TRANS EAST EUROPE
TRANS EAST EUROPE ECON 161
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Allowing for non trivial investment decisions Olivier Blanchard April 2002 14452 Spring 2002 Topic 4 14452 Spring 2002 2 In the benchmark model and the RBC extension there was a clear consumptionsaving decision But there was no investment decision More speci cally c From the point of view of rms there was a demand for capital capital services every period ZtFKt Ni rt 6 The demand for capital was such as to equal to the marginal product of capital to the interest rate plus the discount rate From the point of view of the economy general equilibrium the cap ital stock at t was given from past decisions and so the same equation determined the equilibrium oneperiod interest rate at t In other words the interest rate was always equal to the marginal product of capital In fact the interest rate appears often to differ from the marginal product of capital And the way to explain this is to take into account the fact that rms face costs of adjusting their capital This is very much worth exploring By introducing adjustment costs we shall see that c We can think of the economy as having well de ned consumption and investment demands which depend on current and expected future interest rates pro t wages o In this economy the term structure of interest rates as the set of intertemporal prices which clears the goods market investment plus consumption equal production now and in the future 14452 Spring 2002 5 You can think of this extension as providing a dynamic forward looking version of the IS relation in which aggregate demand depends on current and expected income and interest rates 1 The optimization problem Consider the following modi cation of the benchmark optimization problem ie leaving aside the laborleisure choice 0 maxE Z lUleM t 0 subject to Cti GKti7 Nti71ti7 Zti Nti E 1 Kti1 1 6Kti Iti The change from the benchmark is the presence of a net output func tion which gives the amount of net output given inputs Kt and Ni and investment It So GK gt 0 GN gt 0GI lt 71 Until now we assumed that GHQ Nt7It7 Zt E ZtFKt7 Nt It Net output was simply equal to output minus what was put aside as investment There was no additional cost involved in investing It It is reasonable however to think that rms face costs of adjustment For example once capital is in place it may be very dif cult and costly to remove irreversibility On the other side a high rate of investment may come with t t39 J39 t t and39 t 39 costs Think of building a plant in a month or in a year 14452 Spring 2002 4 A simple way of capturing this is I Gun max 2 ZFKNt 7 Ml f with increasing in IK o This can capture irreversibility For example f 0 for I gt 0 f 71 if I lt 0 0 An easier formulation is to assume that f is linear I GHQ Nun E 2mm Ni 7 M1 1 This is what I shall use below Why make the cost of installation per unit a function of the ratio of investment to capital To maintain constant returns to scale If F itself has CRS then Alt GKt ANt Alt Zt ZtFOth ANt7AIt1aW AGUQ NtJt Zt t 2 The optimization problem for an open economy We could solve for the optimization problem above No particular problem in doing so See in continuous time and no uncertainty Abel Blanchard Econometrica 1983 But it is actually more pedagogical to look at the optimization problem for a small open economy BF Section 2 4 in con tinuous time The reasons is that it makes it easier to look at the consumption and investment decisions separately to understand the behavior of the current account and then to get a sense of what the interest rate would have to do in the closed economy 14452 Spring 2002 5 The economy is the same as above7 but can borrow and lend at a given gross rate Rt stochastic or not Let Bt be the net borrowing position of the country in period t The optimization problem is given by CO maxE Z lUleM t 0 subject to Iti Km Bti1 Cti ZtiFKti71 Iti1 a RtiBti Kti1 1 5Kti Iti The economy has two ways of saving for the future capital at home7 and lendingborrowing tofrom the rest of the world 3 The rst order conditions Let the Lagrange multipliers associated with the rst constraint be i iAHi why de ne it as minus because we are looking at the net borrowing posi tion and that associated with the second constraint be i ti Write the Lagrangian and differentiate The rst two equations characterize the behavior of consumption Ct U Ct At Bt1 1 t El Rt1At1 l Qtl o Marginal utility of consumption has to equal the marginal utility of 14452 Spring 2002 wealth The marginal utility of wealth today is equal to the expected mar ginal utility of wealth tomorrow times the rate of return on bonds discounted by the discount factor If for example borrowing and lend ing can be done at a riskless rate R and if 3R 1 a condition needed if the rate is constant to have a stationary state then U Ct ElU Ct1 l 9t The next two equations describe the behavior of investment I It At12af M I 2 Kt1i M 5ElAt1Zt1FKKt171a 1 5M1 thl The marginal cost of investing times in terms of goods times the mar ginal utility of consumption must be equal to the marginal value of a unit of installed capital The marginal value of installed capital is equal to the marginal product of capital next period plus the discounted marginal value of capital next time adjusted for depreciation Note that the marginal product has two terms The direct marginal product and the marginal de crease in installation cost from the fact that more capital decreases installation costs for a given level of investment It is useful to de ne a new variable in QtiAt 14452 Spring 2002 7 Think of qt as the shadow marginal value of capital in place in terms of goods Then we can rewrite the two first order conditions as 1 iml 2a I 2 q EiRH Z1FKK11 a K 11 1 7 5Qt1 9 t where to derive the second relation 1 use the fact that El At1gtth15 M This gives a simple characterization of investment behavior 0 Investment proceeds until the marginal cost of investment is equal to the marginal value of capital in place If for example qt 1 then the optimal rate of investment is zero Why invest if the marginal value of installed capital is just equal to the cost of good being used for investment So the rate of investment is an increasing function of the shadow mar ginal value of capital of marginal q for short Marginal q is in turn equal to the expected present value of the mar ginal product of capital So if expected future marginal products are high then qt will be high today and by implication the investment rate will be high Make sure you can solve the previous equation recursively forward to get marginal q as an expected present value Note that the system composed of the last two equations is not recursive It depends on future marginal products which depend on future capital which itself depends on investment today But we can solve it using the log linearization methods we saw in the notes for topic 2 14452 Spring 2002 8 Combine the last two FOCs and the accumulation equation 1 It ElRt171Zt1FKKt171 EQt1 12 1 5Qt1l l Qt l 1 Kt1 1 6 EQJt 1Kt This gives a system of two equations in qt Kt Which you can solve in the usual fashion log linearize for example To summarize We have derived a relatively simple characterization of consumption and investment behavior 0 Investment depends on marginal q Which depends on current and future marginal products of capital so on current and expected tech nological shocks Note that the investment decision does not depend on the utility function of consumers 0 Consumption depends on current and future income net of investment spending Consumers tilt and smooth in the usual way 4 Consumption investment and the current account in the open economy From the FCC can guess the effects of a favorable shock on consumption investment and the current account A treatment in continuous time With no uncertainty is in Chapter 2 of BF Consider a favorable technological shock 0 At the earlier path of capital marginal q goes up Investment in creases The more permanent the shock the larger the increase 14452 Spring 2002 9 01 0 Consumption goes up as well No tilting effect here as Rt is not affected So anticipations of higher output net of investment spending lead to higher consumption 0 So higher investment higher consumption Higher output as well Initial current account Relation to Jaume Ventura s paper The role of the term structure of rates in the closed econ omy In a closed economy investment plus consumption must equal to output In other words current and future interest rates have to generate a path of consumption and investment such that the goods market clears and is expected to clear Apply this to for example the anticipation of a favorable technological shock in the future 0 At the previous sequence of interest rates both consumption and in vestment go up 0 This cannot be as output is initially unchanged We want initially investment to go up so consumption has to go down 0 What will achieve this A guess High interest rates in the near future to tilt consumption down initially despite the positive wealth effect Low interest rates later on so the anticipation of those low interest rates leads to higher investment today An increase in marginal q in the stock market With an eye to the rest of the course We have constructed a model where there is a well de ned aggregate demand relation and where the term structure of interest rates plays a central role 14452 Spring 2002 10 Suppose that for any reason interest rates do not adjust in this fashion Then aggregate demand may be larger or smaller What happens then If supply accomodates