Microecon Study Guide 2
Microecon Study Guide 2 ECON 200
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This 20 page Study Guide was uploaded by Jonas on Tuesday January 26, 2016. The Study Guide belongs to ECON 200 at University of Washington taught by in Fall 2016. Since its upload, it has received 30 views.
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Date Created: 01/26/16
Growth - Growth determines output in the long run - For most of human history, everyone everywhere was extremely poor - Long-run economic growth is normally a gradual change. - Rule of 70: tells how long real GDP per capita, or any other variable that grows gradually over time, to double 70 o # years for variable to double = Annualgrowthrateof variable - What is likely reason China’s growth rates are larger than the US o Growing from a lower starting point o Introducing technologies already prevalent in the US o Rapidly increasing capital while the US already has a great deal of capital All of the above End of Lecture 6 Sources of Long-Run Growth - Labor productivity (or simply, productivity) is output per worker - Physical capital consists of human-made resources such as buildings and machines - Human capital is improvement in labor created by the education and knowledge embodied in the workforce - Technology is technical means for the production of goods and services o Workers have the means of accomplishing more with same effort Accounting for Growth: Aggregate Production Function - Aggregate production is a hypothetical function that shows how productivity (real GDP per worker) depends on the quantities of physical capital per worker and human capital per worker as well as the state of technology o i.e. all the inputs mentioned in the previous slide o Aggregate production function: Y/L=f (K /L ,H/L,T) Y is output T is technology K is capital HC is human capital L is population o Important because tells us productivity from inputs o Also tells growth that comes from changes in these inputs importance of investment (and where to invest) - Diminishing returns to physical capital: holding amount of human capital and state of technology fixed, each successive increase in the amount of physical capital leads to a smaller increase in productivity o Why is it reasonable for capital to have diminishing returns: without additional workers, new machinery won’t be as useful - Natural resources – in contrast to earlier times, natural resources are a much less important determinant of productivity than human or physical capital for majority of countries - Haven’t even covered the institutions yet (the entities that actual turn inputs to outputs) – property rights, rule of law, not necessarily democracy; just need to encourage investment o Spending on Research and Development is quite different from investment in physical capital; some argue that physical capital does increase economy’s resources while R&D only helps with creation of “improved instructions” o What is incentive for firms to spend money on development of new instructions when others can copy at no additional cost? technological progress depends on ability of innovators to establish monopolies They are only ones who can use either due to formal patent protection or because they have head start Why Growth Rates differ - Government policies and institutions that alters: o Savings and investment spending o Foreign investment o Education o Infrastructure o Research and development o Political stability o Protection of property rights - Convergence hypothesis: growth rates might start off different, but they will converge (all advanced countries will advance at the same rate) o Not necessarily same GDP, only same growth rate - Long-run economic growth is sustainable if it can continue in the face of the limited supply of natural resources and the impact of growth on the environment Savings - Income = Consumption + Savings o Y = C+S Not a theory, is fact!! - From income accounting identity, we know that income is equal to spending - Assumes at G=0 and NX=0 Y= C+I (simplified national income accounting identity), which can be written as Y-C = I o Since S=Y-C, then S=I o Savings is equal to Investment Which I is income and which is investment? - Let’s add government back in Y = C + I + G o Government taxes and borrows! - Disposable income (income after tax): Y-T - Private saving: Y-T-C o Government uses T to buy G - Public saving: T-G o If negative, government must borrow: deficit o If positive, government can lend: surplus - National savings: Y = C + I + G Y – T – C + T – G = I Private saving + public saving = investment o National Savings = Private saving + public saving End of Lecture 7 10/29 Lecture - Adding rest of the world – Y = C + I + G + NX o Private S + Public S = I + NX o National Saving = I + NX - NX (net exports) can be positive or negative o If NX negative (trade deficit; imports > exports) then National Savings < I Foreign savings is financing our investment o If NX positive (trade surplus, exports > imports) then National