Intermediate Macroeconomics Study Guide for Exam #2
Intermediate Macroeconomics Study Guide for Exam #2 ECON 3020
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This 13 page Study Guide was uploaded by Zachary Hill on Sunday March 13, 2016. The Study Guide belongs to ECON 3020 at Tulane University taught by Antonio Bojanic in Fall 2015. Since its upload, it has received 122 views. For similar materials see Intermediate Macroeconomics in Economcs at Tulane University.
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Date Created: 03/13/16
Intermediate Macroeconomics Study Guide #2 Net Capital Outflows and Trade Balance ● SP= Y − T − C and G = T − G, so S = Y − C − G ● Y = C + I + G + NX , so S = C + I + G + NX − C − G = I + NX ● S = I + NX is useofsavings ident shows that savings are either used for investments in capital stock or acquiring foreign assets ● S − I = NX is etcapitaloutflow ide shows the net capital outflows/inflows = trade balance ○ If S > I , an economy experiences net capital outflows (net foreign assets held are increasing) ○ If S < I , an economy experiences net capital inflows (net foreign assets held are decreasing) ● NX = X − M ○ If X > M , an economy experiences a trade surplus, net capital outflows, and an increase in wealth ○ If X < M , an economy experiences a trade deficit, net capital inflows, and a decrease in wealth ● While this establishes that increased savings can cause increased wealth, it is not the only cause, and this may not always occur, depending on other variables The Closed Economy Assumptions: ● The level of production, Y , is based on the factors available, K and L ● Assume goods market equilibrium ● NX = 0 ● Then Y = C + I + G Analyzation: ● Since Y = C + I + G, Y − C − G = I or S = I ● C = C + C(Y − T, r) where C is the autonomous consumption expenditures and C(Y − T, r) is the function for consumption, C , dependent upon disposable income, Y − T , and the real interest rate, r; there is a positive relationship with Y − T and a negative one with r ● G = G where G is given and constant ● T = T where T is given and constant ● Y = F(K, L) where Y , K , and L are given and constant ● Then S = Y − C − G = Y − C − C(Y − T, r) − G ; this establishes a direct relationship between S and r; as r increases, S increases due to a decrease in consumption ● I = I + I(r) where I is autonomous investment and I(r) is the function for investment dependent upon r; there is a negative relationship with r ● This establishes a direct negative relationship between I and r ● Then desired S and desired I can be graphically represented as follows: ● ○ At 1 Desired I > Desired S; investors/borrowers will pay higher interest rates to incentivize savers/lenders to save more ○ At 2 Desired I < Desired S; savers/lenders will accept lower interest rates to incentivize investors/borrowers to borrow more ● Changes in C , T , and G shift the S curve ○ ○ (1) (an increase in the S curve) occurs when C ↓ (consumers are pessimistic about the future), G ↓, or T ↑ ○ (2) (a decrease in the S curve) occurs when C ↑ (consumers are optimistic about the future), G ↑, or T ↓ ○ Note: when T ↑, SG increases at a onetoone ratio, butPS decreases at a less than onetoone ratio, so the S curve increases; when T decreases, the economy follows the same pattern, and the S curve decreases ● S = The Government Budget; if the deficit grows, either T ↓ or G ↑; if the deficit shrinks G or becomes a surplus, either T ↑ or G ↓ ● Changes in I shift the I curve ○ ○ (1) (a decrease in the I curve) occurs when I ↓ (businesses are pessimistic about the future) ○ (2) (an increase in the I curve) occurs when I ↑ (businesses are optimistic about the future) Small Open Economies Assumptions: ● Perfect mobility ● r = r where r is the domestic real interest rate and r is the world real interest rate ● Assume goods market equilibrium occurs ● NX is part of Y once again, so Y = C + I + G + NX ● The useofsavings ident(S = I + NX ) and tetcapitaloutflows iden(S − I = NX ) are applicable Analyzation: ● What happens in the small open economy does not have much impact of the world economy ● ○ In an economy with 1 , equilibrium occurs at points A and B; this economy experiences net capital inflows and a decrease in wealth ○ In an economy with 2 , equilibrium occurs at points C and D; this economy experiences net capital outflows and an increase in wealth ● Causes of changes in r ○ The world economy can be thought of as a huge closed economy ○ Then if C ↑, G ↑, I ↑ , or T ↓ , then r increases; if C ↓, G ↓, I ↓, or w w T ↑, then r decreases Large Open Economies w ● Large open economies impact r ● In most other matters, large open economies resemble small open economies w w ● Imagine the world is a huge closed economy; Desired S = Desired I ● Divide this into two parts where one part is a large open economy and the other part is the rest of the world’s economies ○ if the large open economy experiences net capital outflows, it will equal the net capital inflows of the other economies at equilibrium ○ if the large open economy experiences net capital inflows, it will equal the net