Macro Midterm 2 Study Guide.pdf

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CAS EC 102
Simon Gilchrist Claudia Olivetti

Chapter 8: The Classical Long-Run Model 11/8/12 CLASSICAL  MODEL  –  over  several  year  periods,  economy  performs  better   Assumptions  of  Classical  Model   • Combine  different  interest  rates  &  refer  w/  one  rate   • Markets  clear:  prince  in  every  market  adjust  until  Q  supplied  &  demanded  equal   How  much  output  will  we  produce?   The  Labor  Market   • Real  wage:  amount  of  goods  can  buy  w/  an  hour’s  earnings   • Labor  supply  curve:  how  many  people  will  want  to  work  @  various  real  wage     o Wage  increases,  employment  increase   • Labor  demand  curve:  how  many  workers  firms  will  hire  at  various  real  wage     o Wage  increases,  employment  decreases   • Equilibrium  Total  Employment:  #  of  workers  firms  will  want  to  hire  =  to  #  of   people  who  want  jobs   • Classical  model  à  economy  achieves  full  employment  on  its  own   From  Employment  to  Output   How  much  output  workers  will  produce  depends  on…   • Amount  of  resources  available  for  labor  use   • State  of  technology  à  how  much  we  can  produce  w/  resources   • Aggregate  production  function:  total  output  economy  can  produce  w/  different   quantities  of  labor,  given  constant  amounts  of  other  resources  and  the  current   state  of  technology   o Declining  slope  à  result  of  diminishing  returns  to  labor   • Output  rises  when  add  worker,  but  rise  smaller  when  each  added   • Equilibrium  real  GDP   o Output  tends  toward  potential,  full  employment  level  on  its  own  w/  no   need  for  gov’t  to  steer  economy   The  Role  of  Spending   Firms  won’t  make  goods  they  can’t  sell  à  decrease  production,  employ  fewer  workers  à   economy  would  not  remain  @  full  employment   Total  Spending  in  Simple  Economy   • Only  households  &  firms,  no  gov’t  spending   • Value  of  economy’s  total  output  =  total  income  of  households   • Total  spending  same  as  total  consumption  spending   • Say’s  Law:  total  spending  will  be  sufficient  to  purchase  total  output  produced   o Firms  create  demand  for  goods  &  services  equal  to  produced   o Supply  creates  its  own  demand   Total  Spending  in  Realistic  Economy   • Assuming:  gov’t  collects  taxes  &  purchases  goods/services,  households  don’t   spend  all  income  on  consumption,  business  firms  purchase  capital  goods   • Planning  investment  spending:  business  purchases  of  plant  &  equip.   o Only  include  spending  that  WANT  to  do  &  will  continue  to  do   o Inventory  changes  often  unintentional  à  when  firms  sell  less  or  more   than  they’ve  produced   o EXCLUDE  unintended  inventory  changes  from  our  measure  of  spending   o Total  investment  (I)  minus  change  in  inventories   I^P  =  I  –  change  in  inventories   • Net  Tax  Revenue:  gov’t  transfer  payments  like  negative  taxes  à  part  of  tax  rev   that  gov’t  gives  back  to  households   o T  =  total  tax  revenue  –  transfers  (T  =  net  taxes)   • Disposable  income:  income  households  have  left  after  net  taxes  taken  away   o Disposable  income  =  total  income  –  net  taxes   Household  saving  =  disposable  income  –  consumption  spending   • Total  spending  in  Classica:  sum  of  purchases  made  by  household  sector  (C),   business  sector  (I^P),  &  gov’t  sector  (G)   Total  spending  =  C  +  I^P  +  G   o Leakages:  income  earned  by  households  that  they  don’t  spend  on   country’s  output   o Injections:  spending  on  country’s  output  from  sources  other  than   households   o Total  spending:  total  output  IF  leakages  =  injections   (S  +  T)  +  (I^P  +  G)   Loanable  Funds  Market:  savers  make  funds  available  to  borrowers   Supply  of  Loanable  Funds   • Households  lend  by  way  of:  banks,  bonds,  &  stocks   • Households  supply  funds  to  market   • Total  supply  loanable  funds  =  household  saving   • Quantity  of  funds  supplied  depends  on  interest  rate  (positively)   Demand  for  Loanable  Funds   • Businesses’  total  demand  for  loanable  funds  =  total  planned  investment   spending   • Funds  obtained  borrowed,  firms  pay  interest   • Budget  deficit:  G  –  T  (gov’t  purchases  –  net  taxes)   • Gov’t  demand  for  LF  =  budget  deficit   • Budget  surplus:  T  –  G   • Interest  rate  decreases,  investment  spending  and  business  borrowing  increase   • Gov’t  sectors  deficit,  demand  for  funds  independent  of  interest  rate   • Interest  rate  decreases,  quantity  of  funds  demanded  by  businesses  increase,   quantity  demanded  by  gov’t  unchanged   o Total  Q  of  funds  demanded  increases   Equilibrium  in  Loanable  Funds  Market :  interest  rate  changes  until  quantity  of  funds   