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Econ 102 Week 2 Notes

by: Andrea Lans

Econ 102 Week 2 Notes Econ 102

Andrea Lans

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These notes cover chapters 3 and 4 of Macroeconomic Theory.
Macroeconomic Theory
Class Notes
Economics, Macroeconomics
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This 5 page Class Notes was uploaded by Andrea Lans on Sunday October 9, 2016. The Class Notes belongs to Econ 102 at University of California - Los Angeles taught by Keskinel in Fall 2016. Since its upload, it has received 63 views. For similar materials see Macroeconomic Theory in Economics at University of California - Los Angeles.


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Date Created: 10/09/16
Chapter 3: National Income Classical Model - Classical model: prices & wages flexible; markets clear rapidly - Factors of production: K (capital), L (labor) • Production function: Y = F (K,L) (Y, K, L fixed unless stated) - Reflects level of tech, constant returns to scale (double input, double output) - Returns to scale: constant, increasing (Y2 > zY1), decreasing (Y2 < zY1) - Factor prices: price/unit firms pay for factors of production (wage & rental rate) • Real wage = W/P P = price of output • Real rental rate = R/P - Marginal product of labor (MPL): extra output firm can produce using additional unit of labor; slope of production function • MPL = W/P = real wage; hire labor at this point • As L ↑ MPL ↓ and vice versa — 1350 in EU Black Death • Diminishing marginal returns: as 1 output ↑, MP ↓ - Marginal Product of Capital (MPK): demand curve for renting capital Rental rate: MPK = R/P • Neoclassical Theory of Distribution - Neoclassical Theory: Each factor input is paid its marginal product • Goods/labor markets perfectly competitive (price takers) • All labor is identical • Firms are profit maximizing • Optimum demand for labor: π = PY - WL - RK (R = rental rate) - National income = labor income + capital income (constant returns to scale) • Y = (MPL x L) + (MPK x K) • Total output (total income) = payment to L + payment to K Cobb-Douglas Production Function - Y = AK L 1-a • capital income = MPK x K = aY MPK = aY/K • labor income = MPL x L = (1-a)Y • (1 - a) = labor income share Demand for Goods & Services ( Y = C + I + G) - Consumption: C = C (Y-T) • Disposable income: income after tax = Y - T (+ Transfer Payments) • Marginal propensity to consume (MPC): ΔC when disposable income ↑ $1; slope of C (ΔC / ΔDI) - Investment: I = I (r) Ex: I = 1200 - 100r • • Real interest rate (r): cost of borrowing, opportunity cost of using one’s own funds to finance investment • I inversely related to r; more expensive to borrow if r high - Loanable funds market: supply-demand model of financial system Demand (investment), supply (saving), price of funds (real interest rate) • • I (r) = demand curve for loanable funds • Private saving (Y - T - C) - Shift savings curve through preferences, tax laws (IRA, 401K, replace income tax w/ C tax) • Public saving (T - G); budget surplus if T > G, deficit if T < G - Gov. finances deficit by issuing Treasury bonds (borrowing) - Shift savings curve through fiscal policy (ΔG or ΔT) • National saving: S - National saving doesn’t depend on r • Private saving + public saving = Y - C - G = S - L.F. market equilibrium: • I = Y - C - G (L.F.) • Y = C + I + G (goods market equil.), no NX, closed economy (Autarky) - Reagan Deficits: early ’80s- ↑ defense spending, big tax cuts • Policies ↓ national saving • Raised real interest rate, ↓ investment - Shifters of investment curve: technological innovations (buy new goods), tax laws that affect investment • ↑ I ↑ r, which ↑ saving & ↑ supply of loanable funds - ↑ r ↑ saving, makes borrowing more expensive, can ↓ saving through income effect Chapter 4: The Monetary System Money - Money: stock of assets that can be readily used to make transactions - Functions: • Medium of exchange • Store of value • Unit of account - Type: • Fiat money: no intrinsic value (paper currency) • Commodity money: has intrinsic value (gold coins) - Money supply: quantity of money available in economy • M1: Currency, demand deposits, travelers’ checks, checkable deposits • M2: M1 + small time deposits, savings deposits, money market mutual funds (MMMFs), money market deposit accounts • M = C + D Banks - Monetary policy: control over the money supply - Central bank: conducts monetary policy • Federal Reserve: U.S. central bank • Open market operations: Fed uses these to control $ supply through purchase/sale of government bonds - Reserves (R): portion of deposits that banks haven’t lent Liabilities- deposits, capital, debt • • Assets- reserves, loans, securities - 100% reserve banking: system in which banks hold all deposits as reserves • No impact on $ supply • Fractional reserve banking: banks hold fraction of deposits as reserves - Banks create money through loans; new $ & new debt - Bank capital: resources bank owners have put into bank (liability) - Leverage: use of borrowed $ to supplement existing funds for investment • Leverage ratio = assets / capital • Makes banks vulnerable - Capital requirement: minimum capital mandated to ensure banks will be able to pay off depositors; higher for banks w/more risky assets 2008 financial crisis: losses on mortgages shrunk bank capital & slowed lending; gov’t • injected $ to encourage more lending Model of Money Supply - Exogenous variables (given) Monetary base: B = C + R controlled by central bank • • Reserve-deposit ratio: rr = R / D regulations & bank policies • Currency-deposit ratio: cr = C / D household preferences • M = m x B - m = (cr + 1) / (cr + rr) - Money multiplier (m): ↑ in $ supply resulting from $1 ↑ in monetary base • If rr < 1; m > 1 Monetary Policy - Fed can change monetary base using: 1. Open Market Operations: Fed buy gov’t bonds using new dollars 2. Discount rate: interest rate Fed charges on loans to banks Lower discount rate, banks borrow more reserves, ↑ base • - Fed can change reserve-ratio using: 3. Reserve requirements: minimum reserve-deposit ration • Fed ↓ reserve requirements to ↓ ratio 4. Interest on reserves: Fed pays interest on bank reserves deposited w/ Fed • Fed pays lower interest rate on reserves to ↓ ratio - Fed can’t precisely control M due to household Δcr & banks holding excess reserves (Δrr, Δm, ΔM) Quantitative Easing - Fed bought long-term gov’t bonds instead of T-bills to ↓ long-term rates - Fed bought mortgage-backed securities to help housing market - After losses on bad loans, banks tightened lending standards & increased excess reserves, m fell - If banks lend more as economy recovers, rapid $ growth causes inflation; “exit strategies” to prevent this •


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