then will get fluctuations from any factor which shifts aggregate demand 6 Marginal and average q and investment We have derived investment as a function of a shadow price marginal q A major insight due to Tobin is that in fact under some conditions marginal q may be equal to average q where average q is the average value of a rm as valued in nancial markets divided by its capital stock Under the assumptions we have made the two q s are indeed equal To see this Think of a rm operating in this economy Its value after pro t this period is given by Vt El Rt1717Tt1 Vt1 l Qtl Assume that the rm rents labor but buys and install capital Let 713 be the cash flow after paying labor and buying and installing capital so 7Tt1 Zt1FKt171 Wt1 It11 a1 t1 We are now going to show that VtKHl qt The timing is a bit awkward But this is the result oftiming conventions where rms decide this period what the capital stock will be next period Also a note on the relation to the problem set Thomas de nes the value before pro t so the relation becomes Vt 7 7nKt1 qt But these all capture the same relation In continuous time the relation reduces to VK 11 14452 Spring 2002 11 I 2 qt EiRHr1ltzt1FKltKth1gt 4511 lt1 7 6mm m t Multiply both sides by Kt17 to get 2 It1 K 1 6Qt1Kt1Qt l t1 tht1 ElRHflthHHKHL 1 Wt1 a From the accumulation equation 1 Kt1 lez It1l From the rst FOC I Qt11t1 1 QaKtll It1 t1 Replacing in the equation for thHl above It1 Kt1 tht1 ElRt1 1Zt1FKt17 1Wt11t11a qt1Kt2l Qtl So 7 Qth1 Vt Replacing in the rst FOC gives a relation between the investment rate and the value of capital in the rm7 as assessed by nancial markets between investment and the stock market7 for short It 1 Vt 71 Kt 2ath1 Note the relation is not causal It is an equilibrium relation7 Which holds 14452 Spring 2002 12 when rms maximize their value Note the assumptions needed to yield equality between marginal and average q o Constant returns in production 0 Competitive goods markets No rents o A correct measure of capital Intangibles High tech rms 0 Correct valuation of rms by nancial markets speculative bubbles How well does it work Decently7 but not more And7 in any case7 even a tight relation would be limited progress A relation between two endogenous variables Evidence lK and q over the last fty years7 using data from Bob Hall Chapter 7 1 Final Lecture Notes Chapter 7 Equilibrium in the FlexiblePrice Model J Bradford DeLong Equilibrium and the Real Interest Rate Under the exibleprice fullemployment classical assumptions GDP and national income Y equal potential output Y Y Y But the determinants of the components of real GDP are various We saw that the exchange rate is a function of a the real interest rate differential between home and abroad and b foreign exchange traders39 opinions 880 8gtltr rf We saw the determinants of consumption spending C CO Cy gtlt1 tgtltY of investment spending 1 10 I X r and of net exports NXnygtltYfXS er Xg x2 XrXg x2 er 1My xY Fourth and last we left the determination of government purchases to the political scientists Chapter 7 2 Final GG These four components add up to aggregate demand or total expenditure written E when we want to emphasize that conceptually at least it is not quite the same as real GDP Y However the circular ow principle guarantees that in equilibrium aggregate demand will add up to real GDP Y CIGNXEY However the determinants of each of the components of total spending E seem to have nothing at all to do with the production function that determines the level of real GDP Y How does aggregate demand add up to potential output Can we be sure that all the output businesses think they can sell when they hire more workers is in fact sold The answer is that in the exibleprice fullemployment classical model of this section the real interest rate r plays the key balancing role in making sure that the economy reaches and stays at equilibrium To understand what makes aggregate demand equal to potential output we need to look at the market in which the interest rate functions as the price the market for loanable funds When you lend money the interest rate is the price you charge and the price the borrower pays Thus we need to look at the ow of loanable funds through the financial markets the places where household savings and other in ows into financial markets are balanced by out ows to firms seeking capital to expand their productive capacity The equilibrium we are looking for is one in which supply equals demand in the financial markets According to the circular ow principle if financial markets are in equilibrium then the sum of all the components of spending is equal to real GDP If supply equals demand in the flowoffunds through financial markets then aggregate supply real GDP Y equal to potential output Y is equal to aggregate demand the sum of all the components of total spending CIGNX To see this begin by assuming that real GDP is equal to potential output Y and that the circular ow principle holds real GDP is equal to aggregate demand YYCIGNX Chapter 7 3 Final Then rewrite this expression by moving everything except for investment spending I over to the lefthand side Y C G NX I Now include taxes T in the lefthand side Y C TT G NXI Note that the righthand side is simply investment the net ow of purchasing power out of the nancial markets as rms raise money to build factories and structures and boost their productive capacity The lefthand side is equal to total savings the ow of purchasing power into financial markets as households the government and foreigners seek to save by committing their money to buy valuable financial assets here at home see Figure 71 Thus we see that whenever the circular ow principle holds the supply and demand in the ow of funds through financial markets balances as well The YCT inside the first set of parentheses are households savings Because national income is equal to potential output Y is just total household income Take income subtract taxes subtract consumption spending and what is left is household savings the ow of purchasing power from households into the financial markets The TG inside the second set of parentheses are just government savings the govemment s budget surplus or government dissaving the govemment s budget deficit if G happens to be larger than T They are the ow of funds from the government into the financial markets Chapter 7 4 Final Minus Net Exports Equals the Capital In ow The Rest Goods imported of the I World Dollars earned by foreigners IM Vollar paid by foreigners for exp ts GX Q Goods exported Excessof dollars earned by foreigners over dollars spent by foreigners on homecountry exports IMGX NX Foreigners savings committed V to us financial markets The only remaining use for these dollars is in financial markets to purchase shares in us companies and us property The last termminus net exports NXis the net ow of purchasing power that foreigners channel into domestic nancial markets If net exports are less than zero foreigners have some dollars left over They then have to do something with these extra dollars Foreigners find dollars useful in only two ways First they are useful for buying our exports but if net exports are less than zero there aren t enough exports to soak up all the dollars they earn Second dollars are useful for besides buying property hereland stocks buildings bonds So this last term is the net ow of purchasing power into domestic financial markets by foreigners wishing to park some of their savings here And when net exports are positive this term is the net amount of domestic savings diverted into overseas financial markets What happens if the owoffunds does not balanceif at the current longterm real interest rate r the ow of savings into the financial markets exceeds the demand by corporations and others for purchasing power to nance investments If the lefthand side is greater than the right some financial institutionsbanks mutual funds venture capitalists insurance companies whateverwill find purchasing power piling up as more money ows into their accounts than they can find good securities and other investment Chapter 7 5 Final vehicles to commit it to They will try to underbid their competitors for the privilege of lending money or buying equity in some particular set of investment projects How do they underbid They underbid by saying that they would accept a lower interest rate than the market interest rate r Thus if the ow of savings exceeds investment the interest rate r falls As the interest rate r fell the number and value of investment projects rms and entrepreneurs found it worthwhile to undertake rises Excess Supply of Savings in the Flow of Funds Market Real Interest Rate Plus International PUbliC Plus Private Savings Equals Savings Savings Total Savings 4 gt Investment Demand FIow ofFunds Through Financial Markets Legend When the interest rate is such that there is an excess supply of savings some savers are about to offer to accept a lower interest rate and the interest rate about to drop The process will stop when the interest rate r adjusts to bring about equilibrium in the loanable funds market The ow of savings into the nancial markets will then be just equal to the ow of purchasing power out of nancial markets and into the hands of rms and entrepreneurs using it to nance investment Chapter 7 6 Final Solving the Model At what level of the real interest rate will the flowoffunds through nancial markets in equilibrium First let s look at the determinants of the supply of private savings Y C T l t l tCyY C0 Second let s look at the determinants of public savings T