Savings > I Savings are leaving the country, financing investment elsewhere - Investment Spending Identity: Investment spending must be equal to savings - Y – C – Private Savings = T, taxes collected Matching Up Savings and Investment Spending - According to the savings-investment spending identity, savings and investment spending are always equal for the economy as a whole. - Budget surplus is difference between tax revenue and government spending when tax revenue exceeds government spending, and budget is when it is the opposite o Budget balance is difference between tax revenue and government spending. o Capital inflow is net inflow of funds into a country (outflow is out of country). Different kinds of capital - Physical capital: manufactured resources; buildings and machines - Hyman capital: improvement in labor force generated by education and knowledge - Financial capital: funds from savings that are available for investment spending Market for Loanable Funds - How savings of consumers get to firms to finance investment? Financial markets - The loanable funds market is a hypothetical market that examines the market outcome of the demand for funds (generated by borrowers) and supply of funds (provided by lenders) - Interest rate is the price, calculated as percentage of the amount borrowed, charged by lender to borrower for use of savings for one year. o Interest rate determines whether project is worth the investment - Rate of return on a project is the profit earned on the project expressed as a percentage of its cost o Profit (revenue – cost) / cost x 100 - If the return is too low, then you are better off leaving money in bank and earning interest. o If interest rate is 12%, then only worth investment if earn 13% o If interest rate fall to 4%, then still worth, and all projects worth if return is >4%. - Demand of loanable funds – at low interest rates, there will be more demand for the project (have to pay less) - Supply of loanable funds – at high interest rates, there will be more demand for the project (they earn more) o Equilibrium is when supply and demand are equal - Factors that will cause demand to change (perception of firms change): o Changes in perceived business opportunities o Changes in government borrowing - Budget deficit – if government is running budget deficit, they are on the demand side of the market. If gov running budget surplus, they will be on the supply side. o Crowding out occurs when government deficit drives up interest rate and leads to reduced investment spending o Increase in borrowing shifts the demand curve to the right, then drives up the equilibrium interest rate o This higher interest rate brings new savers in the market but drives private savers out of the market. o Private savings fund things that promote growth, but if government just burns money then there will be less investment growth. - Shifts in supply of loanable funds are caused by: o Changes in private savings behavior o Changes in capital inflow - Question: If firms believe environment for investment has worsened, then the interest rate will fall. (Fall in estimate of projects, they think the interest is less) - Persistent government deficit will result in slightly slower growth and less private investment o Total lending goes up, but lending to firms (that will result in growth) goes down. Inflation and interest rates - Anything that shifts either supply or demand of loanable funds curve changes interest rate (historically changes in government policy, technological innovations) o Arguably, the most important factor over time is the changing expectations about future inflation - Remember: real rate = nominal interest rate – inflation rate - Fisher effect: increase in expected future inflation drives up nominal interest rate, leaving expected real interest rate unchanged o Supply curve and demand curve shift up by the same amount. o Unexpected inflation will be different (no one sees it coming) o If one shifts without the other, then the interest rates will change. Financial system - A household’s wealth is the value of its accumulated savings - Financial asset is a paper claim that entitles buyer to future income from the seller o Stocks (dividends), bond (money), etc. - Physical asset is claim on tangible object that gives owner right to dispose of object as he or she wishes o Rental property - Liability is requirement to pay income in the future (loans, mortgage) Three tasks of financial system - Reducing transaction costs – cost of making a deal (coordinate borrowing and lending through central entity) - Reducing financial risk – uncertainty about future outcomes that involve financial gains and losses (people avoid risk through bank; banks have many assets). - Providing liquid assets – assets that can be quickly converted to cash o Liquid assets can be quickly converted into cash o Illiquid assets cannot be quickly converted into cash Types of financial assets - Loans - Bonds - Stocks - Bank deposits o In addition, financial innovation has allowed the creation of wide range of loan-backed securities (value comes from your rights to stream of payments from the mortgage). - Loan is lending agreement between particular lender and borrower - Loan-backed security is asset created by pooling individual loans and sharing shares in that pool - Financial intermediary: institution that transforms funds it gathers from individuals into financial assets o Mutual fund, pension fund, etc. get money from savers to borrowers - Bank deposit: claim on bank that obliges bank to give depositor his or her cash when demanded. 