Charles I. Jones Maroeconomics Economic Crisis Update (2010 års upplaga) Kurs 407 Makroekonomi och ekonomisk- politisk analys

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1 HHS Kurs 407 Makroekonomi och ekonomisk- politisk analys VT2011 Charles I. Jones Maroeconomics Economic Crisis Update Sebastian Krakowski Kurs 407 Makroekonomi och ekonomisk- politisk analys

2 Contents Overview... 6 Part 1: Preliminaries... 7 Chapter 1 - Introduction to Macroeconomics What is Macroeconomics? How Macroeconomics Studies Key Questions An Overview of the Book... 7 Chapter 2 - Measuring the Macroeconomy Introduction Measuring the State of the Economy Measuring Changes over Time Comparing Economic Performance across Countries Part 2: The Long Run Chapter 3 - An Overview of Long- Run Economic Growth Introduction Growth over the Very Long Run Modern Economic Growth Modern Growth around the World Some useful Properties of Growth Rates The Costs of Economic Growth Chapter 4 - A Model of Production Introduction A Model of Production Analyzing the Production Model Understanding TFP Differences Evaluating the Production Model Chapter 5 - The Solow Growth Model Introduction Setting up the Model Prices and the Real Interest Rate Solving the Solow Model Looking at Data through the Lens of the Solow Model Understanding the Steady State

3 5.7 Economic Growth in the Solow Model Some Economic Experiments The Principle of Transition Dynamics Strengths and Weaknesses of the Solow Model Chapter 6 - Growth and Ideas Introduction The Economics of Ideas The Romer Model Combining Solow and Romer: Overview Growth Accounting Concluding Our Study of Long- Run Growth Appendix: Combining Solow and Romer (Algebraically) Chapter 7 - The Labor Market, Wages and Unemployment Introduction The U.S. Labor Market Supply and Demand Labor Markets around the World How Much is Your Human Capital Worth? The Rising Return to Education Chapter 8 - Inflation Introduction The Quantity Theory of Money Real and Nominal Interest Rates Costs of Inflation The Fiscal Causes of High Inflation Chapter 20 - Consumption (från kurswebben) Introduction The Neoclassical Consumption Model Lessons from the Neoclassical Model Empirical Evidence on Consumption Chapter 21 - Investment (från kurswebben) Introduction How do Firms Make Investment Decisions? The Stock Market and Financial Investment Components of Physical Investment Part 3: The Short Run

4 Chapter 9 - An Introduction to the Short Run Introduction The Long Run, the Short Run and Shocks The Short Run Model Okun s Law: Output and Unemployment Chapter 10 - The IS Curve Introduction Setting up the Economy Deriving the IS Curve Using the IS Curve Microfoundations of the IS Curve Chapter 11 - Monetary Policy and the Phillips Curve Introduction The MP Curve: Monetary Policy and Interest Rates The Phillips Curve Using the Short- Run Model Microfoundations: Understanding Sticky Inflation Microfoundations: How Central Banks Control Nominal Interest Rates Chapter 12 - Stabilization Policy and the AS/AD Framework Introduction Monetary Policy Rules and Aggregate Demand The Aggregate Supply Curve The AS/AD Framework Macroeconomic Events in the AS/AD Framework Empirical Evidence Modern Monetary Policy Chapter 13 - The Global Financial Crisis: Overview Introduction Recent Shocks to the Macroeconomy Macroeconomic Outcomes Some Fundamentals of Financial Economics Chapter 14 - The Global Financial Crisis and the Short- Run Model Introduction Financial Considerations in the Short- Run Model Policy Responses to the Financial Crisis Part 4: Applications

5 Chapter 15 - The Government and the Macroeconomy Introduction U.S. Government Spending and Revenue International Evidence on Spending and Debt The Government Budget Constraint How Much Can the Government Borrow? The Fiscal Problem of the Twenty- First Century

6 Overview Part 1: Preliminaries 1 Introduction to Macroeconomics 2 Measuring the Macroeconomy Part 2: The Long Run 3 An Overview of Long- Run Economic Growth 4 A Model of Production 5 The Solow Growth Model 6 Growth and Ideas 7 The Labor Market, Wages and Unemployment 8 Inflation 20 Consumption (från kurswebben) 21 Investment (från kurswebben) Part 3: The Short Run 9 An Introduction to the Short Run 10 The IS Curve 11 Monetary Policy and the Phillips Curve 12 Stabilization Policy and the AS/AD Framework 13 The Global Financial Crisis: Overview 14 The Global Financial Crisis and the Short- Run Model Part 4: Applications 15 The Government and the Macroeconomy 6

7 Part 1: Preliminaries Chapter 1 - Introduction to Macroeconomics 1.1 What is Macroeconomics? Macroeconomics is the study of collections of people and firms and how their interactions through markets determine the overall economic activity in a country or region. Microeconomics study individual people, firms or markets. In their studies, macroeconomists construct mathematical models that they combine with real- world phenomena like history, politics and economic policy. 1.2 How Macroeconomics Studies Key Questions Macroeconomic studies generally consist of four steps: 1. Document the facts (i.e. economic data) 2. Develop a model 3. Compare the quantitative predictions of the model with the original facts 4. Use the model to make other predictions that may eventually be tested Models consist of parameters (input that is fixed over time, e.g. minimum wage), exogenous variables (allowed to change over time in a predetermined way, e.g. population that grows at a fixed rate) and endogenous variables (outcomes, e.g. levels of wage and employment in the model for supply and demand). 1.3 An Overview of the Book The Long Run The long run is concerned with economic growth and the determinants of the macroeconomy, as well as the labor market in the long run and the long- run causes of inflation. 7