G tY G Third let s look at the determinants of international savings NX IMyY Xgerr nyYf X920 ngrf These three added together make up the owoffunds supply of savings The owof funds demand for savings is simply the investment function I 10 Lr Equilibrium is of course where the supply of savings is equal to investment demand To get an explicit expression for the interest rate begin by writing out the determinants of all the pieces of savings 1 t 1 tCyY C0 IY G IMyY Xger nyYf X 80 Xgerf 10 1r Group all the terms that depend on Y on the left of the lefthand side all the terms that are constant in the middle of the left ihand side all the terms that depend on international factors on the right of the lefthand side and move all the terms with the real interest rate r over to the righthand side 1 1 rCy 1My Y C0 10 G ngf urge0 2ge 1 Jge r Chapter 7 7 Final And divide by IK X88 to determine the equilibrium real interest rate r C0 10 GnyYfXgeo Jgerrf 1 1 ICy IMyY r I Xge Example Solving for and Verifying the Equilibrium Real Interest Rate Given the parameters of the exibleprice model and the value of potential GDP it is straightforward to calculate the equilibrium real interest rate r by substituting the parameters into the formula C0 10 G ngf urge0 Jgerf 1 1 tcy 1MyY r I Xga For example when parameter values are Potential output Y 10000 billion Baseline consumption C0 3000 billion Baseline investment I0 l000 billion Government purchases G 2000 billion The tax rate t 25 The MPC Cy 067 The propensity to import IMy 02 Abroad ny01 and Yf 10000 billion Foreign exchange speculators longrun view 80 100 The sensitivity of exports to the exchange rate Xg 10 The sensitivity of investment to the interest rate II 9000 The sensitivity of the exchange rate to the interest rate 8 600 Then replacing each of the parameters with its value produces 30001000 2000 01gtlt10000 10 x100 1 1 025 X067 02 10000 r 9000 600 x 10 r 6000 2000 07gtlt 10000 15000 Chapter 7 8 Final An equilibrium real interest rate of 667 per year Is the economy in fact in equilibrium when the real interest rate is 667 per year Yes At that level of the interest rate Private savings equal 500 billion yes they are less than zero households are drawing down their wealth in order to nance high current consumption as you can see by substituting the parameters into the equation Y C T l t l tCyY C0 that determines private saving Government savings equal 500 billion as you can see by subtracting government purchases from taxes The capital in ow from abroadiminus net exportsiequals 400 billion as you can see by substituting the parameter values and a real interest rate of 667 into the equation NX IMyYngr nyYf Xeo Xgerf that determines minus net exports These three components of saving add up to 400 billion 0 And investment is equal to 400 billion Thus the ow of funds through nancial markets balances Looking at the components of real GDP 0 Consumption spending equals 8000 billion 0 Investment spending equals 400 billion 0 Government purchases equal 2000 billion 0 Net exports equal 400 billion 0 All these add up to 10000 billion the level of potential output Total spendingiaggregate demandiis indeed equal to real GDP Comparative Statics as a Method of Analysis Chapter 7 9 Final The exibleprice fullemployment model we have built in the last two chapters gives us the capability to determine the level and composition of real GDP and national income If we know the economic environment and economic policy we can use the model to determine the equilibrium real interest rate either by solving the algebraic equations or by drawing the owoffunds diagram and looking for the point where supply balances demand or both We can then calculate the equilibrium values of a large number of economic variablesireal GDP consumption spending and investment spending imports and exports the real exchange rate and more In fact three of the six key economic variablesireal GDP the exchange rate and the real interest rateicome directly from the model We will see how to calculate the price level and in ation rate in the next chapter Chapter 8 In a exibleprice model like this one the unemployment rate is not interesting for the economy is always at full employment And we have seen that the stock market is proportional to and a leading indicator of investment spending However the model so far gives us the capability not just to calculate the current equilibrium position of the economy but how that equilibrium will change in response to changes in the 39 or in 39 policy To do so we use a method of analysis economists call comparative statics We determine the response of the economy to some particular shift in the environment or policy in three steps We first look at the initial equilibrium position of the economy without the shift We then look at the equilibrium position of the economy with the shift We then identify the difference in the two equilibrium positions as the change in the economy in response to the shift Let s see how the model can be used to analyze the consequences of disturbances to the economy Changes in Fiscal Policy Suppose the economy is in equilibrium when policy makers decide to increase annual government purchases by the amount AGias before A a capital Greek letter delta stands for quotchangequot Let s look at what happens to the components of aggregate demand one by one First the change in government purchases has no effect on consumption Because potential output does not change national income does not change Neither national income baseline Chapter 7 10 Final consumption the taX rate nor the marginal propensity to consume shifts so there is no effect on the consumption function C C0 CyltY Thus AC 0 While the shift in government purchases has no direct effect on investment there will be an indirect effect Investment depends on the interest rate and the interest rate will change as a result of the change in government purchases So from the investment function I I0 Ilr we can conclude that the level of investment spending will change by A IAr That is the shift in investment spending will be equal to the sensitivity of investment to the interest rate times the shift in the equilibrium real interest rate Nothing in the international economic environment changes Nor does the level of potential output does not change So looking at the net exports function NX nyYf X920 X 8r ngrf IMyY it is clear that here as well the only shift will be a proportional change in response to the shift in the equilibrium real interest rate ANX XeAr Finally real GDP Y does not change because otential output does not change and this is a fullemployment model with real GDP is always equal to potential output AY AY 0 Putting all these pieces together we have assembled the relevant components of aggregate demand in quotchangequot form We can see that as government purchases shift the other components of aggregate demand will have to shift with it AY AIAGANX 0 IAr AG 98Ar Chapter 7 11 Final Put the change in the real interest rate on the lefthand side of the equation and everything else on the right we discover that the shift in government purchases means that the equilibrium real interest rate must change by AG Ar I X98 Effect of an Increase in Government Purchases 0n the Flow of Funds Real Interest Rate An increase in government r purchases reduces public savings and shifts the supplyof savings line to the left generates an increase in the real interest rate fal in 2quot Investment Demand invest ent spending FlowofFunds Through Financial Markets gt and an increased inflow of capital from abroad Once the change in the equilibrium interest rate has been calculated determining what happens to the rest of the economy is straightforward Simply substitute the change in the equilibrium interest rate back into the model39s behavioral relationships and so calculate the changes in the equilibrium levels of the components of GDP and in the equilibrium level of the real exchange rate There is no effect on the level of real GDP Y or on consumption spending C Chapter 7 12 Final AY 0 AC 0 The change in government purchases G is just equal to itself the change in government purchases was the trigger that shifted the economy s equilibrium position AG AG The change in investment spending is the interest sensitivity of investment II times the change in the equilibrium real interest rate which we already calculated above r I e The changes in net exports and in the exchange rate are also equal to their sensitivities to A1 1gtltAr AG the real interest rate times the change in the equilibrium real interest rate 8 ANX LAG I X8 i I ge The overall picture of the changes generated by the increase in government purchases is clear The increase in government purchases has led to a shortfall in savings and a rise in A8 real interest rates The higher real interest rates have led to lower investment and to an appreciation in the home currency a lower level of 8 This exchange rate appreciation has led to a decline in net exports The declines in net exports and in investment spending just add up to the increase in government purchases so the level of GDP is unchanged and still equal to potential outpu as we assumed it would be Note that the fall in investment is not as large as the rise in government purchases The increase in government purchases reduced the ow of domestic savings into nancial markets but the increased ow of foreignowned capital into the market partially offset this reduction Example A Government Purchases Boom Assume that the parameters of the model are t 033 Tax rate of 13 of income 