capital outflows of the other economies at equilibrium ○ ● If the large open economy experiences a shift in either the S curve or the I curve, then the r will change so that at the new curves NX = NX where NX is the net exports of the rest of the world and NX is the net exports of the large open economy Money ● Money is: ○ a medium of exchange (something that can be used as a method of payment) ○ a unit of account (a common value utilized to express the value of traded goods and services) ○ a store of value (an expression of wealth; many other assets can serve this purpose, but money is the most liquid) ● Moneyless/barter economies are inefficient, requiring a double coincidence of wants and exchange rates that vary from case to case ● The Federal Reserve System (the Fed) is the US central bank ○ Board of Governors (7 members) are in charge and led by the Chairman ○ There are 12 branches, each headed by a president ○ The Federal Open Market Committee (FOMC) carries out open market operations; 12 members: the 7 governors, the president of the NY branch, and 4 other branch presidents whom are on a rotating schedule ○ How the Fed defines money ■ All values in billions ■ M1 = currency $871.6 + traveler’s checks 5.0 + demand deposits 445.6 + other checking deposits 390.0 Total M1 = $1,712.2 ■ M2 = M1 $1,712.2 + smalldenomination time deposits 1,105.0 + savings deposits and money market 4,935.1 deposit accounts + money market mutual funds shares 759.8 Total M2 = $8,512.1 ■ Note: these values or components do not need to be memorized, just the purposes of M1 and M2 ■ We usually refer to M1 when we talk about money ○ The Fed wants to target interest rates, not monetary aggregates; with new tech, new money, and foreign moneys, the Fed cannot control the quantity of money in the US The Quantity Theory of Money ● Proposed by classical economists, this claims inflation can only be explained by increases in the money supply ● Classicals viewed the economy in the longrun, so they say an economy’s output is fairly stable and a result of just the production function and the factors of production ● Irving Fisher, a classical in the 1920s, tried to explain the relationship between the quantity of money in an economy and totalist spending in the economy ○ He stated the link is given by something he called velocity, V , which is the number of times the average dollar changed hands ○ V = PMY, where P ∙ Y is the nominal GDP and M is the quantity of money ○ So MV = PY ; this is the equation of exchange ○ The assumptions for the quantity theory of money ■ Fisher thought V does not change much in the short run so one can assume V is constant, or V ■ the classical dichotomy: the belief that in the long run, Y will remain fairly constant around some level, Y ○ Then MV = PY ; this is the quantity theory of money, showing M and the nominal GDP are positively related through the price level ○ Then P = MV , where the price level is only affected by a change M and a change Y in the quantity of money does not affect the level of production in the long run ○ Then the Fed controls inflation through open market operations ● Quantity theory of inflation ○ MV = PY %ΔM + %ΔV = %ΔP + %ΔY , because V is constant %ΔV = 0 %ΔP = %ΔM − %ΔY π = %ΔM − %ΔY where π is inflation; this is the quantity theory of inflation ● The Demand for Real Money Balances MV PY ○ Dividing each side of the quantity theory of money by V givVs = V , or d 1 d M = PV where M is the demand for money d ○ Because V is constant, we replaceV with the constant k , so M = kPY ○ Then divide by P , so d= kY ; this is the demand for real money balances P ● the classicals theories hold up in the long run ● the yearbyyear analysis shows no apparent correlation, however, showing that the theories are not applicable to the short run ● Hyperinflation ○ If the classicals are right then we should keep the money supply fairly stable ○ Hyperinflation occurs when monthly inflation rates are 50% or more ○ This happens when fiscal imbalances prompt countries to print excessive amounts of money to solve the shortrun problems, causing hyperinflation in the long run; fiscal imbalances occur if there is a consistently increasing deficit Inflation and Interest Rates e ● Fisher equation: i = r + π , where i is the nominal interest rate, r is the real interest rate, and π is the expected inflation ● If the classical dichotomy holds, then r will be unaffected by π ; then i has a positive onetoone relationship to π in the long run, but this does not hold in the short run ● Costs of inflation ○ when inflation is perfectly anticipated ■ shoe leather costs: when inflation is high enough, people’s wages and money are decreasing in purchasing power so they must constantly put their assets into something that will not decrease with inflation ■ menu costs: when prices of goods have to be constantly adjusted for inflation, the retraining of employees, reprogramming of data bases, etc. costs businesses ■ tax distortions: with inflation, phantom gains occur because inflation increases the nominal price of assets, which one must pay capital gains tax on, but the