8 The Short Run The short run is concerned with the economics underlying fluctuations in GDP deviations of the actual GDP from the potential GDP called economic fluctuations. These deviations usually last only a short time and the forces that cause these fluctuations sometimes produce recessions. Economic fluctuations and inflation are connected one reason for fluctuations is that the central bank leads the economy into a recession to bring down inflation. Over the long term, economic growth swamps economic fluctuations and the underlying growth rate of potential output is quite stable over long periods. Issues for the future This section addresses macroeconomics beyond economic growth and fluctuations, where the government budget constraint and the size of the current deficit and debt are important. Government spending and taxation (especially regarding health care) are examples of such issues. The rise of globalization means that for example, the discovery of new ideas in a distant part of the world affects potential output in every country, and demand for U.S. exports can be a source for domestic short- run fluctuations. Understanding macroeconomics offers the possibility of enormous improvements in welfare throughout the world through the furthering of economic growth and the prevention of depressions and hyperinflations. 8

9 Chapter 2 - Measuring the Macroeconomy 2.1 Introduction National income accounting provides a systematic method for aggregating a country s production into a single measure of overall economic activity. 2.2 Measuring the State of the Economy The key measure of the state of the economy is called gross domestic product (GDP) and is defined as the market value of the final goods and services produced in an economy over a certain period. GDP can be viewed as total expenditure, total income or total production in an economy:!"#$%&'(#) =!"#$%&'()*$ =!"#$%& Economic profits are the above- normal returns associated with prices that exceed those that prevail under perfect competition. Hence, economic profits are zero unless there is some market power by which firms charge prices above marginal cost. The Expenditure Approach to GDP The equation for the national income identity illustrates how expenditures are divided according to their purpose in the expenditure approach for GDP: where! =! +! +! +!"! =!"#!"!"##$%&! =!"#$%&'()"#! =!"#$%&'$"&! =!"#$%&'$&(!"#$h!"#"!" =!"#!"#$%&' =!"#$%&'!"#$%&' Net exports are also called trade balance - a positive trade balance is called a trade surplus, while a negative trade balance is called a trade deficit. A trade deficit is a way to borrow goods and services from other countries in exchange for a future repayment of the loan. Reasons for loaning could be expectations of increased future prosperity or superfluous access to credit. 9

10 The Income Approach to GDP For every dollar of product sold there is a dollar of income earned. Hence, GDP is equal to the value of all goods and services produced in the economy (the expenditure approach), but is also equal to the sum of all income earned in the economy. Capital refers to the inputs into production other than labor that are not completely used up in the process. Depreciation is the wear and tear and subsequent decrease in worth of a firm s capital stock. The Production Approach to GDP Only the final sale of goods and services are counted towards GDP. Alternatively, each producer creates an amount of GDP equal to the amount of value added during production. What is Included in GDP and What s Not? GDP includes only goods and services that transact in markets, which means that following aspects are omitted: private services such as baby- sitting and home cooking the health of a nation s people, e.g. life expectancy changes in environmental resources, e.g. air and water pollution 2.3 Measuring Changes over Time Nominal GDP refers to the measurement when prices and quantities have not been separated out, and real GDP refers only to the actual quantity of goods and services. The two measurements are related thus:!"#$!%&!"# =!"#$%!"#"!!"#$!"# The method of computing change in real GDP with initial prices is called the Laspeyres index, while the use of final prices is called the Paasche index. Differences in results increase with the length of the examined time period and with the magnitude of inflation. The preferred approach is called chain weighting, or the Fischer index, and is calculated by computing the average of the two aforementioned indexes. 10

11 Price Indexes and Inflation For each of the indexes there is a corresponding price index.!"#$!%&!"# =!"#$%!"#"!!"#$!"# The price level that satisfies this equation is called the GDP deflator. %!h!"#$!"!"#$!%&!"# = %!h!"#$!"!"#$%!"#"! %!h!"#$!"!"#$!"# Another name for the percentage change in the price level is the inflation rate. Using Chain- Weighted Data Changes in relative prices over time (or high inflation) can cause large errors in Laspeyres or Paasche indexes when computing real GDP and chain weighting eliminates these errors. However, real shares of GDP (i.e. real consumption, investment, government purchases and net exports) generally do not equal real GDP. Therefore, if you are interested in particular shares, like the share of investment in GDP, then you want to look at the ratio of nominal variables, since the nominal shares will add up. If you are interested in real rates of economic growth, then you want to use the chain- weighted real measures. 2.3 Comparing Economic Performance across Countries International comparisons of GDP involve two conversions. First, the exchange rate (the price at which exchanges of currency occur) is used to convert the measures into a common currency. Second, just like common prices are needed to measure real GDP over time, common prices are needed to compare real GDP across countries. E.g.!.!.!"!"!"#!"#$%&!"#"$ =!"#$%!"#"!!.!.!"#$!%&!"#!"##$%&!"#"$!"#$%!"#"!!"#"$ =!"#$%!"#"!!.!.!"##$%&!"#$!%&!"#!"#$%!"#"!!"#"$!"#"$ 11

