital stock

Effect of K*/N*

Capital does vary a lot across countries

Structural unemployment

Caused by job rationing. sources incl. minimum wage, unions, efficiency wages. When there is job rationing or a high payroll tax, firms want to hire until MRP(L)=wage + tax, causing unemployment to increase. The higher the wage floor, the higher the unemployment

Cyclical unemployment

Caused by output being below potential

Frictional unemployment

Caused by turnover and job search. Takes times to match workers and jobs At microlevel, economy is constantly changing--at any time, there are unemployed workers and job vacancies (church)

Impact of increase in interest rate

Causes PV (stream of MRP(K)s to fall, to restore profit maximization, a firm has to reduce investment in capital

What does saving allow for

Consumption in the future. Households try to maximize utility from consumption today and in the future. So if the real interest rate increases, the opportunity cost of consuming today increase and what you give up to consume today increases because the real return you would earn on savings higher than before. This would cause you to consume LESS today to maximize utility. Real interest rate is a component of opportunity cost of current consumption. When real interest rates rise, households need to increase saving to keep maximizing utility. MUcurrent/Pcurrent=MUfuture/Pfuture

Impact of nominal interest rate rising with real interest rate

Decreases present value, so investment demand decreases.

Factors increasing demand and supply for inventions

Demand: More secure property rights, increased competition, national emergencies Supply: Education, culture, luck Inventions have large positive externalities, causing SMB to be further out than D and PMB of inventions

Where demand and supply curves for labor comes from

Demand: profit maximization on the part of firms. Determined by demand for product it produces, productivity of labor, wage, other labor costs. Profits are maximized where MR=MC (firms will hire labor up to the point where the extra revenue generated by another worker is just equal to cost, and up to where MRP(L)=W). At each wage, firms want to hire up to whatever quantity of labor has a MRP(L)=wage Supply: Utility maximization for household.

"The Power of the Pill: Oral Contraceptives and Women's Career and Marriage Decisions" Goldin and Katz

Development and adoption of the pill was an important factor behind the rise in women's entry into professional occupations in the US Availability lowered costs of long duration professional education directly and indirectly Evidence: data over time and across states Question: if we look across states, did the timing of falls in rates of early marriage line up with the timing of increased access to oral contraceptive?

Effect of N*/POP (employment to population ratio)

Does not vary much across countries and its effects are limited bc it cannot grow indefinitely

Export goods vs. import goods

Export goods: world price is above equilibrium (employment increases in these industries) Import goods: world price is below equilibrium (employment decreases in these industries)

Marginal Revenue Product of Labor (MRP(L))

Extra revenue generated by one more worker, MRP(L)=MP(L)xMR where MP(L) is the marginal product of labor, or the extra output produced by another worker and MR, marginal revenue, is the extra revenue from selling one more unit Declines as L increased bc of diminishing returns (MR is either constant (competitive firms) or declining (imperfect competition)) For competitive firms, MRP(L)=MP(L)xP bc MR=P MP(L)xP is called the value of the marginal product of labor Markets may be imperfect, allowing employers to get away with paying workers less than MRP(L) if employers dont face lots of competition

Effect of a decreasing demand of a product

Fall in the price of product Lowers MRP(L) at each level of employment, causing labor demand curve to shift back, in turn, wages and employment of workers in industry fall

Why supply of machines is perfectly inelastic

Fixed at a given point in time

Financial capital

Funds used to purchase, rent, and build financial capital

Pickety and Saez paper

Get data from income t ax returns with sample period beginning in 1913 (beginning of US income tax)--have information on total income from other sources, total number of households from census, tax data shows number of taxpayers earning different amounts and incomes of different groups Allows them to figure out fraction of total income accruing to top 1%, 10%, etc. of households Shows income inequality began rising in the 1970s Current trends toward increased inequality are due to rising labor income inequality Evidence concerns: reported taxable vs. all income, taxes and transfers, year to year fluctuations in income (depending on questions asked)

Effects of large increases in capital and improvements in technology

Huge shift out of demand curve

Relationship between new capital and interest rate

Negative. Term involving r appears in the denominator of expressions for present value; amount to be received in the future is less valuable when the interest rate is higher; increase in r causes PV (stream of payments) to fall, Makes firms want to buy less capital