11/03 Lecture – Income and Expenditure Equilibrium Spending Multiplier - 1 million new spending (autonomous spending), meaning it happens for some outside reasonsleads to more than 1 million new income - Marginal Propensity to Consume (MPC) is the fraction of income that person choses to consume (as a proportion between 0 and 1). o Save half is 0.5 MPC o What’s left is marginal propensity to save; 1 – MPC Spending - Assume firms treat all prices as fixed (“sticky prices” assumption) o Means assume interest rate r fixed (people’s saving behavior is also fixed o Means market for loanable funds is in equilibrium too. o Also pretend no government: G = 0; only consumption and investment spending Also no trade NX = 0; this will also be the case for next of quarter - Each person who gets new income will consume some of it and save some of it: Y = C + S o Whatever they spend will also become new income to someone else - Assume 1 million dollars spent and becomes new income, then they spend half of that earned money. There will be 1.5 million of new income (1 mill from you, .5 from other people). Spending Multiplier - How much did consumption go up? o Change in consumption (C) = MPC * Change in income (Y) o Change in savings (S) = MPC * Change in income (Y) o Change in consumption plus Change in savings equals Change in income. - So this process will continue forever, so know that this is the equation MPC = .5 o Change in income = 1,000,000 o Change in income = 1,000,000 + 500,000; etc. ∆ Y=1,000,000∗(1/1−MPC) o Use: - Final increase in income was larger than the initial increase in autonomous spending o (1/1-MPC) is the multiplier – multiply this by the initial increase in spending to get the final increase in income - Spending multiplier magnifies any changes in spending (small changes in economy can lead to big changes in income) Consumption Function (simplest possible theory) - C = a + MPC * Y d o C: Consumption o A: Autonomous consumption o Yd: Disposable income o MPC: Marginal Propensity to Consume - Autonomous Consumption: spending done even if income is 0 e.g. food, housing, etc. o Will dig into savings/loans if necessary o Slope is the MPC - Is this reasonable? o Maybe no: saving behavior of rich and poor people are not the same o Maybe: saving behavior of rich and poor countries are similar - What changes/shifts this curve? Changes in the consumption behavior e.g. increase in wealth (inheritance) Shifters of aggregate consumption - Expectations of future income - Expectations of wealth - Changes in price level? Yes! o Increasing price level will increase spending now (will cover later) Permanent Income Hypothesis - How do people decide consumption? They prefer to smooth out their consumptionincome higher, save more; income low, save less. o Consumption remains constant over time - Instead of thinking of income as disposable income, we’re going to think about your “permanent income.” o Permanent income is lifetime expected earnings – this determines consumption plan. o Consumption only changes in reaction to changes in permanent income; only responds to unexpected changes. - According to Pi hypothesis, people will borrow when young (income low), save when middle-aged (income highest to pay loan), and dis- save when retired (consume savings down to 0 or bequeath to heirs). - Remember that in this model we are not worrying about government spending or net exports, so spending in economy only coming from consumption and investment Next up: Firms o Consumption function is our theory of consumer behavior: C o Theory of firm behavior: I o So that’s all, just now need to worry about firms e.g. market for loanable funds? - Nope, that’s just planned investment spending. o Depends negatively on interest rate and existing production capacity. o Depends positively on expected future real GDP. Investment spending - According to accelerator principle, higher rate of growth in real GDP leads to higher planned investment spending o Need to build now to meet future demand, which means GDP grows even faster!! o Also, lower growth rate of real GDP leads to lower planned investment spending o Fall in investment usually kicks off the recession. Investment is very volatile and changes easily. Why? - In long run, planned investment is how much there will be; plans will come true. - In the short run, maybe not – big swings are possible, also unplanned investment. Inventories and unplanned spending - Inventories are stocks of goods held to satisfy