1 9000 A 1 percentage point fall in the interest rate raises investment spending by 90 billion a year C 075A marginal propensity to consume of threequarters Chapter 7 13 Final 8510 With an initial value for the real exchange rate a set at the traditional indexed value of 100 a 1 percentage point change in the interest rate difference visavis abroad generates a 10 shift in the exchange rate Xg600 A 1 change in the exchange rate leads to a 6 billion a year change in exports Suppose that there is a sudden increase in government purchases of 150 billion a year This boom in spending increases the equilibrium real interest rate by one percentage point AG 150 150 I 2ge 9000600 gtlt10 m As a result the equilibrium values of the other variables in the economy will change by Ar 011 AG AG 150 billion 1 9000 A 150 90 billion IX98 9000600gtlt10 AC0 ANX i 8 AG 600 X10 150 60 billion 1 2ge 9000 600 x 10 A8 150 01 10 change i AG I 1 8r 9000 600 X10 In sum the 150 billion increase in annual government purchases has shifted the economy39s equilibrium by raising the real interest rates by 1 Such an increase in the real interest rate carries with it a 10 fall in the exchange rate The interest rate increase reduces investment spending by 90 billion a year The exchange rate decline reduces net exports by 60 billion a year Some additional insight into this example can be gained by looking at the ow of funds diagram in Figure 77 The increase in government spending shifts the supply of loanable funds curve to the left by 150 billion Given the slopes of the loanable funds supply and the investment demand curves the result of this leftward shift is a 90 billion fall in annual investmentand a 1 point rise in the real interest rate Chapter 7 14 Final Flow of Funds Diagram An 150 Billion Increase in Government Purchases Real Interest Rate An 150 billion increase in government r purchases reduces public savings and shifts the supplyof savings line to the eft generates a 1 increas in the real interest rate a 93 billion fall in 2quot Investment Demand invest nent spending FlowofFunds Through Financial arkets gt and a 60 billion increased inflow of capital from abroad Given this 1 point rise in the real interest rate it is straightforward to determine the resulting change in the exchange rate as shown in Figure 78 and thus the change in net exports Chapter 7 15 Final The Impact of a Change in the Domestic Interest Rate 0n the Exchange Rate Real Interest Rate r A 1 increase in the domestic real interest rate produces Exchange Ratethe Value of Foreign Currency lt an appreciation in the home currency a 10 reduction in the exchange ratethat is in the value of foreign currency Supply Shocks So far we have assumed that the level of potential output is fixed Whatever shocks have affected the economy they have had no effect on aggregate supply no effect on potential output But there are shocks to a exibleprice fullemployment economy that change aggregate supply Supply shocks like the 1973 tripling of world oil prices reduce potential output Inventions and innovations can be positive productivity shocks that increase the level of potential output We can use the fullemployment model of this chapter to analyze the effects on the economy of a supply shock However the effects of a supply shock are different in one Chapter 7 16 Final important respect from the effects of the demand or international shocks we have analyzed above In response to a supply shock the level of GDP does changeeven in this fullemployment chapterbecause the level of potential GDP has changed In each case call the resulting supplyshock driven change in potential output AY If we look at the changes in the national income identity ACAI AG ANX AY we will nd them more compleX than in the case of the demand shocks considered in the section above because the change in real GDP is not zero If we expand the changes form of the national income identity by substituting for each component of GDP the equation for its determinants we produce Cy1 tAY 1Ar Xgem IMyAY AYquot We can regroup and solve this equation for the change Ar in the equilibrium interest rate is l C 1 tIM N M IX98 A negative value for AYan adverse supply shock one that lowers the level of potential output and GDPgenerates an increase in the domestic real interest rate Why Because a fall in GDP due to an oil price increase or other adverse supply shock reduces incomes and so reduces the ow of private savings into nancial markets It is true that a decline in incomes carries with it a decline in consumption and in net exports but these declines do not match the decline in income so domestic savings falls From the change in the level of GDP and the change in the interest rate it is straightforward to calculate the effect of the supply shock on the other economic variables Chapter 7 17 Final ACCy1 IAY lIM C l t AIL AY IX98 AG0 lIM C l t ANXXger AHA IX98 lIM C l t A88r Ay IX98 An adverse supply shocka negative value for AYleads to declines in consumption investment and net exports it leads to an appreciation of the home currency and thus to a reduction in the value of foreign currencyin the exchange rate It also leads to a rise in the price level and an acceleration of in ation Real Business Cycles The midtwentieth century economist Joseph Schumpeter was the most powerful exponent of the belief that changes in technology were the principal force driving business cycles Schumpeter saw technological progress as inherently lumpy There were fiveyear periods during which a great deal of new technology diffused rapidly throughout the economy These were booms There were fiveyear periods during which the pace of technological innovation and diffusion was much slower These were periods of relative stagnation Schumpeter saw the key feature of the business cycle as the co movements of output employment investment and interest rates all were high together in a boom all were low together relative to trend in a recession It is easy to see how uneven invention and innovation patterns could generate such real business cyclesibusiness cycles driven by the fundamental technological dynamic of the economy Suppose that the most common shift in technology involves a a sudden step up in the efficiency of labor accompanied by b a sudden rise in investment demand as it becomes more profitable for a business to enlarge its capital stock Such a shock has a supply componentan increase AY in this year39s potential outputand an investment demand componentan increase A10 in this year39s investment demand Chapter 7 18 Final How does the economy39s fullemployment equilibrium shift in response to such a combined shock We simply add together the effects of a supply shock outlined immediately above and the effects of an investment boom driven by investors39 increasing optimism outlined in the previous section The change in the equilibrium domestic real interest rate from a supply shock is l C 1 IM Ar y Myquot 1 X88 The change from an investment demand shock is Al Ar 1 X98 Adding them together the change in the equilibrium interest rate from this Schumpeterian technology shift is Ar 1 Cy1 tIMyAY NO I X98 I X98 The increased profitability of investment expands investment demand shifting the red investment demand curve to the right But the positive technology shock does more than just make investment more profitable it boosts the current efficiency of labor as well Higher productivity means higher incomes which means more savings which shifts the total savings line to the right as well The increase in investment demand tends to raise the interest rate The increase in savings caused by higher incomes tends to lower it Which dominates Suppose that the investment demand term dominates Then the domestic real interest rate will rise Chapter 7 19 Final A Schumpeterian Combined Productivity and Investment Shock as Seen in the Flow of Funds A n increase in investment but the increase in today39s pro tability shi s investment productivity increases incomes demand tothe right and increases savings too Real Interest Rate r if the investment demand effect dominates the real interest rate increases and invest ne saending ris s Investment Demand FlowofFunds Through Financial Markets by more ha the shi in savings b use higher interest rat s thome pull more 39 quot ca ital into uume llL Ilnancial markets 0 Legend Higher productivity today and optimism about future technological developments affect both the supply and demand curves in the market for loanable funds It is plausible to conclude that the economy will boom with real GDP and investment rising domestic real interest rates rising the exchange rate falling and capital owing in to finance domestic investment This pattern is the standard pattern seen in a business cycle boom It is then straightforward to calculate the changes in the components of aggregate demand Chapter 7 20 Final ACCy1 IAY X3 l C 1 tIM AI4AIOLM IX98 IX98 AG0 AY 1 Cy1 tIMy I X er XgerAl0 ANX X88 1 X98 IMyAY And the change in the equilibrium level of the exchange rate is 8A0 I X98 l C 1 tIM ASH ylt gt y IX98 1My JAY As long as the shock shifts the investment demand curve in Figure 715 to the right by more than it shifts the total savings line the value of the exchange rate will fall Thus this combination positive technology shock to the efficiency of labor and the profitability of investment has produced 0 A rise in output 0 A sharp rise in investment 0 A decline in the exchange rate an decrease in the value of foreign currency and an increase in the value of domestic currency 0 A decrease in net exports an increase