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Chapter 7 Study Guide

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by: Nolan Shapiro

Chapter 7 Study Guide ECON 2

Nolan Shapiro
GPA 3.6

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I am a DRC accommodated note taker and these are the notes that I provide to the DRC. I have also included a summarization of notes from the book readings. This is a complete study set for Chapter 7.
Intro to Macroeconomic
Aaron Meininger
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This 4 page Study Guide was uploaded by Nolan Shapiro on Monday November 2, 2015. The Study Guide belongs to ECON 2 at University of California - Santa Cruz taught by Aaron Meininger in Fall 2015. Since its upload, it has received 54 views. For similar materials see Intro to Macroeconomic in Economcs at University of California - Santa Cruz.


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Date Created: 11/02/15
Lecture Notes: Catch Up growth: Poor countries tend to grow faster, or "catch up," to rich countries as  they adopt the production and technologies of the richest countries. B/c diminishing  marginal utility ­> first few machines will make a much larger than 2001st and 2002nd  machines Sustained growth: Some countries experience positive and relatively steady growth rates over 50,100, and 200 year periods. Developed countries A nation can increase its GDP by: 1. Increasing its stock of physical capital K 2. Increasing the total efficiency units of labor, H 3. Improving its technology, A Consider a simply economy where there is no government nor exports nor imports, so  that G=X=M=0. Y= C+I for expenditure side Income side­ Y=C+S (S=savings) Ultimately I=S Consumers save money in banks. Banks lend our saved money to businesses to invest  in the machines and new facilities What determines aggregate saving, S? Individual households decide how much of their income and how much they save.  Consumption brings instant happiness while savings brings delayed. The individual consumption­saving decision is ultimately an optimization problem where  the relevant price is the interest rate. The sum of these individual decisions determine  the saving rate of the economy: Saving rate= total saving/ GDP Physical capital accumulation by itself cannot generate sustained growth due to the  diminishing marginal product of physical capital. Why? More and more capital will  generate smaller and smaller increases in GDP. Therefore a constant or sustained  growth cannot be achieved. Similarly, population growth and education by themselves cannot generate sustained  growth due to the diminishing marginal product of labor and diminishing marginal  product of skills Why? More and more labor will generate smaller and smaller increases in GDP.  Therefore, a constant or sustained growth rate cannot be achieved Technological change The process in which new technologies and new goods and services are invented,  introduced, and used in the economy. Such change can generate sustained growth Technological change is more than a constant increase, such as 10 more units. Rather,  it is exponential in that the rate of increase is approximately constant, such as 10%. Why? New innovations and technologies build on the existing stock of knowledge­­  "building on the shoulders of giants"­­ and thus are not subject to diminishing returns. The economic history of the world can be broken into: Pre modern times­ up t0 1800 Industrial revolution­ 1800­1820 Post industrial revolution­ 1820 to present Thomas Malthus, writing in 1798, argues that humankind was destined to live at the  subsistence level­­ the minimum level of income 7A The Solow Growth Model Key Ideas] 1. There are three building blocks of the Solow growth model 2. The Solow growth model can be solved for a steady­state equilibrium 3. IN the Solow growth model, increases in the saving rate, human capital, and tech increase the level of real GDP 4. In the Solow growth model, the steady­state equilibrium is dynamic 5. In the Solow growth model, sustained economic growth can be achieved only  with increases in tech 6. The compound growth formula is used to calculate average annual growth rates Three building blocks 1. The aggregate production­ the first block of the Solow growth model 2. An equation for physical accumulation 1. Know= K last year ­ K depreciated + I (new investment) 2. Where K is the stock of capital, and I is the flow of new investment 3. Assuming a constant depreciation rate, the physical capital accumulation  becomes: 1. K now= K last year ­(Depreciation rate x K last year + Investment) 2. K now= (1­d) x K last year + I b. I= s (savings rate) x GDP= x A x F (K, H) Total output Y is divided between C and I: Steady State equilibrium An economic equilibrium in which the physical capital stock remains constant over time: K now= K last year= K A steady­state equilibrium occurs when new investment is equal to depreciation: I= depreciation S x Y= d x K S x A x K (K, L) = d x K An increase in either the saving rate, s, or the stock of human capital, h, will increase the output of GDP A dynamic equilibrium traces the behavior of the economy over time. Suppose the  economy begins with a physical capital stock of K0<K* K*=quantity at equilibrium Increase in the saving rate, s, is not a source of sustained growth in GDP. Why?  