12 Part 2: The Long Run Chapter 3 - An Overview of Long- Run Economic Growth 3.1 Introduction Statistics on GDP per person are used to quantify differences in economic performance. The long- run perspective uses mathematical tools to provide economic theories for understanding facts of economic growth. 3.2 Growth over the Very Long Run On a long time scale, economic growth is very recent. Thus, living standards vary dramatically today. In the last three centuries, standards of living have diverged dramatically; a phenomenon that has been called the Great Divergence. 3.3 Modern Economic Growth The Definition of Economic Growth A growth rate in some variable y is the percentage change in that variable. The growth rate between period t and t + 1 is!!!!!!!! If the growth rate of per capita income is equal to!, the level of per capita income is!!!! =!! (1 +!) According to the constant growth rule, a variable with the initial value!! that grows at the constant rate! has the value!! in the future time t:!! =!! (1 +!)! The Rule of 70 states that if!! grows at a rate of g percent per year, then the number of years it takes for!! to double is approximately equal to 70/g 12

13 The Definition of Economic Growth The rule for computing growth rates states that the average growth rate between year 0 and year t is given by! = (!!!! )!! Modern Growth around the World Following World War II, many countries have stabilized at similar per capita GDP levels. This catch- up behavior is known as convergence. Growth rates range from - 2% to +6% per year. Per capita GDP in 2000 varies by about a factor of 64 across countries. 3.5 Some useful Properties of Growth Rates Growth rates of ratios, products and powers: Suppose two variables x and y have annual growth rates of!! and!!, respectively. Then the following rules apply: 1.!"! =!!,!h!"!! =!!!! 2.!"! =!!,!h!"!! =!! +!! 3.!"! =!!,!h!"!! =!!!!! is the average annual growth rate of z. 3.6 The Costs of Economic Growth Examples of costs are pollution, depletion of natural resources and loss of jobs through technological advances. However, the benefits, such as increased life expectancy, generally outweigh the costs. 13

14 Chapter 4 - A Model of Production 4.1 Introduction A model is a mathematical representation of a hypothetical world that we use to study economic phenomena. 4.2 A Model of Production Setting up the Model A production function tells us how many goods can be produced if L workers are combined with K machines and is given by! =!!,! =!!!!!!! where A is some positive constant, the productivity parameter. The equation implies that one third of GDP is paid out to capital and two thirds is paid out to labor. The second part specializes the production function to the Cobb- Douglas production function. The production function exhibits constant returns to scale if a doubling of the amount of each input leads to a doubling of total output. If the doubling leads to more than doubled production, there are increasing returns to scale, while if the doubling leads to less than doubled production, there are decreasing returns to scale. The (logical) justification for constant returns (e.g. setting up another identical factory with consequent doubling in production) is called the standard replication argument. Allocating Resources A typical firm will solve the following problem to maximize profits: max! =!!,!!"!"!,! taking the wage ω and rental price of capital r as given. 14

15 The good that is used to express prices is called the numéraire. The solution is to hire capital until the marginal product of capital is equal to the rental price r and to hire labor until the marginal product of labor equals the wage ω. The marginal product of capital (MPK) is the extra amount of output that is produced when one unit of capital is added, holding all the other inputs constant.!"# =!!! (!! )!! =!!!! The marginal product of labor (MPL) is the extra amount of output that is produced when one unit of labor is added, holding all the other inputs constant.!"# =!!! (!! )!! =!!!! Solving the Model: General Equilibrium The Production Model: Unknowns/endogenous variables: Y, K, L, r, w Production function Rule for hiring capital Rule for hiring labor Demand = supply for capital Demand = supply for labor! =!!,! =!!!!!!! 1 3!! =! 2 3!! =!! =!! =! Parameters/exogenous variables:!,!,! The solution of this model is called the equilibrium. It is a general equilibrium because more it clears more than one market (i.e. capital market, labor market and entire economy). 15

16 The Solution of the Production Model: Capital Labor Rental rate Wage Output! =!! =!! = 1 3!! = 1 3! (!! )!!! = 2 3!! = 2 3! (!! )!!!! =!!!!! 4.3 Analyzing the Production Model y, output per person, is defined as k, capital per person, is defined as!!!! output per person in equilibrium is! =!! =!!!!!!!! =!!!!!!!!! =!! Thus, output per person tends to be higher when (1) the productivity parameter is higher and (2) the amount of capital per person is higher. Solving the Model: General Equilibrium In development accounting, models are used to account for differences in incomes across countries. With no difference in productivity, the model predicts smaller differences in income across countries than is observed because of diminishing returns to capital. 16

17 ! is referred to as total factor productivity, or TFP and measures how productive countries are at using their factor inputs (i.e. K and L). Differences in capital account for one third of the differences, while TFP accounts for two thirds of the differences. 4.4 Understanding TFP Differences TFP is a residual that captures any factors omitted from the production function. Human Capital Human capital is the stock of skills that individuals accumulate to make them more productive. Returns to education is one aspect that can be used to explain differences in income. Technology The fact that countries produce with different technologies is another possible explanation for the differences. Institutions Differences in institutions (government policies, rules, regulations etc.) may be another important part of the answer. 4.5 Evaluating the Production Model Per capita income will be higher in countries that (1) have high quantities of capital per person and (2) use that capital efficiently The production function features constant returns to scale in capital and labor, so output per person can be written as a function of capital per person, which features diminishing returns In absence of TFP differences, the model vastly underpredicts the differences in income and provides little guidance about why countries exhibit different TFP levels and different amounts of capital per person 17