in the ow of foreign capital into the country to finance domestic investment These shifts in the economy are those that are typically found in a business cycle boom Perhaps these Schumpeterian forces are the principal cause of the booms and recessions that we see in our economy Most economists however would be skeptical of the claim that most of our business cycles are such real business cycles There is one characteristic feature of the quotboomquot phase of the business cycle as defined by Schumpeter that the model cannot produce a fall in unemployment It cannot do so this chapter s model after all is one in which the economy is always at full employment so how could the model produce an increase in employment correlated with its technologydriven boom Chapter 7 21 Final Some economists speculate that the pattern of unemployment found in the business cycle is due to movements in the level of real wages When real wages are higher than expected or than average more people will be willing to work for wages When real wages are temporarily lower than their average trend some workers will choose to forego working for a month or a season or a year According to this approach unemployment is high whenever a significant fraction of the labor force have looked at their employment opportunities found that they were being offered unusually low wages and decided to do something other than work for a while There is however a serious problem with this approach Few of the cyclically unemployed in a business cycle slump choose to describe themselves as quotvoluntarily unemployedquot They see themselves not as people making a rational economic decision to spend a lot more time being leisurely but as people who want to workwho would be eager to work if only someone would hire them at the wages others are being paidbut who can t find work because there is excess supply in the labor market A second problem is that real business cycle theory explains boomsrapid rises in outputas the result of the rapid diffusion of technology and a sharp increase in the efficiency of labor But how is it to describe a recession or a depressiona time when production does not grow at all but declines Does the efficiency of labor decline because of technological regress Are we supposed to believe that production was lower in 1991 than in 1990 because businesses had forgotten how to use their most productive modes of operation It seems unlikely Thus the Schumpeterian approach may well provide a correct theory of booms or of some booms It is harder to see how it could provide an accurate account of recessions and depressions or of the high levels of cyclical unemployment found in times of recession and depression World Economic Outlook 1 J Brddford De Long FOCUS on the Pacific Associate Professor of Economics University of Colifronio at Berkeley 7I92OIO 1239 PM delongeconberllteeyedu httpeconi iberllteeyedu Short Run Recent Growth and Inflation Change on Year Earlier Industrial Consumer Real GDP Production Price Economy Gr vth Grclrvth Inflation China 95 106 81 Hong Kong 31 26 51 India 70 77 88 Indonesia 81 180 68 Malaysia 84 125 35 Philippines 47 249 89 Singapore 71 13 14 South Korea 67 80 47 Taiwan 66 17 51 Thailand 86 83 46 Chile 66 34 63 Mexico 72 171 306 Australia 45 32 31 N America United States 27 34 29 Canada 12 15 14 Europe Britain 22 08 21 France 04 05 16 Germany 12 20 14 Italy 15 41 34 Japan 39 22 02 0 With respect to output and productivity growth the industrialized core of the world economy continues to behave as it has since the oil shock of the early 1970s slow and unstable growth 0 None of the economies of the industrialized core are currently suffering from recession 0 All of the economies of the industrialized core exhibit very low in ation rates by postWorld War 11 standards none shows any signs of an in ationary spiral taking hold not even Italy World Economic Outlook 2 J Bradford De Long FOCUS on the Pacific Associate Professor of Economics University of Colifronio at Berkeley 7192010 1239 PM delongeconberllteleyedu httpeconl 61 berkeleyedu 0 India may have finally turned the corner and joined the rapid industrializing economies of Asia Short Run Recent Growth and Inflation by Region Change on Year Earlier Industrial Consumer Real GDP Production Price Region Gr vth Grclrvth Inflation East Asia 77 59 60 Latin America 41 50 311 Mediterranean 39 19 251 South Africa 35 07 84 Eastern Europe 23 39 169 Industrial Core 22 24 20 The East Asian economies with the exception of Hong Kong and its peculiar situation continue to exhibit siX to ten percent per year growth in real GDP East Asian growth continues to outstrip growth in all of the other regions of industrialization There is an even larger gap between East Asian growth and growth in regions that are not successfully industrializing like tropical Africa North Africa the Middle East and the former Soviet Union 0 In ation remains moderate throughout East Asia Other industrializing regions see some economies that are on track for yet another hyperin ationary spiral This is not the case in East Asia at least not yet World Economic Outlook 3 J Brddford De Long FOCUS on the Pacific Associate Professor of Economics University of Colifronio at Berkeley 7I92OIO 1239 PM delongeconberllteleyedu httpeconi 61 berkeleyedu Short Run Interest and Exchange Rates ShortTerm ShortTerm Real Dollar Interest Interest Exchange Economy Ries Rites Rate China 118 37 83 Hong Kong 56 05 77 India 102 14 357 Indonesia 153 85 2324 Malaysia 73 38 25 Philippines 114 25 262 Singapore 32 18 141 South Korea 137 90 822 Taiwan 52 01 275 Thailand 125 79 254 Chile 127 64 414 Mexico 231 75 752 Australia 68 37 126 N America United States 55 26 1 Canada 38 24 136 Europe Britain 59 38 064 France 35 19 517 Germany 31 17 153 Italy 82 48 1517 Japan 04 02 112 0 Exchange rates are not pushing the bounds of their normal trading ranges in either direction Anomalous largescale movements in exchange rates like the appreciation of the U S dollar in the 1980s in response to the Reagan deficits or the appreciation of the yen in the early 1990s in response to the collapse of Japan s bubble economy are absent 0 After a prolonged period of relatively high real interest rates in the industrialized core real interest rates in Europe and North America are for the most part back to normal trading ranges o Japan s shortterm interest rates continue to be ludicrously low suggestive of a liquidity trap and of a substantial expected future appreciation of the yen World Economic Outlook Focus on the Pacific 7l92010 1239 PM J Brddford De Long Associate Professor of Economics University of Cdlifronid of Berkeley deongeconberllteeyedu httpeconl lberllteeyedu Short Run Forecasts Foecast Consumer Forecast Price GDP Growth Inflation 1997 1997 China 79 71 Hong Kong 04 73 India 60 76 Indonesia 69 60 Malaysia 71 34 Philippines 43 77 Singapore 61 17 South Korea 58 44 Taiwan 57 47 Thailand 73 43 Chile 57 56 Mexico 62 140 Australia 32 31 North America United States 23 31 Canada 29 19 Europe Britain 34 29 France 25 19 Germany 23 19 Italy 21 35 Japan 22 13 o The forecast for 1997 and for a year or two beyond is more of the same 0 Growth in the siXtoten percent per year range in Pacific Asia growth in the twotothree percent per year range in the industrialized core 0 The peculiar situation of Hong Kong the peculiar situation of Mexico 0 But should a worldwide recession develop it would probably come on in advance of any reliable forecasts World Economic Outlook 5 J Bradford De Long FOCUS on the Pacific Associate Professor of Economics University of Colifronio at Berkeley 7192010 1239 PM delongeconberkeleyedu httpeconl 61 berkeleyedu 0 And should a full edged international financial crisis develop it would certainly come on in advance of all forecasts World Economic Outlook 6 J Bradford De Long FOCUS on the Pacific Associate Professor of Economics University of Colifronio at Berkeley 7192010 1239 PM delongeconberkeleyedu httpeconl 61 berkeleyedu Short Run Risks to the Forecast Japan39s Quiet Depression Appears Over Size of the Japanese Recessmn 170 Continuation of 1980s Trend 160 v 150 O 140 039 130 o 120 Actual GDP 110 100 I I I I I I I I I I 1986 1989 1992 1995 Year 0 Since the collapse of the bubble Japan has not seen a formal recession 0 Nevertheless compared to the pace of economic growth that was established in the l980s the shortfall of Japanese GDP today from what one would in 1990 have projected it would be today is astonishing 20 of what could be Japan s potential national product today is missing In a differentlystructured economy unemployment would now be fifteen percent and political and social tensions would be immense World Economic Outlook 7 J Bradford De Long FOCUS on the Pacific Associate Professor of Economics University of Colifronio at Berkeley 7192010 1239 PM delongeconberkeleyedu httpeconl 61 berkeleyedu o The Japanese economy has room to grow when and it its banking system is recapitalized and its banks begin serving as sources of funds for investment This room for growth makes the chance of global recession small World Economic Outlook 8 J Bradford De Long FOCUS on the Pacific Associate Professor of Economics University of Colifronio at Berkeley 7192010 1239 PM delongeconberllteeyedu httpeconl 61 berkeleyedu Short Run Risks to the Forecast America s Best Economy in a Generation US Unemployment and Inflation since 1970 012 01 008 006 39 1970 004 39 002 39 0 4 5 6 7 8 9 10 Unemployment 0 Today the United States sees a tradeoff between unemployment and in ation that is more favorable than in any