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Chapter 2-5

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Chapter 2  {Intermediate Macro} The Data of Macroeconomics 03/04/2014 Chapter 2: Intermediate Macro, Class 1, January 22, 14 GDP= Gross Domestic Product Expenditure Approach Total expenditure on domestically-produced final goods and services. “Final Good= any tangible commodity which is produced and subsequently consumed by the consumer (ex. Hamburger=Final Good but the Beef=Intermediate good (used in the production of another good) Total income earned by domestically-located factors of production. Expenditure equals income because every dollar a buyer spends becomes income to the seller Income = Sum of Wages + Profits Y= C+I+G+NX Y= value of total output [C+I+G+NX]= Aggregate Expenditure “C”= spending by consumers, includes: Durable Goods= Last a long time (Cars, homes, appliances) Nondurable Goods= last a short time (food, clothing) Services= intangible items purchased by consumers “I”= investment by businesses / spending on new capital (a physical asset used in future production) Business fixed investment = spending on plant & Equipment Residential fixed investment = spending by consumers and landlords on housing units Inventory investments = The change in the value of all firms’ inventories Example Pg.12: after investing $2 trillion during 2012 we add that to the $10 trillion worth of already existing capital “G”= all government spending on goods and services Excludes transfer payments (ex. Unemployment insurance payments) because they do not represent spending on goods and services [these payments would be double counted because they would turn into an expenditure once received by the other party] “NX”= (Ex - Im) equals net exports, that is, the value of exports minus imports. Hence, NX= net spending from abroad on our goods and services (Nx can be negative) Exports= The value of goods and services sold to other countries Imports= The value of goods and services purchased from other countries Value Added Approach  Value of Output­Value of Intermediate Goods used to produce that output Pg.5: GDP=2+3+1=6 GDP: Market value of all final goods and services produced within an economy in a given period of time GDP = value of final goods produced= sum of value added at all stages of production. The value of the final goods already includes the value of the intermediate goods,so including intermediate and final goods in GDP would be double counting Example: Apples(4) P.A=$.5 & Oranges(3) P.O=$1 GDP=(P.A)x(Q.A)+(P.O)x(Q.O) .5x4 + 1x3 = $5 Nominal GDP measures these values using current prices. Changes in nominal GDP can be due to: Changes in prices Changes in quantities of output produced Real GDP measures these values using the prices of a base year. Real GDP controls for inflation Changes in real GDP can only be due to changes in quantities, because real GDP is constructed using constant base-year prices. Examples on pages 24,25,26 of chapter 2 (of both type) GDP Deflator Inflation rate: the percentage increase in the overall level of prices GDP deflator: one measure of the price level       Examples on pages 24,25,26 of chapter 2 (of both type) Pg. 31: (Deflators=100,102.8,112.1 & Inflation Rates=N.A,2.8%,9.1%) Calculating inflation is comparing the percent changes in the DGP deflator between each year. EX: If your hourly wage rises 5% and you work 7% more hours, then your wage income rises  approximately 12%. EX: GDP deflator = 100 × NGDP/RGDP.If NGDP rises 9% and RGDP rises 4%, then the inflation rate is approximately 5% Consumer Price Index: A measure of the overall level of prices Published by Bureau of Labor Statistics (BLS); Constructed by: Steps: 1. Survey consumers to determine composition of the typical consumer’s “basket” of goods 2. Every month, collect data on prices of all items in the basket; compute cost of basket CPI EXAMPLE 1: Consumer buys: 5 apples and 2 oranges every month. Then the basket of goods consists of 5 apples and 2 oranges. Suppose 2011 is the base year, the CPI: CPI=[ ×Current price of Apples ×(2 Current price of Oranges×] ÷ [5 2011price of Apples  +(2×2011 price of Oranges)] CPI EXAMPLE 2:  Why the CPI may overstate inflation: Substitution bias: The CPI uses fixed weights, so it cannot reflect consumers’ ability to substitute toward goods whose relative prices have fallen. Introduction of new goods: The introduction of new goods makes consumers better off and, in effect, increases the real value of the dollar. But it does not reduce the CPI, because the CPI uses fixed weights. Unmeasured changes in quality: Quality improvements increase the value of the dollar but are often not fully measured The Size of the bias: In 1995, a Senate-appointed panel of experts estimated that the CPI overstates inflation by about 1.1% per year. So the BLS made adjustments to reduce the bias. ow, the CPI’s bias is probably under 1% per year. CPI vs. GDP Deflator Prices of Capital Goods: Included in GDP Deflator (if produced domestically) Excluded from CPI Prices of Imported Consumer Goods: Excluded from GDP Deflator Included in CPI The Basket of Goods: GDP Deflator: changes every year CPI: fixed Catagories of the Population: Employed: working at a paid job Unemployed: not employed but looking for a job Labor Force: the amount of labor available for producing goods and services; all employed plus unemployed persons Not In Labor Force: Not employed or looking for work Chapter 3 Power Point Outline {Intermediate Macro} National Income: Where it Comes from and Where it  Goes 03/04/2014 Income/expenditure components  • Y=C+I+G+(X­M   Markets • Labor  • Capital  • Goods/services • International • Financial  A closed economy, market­clearing model • Supply side  factor markets (supply, demand, price)  determination of output/income • Demand side  determinantsC I  , G, and   Consump, Invest, and gov. expen • Equilibrium Chapter 3 Power Point Outline {Intermediate Macro} National Income: Where it Comes from and Where it  Goes 03/04/2014  Goods market   Loanable funds market              ~SUPPLY SIDE~ Chapter 3 Power Point Outline {Intermediate Macro} National Income: Where it Comes from and Where it  Goes 03/04/2014  Factors of production • K= capital:tools, machines, and structures used in production • L= labor:the physical and mental efforts of workers  The production function: Y = F(K,L) • shows how much output (Y )the economy can produce fromK units of capital and L  units of labor reflects the economy’s level of technology • • exhibits constant returns to scale  constant returns to scale: A production function exhibits constant  returns to scale if changing all inputs by a positive proportional factor  has the effect of increasing outputs by that factor. Initially Y1=F(K1,L1)  ♦ Scale all inputs by the same factor z: K  =2K  a1d L =z2 (e.1., if z =  1.2, then all inputs are increased by 20%) What happens to output, Y  = 2 (K , L2)?2 If constant returns to scale, Y 2= zY 1 If increasing returns to scale, Y  > zY 2 1 If decreasing returns to scale, Y <2 Y 1 Example: Constant Returns for: z>0???  F(K,L) = √[L] F(zK,zL) =  √[K )(zL)] =√[z KL] =√[z ] √[KL] =z√[KL] =zF(K,L) Chapter 3 Power Point Outline {Intermediate Macro} National Income: Where it Comes from and Where it  Goes 03/04/2014 Example: Decreasing Returns for any z>1 F(K,L)=  √+√L F(zK,zL) =√ zK +√ zL =√z√K+√z√L = √z( √K+√L) = √z F(K,L) Example: Increasing Returns for any Z>1 2 2 F(K,L) = K  +L F(zK,zL) = (zK)  +(zL) 2  2 2 = z (K +L ) = z  F(K,L) In Class Example Pages 10,11,12 Assumptions Technology is fixed bar bar The economy’s supplies of capital and labor are fixed at K=K  and L=L  Determining GDP BAR  • Output is determined by the fixed factor supplies and the fixed state of te= nology: Y F(K BAR,LBAR)  The distribution of national income • determined by factor prices  the prices per unit firms pay for the factors of production  wage = price of L Chapter 3 Power Point Outline {Intermediate Macro} National Income: Where it Comes from and Where it  Goes 03/04/2014 rental rate = price of K   Notation • W = nominal wage • R = nominal rental rate • P = price of output • W/P = real wage (measure in units of output) • R/P= real rental rate • MPL = Marginal Product of labor = W/P (real wage) • MPK = Marginal Product of Capital = R/P (real rental rate)  How factor prices are determined • Factor prices determined by supply and demand in factor markets. • Recall: Supply of each factor is fixed. • what about demand?  Demand for labor • Assume markets are competitive: each firm takes W (nom. Wage), R (nom. Rental rate) , and P  (price of output) as given. • Basic idea:A firm hires each unit of laborif the cost does not exceed the benefit.  Cost = real wage  Benefit = rginal product of labor (MPL)  Marginal product of labor (MPL): •  The extra output the firm can produce using an additional unit of labor (holding other inputs fixed):  MPL = F(K,L+1) – F(K,L) • Chapter 3 Power Point Outline {Intermediate Macro} National Income: Where it Comes from and Where it  Goes 03/04/2014 (MPL EXAMP PICTURES) • EXAMPLES: • Diminishing marginal returns  • As an input is increased,its marginal product falls (other things equal). • Intuition:Suppose L while holding K fixed   fewer machines per worker  lower worker productivity  Examples: Diminishing Returns? ♦ F(K,L)=2K+15L ?   