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Watson EC 102 (Macro) COMPLETE SEMESTER Notes.docx
Watson EC 102 (Macro) COMPLETE SEMESTER Notes.docx

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School
Boston University
Department
Economics
Course
CAS EC 102
Professor
Neil Watson
Semester
Fall

Description
Unit 1: Key Macroeconomic Variables Gross Domestic Product: market value of all final goods and services produced in a country during a period of time, usually one year. a. Measured using market values (dollars), not quantity b. GDP includes only market value of FINAL goods, not intermediate goods c. GDP includes only current production (in that year) d. Potential GDP: level of GDP when all firms are producing a max capacity (normal rates) Factors of Production: Land, Capital, Natural resources, entrepreneurship to produce Components of GDP(CIGX) a. Equation for GDP: Y = C + I + G + X 1. “Consumption” a. expenditures on services (hospital, haircut), b. non durable goods c. durable goods. ** NEW HOUSES ARE NOT INCLUDED, that is in investment 2. “Investment”: a. business fixed investment: spending by firms on new factories, office buildings…to produce goods b. residential investment: spending by HH and firms on housing c. changes in business inventories: goods produced but not sold i. if ford has $2M of unsold cards and $3.5M at the end of year, the firm has spent $1.5M on inventory investment 3. “Government”: a. Spending by gov on pretty much anything besides transfer payments b. Transfer payment: social security 4. Net Exports: exports minutes imports Shortcomings of GDPand shortcomings as a measure of well-being a. Does not count for HH production (households producing something, but not selling it) b. Does not count the underground economy c. The value of leisure is not included in GDP d. GDP is not adjusted for pollution or affects of pollution e. GDP is not adjusted for changes in crime or other social problems f. GDP measures wealth, but not how it is distributed Real GDPvs. Nominal GDP ­ Calculating Real GDP: designate a base year and compare current year to it. Multiple quantity of current year by price in base year and add it up ­ Real GDPholds constant ­ Nominal interest rate = i ­ Real interest rate = r ­ Inflation rate = pi ­ Value in later year dollars = (value in later year dollars) (cpi later/cpi earlier) GDPDeflator A. Ameasure of the price level B. GDPdeflator = Nominal GDP/ Real GDPx100 C. GDP deflator will equal 100 when nominal and real are the same (base year) Consumer Price Index : measure changes in prices of things that an average consumer buys. a. MOST CLOSELYWATCHED b. Uses: tracks changes in the typical HH cost of living, adjusts many contracts for inflation (COLA) c. Allows comparison of dollar amounts over time. d. Calculate: [Cost of basket in that month / cost of basket in base year] x (100) Calculating Inflation Rate with CPI: CPI(later) – CPI(early) / CPI(early) x 100 Calculating inflation Rate with GDPDeflator: (Current Year’s GDP Deflator – Previous Year’s GDP Deflator) / Previous Year’s GDP Deflator X 100 Deflation vs. Disinflation Deflation is when prices are going down (negative inflation) real is higher than nominal Disinflation is when prices are going up, but not as fast, so inflation rate is decreasing BUT NOT NEGATIVE Costs of Inflation ­ Inflation is “bad” because people learn purchasing power is ONAVERAGE not true 1. Distributional effects: Some workers incomes will not keep up with inflation. 2. Shoeleather costs: Resources wasted when inflation encourages people to reduce their money holdings (what resources are wasted?... Zimbabwe) 3. Menu costs: the costs of changing prices (restaurant having to print new menu because of changing prices) 4. Confusion and Inconvenience: inflation changes the yardstick we use to measure transactions, complicates long range planning and comparison of dollar amounts over time 5. Tax distortions: you are taxed on nominal income, inflation makes nominal income grow faster than real income, so inflation causes people to pay more taxes even when their real incomes don’t increase 6. Arbitrary redistribution of wealth: higher than expected inflation transfers purchasing power from creditors to debtors, debtors get to repay debt with dollars that aren’t worth as much o Inflation is good for debtors but bad for lenders Unemployment ­ Employed: worked, even part time, in the last week ­ Unemployed: did not work in the last week, but did look for a job over the last month o Frictional: in between jobs (includes seasonal unemployment) o Structural: need to update their skills in order to find a job o Frictional + structural = natural rate of unemployment o Cyclical: deviation from unemployment from its natural rate (what we worry about) ­ Labor force = Employed + Unemployed ­ Unemployment rate = Number unemployed / number in labor force (x100) ­ Labor force participation rate: percentage of adult population that is in labor force o Labor force/adult population (x 100) ­ Not in labor force: did not work, not looking for a job, discouraged workers, those in jail, retirement, maternity leave, in school Factors thatAffect Natural Rate of Unemployment a. Government policies: training programs (decrease structural employment) b. Unemployment compensation (increase frictional unemployment) a. Reduces opportunity cost of unemployment c. Labor market policies: legal restrictions on hours, vacations, retirement