18 Chapter 5 - The Solow Growth Model 5.1 Introduction The accumulation of capital is endogenized in the Solow growth model. Other than that, the Solow model is the production function. The Solow model allows us to consider the accumulation of capital as a possible engine of long- run economic growth. 5.2 Setting up the Model Production Cobb- Douglas production model:! =!!!,!! =!!!!!!!!! Output can be used for consumption or investment, so the resource constraint is given by:!! +!! =!! Capital Accumulation The capital accumulation equation:!!!! =!! +!!!!! Output invested in the future (!! ) determines the capital accumulation, where a fraction is eliminated due to depreciation (!). Labor Labor is exogenously given by!. Investment A constant fraction (!) of output is invested each period!! =!!! 18

19 Thus, total output used for consumption is given by!! = 1!!! The Model Summarized The Solow Model: Unknowns/endogenous variables:!!,!!,!!,!!,!! Production function Capital accumulation Labor force Resource constraint Demand = supply for capital!! =!!!!!!!!!!!! =!!!!!! =!!! +!! =!!!! =!!! Parameters/exogenous variables:!,!,!,!,!! 5.3 Prices and the Real Interest Rate The real interest rate in an economy is equal to the rental rate of capital, which in turn is given by the marginal product of capital. The real interest rate is the amount a person can earn by saving one unit of output for a year, or equivalently the amount a person must pay to borrow one unit of output for a year.!!!! =!! saving investment Saving is the difference between income and consumption. The real interest rate equals the rental price of capital that clears the capital market, which in turn is equal to the marginal product of capital. 19

20 5.4 Solving the Solow Model!!! =!!!!!!!!!!! is often called net investment. The Solow diagram: Using the Solow Diagram In the absence of any shocks, the capital stock will remain at the steady state! forever, as each period s investment is just enough to offset the depreciation that occurs during production. The behavior of the economy away from its steady state is called transition dynamics. 20

21 Solving Mathematically for the Steady State In the steady state, output per person (y) is given by The Solow Diagram with Output:! =!!! =!!!!!! 5.5 Looking at Data through the Lens of the Solow Model The Capital- Output Ratio A key determinant of a country s capital- output ratio is its investment rate. The capital- output ratio in steady state is given by!! =!! Differences in!/! Some of the differences observed in capital are themselves due to differences in productivity. TFP thus plays an even bigger role in the Solow model than in the original production model. 21

22 5.6 Understanding the Steady State The fact that production exhibits diminishing returns to capital accumulation means that each addition to the capital stock increases production and therefore investment by less and less. But it increases depreciation by the dame amount!. Eventually, the amount of investment the economy generates is equal to the amount of capital that depreciates. Net investment is zero and the economy stabilizes at the steady state. 5.7 Economic Growth in the Solow Model The steady- state result implies that there is no long- run growth in the Solow model. Capital accumulation cannot serve as the engine of lon- run economic growth. 5.8 Some Economic Experiments 22

23 5.9 The Principle of Transition Dynamics The principle of transition dynamics states that the farther below its steady state and economy is (in percentage terms), the faster the economy will grow, and the farther above its steady state, the slower it will grow. 23

24 5.10 Strengths and Weaknesses of the Solow Model Strengths It provides a theory that determines how rich a country is in the long run (i.e. in the steady state) It helps to understand differences in growth rates by using the principle of transition dynamics Weaknesses The main mechanism studied in the model is investment in physical capital, that explains only a small fraction of the differences in income across countries The model doesn t explain differences in investment rates, that drives growth It does not provide a theory of long- run growth 24

25 Chapter 6 - Growth and Ideas 6.1 Introduction Economic goods are divided into objects (land, oil, cell phones etc. as well as capital and labor) and ideas (instructions, management techniques etc.), that are used for making objects. 6.2 The Economics of Ideas Economics of ideas are what make sustained economic growth possible and its implications are illustrated in the following idea diagram: ideas nonrivalry increasing returns Ideas problems with pure competition The number of possible ideas is virtually infinite. Economic growth occurs as we discover better and better ways to use the finite resources available to us. Nonrivalry Rivalrous goods cannot be used by more than one person at a time, which gives rise to scarcity. Ideas, however, can and are thus nonrivalrous. Excludability refers to the extent to which someone has property rights over a good and can legally restrict the use of that good. Increasing Returns According to the standard replication argument, there are constant returns to scale in production; the same stock of ideas can be drawn on, since ideas are nonrivalrous. If doubling the objects is enough to double production, then doubling the objects and the stock of knowledge will more than double production. 25

26 Problems with Pure Competition Under the assumption of perfect competition, markets lead to a Pareto optimal allocation of good (i.e. no one can be made better off without making someone worse off. But if prices are equal to marginal cost, no firm will undertake the costly research that is necessary to invent new ideas. Patents and copyrights or trade secrets are used to encourage innovation. 6.3 The Romer Model The Romer Model incorporates increasing returns and distinguishes between output and idea production. Unknowns/endogenous variables: Output production function!! =!!!!"!!,!!,!!",!!" Idea production function Resource constraint Allocation of labor!!! =!!!!!"!!" +!!" =!!!" = l! Parameters/exogenous variables:!,!, l,!! 26