Impact of nominal interest rate rising only bc pi rises

Nothing in expression changes to investment demand does not change. Investment demand is only based on real interest rates. Likewise, PV won't change bc prices will also rise when i rises

Problems with looking at correlation between trade and growth

Ignores reverse causation (if being rich makes good want to engage in a lot of trade) May be systematic relationship between trade and omitted influences on growth

Possible remedies for rising inequality

Increased education, rates of return on human capital investment, trade adjustment assistance, place based policies, wage based policies

Impact of new technology on savings and investment diagram

Increases future MRPKs Causes investment curve to shift out Ex: 1990s tech boom

Ways to increase financial capital

Issue bonds: borrow funds in return for a promise to repay them later with interst Issue stocks: sell people shares of a company for future share of profits

What we assume about G*

It is constant; take it as given

Marginal utility of leisure

MU(L) declines as quantity of labor increases. The price of leisure (P(L)) is the wage (1-t)wage where t=marginal tax rate Utility maximized when MU(L)/P(L)=MU(ee)/P(ee)

Three key features of institutions contributing to high normal output per person

Market based system for allocating resources, gov protection of p property from others, protection of property from gov corruption, theft, arbitrary taxation

Real GDP

Market value of final goods and services NEWLY PRODCED WITHIN a country during SOME PERIOD of time, adjusted for price changes To calculate: choose base year and always use prices from base year to multiply quantities Growth rate of GDP: % ∆ in real GDP from one year to the next ((x(t)-x(t-1))/x(t-1))x100 Also=nominal GDP(t)/GDP price index, using a price index that tries to account for quality changes and new goods

Consumer Price Index

Measure of overall aggregate level of prices To calculate: choose base year and find basket of goods and services households purchased in that year (ex. base year 1983)=price of 1983 market basket in 2018/price of 1983 price basket in 1983 x 100 Value of price index in year a/b $Xb/Pb=$Xa/Pb where P is the value of the price index in a year

Sources of high natural unemployment rates in Europe

Measurement issues, high min wages, strong unions, high payroll taxes, high firing costs--less churn

Stock price

PV(stream of expected future dividends) Changes due to change in interest rate: (decreased interest rates increase stock prices bc makes investing more attractive) Change in expected future dividends --if something makes people expect increases in future dividends, stock prices will decrease Hard to make money off news in stock market bc news is processed very quickly

Employment effects of tariff

Probably raises employment in protected industry, but does not raise overall employment May be unintended effects on workers in other industries

How firms decide how much capital to rent

Profit maximization (looks at MRP of another machine where MRP(K)=MP(K)xMR; MRP(K) declines as more machines are rented. Want to rent machines until MRP(K)=rental price

real vs. nominal

Real--measured in terms of goods and services rather than dollars (adjusted for price changes) Nominal--measured in terms of dollars (not adjusted for price changes). If calculating a nominal amount, use nominal interest rate

Point of tangency for PPC and CPC

Shows combination of two goods that the country can produce that has the largest value in world markets; countries can trade the combination of goods at the point of tangency for any other combination along the CPC

Consumption possibilities curve

Shows combinations of two goods countries can have with trade, where the slope is the (-)ToT for the good on the x axis With trade, shows the combinations of the two goods that the country can consume if it makes the bundle at the point of tangency and then trades at world prices

Increase in wage substitution and income effect

Substitution effect: consumer wants to substitute a way from leisure and work more Income effect: consumer is richer and wants more leisure (to work less)

Calculating 2018 GDP with 2012 base year CPI(t)

Sum(P(2012)) x Q(2018)

Calculating current CPI w/ 2012 base year CPI(t)=

Sum(P(t)) x Q(2012) / SumP(2012) x Q(2012) CPI(t)=price of market basket in year t/price of market basket in base year

Effect of reduction in marginal tax rate

Supply curve of labor shifts out

Impact of technological changes recently

Tended to favor high skilled workers bc they make them more productive, shifting out MRP(L)/demand for high skilled workers. If a change is so skill biased that it replaces low skill workers, it could also shift back demand curve for low skill workers Modern technology may increase rewards to very top skilled people Skill biased technology tends to increase inequality, while increased education tends to decrease inequality. In the 1970s, increases in education slowed, so effects of skill biased technology changes dominated