and difficulties to fire, d. Minimum Wage Laws: forces wage to remain above equilibrium of labor supply and labor demand a. Surplus of labor = unemployment, labor supplied > labor demanded e. Labor Unions: keeps wages above equilibrium, creates surplus of labor demands, creates unemployment f. Efficiency wages: wages kept above normal to increase worker productivity (Henry Ford) Unit 2: The Economy in the Long Run Economic Growth a. Economic Growth: ability of economy to produce increasing quantities of goods and services. If it grows too slowly economy fails to raise living standards b. Growth is change in real gdp over time (%deltaY) c. Real GDP (later year) – Real GDP (early year) / Real GDP (Early year) d. Rule of 70: 70 / growth rate … gives you number of years it takes growth to double e. WHAT WE REALLY CARE ABOUT: is change in real per capita GDP… shows improvement in living standards f. Per capita GDP = GDP / pop. g. Growth rate of real per capita gdp: %Change Y/ pop = growth rate of Y – Growth rate of pop = %changeY-%changePop h. Economic growth effects: nutrition, literacy, infant mortality, life expectancy i. Reasons we make more money for less hours is attributed to technology j. In a recession real gdp per capita in the u.s. falls just 1-2% relative o the level of potential GDP Why do Economies Grow? a. Key of Growth: Productivity (what amount of goods can be produced in an hour) a. Person hour: on worker one hour b. Productivity = GDP/Person Hours b. Country’s standard of living depends on its productivity c. Y = Real GDP, L = labor hours so Productivity = Y/L d. Factors of productivity: a. Capital: machinery, office buildings…. Goods used to produce other goods b. Technological change: depends on better machinery, increases in human capital, better management e. Productivity services are hard to measure, but it became more important in economy Neo Classical Growth Model: ­ Stock of equipment and structures used to produce G&S called physical capital (K) ­ K/L = average amount of capital per labor hour ­ Y/L= output per labor hour ­ Productivity is higher when the average worker has more capital ­ An increase in K/L causes increase in Y/L ­ Human Capital: skills, abilities, experience, (the intangibles) that enables them to give more output. ­ Technology: processes a firm uses to turn inputs into outputs; technological change: an increase in the quantity of output firms can produce with a given quantity of inputs ­ Per-worker production function: Shows relationship between real GDP per hour worked and capital per hour worked, holding the level of technology constant. (Y/L and K/L) a. Y/L on y axis and K/L on x axis, up ward sloping but bowed because of diminishing returns capital per working hour b. Will shift up with technological improvement… helps economies overcome diminishing marginal returns c. If workers have little K (physical capital) then giving them more increases productivity a lot, it they have a lot of K, giving them more increases productivity little. New Growth Theory ­ Amodel of long run economic growth that emphasizes that technological change is influenced by economic incentives and so is determined by the working of the market system ­ Key to economic growth is the accumulation of knowledge capital d. Physical capital is subject to decreasing returns e. Knowledge capital subject to increasing returns f. Role of Gov. in accumulation of knowledge capital i. In the US, protecting intellectual property with patents and copyrights ii. Subsidize research and development iii. Subsidizing education Convergence ­ Poor Countries grow faster than richer countries and will eventually catch up in terms of GDP per capita ­ Why would we expect convergence? o Technology Transfer: making technology in poorer countries o Poorer countries can attract more capital because of higher returns on investment  Diminishing returns: Low K stock = high Marginal Product of capital (MPk) = high returns on investment = higher domestic saving and higher investment by foreigners - What the theory predicts… a mixed bag. Happening for some countries, not happening for others ­ Absolute Convergence: technology transfer and the ability to attract more capital will happen universally. o Poor countries never have to reinvent the wheel, they just take technology already present ­ Contingent Convergence: In a lot of countries convergence will happen IF certain conditions are present first. (approaches to development) ThreeApproaches to Development 1. EnvironmentalApproach (Jeff Sachs – Institutions Matter):Addressing the issues of: Geography, Climate, Endemic Disease, Inaccessibility of trade routes, lack of natural resources. - Policy implications: Foreign Aid 2. International TradeApproach: country will grow depending on the extent to which it is integrated with the wider world economy (open to trade) 1. Trade in goods and services (import-substitution industrialization has never worked) 2. Capital Inflows -Financial Capital (Stock) - investing in a foreign economy through stocks and bonds. -FDI (Foreign Direct Investment) - Opening anAmerican business in foreign country (In favor of globalization) 3. Institutional Approach: Countries will invest when they are confident in the stability of the legal system, security of institions, political system, monetary stability, and lack of corruption. Assigned Readings Notes The Poor and the Rich The Economist • Robert Solow and Trevor Swan  neoclassical