27 Solving the Romer Model! =!!! =!! 1 l!! =!! 1 +!!! =!!!!! =!l!!! =!! 1 l 1 +!! Why is There Growth in the Romer Model? The nonrivalry of ideas means that per capita GDP depends on the total stock of ideas. As opposed to where the accumulation of capital (being an object) leads to diminishing returns because of depreciation, there is no restriction on the returns to ideas. Balanced Growth The Romer model does not exhibit transition dynamics. The growth rate! is constant and the economy is on a balanced growth path as long as all parameters are constant. Experiments in the Romer Model A one- time permanent increase in! imminently and permanently raises the growth rate. A one- time permanent increase in l imminently and permanently raises the growth rate with a decline in initial output because of fewer workers producing object goods. Growth Effects versus Level Effects Changes in parameters that lead to permanent increases in per capita GDP growth (above) are known as growth effects. If the exponent on ideas is less than 1, increases in ideas run into diminishing returns and changes in parameters only lead to short- term increases in growth known as the level effect. 27

28 Recapping Romer Economic goods are divided into two categories; objects and ideas. The Solow approach studies a model based solely on objects and cannot provide a theory on sustained growth. The Romer approach shows that the discovery of new ideas can provide such a theory. Ideas are nonrivalrous and since objects have constant returns to scale, ideas and objects taken together have increasing returns. It s the total stock of ideas, not ideas per capita, that is the key to sustained growth in per capita GDP. 6.4 Combining Solow and Romer: Overview In the combined Solow- Romer model, nonrivalry of ideas is the key to long- run growth. Transition dynamics also apply and foresee rapid (slow) growth for an economy that starts out below (above) its balanced growth path. In the long run, all countries grow at the same rate but because of transition dynamics, actual growth rates can differ across countries for long periods of time. 6.5 Growth Accounting The application of the combined Solow- Romer model to determine the sources of growth in a particular economy and how they may have changed over time is called growth accounting. The growth rate of output per hour can be decomposed into contributions from capital, labor and TFP:!! =!!!!!!!!!"!!" =!!" +!!!!" +!!!!"#!!" =!"!!!!"#.!!"!!" =!!!!"!!" +!!!!"#!!" +!!" growth constribution labor TFP of Y/L from K/L composition growth 28

29 The years 1973 to 1995 saw output per hour grow less than half as fast as in the preceding time period, which is called the productivity slowdown. The era after with the rise of the World Wide Web and the dot- com boom and the following sharp decline in stock prices is called the new economy. 6.6 Concluding Our Study of Long- Run Growth The Solow and Romer frameworks provide a sound foundation for understanding why some countries are much richer than other and why economies grow over time. However, they don t explain why countries exhibit different investment rates and TFP levels. Appendix: Combining Solow and Romer (Algebraically) Setting up the Combined Model! =!!!!"!!! =!!!!!"!!" +!!" =!!!" = l! Solving the Combined Model The model helps to understand how capital and output continues to grow in a balanced growth path. Long- Run Growth!! = 3 2! = 3 2!l! Output per Person!! =!!! =!!! +!!!!!!! 1 l 29

30 Transition Dynamics 30

31 Chapter 7 - The Labor Market, Wages and Unemployment 7.1 Introduction College education comes with a premium in terms of increased salary and understanding why it does leads to significant implications for public policy and understanding economic growth with help of the concept of present discounted value. 7.2 The U.S. Labor Market The employment- population ratio for the U.S. has increased during the last 50 years, whereby employment drops around recessions. Another common statistic for the labor market is the unemployment rate. The Dynamics of the Labor Market Large quantities of jobs are created (job creation) and destroyed (job destruction) every month in the gross flows that are a normal part of the economy. 7.3 Supply and Demand The labor market clears at the wage w and level of employment L so that labor supply equals labor demand. A Change in Labor Supply A tax on labor supply, for example, shifts back the labor supply curve, which raises the wages and reduces employment. A Change in Labor Demand A reduction in labor demand (e.g. an increase in the oil price) causes both the equilibrium wage and level of employment to decline. Wage Rigidity If wages are rigid, the result is a larger reduction in employment than would be normal in response to a change in labor demand. 31

32 Different Kinds of Unemployment The natural rate of unemployment is the rate that would prevail if the economy was in neither a boom nor a recession. Cyclical unemployment is the difference between the actual rate and the natural rate and is associated with short- run fluctuations, such as occur in booms or recessions. The natural rate is decomposed into frictional unemployment (the time associated with job search as workers change jobs in a dynamic economy) and structural unemployment (the result of costs associated with labor market institutions that match up workers and firms, e.g. unemployment benefits or the level of the minimum wage).!"#$!%!"#$%&'($#") =!"#$%#&'() +!"#$%"$#&' +!"!#$!%#!"#$%"& 7.4 Labor Markets around the World European unemployment has been substantially higher than in the United States in recent decades. Unemployment in Japan, after being low for many decades, is now at the U.S. level. The reason for the high European unemployment rate could be a combination of adverse shocks (high oil prices with productivity slowdown in the 1970s) and inefficiencies in labor market institutions (high unemployment benefits etc.). Hours of Work A substantial part of the explanation for why per capita GDP is lower in Europe than in the U.S. is that Europeans work fewer hours, since GDP per hour is similar between the two. 7.5 How Much is Your Human Capital Worth? Present Discounted Value Present discounted values help compare financial payments received at different times.!"#$#%&!"#$%&'()!!"#$% =!"#"$%!"#$% 1 +!"#$%$&#!"#$! 32

