Ch 8-10 Econ

When real GDP declines during a recession, what typically happens to consumption, investment, and the unemployment rate?

Consumption declines, investment declines and unemployment goes up.

What relationship should we expect to find between unemployment and real GDP? What is this law called? Write the equation and explain using an example.

Negative relationship. Okun's law. Change in real GDP = 3%-2 (change in unemployment rate)

SR vs LR AD/AS

Over long periods of time, prices are flexible, the AS curve is vertical, and changes in AD affect price but not output. Over short periods of time, prices are sticky, the AS curve is flat, and changes in AD do affect the economy's output of goods and services.

Percent change in real GDP

-3%-(2*change in unemployment rate)

If the per-worker production function is given by Y=K^1/2, the saving rate is 0.2 and the depreciation rate is 0.1, then the steady-state ratio of capital to labor is:

4.

If capital lasts an average of 25 years, the depreciation rate is _____ per year.

4. In the first year the value of the capital is 100%. Since it lasts for 25 years, and we assume constant rate of depreciation each year, 100/25=4.

Depreciation (Solow Graph)

A constant fraction δ of the capital stock wears out every year. Depreciation is therefore proportional to the capital stock. Straight line, intersects with Investment curve.

Shocks to AS

A drought that destroys crops - reduction in food supply forces up food prices A new environmental protection law that requires firms to reduce their emission of pollutants. Firms pass on added costs to customers in the form of high prices. Increase in union aggressiveness - pushes up wages and the prices of the goods produced by union workers Organization of international oil cartel - by curtailing competition, the major oil producers can raise the world price of oil. ADVERSE supply shocks - meaning they push costs and prices upward Opposite (eg breakup of an international oil cartel) is a favorable supply shock that reduces costs and prices

An economy begins in LR equilibrium and there is an introduction and expanded availability of credit cards. What are the SR and LR impacts of this policy. Show using AD, SRAS, LRAS

People hold less money in person, and that increases velocity shifting AD to the right in the SR. Output is higher than the full employment level of output and in the LR, prices rise.

Aggregate demand

AD is the relationship between the quantity of output demanded and the aggregate price level -tells us the quantity of goods and services people want to buy at any given level of prices MV = PY

Saving and Investment around the world

According to the Solow model, if a nation devotes a large fraction of its income to saving and investment, it will have a high steady state capital stock and a high level of income. If a nation saves and invests only a small fraction of its income, its steady-state capital and income will be low. The association between investment rates and income per person is an important clue as to why some countries are rick and other poor, but it is not the whole story.

The Impact of Population Growth (Solow)

An increase in the rate of population growth from n1 to n2 shifts the line representing population growth and depreciation upward. The new steady state k*2 has a lower level of capital per worker than the initial steady state k*1. Thus, the Solow model predicts that economies with higher rates of population growth will have lower levels of capital per worker and therefore lower incomes.

An increase in the saving rate (Solow Model)

An increase in the saving rate s implies that the amount of investment for any given capital stock is higher. It therefore shifts the saving function upward. At the initial stead state, investment now exceeds depreciation. The capital stock risks until the economy reaches a new steady state with more capital and output. An increase in the saving rate raises investment, causing the capital stock to grow toward a new steady state.

Population Growth in the Solow Model

Depreciation and population growth are two reasons the capital stock per worker shrinks. If n is the rate of population growth and δ is the rate of depreciation, then (δ+n)k is break-even investment - the amount of investment necessary to keep constant the capital stock per worker k. For the economy to be in a steady state, investment sf(k) must offset the effects of depreciation and population growth (δ+n)k. This is represented by the crossing of the two curves.

If an economy begins above golden rule, reaching the golden rule produces higher consumption at all points in time. Explain.

If economy begins with more capital than the Golden Rule level and the saving rate is reduced, then the reduction in the saving rate cause an immediate increase in consumption and an equal decrease in investment. Over time, as the capital stock falls, out, consumption and investment fall together. Because the economy began with too much capital, the new steady state has a higher level of consumption than the initial steady state.

What happens with an increase in the saving rate?

In the Solow model, an increase in the rate of saving has a level effect on income per person: it causes a period of rapid growth, but eventually that growth slows as the new steady state is reached. Thus, although a high savings rate yields a high steady-state level of output, saving by itself cannot generate persistent economic growth.

LR v SR

In the long run, prices are flexible and can respond to changes in supply and demand. In the short run, many prices are "sticky" at some predetermined level.

Shocks to AD

Introduction and expanded availability of credit cards - reduce quantity of money that people choose to hold. Reduction in money demand is equivalent to an increase in the velocity of money. the Fed can reduce or eliminate the impact of demand shocks on output and employment if it can skillfully control the money supply.

Change in capital stock

Investment - depreciation when they are equal and change in capital stock = 0, the economy is at the steady state

Which are the two forces that influence the capital stock? Draw the Solow growth and explain the steady state.

Investment and depreciation are the two forces that influence capital stock. Three curves: Y, savings rate, depreciation rate.

Long run aggregate supply

LRAS - in the long run, the level of output is determined by the amounts of capital and labor and by the available technology, it does NOT depend on the price level. LRAS curve is vertical.