years since the mid1960s The United States central bank the Federal Reserve believes that it has a very strong mandate to fight in ation every time in ation has approached ten percent per year the Federal Reserve has tightened monetary policy to in ict a significant recession on the U S and on the rest of the world to reduce in ation World Economic Outlook 9 J Bradford De Long FOCUS on the Pacific Associate Professor of Economics University of Colifronio at Berkeley 7192010 1239 PM delongeconberkeleyedu httpecon61berkeleyedu 0 But the U S is now very very far away from any situation in which even the most cautious central bank might believe that in ationfighting requires a recession World Economic Outlook 10 J Bradford De Long FOCUS on the Pacific Associate Professor of Economics University of Colifronio at Berkeley 7192010 1239 PM delongeconberllteleyedu httpeconl 61 berkeleyedu The Medium Run GDP per Capita Basic Economic Indicators Pacific Region All Estimates as of 1993 GDPper Capfa Total Exports recent GDPper Billion per Population Count exchah e rates Ca ifa PPP Year Millions United States 24740 24740 465 258 European Union 19515 16717 548 347 Japan 31490 20850 362 125 Canada 19970 20230 145 29 Australia 17500 17910 43 18 New Zealand 12600 16040 11 4 China 490 2330 92 1178 Hong Kong 18060 21560 135 6 India 300 1220 22 898 Indonesia 740 3150 34 187 Malaysia 3140 7930 47 19 Philippines 850 2670 11 65 Singapore 19850 19510 74 3 South Korea 7660 9630 82 44 Taiwan 10852 13643 85 22 Thailand 2110 6260 37 58 Chile 3170 8400 9 14 Mexico 3610 6810 30 90 o The economies bordering the Pacific still exhibit some of the widest divergences within a region found in the world today 0 The developing countries of this region have already become an important weight in the international economy The exports of the developing countries of this region are already some onethird greater than the exports of the United States and greater than the outsideEurope exports of the European Union World Economic Outlook Focus on the Pacific 7l92010 1239 PM J Bradford De Long Associate Professor of Economics University of Colifronio of Berkeley delongeconberllteleyedu httpeconl lberllteleyedu The Medium Run GDP per Capita by Region GDP per Capita Levels US Dollars 30000 25000 39 20000 39 15000 39 10000 5000 39 0 Japan Canada W Europe East Asia Mexico Brazil E Europe Russia N A 39ica China Asia South Asia A 39ica India East in 2 m 7 39c 2 39E 3 Australia amp NZ OilRich Middle Lain America Form erSoviet SubSaharan Large chunks of East Asia are now joining the world s industrial core the first significant expansion since the latenineteenth century industrialization of continental Europe and the preWorld War II industrialization of Japan South Asia remains very poor Other potentially industrializing regions have closed little of the relative gap Visa Vis the industrial core over the past few decades World Economic Outlook 12 J Bradford De Long FOCUS on the Pacific Associate Professor of Economics University of Colifronio at Berkeley 7192010 1239 PM delongeconberkeleyedu httpeconi 61 berkeleyedu The Medium Run Differences in Estimates of GDP per Capita Current Exchange Rate and PPP GDP per Capita 25000 v 0 20000 O 15000 9 10000 t 0 5000 0 0 10000 20000 30000 40000 Current Exchange Rate 0 There are systematic differences between purchasingpowerparity PPP and market exchange rate calculations of relative income and wealth levels the poorer the economy the greater is the amount by which the exchange rate based calculation must be multiplied in order to arrive at the PPPbased calculation 0 World trade tends to set exchange rates to make the prices of frequentlytraded manufactured goods roughly equal in different countries And in general the richer a country is the lower is its price of manufactured goods relative to the price of personal services or of unskilled labor Thus exchange ratebased calculations systematically understate the value of production in the nontraded goods sector in relatively poor economies World Economic Outlook 13 J Bradford De Long FOCUS on the Pacific Associate Professor of Economics University of Colifronio at Berkeley 7192010 1239 PM delongeconberllteleyedu httpeconl 61 berkeleyedu The Medium Run Exports Economies Ranked by Total Exports Billion DollarsperYear Europe Canada Mexico D India G China Taiwan Thailand 3 Hong Kong l Singapore Malaysia Australia Indonesia C1 New Zealand Philippines United States South Korea 0 Total exports in Europe s case only exports from the EU are perhaps a better way of measuring the relative importance of different economies to companies engaged in international trade On the other hand companies interested in world trade are more interested in how many traded manufactures a country s income would buy and that is better captured the exchange ratebased estimates After all a country s potential demand for foreignproduced imports is in the end limited by the amount of foreign exchange it earns through it exports World Economic Outlook 14 J Bradford De Long FOCUS on the Pacific Associate Professor of Economics University of Colifronio at Berkeley 7192010 1239 PM delongeconberllteeyedu httpeconl 61 berkeleyedu The Medium Run Information Technology The Information Technology Sector and Aggregate Economic Growth Growth in Info Tech a5 World Real Information Prop of Decade GDP Technology Growth 19605 47 71 41 19705 33 75 87 19805 24 83 220 19905 26 85 375 o It is extremely difficult to arrive at coherent estimates of the share of economic growth due to information technology The price of information technology is falling extremely rapidly so that capabilities that would have been seen as miraculous and extremely valuable a generation ago are now commonplace Estimates using the relative prices of the late 1980s assign information technology about threeeighths of world economic growth estimates using later relative prices find smaller and those using earlier relative prices larger proportions There is every reason to expect the share of economic growth attributable to information technology to continue to increase in the future World Economic Outlook 15 J Bradford De Long FOCUS on the Pacific Associate Professor of Economics University of Colifronio at Berkeley 7192010 1239 PM delongeconberllteeyedu httpeconl 61 berkeleyedu The Long Run The Industrial Revolution GDP per Capita Industrial Core 20000 15000 10000 5000 0 1800 1850 1900 1950 2000 0 Before the industrial revolution of the lateeighteenth century living standards had advanced little since the invention of agriculture 0 Growth in technology had before 1800 been swallowed up by growth in population and diminishing returns It led to increases in population and to the wealth of the elite but not to overall increases in standards of living 0 Since 1800 average living standards labor productivity levels GDP per Capita and other macroeconomic indicators have multiplied by a factor of fifteen in what is now the industrialized core of the world economy World Economic Outlook 16 J Bradford De Long FOCUS on the Pacific Associate Professor of Economics University of Colifronio at Berkeley 7192010 1239 PM delongeconberkeleyedu httpecon61berkeleyedu o The industrial revolution marked a qualitative break not just an advance but a revolution in the pace at which fuIther advances are being made World Economic Outlook 17 J Bradford De Long FOCUS on the Pacific Associate Professor of Economics University of Colifronio at Berkeley 7192010 1239 PM delongeconberllteleyedu httpeconl 61 berkeleyedu The Long Run Occupational Distribution and the Industrial Revolution Approximate Occupational Distribution of the Labor Force 100 75 39 39 Agriculture U Manufacturing mining construction 5 Other service 50 quot I Control education entertainment 25 39 FIquotI39I E 0 l l 1100 1700 1800 1900 2000 Britain Britain Britain u s u s o In preindustrial societies informationintensive activities are small control accounting recordkeeping and so forth education and entertainment are carried out by a very small proportion of the labor force In industrial and postindustrial economies the share of the labor force in informationintensive activities grows rapidly education because an industrial economy requires a trained workforce entertainment because of new technologies and control to manage the distribution of industrial wealth 0 Many informationintensive occupations are very low paying World Economic Outlook 18 J Bradford De Long FOCUS on the Pacific Associate Professor of Economics University of Colifronio at Berkeley 7192010 1239 PM delongeconberkeleyedu httpeconl 61 berkeleyedu 0 But also note that agriculture has become a marginal economic activity although food has not and industry is becoming a marginal economic actiVity although industrial commodities will not World Economic Outlook 19 J Bradford De Long FOCUS on the Pacific Associate Professor of Economics University of Colifronio of Berkeley 7192010 1239 PM delongeconberkeleyedu httpeconl 61 berkeleyedu The Long Run Divergence 18201960 Divergence 1820 Loss of Relative Economic Position 90 80 39 70 39 60 Europe 50 39 40 Americ 30 39 E Europe 20 39 0 106 lfrica 0 l l l 1800 1850 1900 1950 2000 0 To date the spread of the productivity level and growth gains of the industrial revolution has been extremely uneven o Africa with a GDP per Capita level of perhaps 30 of that of the industrialized core in 1820 n0w has a level of less than 10 0 From 1820 to 1950 all other regions of the world save Latin America lost ground relative to the industrialized core 0 Since 1950 E Europe and