33 7.6 The Rising Return to Education The economy has experienced a large and sustained shift out in the demand for highly educated workers. The first reason is skilled- biased technical change; new technologies are more effective at improving productivity when used by skilled labor. The second reason is globalization, which has opened up markets and made skilled labor scarcer in developed countries. 33

34 Chapter 8 - Inflation 8.1 Introduction Inflation is the percentage change in an economy s overall price level, and episodes of very high inflation (approximately greater than 500 percent per year) are called hyperinflations. The consumer price index (CPI), a price index for a bundle of goods, is a measure of the price level. 8.2 The Quantity Theory of Money Measures of the Money Supply C MB M1 M2 currency monetary base = currency + reserves currency + demand deposits (e.g. checking accounts) M1 + savings deposits and individual money market accounts The Quantity Equation The quantity theory of money predicts that the money supply is a key determinant of the price level and that the growth rate of the money supply is a key determinant of the inflation rate:!!!! =!!!! where!! is the price level and!! is called the velocity of money (i.e. the average number of times per year that each piece of currency is used in a transaction). The equation is called the quantity equation. The Classical Dichotomy, Constant Velocity and the Central Bank The assumption of the classical dichotomy states that in the long run, the real and nominal sides of the economy are completely separate, i.e. that real GDP in the long run is determined only by real considerations such as TFP and the investment rate and not money or aggregate price level.!! =!! 34

35 The velocity of money is assumed to be constant:! =! Money supply is also made exogenous as it is decided by the central bank:!! =!! The Quantity Theory for the Price Level!! =!!!!! The Quantity Theory for Inflation Unknowns/endogenous variables:!!,!!,!!,!! The quantity equation!!!! =!!!! Read GDP from growth model (classical dichotomy)!! =!! Exogenous and constant velocity Exogenous money supply Parameters/exogenous variables:!! =!!! =!!!!,!,!!!! +!! =!! +!!!! = 0 è! =!!!! 35

36 Revisiting the Classical Dichotomy The proposition that changes in the money supply have no real effects on the economy and only affect prices is called the neutrality of money. The neutrality of money holds in the long run but not in the short run. 8.3 Real and Nominal Interest Rates The real interest rate is equal to the marginal product of capital in the long run. The nominal interest rate is the rate at which a unit of currency can be traded for other units in the future. The Fisher equation states that the nominal interest rate is equal to the sum of the real interest rate and the rate of inflation:! =! +! 8.4 Costs of Inflation Inflation generally transfers resources from lenders and savers to borrowers because borrowers can repay their loans with dollars that are worth less. Other costs include high effective tax rates (taxation of high nominal yet low real income), distortions to relative prices (because of different response times to inflation), shoe- leather costs (increased opportunity cost of holding cash balances causes more frequent withdrawals) and menu costs (price changes). 8.5 The Fiscal Causes of High Inflation The government budget constraint is given by the following equation:! =! +!" +!" uses sources of funds G: government spending T: tax revenue ΔB: change in the stock of debt/new amount of borrowing ΔM: change in the stock of money/amount of new money issued The Inflation Tax The revenue the government obtains by issuing new money is called seignorage or the inflation tax. 36

37 Chapter 20 - Consumption (från kurswebben) 20.1 Introduction The neoclassical consumption model describes how individuals choose consumption at each point in time to maximize a lifetime utility function that depends on current and future consumption The Neoclassical Consumption Model Time is divided into two periods: today and the future. The neoclassical consumption model then has two main elements: an intertemporal budget constraint and a utility function. The Intertemporal Budget Constraint Consumption equals income less saving:!!"#$% =!!"#$%!!"#"$%!!"#$%!!"#"$% =!!"#"$% + 1 +!!!"#"$% The intertemporal budget constraint is given by:!!"#$% +!!"#"$% =!!!!!"#$% +!!"#$% +!!"#"$%!!! present value financial human of consumption wealth wealth total wealth Utility Consumption delivers utility through a utility function that runs into diminishing marginal utility.! =!!!"#$% +!"!!"#"$% The β is a parameter that captures the weight that is placed on future consumption relative to today. 37

38 Choosing Consumption to Maximize Utility Consumption is chosen to maximize utility!"#! =!!!"#$% +!"!!"#"$% subject to the budget constraint:!!"#$% +!!"#"$% 1 +! =! (!"!#$!"#$%h) The Euler equation says that a person must be indifferent between consuming one more unit today or saving that unit and consuming in the future:!!!"#$% =!(1 +!)!!!"#"$% Solving the Euler Equation: Log Utility If!!, then the marginal utility of consumption is!! (!) =!! The Euler equation explains how interest rates and growth rates are closely related:!!"#"$%!!"#$% =!(1 +!) Solving for!!"#$% and!!"#"$% : Log Utility and! =!!!"#$% = 1 2!!!"#"$% = !! The Effect of a Rise in R on Consumption The wealth effect states that a high interest rate will reduce the present value of total wealth and thus, consumption. 38