Technological progress and the Solow growth model

Labor-augmenting technological progress at rate g enters our analysis of the Solow growth model in much the same way as did population growth at rate n. Now that k is defined as the amount of capital per effective worker, increases in the effective number of workers because of technological progress tend to decrease k. In the steady state, investment sf(k) exactly offsets the reductions in k attributable to depreciation, population growth, and technological progress. Now the straight line is labeled break even investment (δ+n+g)k According to the Solow model, only technological progress can explain sustained growth and persistently rising living standards. MPK=δ+n+g <- steady state consumption is maximized Balanced growth

Golden Rule level of capital

MPK equals the depreciation rate

The US consumes more than it saves, relative to Japan. What implications does that have on each country's steady state if a war affects both countries? (Both start at the same steady state pre-war)

Post-war, both countries see a decline in capital stock due to war. In the long-run, the steady state equilibrium would be higher for Japan since the country saves more (has a higher savings rate.)

The organization of an international oil cartel, by curtailing competition, the major oil producer can raise the world price of oil. How does the Fed accommodate such a shock in the economy?

Prices of oil are going up raises production costs for firms and reducing the output in the SR. The fed accommodates by increasing the money supply in the economy.

In the Solow model, what determines the steady state rate of growth of income per worker?

Technological progress that increases productivity per worker

Aggregate demand curve

The AD curve shows the relationship between the price level P and the quantity of goods and services demanded Y. It is drawn for a given value of the money supply M. The AD curve slopes downward: the higher the price level P, the lower the level of real balances M/P, and therefore the lower the quantity of goods and services Y.

What does Solow growth model show?

The Solow growth model shows that in the long run, an 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.

Rate of population growth and Solow

The Solow model shows that an economy's rate of population growth is another long-run determinant 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.

How savings affects growth

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 a low level of output in the steady state. Higher saving rate is said to have a "level effect" because of the level of income per person - not the growth rate - is influenced by the saving rate in the steady state.

Reduction in AD on SRLR graph

The economy begins at LR equilibrium. A reduction in AD (caused by decrease in the money supply) moves the economy to where output is below its natural level. As prices fall, the economy gradually recovers from the recession, moving back to LR output, but at a lower price. A fall in AD lowers the output in the short run but in the LR only affects the price level.

Steady-State Consumption (Solow)

The economy's output is used for consumption or investment. In the steady state, investment equals depreciation. Therefore, steady-state consumption if the difference between output f(k*) and depreciation δk*. 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. Below the Golden Rule steady state, increases in steady-state capital raise steady-state consumption. Above the Golden Rule steady state, increases in steady-state capital reduce steady-state consumption.

Golden rule level Solow

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 GRSS, then reaching the GR requires increased investment and thus lower consumption for current generations.

Production Function (Solow 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 increase by 1 unit, y increases by MPK units. The production function becomes flatter as k increases, indicating diminishing marginal product of capital. (Y and k on axes)

Output, Consumption, and Investment (Solow Graph)

The savings 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). i=sy Difference between output and investment lines = consumption per worker, undernation the investment line is investment per worker.

Investment, Depreciation, and the Steady State (Solow Model)

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 Saving Rate and the Golden Rule (Solow)

There is only one saving rate that produces the Golden Rule level of capital k*gold. Any change in the saving rte would shift the sf(k) curve and would move the economy to a steady state with a lower level of consumption. To reach the Golden rule steady state, the economy needs the right savings rate.

leading indicators

Variables that tend to fluctuate in advance of the overall economy Average weekly hours in manufacturing, average weekly initial claims for unemployment insurance, manufacturers' new orders for consumer goods and materials, index of stock prices, leading credit index, interest rate spread, etc.

Average weekly hours in manufacturing are increased. What would be your forecast about future output?

Weekly hours are increasing, which means there is a high demand and firms want workers to work longer hours to meet the increasing demand. Therefore, future output increases.

Convergence

Whether two economies with converge depends on why they differ in the first place. .eg different stocks, but have same steady state and determined by saving rates, pop growth and labor efficiency = should expect to converge eg if two economies have different steady states, bc diff rte of saving = should not expect convergence, but each economy will approach its own steady state.

output per worker

Y/L=yE SSGR = g

New production function (tech progress in Solow)

Y=F(K,L X E) where E is the efficiency of labor. LxE can be interpreted as measuring the effective number of workers, measuring both the number of workers and the technology with which the typical worker comes equipped. Technological progress causes the efficiency of labor E to grow at some constant rate g.

total output

Y=y(EL) SSGR=n+g

Steady state with tech progress (change in k)

deltak = sf(k) - (δ+n+g)k

SRAS

horizontal curve, because prices are fixed in the short run

long run equilibrium

in the long run, the economy finds itself at the intersection if LRAS curve and the AD curve. Because prices have adjusted to this level, the SRAS also crosses this point

Shifts in the AD curve

increase money supply shifts AD right, decrease in M shifts AD left

Capital per effective worker

k=K/(EL) SSGR = 0

Okun's law

negative relationship between unemployment and GDP

business cycle

short run fluctuations in output and employment

output per effective worker

y=Y(EL)=f(k) SSGR=0