L America have lost relative ground World Economic Outlook Focus on the Pacific 7l92010 1239 PM 20 J Brddford De Long Associate Professor of Economics University of Cdlifronid at Berkeley deongeconberllteeyedu httpeconl lberllteeyedu Since 1950 S Europe and Asia have gained and Asia enormously The Long Run Asia s Industrialization and Convergence 1960 Asian GDP per Capita as a Share of Industrial Core PPP Estimates 120 Japa 100 80 Korea 60 40 Ctina 20 India 0 1800 1850 1900 1950 2000 The economic destinies of Latin America Eastern Europe and Africa remain unclear But it is clear that S Europe and large chunks of Asia will have joined the industrialized core within a generation or so It seems likely that at least one of China and India will undergo its industrial revolution in the next fifty years although which is very hard to predict And much of the rest of Asia is about to join or has joined the industrialized core of the world economy already World Economic Outlook Focus on the Pacific 7192010 1239 PM 21 J Brddford De Long Associate Professor of Economics University of Cdlifronid at Berkeley delongeconberllteleyedu httpeconl lberllteleyedu The Long Run Toward the Pacific39s SteadyState Distribution of Income and Wealth 120 Predicted Relative GDP per Capita 2040 US 100 100 quot 39 30 60 f 40 20 0 N g 2 x m a g N I 5 z Japan l U S A Canada Korea Chile l China India Indonesia l Thailand Papua NG l Singapore Australia Malaysia l Mexico SriLanka Pakistan Bangladesh Professor Charles Jones of Stanford has projected the longrun development of individual national economies assuming that their investment and population growth rates follow observed trends and in the figure above assuming that they close half of their productivity gaps visa vis the United States Even with such substantial catch up in the ability to use modern technologies a large number of Asian economies are predicted to remain poor relative to the world s industrial leaders World Economic Outlook 22 J Bradford De Long FOCUS on the Pacific Associate Professor of Economics University of Colifronio at Berkeley 7192010 1239 PM delongeconberllteleyedu httpeconl 61 berkeleyedu 0 Of course even a country with a relative GDP per capita score of 60 in 2040 is as well off as the most well off of today s economies The Long Run Pacific Growth 19602040 Pacific Region Growth 19602040 5 Steady State 2040 I Rel Income 1990 D Rel Income 1960 GDP plr Clplll I 5 of US 8 Korea China Mexico Singapore Japan USA Canada Australia Hong Kong New Zealand Malaysia Indonesia Thailand SriLanka IndIa Papua NG Pakistan Bangladesh o A comparison of projected GDP per capita levels relative to the United States in 2040 with relative GDP per capita levels in 1990 and in 1960 reveals the extraordinary speed of the Asian industrial revolution The high investment rates and low population growth rates of a number of Asian economies Singapore Japan and Korea are unless reversed likely to produce GDP per capita levels that equal those of any other economies in the world even if there remains a technology gap visa vis North America 0 Why Because the greater capitalperworker levels anticipated are at least as powerful a plus as any residual technology gap is a minus World Economic Outlook 23 J Bradford De Long FOCUS on the Pacific Associate Professor of Economics University of Colifronio of Berkeley 7192010 1239 PM delongeconberkeleyedu httpeconl 61 berkeleyedu 0 Should the center of world invention and innovation move from North America to Asia as it may it moved from Europe to North America around l900 then the technology gap will work the other way and the richest economies of Asia will by the middle of the next century bear the same relationship to North America and Europe that the North American economies bore to Europe for most of the twentieth century World Economic Outlook 24 J Bradford De Long FOCUS on the Pacific Associate Professor of Economics University of Colifronio at Berkeley 7192010 1239 PM delongeconberllteeyedu httpeconl 61 berkeleyedu The Long Run Economic Prosperity and Political Democracy Proportion of Countries with Established Political Democracy 100 80 quot 60 39 40 quot 20 39 0 O O 0 O O O O O O O OO O O O O O l 039 o o o V 8 M e e a 69 a m l r A 9 9 0 9 e Income Category 0 To date rich countries have been democratic countries 0 There is good reason to think that this pattern will continue to hold that formal political democracy will become a more urgent demand as countries gain in relative wealth o The creation of stable political democracies is far from easy successful management of the process is essential to avoid economic and political collapse World Economic Outlook 25 J Bradford De Long FOCUS on the Pacific Associate Professor of Economics University of Colifronio at Berkeley 7192010 1239 PM delongeconberkeleyedu httpecon61berkeleyedu o Interwar Europe and postWorld War 11 South America provide painful object lessons of the consequences of failing to manage the process of democratization World Economic Outlook 26 J Bradford De Long FOCUS on the Pacific Associate Professor of Economics University of Colifronio of Berkeley 7192010 1239 PM delongeconberllteleyedu httpeconl61berllteleyedu The Long Run Economic Prosperity and the Welfare State Federal Revenues and Expenditures as Shares of National Product 45 40 39 35 39 30 39 25 Expenditures 20 39 Rev en ues 15 10 5 0llrrrrrrrrrrrrrrrrrrrrrr 1870 1890 1910 1930 1950 1970 1990 Political democracies institutionalize economic redistribution Larger social insurance programs have been the counterpart of political democracy wherever it has been established 0 Do large welfare states retard economic growth Political democracy as a guarantee that economic policy won t be too destructive of growth World Economic Outlook 27 J Bradford De Long FOCUS on the Pacific Associate Professor of Economics University of Colifronio at Berkeley 7192010 1239 PM delongeconberllteeyedu httpeconl 61 berkeleyedu World Economic Outlook with a Focus on the Pacific Basin J Bradford De Long Associate Professor of Economics UC Berkeley October 1996 I The ShortTerm 05 years The Business Cycle ShortTerm Economic Growth and In ation World Trade Exchange Rates Asset Markets Focus on the Information Technology Sector Risks to the Forecast The MediumTerm 315 years Expanding World Trade Shifting Comparative Advantage Changing Industrial Structure Politics Risks to the Forecast The LongTerm 1050 years The Spread ofthe Industrial Revolution Divergence 18201960 Convergence for Asia at Least 1960 Information Technology and the Industrial Revolution The Evolution of Productivity and Living Standards Absolute Levels The Evolution of Productivity and Living Standards Relative Levels Political Democracy and Economic Prosperity World Economic Outlook 28 Focus on the Pacific 7192010 1239 PM The creation of Asian welfare states 0 Risks to the Forecast J Bradford De Long Associate Professor of Economics University of Colifronio of Berkeley delongeconberkeleyedu hiipeconi iberkeleyedu Why a Stimulus Package Might Be Desirable The terror attack on the World Trade Center on September ll 2001 reduced consumer confidenceithus lowering likely future purchases of durable goods by householdsiand reduced businesses willingness to spend money on investment projects at least until the future becomes clearer But nobody knows how large or how longlasting these shocks to household and business behavior will be In response the Federal Reserve has reduced interest rates by a full percentage point in an attempt to stimulate investment spending and offset the contractionary impact of the shock But can the Federal Reserve do enough Its ability to reduce interest rates is limited by the fact that the nominal shortterm interest rates it controlsiand that now stand at 25 per yearicannot go below zero Moreover the effect of interest rate reductions may be limited to the extent that investment spending is limited not by the cost of finance but by the fact that businesses value keeping the option to delay decisions about the future until the uncertainty generated by the terror attack is resolved the Federal Reserve s tools may be weak The Central Bank May Not Be Able to Prevent a Deep Recession Real Interest Rate 1 The IS curve shiftslef39t 2 the central bankcuts interest rates to try to 3 but it may not be able to cut offset the them enough because nominal leftward shift interest ratescannot drop belowzero in the IS Real interest rate corresponding a zero nominal interest rate 39 Real GDP 4 so the central bankmay not be able to prevent a deep rece ion If it does turn out to be the case that the fall in spending produced by the terror attack is large and that the Federal Reserve s tools to fight the resulting recession are weak then there will be a strong argument for stimulative policiesilike expanded government spendingithat affect the position of the IS curve directly and would shift it to the right Unfortunately the decision about a stimulus package must be made now before we understand the magnitude and persistence of the shock to consumer confidence and business willingness to invest Olivier Blanchard E52373 38891 14454 Fall 1998 Macroeconomic Theory IV Imperfections and Macro A star denotes required reading 1 Labor markets Blanchard O Flows Bargaining and Unemployment Notes February 1998 Mortensen D and C Pissarides Job Reallocation Employment Fluctuations and Unemployment mimeo March 1998 Shapiro C and J Stiglitz Equilibrium Unemployment as a Worker Discipline Device AER x 1984 74 259293 Caballero R and M Hammour The Fundamental