US comparative advantage

Tends to have comp adv in goods using high skilled laborer comparative disadvantage. in goods that use low skilled labor (based on opportunity cost). Reduced trade barriers lower prices in the US of goods using low skilled labor, raise prices in US of goods using high skilled labor Countries tend to have comp adv in the production of goods that use inputs it has in abundance. Many developing countries have abundance of less skilled labor and comp adv in low tech manufactured goods. Some comparative advantage can be acquired

Aggregate demand

Total amount that people in the economy want to spend--plays a crucial role in output

Effect of T

Types of technology vary significantly across countries are institutions and culture. Variation is an important source of the variation in normal output per capita

David Card paper

Uses Mariel Boatlift to illustrate impacts of increased immigration (occurred May-Sept. 1980) raised supply of low skill workers 125k Cuban migrated to the US, most went to Miami Some migration that would have occurred didn't because of the boatlift Labor demand may have been quite elastic, Miami had many industries that used low skilled workers and could expand easily. Wages in Miami did not fall bc of the boat lift

Explanation for cross-country income differences

Variation in normal capital per worker (physical and human) and in technology. Most important variation in technology is variation in institutions

Effect of an increase in machines/technological progress

Will increase MP(L) (makes workers more productive) causing MRP(L) to increase Labor demand curve shifts out, so wages and employment of workers in the industry both rise. Could possibly shift out supply and reduce price too Capital accumulation and tech progress generally have been good for workers' wages

Present value--what something received in the future is worth today (how much you would n need to put in the bank to get the amount of that payment in the future)

X=PV(F)=F/(1+r)^T where F=future payment F=x(1+r)^T PV of a constant stream of payments PV (stream of Fs)=F(1)/1+r + F(2)/(1+r)^2 +...+ F(t)/(1+r)^t Same for MRP(K) just replace F(t) with MRP(K) Firms want tot purchase capital up to point where PV (or stream of MPRKs)=purchase price based on what they expect MRPk to be To compute PV of a nominal amount to be received in the future, you need to use the nominal interest rate

Uses of potential ouput

consumption (c*) (biggest use roughly 2/3) Investment(I*), government purchases (G*), net exports (NX)--for now assume NX*=o Equilibrium condition: Y*=I*+C*+G*

Variable that brings S* and I* to equilibrium

the real interest rate (r*) (y axis on long run savings and investment diagram

Aggregate production function (Y*/POP)

f(K*/N*,T)x(N*/POP) Normal output per person is the product of the normal employment to population ratio and normal output per worker Implies that for a given level of normal output per worker, normal output per person is proportional to the normal employment to population ratio. Normal output per worker depends on normal capital per worker and technology

"Crowding out"

idea that with a tax cut, increased deficit because of constant government spending and less revenue crowds out investment because of the increased interest rate at the same amount of savings. However, some people think tax cuts increase investment or normal employment

Curved PPC

indicates optimal specialization

Long run saving and investment diagram

r* (real interest rate) on y axis, S* (savings), I* (investment) on x axis Helps us understand determination of long run/real interest rate, capital interest Important for understanding short term fluctuations

If the normal interest rate only increases because inflation increases

real IR is unchanged. Interest rate (i)=r + pi where pi=inflation rate, r=real interest rate r=i-pi use expected rate of inflation bc you dont know for sure

Terms of trade

terms at which goods trade in world markets (expressed as a relationship between two goods, ex. P(good a)/P(good b)--the good you want to find the price of is in the numerator, expressed in terms of the other good) Depend on world prices, also called world relative price Countries want to trade when ToT is between the opportunity cost of producing the good in the two countries. Market forces tend to move world prices so both countries want to trade (ex. excess demand for a good would push up prices)

Unemployment rate

unemployed/labor force x 100 (labor force includes employed and unemployed workers) natural rate of unemployment is the economy's normal/usual employment rate, more than zero (incl. structural and frictional unemployment)