growth theory o Perfect competition, output grows with larger inputs of capital and labor o Law of diminishing returns o Technological growth outside of neoclassical model (unexplained) o Poor countries will grow faster than rich countries (diminishing returns) • New Growth Theory o Imperfect competition, investment can bring abnormal profits o Includes human capital in capital o Technological progress is key part of growth model o Convergence  poorer countries grow faster holding other factors constant  With policies that encourage competition and investment • Mr. Olsen Theory  importance on government policies o Economic opportunities for poor countries are phenomenal o Poor countries inability to use existing resources well Intuitions Matter, But Not For Everything by Jeffrey Sachs • Institutions aren’t the only factor in economic growth • Poor countries cannot trade because transport costs are too high o Condemned to small internal markets o Inefficient division of labor o Continued poverty • Malaria disease prevented Africa from economic growth • Institutions and geography matter o Isolated, landlocked regions can be stuck in poverty without help  Continued impoverishment of its population  Migration of population from interior to coasts  Sufficient foreign aid to build infrastructure  Breakdown of artificial political barriers Grinding the Poor The Economist • Trade is good for rich and poor countries • What can go wrong? o If all poor countries trade  price of their exports goes down  Developing countries are 5% of global output, would not affect global trading system  EG: Asian tigers traded and grew economically o Inflow of capital may produce nothing of value  Developing countries with growth have reduced poverty o Workers in developing countries lack legal/union rights • Studies show trade can promote growth • Foreign firms can pay higher wages and stop labor abuse Unlocking Growth in Africa by Kenneth Rogoff • Recent aid pledges could give poor countries 20% of the GDP annually o Should come in the form of grants not loans  debt wont help o Shouldn’t be viewed as a final goal forAfrica  future help • Give grants, debt burdens of poor countries weigh down growth o Increased capital needs to come with property rights, law, etc o Anticipated growth never materializes  government corruption • After goals are achieved, what next? o African countries open to trade and FDI, their efforts reciprocated o Governments cannot fall into debt traps o Need more flexible exchange rate and price systems o Improve flexibility of their product and labor markets AModel of Reform The Economist • China reforms closes many state-controlled firms  offset by growth in private sector o urges a reform of corporate law to remove barriers to the entry and expansion of new firms to Allow foreign competition and investment o Return on capital for private sector firms rose from 8% to 15% o Shift of resources from public to private sector boost productivity Micro No More The Economist • Microfinance offers transactions you would expect in any branch of finance o loans, deposits, money transfers, insurance o only difference is money amount is much smaller • Evolution of microfinance into a serious and viable business has many benefits o Bulk of capital go to most efficient institutions with best growth prospects o Select their clients on the basis of merit rather than cronyism or bribery o People will have economic stake in country  promote growth • Reach people who currently lack access to financial markets o Microfinance must change  culture, products, funding, cost of operation • Culture  transform charity operation into viable business • Products  expand beyond credit, include modern financial products • Funding  banks/private investors will increase capital, decrease cost of funds • Costs  new technology and more competition will bring down costs Reading the Tea Leaves The Economist • India given notion that its economy could grow like China o Their TFP accelerated while China’s slowed • Breaking down the two economies o China's GDP grew by an average of 9.7% a year, India's by 6.5% o Employment increased faster in India than in China  Offset by rise in output per worker: 4.6% (India) 8.5% (China) o China TFP actually increased form 3.6% to 4% • India can sustain rapid growth by shifting work from agriculture to industry • Rate of increase of China's service-sector jobs 4x industrial jobs, exceed India o India workforce stronger but productivity weaker • Main difference India  Not strength of service but weakness of manufacturing Catching Up The Economist • Globalization helps poor countries catch up to richer countries o Chart doesn’t show this pattern o Rich are getting richer faster than the poor are getting richer. • Second chart shows how people in poor countries are compared to rich o The poor are catching up o Two of the poorest countries  China and India  Enormous population and rapid growth in income per head • Globalization is good  some countries still doing bad o America/Europe trade restrictions hurt development o Poor country governments trade barriers, public expenditure o failure to provide security or stability, or of the enormous sums (including money received as aid) squandered on vanity public projects or luxuries for the ruling circles and their chums. Can India Overtake China by Tarun Khanna • China’s manufacturing boom is largely from FDI o Chinese Diaspora wealthy and keen