39 20.3 Lessons from the Neoclassical Model The Permanent Income Hypothesis According to the permanent income hypothesis, consumption in each period is a fraction of total wealth, where total wealth includes financial resources, current income and the present discounted value of future income. The marginal propensity to consume states how much consumption rises in response to a fixed increase in income. Ricardian Equivalence The Ricardian equivalence claim is that a change in the timing of taxes does not affect consumption. Borrowing Constraints Consumers may be unable to borrow in financial markets, in which case the following borrowing constraint applies:!!"#$%!!"#$% Consumption as a Random Walk According to the random walk view of consumption, all known information should be incorporated into current consumption and changes in consumption should be unpredictable. Unexpected changes should thus have larger effects on consumption than expected ones. Precautionary Saving Consumers may engage in precautionary saving when income is uncertain. Thus, consumers with low income who look like they should be borrowing may save instead. 39

40 20.4 Empirical Evidence on Consumption Evidence from Individual Households The permanent income hypothesis accurately describes households with average wealth. Households with low income and wealth, however, behave as if they are borrowing constrained or are engaging in precautionary saving. Here, consumption tracks income quite well. There are many anomalies and departures from the permanent income model and the research in this field is called behavioral economics. Aggregate Evidence The personal saving rate is the ratio of personal saving to disposable income (i.e. income net of taxes). The aggregate evidence from the 1980s and 1990s shows a rise in debt as a ratio to income and a decline in the personal saving rate. Despite this, household wealth as a ratio to income also rises during this period before falling in response to the recent financial turmoil. 40

41 Chapter 21 - Investment (från kurswebben) 21.1 Introduction Investments in all kinds - in physical capital, human capital, in new idead and in financial assets are ways of transferring resources from the present to the future How do Firms Make Investment Decisions? A Business should keep investing in physical capital until the marginal product of capital (MPK) falls to equal the interest rate (r).!"# =! Reasoning with an Arbitrage Function Arbitrage equation:!!! =!"# +!!! return from bank account return from capital!!! denotes the change in the price of capital:!!! =!!,!!!!!,! The arbitrage equation is a fundamental tool for studying investments. Two investments of equal riskiness must have the same return. Reasoning with an Arbitrage Function The capital gain is the growth rate of a price:!!!!!!"# =! +!!!!!! user cost of capital The user cost of capital is the total cost to the firm of using one more unit if capital and includes the interest rate (cost of financial funds), the depreciation rate and any capital gain or loss associated with a change in the price of capital. 41

42 From Desired Capital to Investment If then! =!!!!!!!!! =!!" +!! 3!" where!" = user cost of capital and!!" =!!!!! 21.3 The Stock Market and Financial Investment A stock has two payoffs: dividends (payments by a firm to its shareholders) and the price change!!! According to the arbitrage equation: or!!! =!"#"!$%& +!!!! =!"#"!$%&!! +!!!!! dividend return capital gain!! =!"#"!$%&!!"!#$%&!!! =!!"#$%$&#!"#$!"#$%"&!"#$!! When dividend growth is constant:!! =!"#"!$%&!!! P/E Ratios and Bubbles? The price- earnings ratio for the stock market may indicate if there are bubbles in stock prices.!!!"#$%$&' =!"#"!$%&/!"#$%$&'!"#$%$&#!"#$!"#$%"&!"#$ Thus, the price- earnings ratio should equal the dividend- earnings ratio divided by!!. 42

43 Efficient Markets A financial market is said to be informationally efficient if financial prices fully and correctly reflect all available information. The only thing that moves stock prices is unexpected new and the stock prices thus follow a random walk. Mutual funds are collections of stocks and other financial assets that are held together in a large portfolio, small pieces of which are sold off to individual investors Components of Physical Investment Nonresidential fixed investment (equipment and structures purchased by businesses) Residential fixed investment (new housing purchased by households) Inventory investment (goods produced by firms that have not been sold) Residential investment!!"#$%&'()$* =!"#$!!!!"#$ +!!!"#$ return from saving the downpayment return from investing in condo Inventory Investment Inventories are held because of production smoothing (evening out of production rate), the pipeline theory (inventories are held as supplies in the production process) and stockout avoidance (making certain of having goods available at all times) 43

44 Part 3: The Short Run Chapter 9 - An Introduction to the Short Run 9.1 Introduction The economy typically deviates from its long run trend in the short run. Short run output and inflation is analyzed with the short- run model. 9.2 The Long Run, the Short Run and Shocks long- run model short- run model potential output, long- run inflation current output, current inflation The short run is defined to be the length of time over which actual output deviates from potential output because of shocks such as sudden changes in oil prices, changes in taxes and government spending, natural disasters etc. and typically last for about 2 years. Trends and Fluctuations Actual output can be viewed as the sum of the long- run trend and short- run fluctuations:!"#$!%!"#$"# =!"#$!"#!"#$% +!h!"#!"#!"#$%#&%'()*!! =!! +!!! is short- run output, the deviation from potential output. Short- Run Output in the United States There was a large gap between potential and actual output during the Great Depression in the 1930s. A recession begins when actual output falls below potential; that is, when short- run output becomes negative. A recession is costly (typically 6% of GDP) because of lost output and jobs. The gains from eliminating recessions are smaller than this because of the benefits associated with a booming economy. 44