supplied  and  demanded  are  equal   Loanable  Funds  Market  &  Say’s  Law   • As  long  as  loanable  funds  market  clears,  Say’s  Law  holds   • Total  spending  =  total  output   • Say’s  Law  w/  Equations   o S  =  Q  of  funds  supplied   o Loanable  Funds  Market  Clears  à  S  =  I^P  +  (G  –  T)   S  +  T  =  I^P  +  G   leakages  =  injections   o AS  LONG  AS  loanable  funds  market  clears,  leakages  =  injections     leakages  =  injections  à  total  spending  =  total  output   Fiscal  Policy  in  the  Classical  Model   • Fiscal  policy:  change  gov’t  purchases/net  taxes  designed  to  change  total  output   • Demand  side  effects:  macro  policy  effects  on  total  output  that  work  through   changes  in  total  spending   Increase  in  Gov’t  Purchases   Crowding  out  &  complete  crowding  out   • Increase  in  gov’t  purchases  cause  planned  investment  spending  and   consumption  to  go  down   • Crowding  out:  decrease  in  one  sector’s  spending  caused  by  increase  in  other   sector’s  spending   • Complete  crowding  out:  $  for  $  decrease  in  one  sector’s  spending  caused  by   increase  in  other  sector’s  spending   o Increase  gov’t  purchases  completely  crowds  out  private  sector’s   spending,  so  total  spending  is  unchanged   • Increase  in  gov’t  purchases  no  demand  side  effects  on  total  output/employment   Decrease  in  Net  Taxes   Increase  consumption,  completely  crowds  out  planned  investment   Chapter 9: Economic Growth & Rising Living Standards 11/9/12 The  Meaning  and  Importance  of  Economic  Growth   Economic  Growth :  rise  in  standard  of  living  in  a  country   Measuring  Living  Standards   • Best  measure:  real  gross  domestic  product  (real  GDP)  divided  by  population   o Real  GDP:  ratio  of  one  aggregate  (real  GDP)  to  another  (total  population)   • If  real  GDP  is  high,  countries  have  greater  desire  and  ability  to  improve  other   aspects  of  life  (like  health,  fairness,  and  safety)   • Wealthy  countries  have  high  real  GDP  per  capita   • In  poor  nations,  almost  all  production  goes  toward  food  and  primitive  housing,   little  left  for  health  care,  workplace  safety,  or  education   Small  Differences  and  the  Rule  of  70   • Most  growing  countries,  real  GDP  rises  by  a  few  percent  in  an  average  year   o Over  many  years,  few  percentage  points  in  growth  makes  big  difference   • RULE  OF  70   o If  variable  growing  by  X  percent/year,  will  double  in  approx.  70/x  years   Growth  Prospects   • Rich  countries  seem  to  get  richer,  poor  stay  poor  or  get  poorer   What  Makes  Economies  Grow?   The  Determinants  of  Real  GDP   • Can  view  real  GDP  by  4  numbers   o Amount  of  output  average  worker  produces  in  an  hour   o Number  of  hours  average  worker  spends  at  the  job   o Fraction  of  population  that  is  working   o Size  of  population   • increase  in  those  will  cause  real  GDP  to  rise   • PRODUCTIVITY:  amount  of  output  the  average  worker  produces  in  an  hour   o Productivity  =  Output  per  hour  =  Total  Output                                                                                                                      Total  hours  worked   • AVERAGE  HOURS:  average  #  of  hours  worker  spends  on  job   o Average  Hours  =  Total  hours                                                    Total  employment   • Employment-­‐Population  Ratio  (EPR):  fraction  of  population  working   o EPR  =  Total  employment                                        Population   • Combining  Determinants   o Real  GDP  =  Total  Output  x    Total  Hours  x  Total  employment  x  Population                                              Total  Hours    Total  Employment        Population   o Real  GDP  =  Productivity  x  Average  Hours  x  EPR  x  Population   The  Growth  Equation   • To  change  real  GDP  to  equation  for  real  GDP  per  capita,  divide  both  sides  by   population   o    Real  GDP      =  Productivity  x  Average  Hours  x  EPR  x  Population   Population   o Real  GDP  per  capital  =  Productivity  x  Average  Hours  x  EPR   • Growth  rate  of  total  output  over  any  period  of  time  (aka  Growth  Equation  à   how  3  variables  contribute  to  growth  rate  of  real  GDP):   o %change  Real  GDP  per  capita  =  %change  Productivity  +  %change  Average  Hours  +  %change  EPR   o Increase  in  terms  on  right  will  create  rise  in  living  standards   Growth  in  Employment-­‐Population  Ratio  (EPR)   • Only  increases  when  total  employment  rises  @  faster  rate  than  population   • With  given  population,  greater  total  employment  means  increase  in  EPR,  &  rise   in  real  GDP  per  capita   Changes  in  Labor  Supply  &  Labor  Demand   • Increase  in  labor  supply:  rise  in  tota
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