on giving back to homeland o India supports private enterprise much more  More sustainable progress than China o China not democratic, India is  Private entrepreneurs couldn’t challenge state-owned enterprises  Pays off for foreign investors  less competition  Entrepreneurship and free enterprise are flourishing in India • India better system than China  why isn’t it showing in the numbers? o India reforms had a late start o less national savings to work with o Ethnic and religious tensions in India o China has had peace and able to focus on economic development • India’s ground up approach may be better in the future o China growth will slow down in future  Limits of FDI dependent approach  Benefit of homegrown entrepreneurship The Hidden Wealth of the Poor The Economist • Financial services spreading from rich to developing world • Microfinance in poor countries has been largely absent o People with little money aren’t suitable clients for financial services  Don’t have things as collateral loans  Government is corrupt • Microloans can reduce poverty  poor people improve their own lives o Organizations providing credit to the poor o Low loan losses 1-3% Why Poor Countries are Poor ­ Corruption and power hungry government are the biggest inhibitor to growth. No accountability or stability. McCurrencies The Economist • Bic Mac Index based on the theory of purchasing-power party (PPP) o Long run: exchange rates should move towards levels that would equalize the prices of an identical basket of goods and services in any two countries o Big Mac in China should cost the same as a Big Mac in US • Burgernomics is close in predicting exchange rates o Currencies that show up as overvalued tend to weaker in later years An Idea to Relish • Natural for average prices to be lower in poorer countries than in developed ones o Prices of tradable things should be similar o Non-tradable services will be cheaper because of lower wages • PPP more reliable way to convert GDP per head into dollars than market exchange rate o Cheaper prices mean that money goes further • Long run: adjustments toward PPP shouldn’t come from a shift in exchange rates o Relative prices can change instead • Bic Mac index most useful for assessing exchange rates of countries with similar incomes per head o Chinese yuan is 43% undervalue on basic guage o Adjusted for GDP per person, it is only 4% below fair value Unit 3 Determinants of Consumption (DI, FDI, HW, PL) 1. Current Disposable Income: income after taxes: (Y^D) = Y(real GDP) – T(taxes) + TR (transfer payments) a. CDI can go down if taxes go up, recession, unemployment, transfer payments goes down b. Consumption function: shows relationship between total aggregate consumption and real disposable income i. C = f(((Y-T), (Y-T)^e, r, wealth, price level) [ + + - + - ] ii. Wealth Effect: the price level increases, lower the purchasing power… consumption decreases… AE decreases iii. Interest Rate Effect: price level increases, r increases, C/I/NX decreases…AE decreases iv. International Trade Effect: P increases, real exchange rate increases, NX decreases,AE decreases c. Marginal Propensity to Consume: the slope of the consumption function: that amount by which consumption spending changes when disposable income changes i. MPC = Changes in Consumption/Change in Disposable Income d. Marginal propensity to save: the change in saving divided by the change in disposable income i. MPS = 1 – MPC 2. Expected Future Disposable Income (Y – T + TR) 3. Real Interest Rate (r) real interest rate = nominal interest rate (i) – inflation (Pi) a. High interest rate = lower consumption because it costs more to borrow to finance consumption so there is more incentive to save b. LOWER INTEREST RATE = LOWER PRICES 4. Household Wealth: household assets (what you have) - household liabilities (what you owe) 5. Price Level: price level goes up, purchasing power goes down Investment = f(r, Y, Ye, tax policy) - Interest rate effect: r increases, I decreases 1. Plant and Equipment, Housing 2. Change in inventories a. Finished goods not yet sold b. Raw materials not yet used c. Unfinished goods still in production process 3. Determinant of Investment (F,T,C,r) a. Expectation of future profitability b. Taxes (corporate income tax and investment tax incentives) c. Cash flow d. Real interest rate 4. Financing alternatives: loans, bonds, stocks, savings (retained earnings) Loanable Funds Market Fundamental Identity: Savings = Investment (S = I) Saving (S = Income – Expenditures) - Private Saving (Households) = Y + TR – (C+T) = Y + TR – C – T - Public Saving (Government) = T - (G+TR) • T > (G+TR)  public savings is positive - National Saving (S) = Saving (private) +Saving (public) o S = Y - C - G o Investment = S - The Equality of Saving and Investment o S = Y - C - G o I = Y - C - G o S = I The Market For Loanable Funds ­ The interactions between borrower and lenders that determines the market interest rate and the quantity of loanable funds exchanged. ­ Supply of funds = private and public savings [T – (G + TR)] ­ Demand of funds: companies, governments (savings bond), consumers (loans) … Investment ­ Funds flow from Supply  LBF Market (Financial Markets – Bonds/stocks/mutual funds/savings)  Demand for funds (companies, governments, consumers) ­ Supply = Demand  Private Savings = (T – G + TR) = I ­ As real interest rate decreases, it is less to borrow so
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