45 Measuring Potential Output An annualized rate is the rate of change that would apply if the growth persisted for an entire year. It is hard to establish if an increase in GDP reflects an increase in potential output or actual output. The Inflation Rate The rate of inflation typically falls during a recession. 9.3 The Short Run Model The short- run model is based on three premises: 1. The economy is constantly hit by economic shocks such as changes in oil prices or natural disasters. 2. Monetary and fiscal policy affect output, which implies that policymakers in principle are able to neutralize economic shocks. 3. There is a dynamic trade- off between output and inflation as an output that exceeds the potential level leads to an increase in the inflation rate (and vice versa). This trade- off is known as the Phillips curve. 45

46 A Graph of the Short- Run Model How the Short- Run Model Works If inflation creeps upward (because of economic shocks or monetary policy), policymakers will tighten monetary policy to bring it under control, causing a recession. Summary The short- run model says that a booming economy leads the inflation rate to increase, and a slumping economy leads the inflation rate to fall. 9.4 Okun s Law: Output and Unemployment Okun s law says that for each percentage point that output is below potential, the unemployment rate exceeds its long- run level by half a percentage point:!! = 1 2!! where! is the unemployment rate and! is the natural rate of unemployment 46

47 Chapter 10 - The IS Curve 10.1 Introduction Movements in interest rates affect the economy in the short run, which is captured in the IS curve.!"#$%$&#!"#$.!"#$%&'$"&.!"#$"# The IS curve captures the fact that high interest rates reduce output in the short run. This occurs because high interest rates make borrowing expensive for firms and households, reducing their demand for new investment. The reduction in demand leads to a decline in output in the economy as a whole Setting up the Economy Unknowns/endogenous variables:!!,!!,!!,!!,!"!,!"! National income identity:!! =!! +!! +!! +!!!!!! Consumption: Government purchases: Exports: Imports: Investment!! =!!!!!! =!!!!!"! =!!"!!!"! =!!"!!!!!! =!!!!!! Parameters/exogenous variables:!!,!,!!,!!,!!,!!",!!",! Exogenous for now (until next chapter):!! 47

48 10.3 Deriving the IS Curve!! =!!(!!!) where! =!! +!! +!! +!!" +!!" 1 Because! is derived from the demand equations, we call it aggregate demand shock Using the IS Curve The Basic IS Curve The Effect of a Change in the Interest Rate (Central banks control the nominal interest rate, but the IS curve depends on the real interest rate. See chapter 11.) An increase in the real interest rate is a movement along the IS curve that results in a decline in output in the short run. An Aggregate Demand Shock An increase in aggregate demand (!) that makes! positive means that the IS curve shifts out and increases output above potential. 48

49 A Shock to Potential Output Short- run output is unaffected by a change in potential output. However, the same changes may also affect short- run output Microfoundations of the IS Curve Consumption The permanent income hypothesis concludes that people will base their consumption on an average of their income over time rather than their current income. The life- cycle model of consumption applies this same reasoning to a person s lifetime. Multiplier Effects A shock to one part of the economy may get multiplied by affecting other parts of the economy:!! = 1 1!!!(!!!) multiplier original IS curve Investment The two major determinants of investment at the firm level are the gap between the real interest rate and the marginal product of capital on the one hand and the firm s cash flow (available internal resources after paying expenses) on the other. Agency problems such as adverse selection (firms loaning money before particularly risky time period because of opportunity to declare bankruptcy) and moral hazard (firms loaning money to engage in risky investments because of opportunity to declare bankruptcy). 49

50 Government Purchases Government purchases of goods and services affect short- run economic activity in two ways: as a shock that can function as a source of fluctuations and as a policy instrument that can be used to reduce fluctuations. Policymakers may expand fiscal policy when shocks have caused the IS curve to shift back to restore demand for goods and services and avoid a recession. For the same reason, they may offer tax credits to increase investment. Another option is transferring resources in recessions with automatic stabilizers (e.g. unemployment insurance and welfare programs). The government has a budget constraint and is subject to the no- free- lunch principle. Spending must be paid for now or in the future by taxes or loans. Using the permanent income hypothesis, the Ricardian equivalence states that consumption depends on the present value of what the government takes from consumers, rather than the specific timing of taxes. Generally, an increase in government purchases financed by taxes of the same amount will have a modest positive impact on the IS curve, raising output by a small amount in the short run. An increase in spending today financed by an unspecified change in taxes and/or spending at some future date will shift the IS curve out by a moderate amount (25-50% of spending). These limitations mean that discretionary fiscal policy is only used in severe situations. Net Exports!"#!"#$%&' =!"#$%&'!"#$%&' An increase in exports stimulates the economy by shifting the IS curve out whereas an increase in imports shifts the IS curve back. 50

51 Chapter 11 - Monetary Policy and the Phillips Curve 11.1 Introduction The Federal Reserve uses the federal funds rate (the interest rate paid from one bank to another for overnight loans) as its main policy tool The MP Curve: Monetary Policy and Interest Rates The fed funds rate sets the highest possible rate for overnight bank loans because of the otherwise present arbitrage opportunity. From Nominal to Real Interest Rates Changes in the nominal interest rate will lead to changes in the real interest rate as long as they are not offset by corresponding changes in inflation:!! =!!!! The short- run model assumes sticky inflation; that the rate of inflation displays inertia/stickiness so that it adjusts slowly over time and does not react to changes in monetary policy within the very short run (i.e. 6 months). 51

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