future sales. - Inventory investment is the value of the change in total inventories held in the economy during a given period. o When stock goes up, then that’s positive investment. - Unplanned inventory investment occurs when actual sales are more or less than business expected, leading to unplanned changed in inventories o E.g. buy a lot for Christmas but not everyone bought - Actual investment spending is the sum of planned investment spending and unplanned inventory investment. o I = Unplanned IPlanned - Unplanned Investment is pretty much when sales weren’t what firms expected o Sales too big, actual inventories too smallNegative unplanned investment o Sales too small, actual inventories too bigPositive unplanned investment Income-Expenditure Model (Keynesian Cross) - Let’s collect all equations - Y = C + I (by definition; remember G=0, NX=0) - Yd= Y (by definition; since T=0) - C = a + MPC * Y (not by definition, a theory) d - I = Planned IUnplannednot by definition, a theory) - Assumptions underlying multiplier process: o Changes in overall spending lead to changes in aggregate output. Aggregate price level fixed. o Interest rate fixed. o Taxes, transfers, and government purchases are all zero. o Exports and imports are both zero; no foreign trade. Planned Aggregate Expenditure and GDP - Planned Aggregate Expenditure is total amount of planned spending in economy o AE PlannedC + I Planned o AE PlannedC(Y) + I Planned Planned investment doesn’t vary systematically with income, but consumption does. AE varies with income Y through consumption o Consumption Function of individual + firms leads to Aggregate Expenditure We are going to find out which plans can/will come true. 11/05 - Consumption function plus planned spending equals the Planned Aggregate Spending (will also be actual income earned) Income-Expenditure Equilibrium - Economy is in income-expenditure equilibrium when aggregate output (measured by real GDP is equal to planned aggregate spending) - Income-expenditure equilibrium GDP – noted Y* - is the level of real GDP at which real GDP equals planned aggregate spending. o GDP = C + I o = C + I PlannedIUnplanned o = AE Planned IUnplanned o At equilibrium, unplanned investment is 0 and all plans will come true. - When planned aggregate spending is larger than Y*, unplanned inventory investment is negative; there is an unanticipated reduction in inventories and firms increase production to make up for it. o When planned aggregate spending is less than Y*, unplanned inventory investment is positive, and there is unanticipated increase in inventories and firms decrease production. - Add 45-degree line (set of points where x=y; slope=1) to GDP vs Planned Aggregate Spending graph, so economy can only be on the 45-degree line. o Below the intersection (to the left) (AE Plannedeater than 45- degree line), spending was more and firms increase production to make up for it. o To the right of intersection (to the right), inventories are larger than actual spending so firms decrease production. o To the left, Unplanned negative (vertical difference between 45- degree line and AE Plannednd GDP rises o To the right, Unplanneds positive and GDP falls - Keynesian cross is a diagram that identifies income-expenditure equilibrium as the point where a planned aggregate spending line crosses the 45-degree line. o This model is missing prices. - How to read the graph: o X Axis: Income “Expected income;” consumers make their plans on basis of this income. Plus this income into their consumption function. o Aggregate Expenditure: Planned Spending Depends on expected Income, Planned Investment o Y Axis: Output “Actual Output;” Remember Output = Income so o 45 degree line is where Income (X axis) is equal to Output (Y axis) - Consumers make their plans on the basis of the Expected Income on the X axis o These plans determine the planned expenditure. o This level of spending determines Actual Output o If their Actual Output is that same as Expected Income, then the economy is in equilibrium. o If not, then actual won’t be the expectedunplanned investment happens! - Question: Supposes sales bigger than expected. Then unplanned inventories are (negative) and GDP must (rise). - Applying the multiplier (after autonomous change) - How much bigger the horizontal component is to the vertical component is the multiplier. - Change in Y* (Income-Expenditure Equilibrium GDP) is equal to Multiplier times change in Planned Aggregate Expenditure Paradox of Thrift - In paradox of thrift, households and producers cut their spending in anticipation of tough future economic times. o Actions actually depress the economy, leaving households and producers worse off than if they hadn’t acted virtuously to prepare for tough times. o Paradox because what’s good/prudent for family is bad for economy/everyone else. - Suppose firms expect future GDP to be larger, so they increase planned investment. This will lead to (A rise in equilibrium GDP) o Mathematically, it will look like this: Some Calculations - Following is just algebraic expression of Keynesian Cross - C = 10 + .75Y - IPlanned - Y = 10 + .75 Y + 50 o Y = 240 - *reminder: 1/(1-MPC) is also known as the multiplier - C = 10 + .75*240 = 190 - S = Y – C = 50 - Instead of Income-Spending Identity to solve, we can also use Savings- Investment Identity because they are the same equation. o Could graph Savings instead of AE - Practice: Suppose C = 10 + .75 Y and I Planned100. o Planned investment and autonomous spending is 110. o MPC is .75, Multiplier is ¼ o 110 times 4 is 440. What did I just spend for? 10/10 – GDP Equilibrium, AD-AS If planned spending is below actual expenditure, - People are planning to spend less than they earn – inventories growing unexpectedlyemployers slow down production/salesincomes fall - Question: suppose current expected income is 100 bill. On basis of this income, consumers plan 70 bill in consumption and firms plan 20 bill in investment. The MPC is .75. Is the economy currently in equilibrium? No. Aggregate Demand - First, remove micro supply and demand from your mind; aggregate demand is very different. - The aggregate demand curve shows relationship between the aggregate price level and the quantity of aggregate output demanded by households, businesses, the government, and the rest of the world. - AD will tell us the relationship between the price level P and the rest of the economy o Y = C + I + G + NX - Not true that lower prices mean buy more stuff. - AD Curve downward-sloping for 2 reasons: - First: Wealth effect of a change in the aggregate price level – higher aggregate price level reduces the purchasing power of households’ wealth and reduces customer spending. o If you have money, a fall in the price level is an increase in purchasing power; a rise in wealth (can buy more stuff w/money). o If wealth rises, you will consume more: shift upward of Planned Aggregate Expenditure (AE), and shift down along Aggregate Demand. - Second: interest rate effect of a change in aggregate the price level. o If prices rise, you will need more money to carry out transactions – income is lower and you will save less! o Less savings is an inward shift of supply of loanable funds o Higher interest rate, lower investment; lower equilibrium GDP - One of the first things that happened in Great Depression was fall of price level: households should have invested more (lower interest, etc.) o If only move down the Aggregate Demand Curve, then only thing changed is the price level. - Question: suppose that the price level rises, increasing interest rates and decreasing planned investment. This leads to: Upward shift of AE, upward movement along AD. o Move to a higher price level, lower output – upward movement along AD. - Downward Slope o Wealth Effect: Higher P means lower Wealth, lower C AE shifts down Lower equilibrium output; equilibrium Y is smaller Higher P, Lower Y: Downward slope. o Income Effect: Higher P means less C, but also less S Inward shift of supply of loanable funds. Higher interest rates Lower investments lower AE, lower equilibrium Y Higher P, Lower Y: Downward Slope o These two curves are very closely connected. - An upward shift of AE from something besides price level will corresponds with upward shift of Aggregate Demand. The Aggregate Demand Curve - A change in price level: shift along the AD curve - If something else besides P(rice) shifts the AE curve, there is a shift of AD curve. o AD is drawn holding constant all stuff that is held constant when drawing AE, except the price level - Aggregate demand curve shifts because of: o Changes in expectations o Wealth o Stock of physical capital o Government policies - Rightward shift: Increase in aggregate demand - Leftwards shift: Decrease in aggregate demand Aggregate Supply - Aggregate supply curve shows relationship between aggregate price level and the quantity of aggregate output in the economy (don’t think about micro supply!) o AS something like total possible production (like production function) - In long run, total possible production doesn’t depend on prices. o Depends only on physical capital, human capital, technology - In short run, however, prices may affect how much production is possible. - Story; wages are different from other prices (bargained between workers and firms) o Wages are sticky. - Short-run aggregate supply curve is an upward-sloping because nominal wages are sticky in the short run: o Higher aggregate price level leads to higher profits and increased aggregate output in the short run. o Revenue rises, but wages do not. - Nominal wags is the dollar amount of the wage paid. - Sticky wages are nominal wages that are slow to fall even in the face of high unemployment and slow to fall even in face of labor shortages - What shifts SRAS? – anything that affects profitability o Changes in commodity prices, nominal wages, productivity o Leftward shift: decrease in short-run aggregate supply; negative shock o Rightward shift: increase in SRAS; positive shock - Factors that shift SRAS - The long-run aggregate