No, MPL = 15 for all L ♦ F(K,L) = 2√K + 15√ L  Yes, MPL falls as L rises ♦ F(K,L) =√(KL)  Yes, MPL falls as L rises ♦ Chapter 3 Power Point Outline {Intermediate Macro} National Income: Where it Comes from and Where it  Goes 03/04/2014 • If   = 3, should the firm hire more or less labor? o Answer: YES, because the benefit of the 4th worker  which is MPL = 7 exceeds its cost which is W/P = 6 If  = 7, should firm hire more or less labor? Answer: NO, the firm should reduce labor. The 7th worker addsMPL = 4 units of output  but costs the firm W/P = 6.  MPL and the demand for labor & The equilibrium real wage • Chapter 3 Power Point Outline {Intermediate Macro} National Income: Where it Comes from and Where it  Goes 03/04/2014 • Determining the rental rate  • Known: MPL = W/P  (MPL=(nom. Wage/Price of output)=(real wage) • Same logic shows: MPK = R/P (MPK=(nom. Rent rate/Price of output)=(real rental rate)  diminishing returns to capital:M as   The MPK curve is the firm’s demand curve for renting Capital  Firms maximize profits by choosing K such that MPK=R/P   The Neoclassical Theory of Distribution (How income is distributed to L and K) • states that each factor input is paid its marginal product • a good starting point for thinking about income distribution • How income is distributed to L and K: Chapter 3 Power Point Outline {Intermediate Macro} National Income: Where it Comes from and Where it  Goes 03/04/2014   The Cobb­Douglas Production Function • The Cobb­Douglas production function has constant factor shares:   \alpha  = capital’s share of total income:   capital income = MPK×K = aY   labor income = MPL×L = (1– )Y • The Cobb­Douglas production function is:  Y  = AK  * L­a  a = alpha & A = level of technology. • Each factor’s marginal product is proportional to its average product:   Labor productivity and wages                  ~DEMAND SIDE~ • Theory: wages depend on labor productivity                                 Chapter 3 Power Point Outline {Intermediate Macro} National Income: Where it Comes from and Where it  Goes 03/04/2014   Components of aggregate demand: • C = Consumption: consumer demand for g & s  Disposable income is total income minus total taxes: Y – T  Consumption function: C=C(Y–T)  Shows that (Y – T) C  Marginal propensity to consume (MPC) is the change in C when disposable  income increases by one dollar.  • I = Investment: demand for investment goods  The investment function: I = I(r) where r denotes the real interest rate, the nominal interest rate corrected for inflation.   The real interest rate:  The cost of borrowing  The opportunity cost of using one’s own funds to finance investment spending  THUS: (  r)  I) Chapter 3 Power Point Outline {Intermediate Macro} National Income: Where it Comes from and Where it  Goes 03/04/2014  • G = Government Spending: government demand for g & s  G excludes transfer payments because:  they would become double counted (through consumption) when calculating aggregate  demand;  ♦ Examples of transfer payments  Social Security benefits,  unemployment insurance benefits)  Assume government spending and total taxes are exogenous: BAR  G=G  T=TBAR • *CLOSED ECONOMY HAS NO NET EXPORTS (M­X  The market for goods and services equations: • Aggregate demand: C(Y ­T)+I(r)+G • Aggregate supply: Y =F(K,L) • Equilibrium: Ag. Supply=Ag. Demand Y BA=(Y ­T)+I(r)+G   The real interest rate adjusts to equatewith supply      If you want to analyze interest rates the rkets  re the best one to  examine  The loanable funds market • A simple supply–demand model of the financial system • One asset: “loanable funds” demand for loanable funds   comes from investment: Chapter 3 Power Point Outline {Intermediate Macro} National Income: Where it Comes from and Where it  Goes 03/04/2014 ♦ Firms borrow to finance spending on plant & equipment, new office buildings, etc.  Consumers borrow to buy new houses.  Depends negatively on r: ♦ the “price” of loanable funds (cost of borrowing)  • supply of funds: saving  The supply of loanable funds comes from saving:  Households use their saving to make bank deposits, purchase bonds and other assets.  These funds become available to firms to borrow to finance investment spending.  The government may also contribute to saving if it does not spend all the tax revenue it  receives.  Types of saving  private saving = (Y – T) – C public saving = T – G   national saving, S = private saving + public saving ♦ = (Y–T)–C + T–G  = Y–C–G • “price” of funds: real interest rate   Notation: Δ = change in a variable Chapter 3 Power Point Outline {Intermediate Macro} National Income: Where it Comes from and Where it  Goes 03/04/2014 •    Budget surpluses and deficits • If T > G, budget surplus = (T – G)= public saving. • If T 
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