real price does not change ■ increased variability: different companies change prices at different times and different prices across the market occur which costs the consumers that pay the higher prices or take the time to find the lowest prices ■ loss in the meaning of the unit account function of money: with inflation comes changes in price; it can become confusing as to when the real price of items decreases ○ cost of unanticipated inflation ■ all of the anticipated inflation costs occur ■ if the inflation is higher than expected, then borrowers are favored and there are more costs for lenders; if the inflation is lower than expected, then lenders are favored and there are more costs for borrowers The Solow Growth Model ● The Solow Growth Model intends to explain why different economies have different growth rates 0.3 0.7 ● We know in the US Y = F(K, L) = AK L ● Then g =Yg + 0A3g + 0.7K , wherL the growth rate of any value, x, is the change in x divided by x, g = x Δx; this is called the growth accounting function x ● Diminishing marginal returns on g and gK is shownLthrough their coefficients; g is not A subject to diminishing marginal returns, as shown by the lack of a coefficient, because A causes a shift in the production function, not a movement along it like K and L do ● Remember that MP = 0.3Y and MP = 0.7Y K K L L 0.3 0.7 ● Than from Y = AK L , ΔY = ∂Y ∙ ΔA + ∂Y ∙ ΔK + ∂Y ∙ ΔL = K L0.3 0.7∙ ΔA + MP ∙ ΔK + MP ∙ ΔL ∂A ∂K ∂L K L 0.3 0.7 =AK A ∙ ΔA + 0K3Y∙ ΔK + 0L7Y∙ ΔL = A ∙ ΔA + 0K3Y∙ ΔK + 0L7Y∙ ΔL 1 ΔY ΔA ΔK ΔL ● When you divide each side by , Y Y = A + 0.3 K + 0.7 L , or gY= g +A0.3g + 0K7g L 0.3 0.7 ● A, the total factor productivity, is difficult to measure g ; weAcan rearrange Y = AK L Y Yt to A = K L3 0.7to specify, we will notate this as A = t K0.L0.7 where t is some time; A is t t t called the Solow Residual and has the greatest impact on g Y ● The Solow Growth Model attempts to explain what allows K per worker to grow over time; assume L is fixed over a period of time ● Because we are working with per worker values, Y = Y t, C = Ct, i = It, and K = Kt; t Lt t Lt t Lt t Lt Y 0.3 0.7 0.3 0.3 then Y =t t = AK L = AK0.3= AK t Lt L L ● ● Assume we are working with a closed economy with no government, then Y = C + i t t t ● Solow assumed households would save a fixed fraction of their disposable income, so Y t C = tY whert S is the savings rate ● Then i = SY , which we know to be true in a closed economy, so i = SAK 0.3; this t t t t establishes a relationship between investment per worker and capital per worker ● Solow assumed depreciation would be a constant fraction of the existing capital stock; depreciation = dK t ● ● ΔK = i − dK = SAK 0.3− dK ; this is the capital accumulation equation t t t t t ● At point S, capital stock stays the same; referred to as the steady state, where 0.3 SAK t = dK t ● If a country is operating at K , then i > dK , so capital stock is increasing until it reaches 1 t t the steady state; if a country is operating at K , then i <2dK , so catital stock is decreasing until it reaches the steady state ● So all economies will tend toward the steady state in the long run ● Since Y = t + i t thtn C = Y − t = Y t SYt= Y (t − S)t t ● ● So when K goe1 to K , Y and C itcrease; wten K goes to K , Y a2d C * t t decrease ● ● If a country decides to save more, the savings rate, S, increases, raising investment ● Then i >tdK , st there is capital accumulation; this grows the economy to the new * steady state, S ′, with a new capital labor ratio K 1 ● The Solow Growth Model suggests richer countries tend to save more simply because they’re richer, not that they’re richer because they save more ● We need to expand our model to include population growth ● Assume changes in population have a onetoone relationship with changes in the labor force 0.3 0.7 ● Because Y = AK L , if L ↑, then Y ↑ ● Assume the labor force grows at 1% per year; if the capital stock does not grow, a country will experience capital dilution (the decrease of K ); represented by nK t t 0.3 ● The capital accumulation equation becomes ΔK = SAK t t − (d + n)K t ● 0.3 ● Then the steady state now occurs where SAK t = (d + n)K t ● For the economy to remain at S, K must increase at a rate equal to the growth of L K (because K = t L ) Y ● Because Y = t L , and the same level of Y occtrs over time at S, Y must be growing at the same rate as L ● Then a country continues to experience economic growth at its steady state, but Y t remains constant according to the Solow Growth Model ● If the growth rate increases from n to n 1 then 2d + n)K becomes tteeper and 0.3 (d + n)K t SAK t , so the steady state must move left to S ′ due to a reduction in capital accumulation ● ● Then when there are population growth rates, K ↓ and Y ↓ ;tthis is a htghly debated part of the Solow Growth Model because it can be argued that higher Y is a cause of t low population growth rates, not the other way around ● ● Assume A ↑; then i ↑ andtK ↑; the intrease in A has a magnified impact on income per worker because it increases Y as well t
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