supply curve shows relationship between the aggregate price level and the quantity of aggregate output supplied that would exist if all prices, including nominal wages, were fully flexible (i.e. no sticky wages) o This is the maximum potential output our economy could achieve o Fall in aggregate price level leaves the quantity of aggregate output supplied unchanged in the long run. o Potential output, Yp, probably unattainable in real life. - Growth is LRAS Curve shifting rightward. - The AS-AD model uses the AS and AD curve together to analyze economic fluctuations. Short-Run Macroeconomic equilibrium - Economy is in short-run macroeconomic equilibrium when the quantity of aggregate output supplied equal to quantity demanded. o Also short-run equilibrium aggregate price level and short-run equilibrium aggregate output (pretty self-explanatory) Shifts of Aggregate Demand: Short-run effects o Recovery would be opposite reaction to fall in price level. Shifts of Aggregate Supply - Positive supply shock could be technological improvement. - This is how we will understand recessions + cycles and stuff – just look at which curve is affected/shifted - Question: suppose that because of lowered profit expectations, the SRAS curve shifts inwards. Then, (output will fall in the short run). Long-Run Macroeconomic Equilibrium - Economy is in long-run Macroeconomic equilibrium when the point of short-run macroeconomic equilibriums is on the long-run aggregate supply curve. - Long run says aggregate output fluctuates around potential output, rarely getting too far from it. 11/12 Lecture The lowdown hoedown Chapter 9: Long Run Growth - Labor productivity, Physical capital, Human capital, Technology - Production function, growth accounting - Diminishing returns (to capital) - Institution, Convergence Chapter 10: Savings and Investment - Translating the accounting Identity to the Savings-Investment Identity o Public and private savings o Capital inflows and outflows - Demand for Loanable Funds by Firms - Supply of Loanable Funds by Savers - Equilibrium in the market for Loanable Funds - Financial Markets o Assets o Efficient Market Hypothesis Chapter 11: Income and Expenditure - Marginal Propensity to Consume - Consumption Function - Planned and Unplanned Investment - Planned Aggregate Expenditure - Keynesian Cross: Equilibrium Output Chapter 12: Aggregate Demand and Supply - Aggregate Demand and the Keynesian Cross o Slope of the AD curve - Short Run Aggregate Supply and stick wages o Slop of the SRAS Curve - Short Run Macroeconomic Equilibrium - Shape of the LRAS Curve - Adjustment to Long Run Equilibrium Downward Slope + review - Wealth effect and income effect. - If anything other than price changes, then would be outward shift of aggregate demand. o AD drawn holding constant all things held constant when drawing AE except price level. - Aggregate supply: in long run, total possible production doesn’t depend on prices, only on physical capital, human capital, technology. o In short run, however, prices may affect how much production done. - SRAS is upward-sloping because nominal wages are sticky in the short run. o Higher aggregate price level leads to high profits and increase aggregate output in the short run. o Revenue rises, but wages don’t. - Wages may be raised above the equilibrium as an incentive/motivation for workers. o May be one of the explanations for sticky wages - Actual aggregate output fluctuates around potential output - Initial negative demand shock: Reduced aggregate price level and aggregate output and leads to higher unemployment in the short run (difference between real GDP is the recessionary gap). o In the short-run, wages are stuck at previous price level. In long- run, will fall and at the new price level. o Eventually nominal wages will fall in long run, increases SRAS, and moves economy back to potential output. Gap Recap - Recessionary gap: when aggregate output is below potential output - Inflationary gap: when aggregate output is above potential output - Output gap: percentage difference between actual aggregate output and potential output. Actual aggregateoutput−Potentialoutput o Outputgap= x100 Potentialoutput - Question: suppose economy is currently in short run equilibrium at an output above potential. In the long run, wages are artificially low wages will rise shift SRAS, upward along the AD curve, decreasing output and raising prices. - Economy is self-correcting when shocks to aggregate demand affect aggregate output in the short run, but not in the long run. o Meaning that economy will eventually return to potential output Nominal wages will adjust During boom, they will rise, shifting AS in During recession, they will fall, shifting AS out o In this economy, there is no need for government policy/intervention. End of Exam 2 Material Macroeconomic Policy - Economy is self-correcting in the long run, but could take a decade or longer! o Can’t wait for the long run – need to do in the short run -
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