Increases in saving shift the investment curve up and thus provide an increase in the  level of GDP Technological process is a source of sustained growth in GDP. Why? An increase in tech, a, raises productivity, thus allowing physical and human  capital to produce more output. Another prediction of the Solow growth model is that the ration of the physical capital  stock to GDP should be constant through time: At steady state, investment=depreciation Catch­up growth is driven by the accumulation of physical and human capital. Catch­up  growth leads to increases in the level of real GDP. Although it can dramatically raise the  level of GDP, catch­up growth is not a source of sustained growth in real GDP. Compound growth is the phenomenon whereby growth builds on growth. R= P(1+r)^t Book Notes: 7.1 The Power of Economic Growth  Economic growth, or growth, is the increase in GDP per capita of an economy  The growth rate is the change in quantity, for example, GDP per capita, between  two dates, relative to the baseline (beginning of period) quantity ­> new­old/old  Exponential growth refers to a situation in which the growth process can be  described by an approximately constant growth rate of a variable such as GDP or GDP per capita  Exponential growth results because new growth builds on past growth and its  effect compound  Ex.: Two countries start with the same level of GDP per capita in 1810 at 1,000.  One country has a 1% growth rate while the other has a 2%. At first, the  differences seem small. Over 200 years, the 1% rate gets to a GDP of 7,316  while the 2% gets to $52,485. This is more than a seven­fold difference.  Catch­up growth refers to a growth process whereby relatively poorer nations  increase their incomes by taking advantage of knowledge and technologies  already invented in other, technologically more advanced countries o Usually done by benefiting from available technologies, but also by  increasing their saving, efficiency units of labor, and efficiency of  production  Sustained growth refers to a growth process where GDP per capita grows at a  positive and relatively steady rate for long periods of time 7.2 How does a Nation’s Economy Grow?  A nation can increase its GDP by: o Increasing its stock of physical capital o Increasing the total efficiency units of labor o Improving its technology  All resources households decide to save will be allocated to firms that will use  them for investment  Saving is a way of allocating some of today’s resources for consumption  tomorrow  Interest rate­ rate of return that households expect on their savings o Higher interest rate= more saving, lower= more consumption  The saving rate designates the fraction of income that is saved o Saving rate= total saving/ GDP  Because of diminishing marginal product of physical capital, more and more  physical capital will translate into smaller and smaller increases in GDP  Holding all factors of production and tech constant, every additional worker will  increase GDP by less and less b/c diminishing marginal product  If we increase the efficiency units of labor for a given work force, there will not be  sustained growth b/c each worker has a finite life  Technology is the only component that can sustain GDP growth  Technological change is the process of new technologies and new goods and  services being invented, introduced, and used in the economy, enabling the  economy to achieve higher levels of GDP for given levels of physical capital  stock and total efficiency units of labor o Technological change is exponential  Improvements in technology need not necessarily run into diminishing marginal  product ­> most plausible engine for sustained growth 7.3 The History of Growth and Technology  The subsistence level is the minimum level of income per person that is generally necessary for the individual to obtain enough calories, shelter, and clothing to  survive  2 reasons for lack of sustained growth before 1800 o Before 1800 technological growth was almost stagnant compared to  today o Whatever improvements in aggregate incomes were realized did not  typically translate into increases in income per capita  Fertility refers to the number of children per adult or per woman of childbearing  age  Malthusian cycle refers to the preindustrial pattern in which increases in  aggregate income lead to an expanding population, which in turn reduces income per capita and puts downward pressure on population  Industrial Revolution is the term describing the series of innovations and their  implementation in the production process that started to take place at the end of  the eighteenth century in Britain 7.4 Growths, Inequality, and Poverty  Even though this association does not prove that growth in income per capita is  the direct cause of declining poverty, it is the type of evidence that bolsters many  economists’ belief that economic growth is one of the most effective ways of  reducing poverty


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