Transformation in Macroeconomics AER May 1997 181186 Blanchard O and L Katz What we Know and Do Not Know about the Natural Rate of Unemployment JEP Winter 1997 111 5173 Blanchard O The Wage Equation Notes April 1998 Nickell S Unemployment and Labor Market Rigidities Europe versus North America JEP Summer 1997 113 5574 2 Goods Markets Bils M The Cyclical Behavior of Marginal Cost and Price AER 77 1987 838855 Shea J Do Supply Curves Slope Up QJE February 1993 1081 132 Rotemberg J and M Woodford Markups and the Business Cycle NBER Macro 1991 10031026 Chevalier J and D Scharfstein CapitaliMarket Imperfections and Countercyclical Markups Theory and Evidence AER September 1996 864 703725 Basu S Procyclical Productivity Increasing Returns or Cyclical Utilization QJE August 19961113 719752 Phelps E Consumer Demand and Equilibrium Unemployment in a Working Model of CustomerMarket IncentiveWage Economy QJE August 1992 1073 10031033 Kiyotaki N Multiple EXpectational Equilibria Under Monopolistic Competition QJE 1988 103 695713 Murphy K A Shleifer and R Vishny Building Blocks of Market Clearing Business Cycle Models NBER Macro 1989 Shleifer A Implementation Cycles JPE December 1996 94 11631190 3 CreditFinancial Markets Townsend R Optimal Contracts and Competitive Markets with Costly State Veri cation JET October 1979 21 265293 Bemanke B and M Gertler Agency Costs Net Worth and Business Fluctuations AER March 1989 79 1431 Kiyotaki N and J Moore Credit Cycles JPE April 1997 1052 211248 Bemanke B M Gertler and S Gilchrist The Financial Accelerator in a Quantitative Business Cycle Framework NBER WP 6455 March 1998 Aghion P Banerjee A and T Piketty Dualism and Macroeconomic Volatility mimeo November 1997 Holmstrom B and J Tirole Financial Intermediation Loanable Funds and the Real Sector QJE August 1997 1123 663692 Diamond D and P Dybvig Bank Runs Deposit Insurance and Liquidity JPE 1983 91 401419 Krugman P What Happened in Asia mimeo MIT 1998 Bemanke B and A Blinder Credit Money and Aggregate Demand AER May 1988 782 435439 Kashyap A and J Stein Monetary Policy and Bank Lending in Monetary Policy NG Mankiw ed NBER 1994 221262 x Shleifer A Inef cient Financial Markets Clarendon Lectures mimeo 1997 Calvo G Rational Herd Behavior and the Globalization of Securities Markets Minneapolis Fed DP120 August 1997 4 The Use of a Numeraire and Nominal rigidities Blanchard 0 Why Does Money Affect Output A Survey in BM Friedman and F Hahn eds Handbook ofMonetary Economics 1990 Vol 2 779835 Akerlof G and J Yellen A NearRational Model of the Business Cycle with Wage and Price Inertia QJE 1985 823838 Shiller R Public Resistance to Indexation A Puzzle BPEA 19971 159228 Sha r E P Diamond and A Tversky Money Illusion QJE May 1997 1122 341374 Fehr E and J R Tyran Does Money Illusion Matter mimeo February 1998 Akerlof G W Dickens and G Perry The Macroeconomics of Low Inflation BPEA 19961 176 x Chapter 10 1 Final Candidate Lecture Notes Chapter 10 Investment Net Exports and Interest Rates J Bradford DeLong httpeconl6lberkeleyedu delongeconberkeleyedu Interest Rates and Aggregate Demand The Importance of Investment Changes in investment spending are the driving force behind the business cycle Without exception reductions in investment have played a powerful role in every single recession and depression Increases in investment have spurred every single boom Thus if we can understand the causes and consequences of changes in investment spending we will understand most of what we need to know about business cycles Chapter 10 2 Final Candidate Investment as a Share of Real GDP 1970 Real Gross Investment Divided by Real DP 20 18 r 16 r 5 e I n 14 r 12 r 10 1970 1975 1980 1985 1990 1995 2000 Year Legend The substantial yeartoyear swings in investment are one of the principal drivers of the business cycle When investment booms the economy as a whole booms too In the exibleprice model the real interest rate was a marketclearing price It was pushed up or down by supply and demand to equate the ow of savings into nancial markets from households and businesses the government and foreigners to the ow of investment funding out of nancial markets to nance increases in the capital stock Supply and demand in the loanable funds market determined the interest rate In the exibleprice model the level of savings determined the level of investment and the strength of investment demand determined the interest rate Chapter 10 3 Final Candidate In the stickyprice model the interest rate is not set in the loanable funds market Instead it is set directly by the central bank or indirectly by the combination of the stock of money and the liquidity preferences of households and businesses The interest rates then determines the level of investment which then plays a key role in autonomous spending Together autonomous spending and the multiplier determine the level of output What happened to equilibrium in the loanablefunds market you may ask In a sticky price model the fact that businesses match the quantity they produce to aggregate demand automatically creates balance in the nancial market no matter what the interest rate Any interest rate can be an equilibrium interest rate because the inventoryadjustment process has already made savings equal to investment Fluctuations in investment have two sources Some are triggered by changes in the real interest rate r A lower real interest rate means higher investment spending and a higher interest rate means lower investment spending Other uctuations are triggered by shifts in investors expectations about future growth profits and risk These two sources of uctuations in investment correspond respectively to i changes in investment spending I produced by the interest sensitivity of investment parameter II times changes in r and ii changes in the baseline level of investment I0 in the investment function 110 1gtltr Investment and the Real Interest Rate A business that undertakes an investment project always has alternative uses for the money One alternative would be to take the money that would have been spent building the factory or buying the machines and place it instead in the financial marketsithat is lending it out at the market real rate of interest Thus the opportunity cost of an investment project is the real interest rate The higher the interest rate the fewer the number and value of investment projects that will return more than their current cost and the lower the level of investment spending But which interest rate is the relevant one There are many different interest rates First the interest rate that is relevant for determining investment spending is a longterm interest rate This distinction matters because long and shortterm interest rates are Chapter 10 4 Final Candidate different and do not always move in step Looking at the shifts over time in the yield curve chart shows that different interest rates do not always uctuate together It also shows that longterm interest rates are usually higher than shortterm ones Second the interest rate that is relevant for investment spending decisions is not the nominal but the real interest rate The nominal prices a business charges rise with in ation If a business is willing to invest when the interest rate is 5 and in ation is 2 per year and so the real interest rate is 3 per year then the business should also be willing to invest when the interest rate is 10 and in ation is 7 per year and so the real interest rate is still 3 per year Third there is risk Lending money to a business always carries an element of risk Perhaps the borrower will go bankrupt before the loan is due Perhaps the creditors will find themselves last or nearly last in line as a small amount of leftover postbankruptcy assets are divided up Financial institutions lending money are keenly interested in the financial health of those to whom they lend The riskier they believe the loan isthe larger the possibility of a bankruptcy or a debt rescheduling appears to bethe higher is the interest rate that lenders will demand to compensate them for risk Thus to determine the level of investment spending take the baseline level of investment I0 determined by businesses optimism expected economic growth and a bunch of other factors for which the level of the stock market serves as a convenient thermometer Subtract from this baseline level the interest sensitivity of investment parameter II times the relevant interest rate r The relevant interest rate must be long term because most investments are longterm The relevant interest rate must be real because investment projects are real assets their value rises with in ation And the relevant interest rate must be risky because businesses borrowing to invest may go bankrupt In the investment function I 10 I X r the relevant interest rate r is the longterm real risky interest rate Exports and Autonomous Spending Chapter 10 5 Final Candidate Investment spending is not the only component of autonomous spending that is affected by the real interest rate In the plannedexpenditure function E A MPE x Y autonomous spending includes gross exports as well AC0IGGX So we can expand the determinants of gross exports in the expression for autonomous spending AC0 10 1 XrGXfogxe The real exchange rate 8 depends on the domestic real interest rate r as well as on foreignexchange speculators39 opinions of fundamentals and foreign interest rates 880 8gtltr rf Substituting the determinants of the exchange rate into the autonomous spending equation A C0 10 1 XrGXfo X 80 X88 er X 8 Xr it becomes clear that there are two components of autonomous spending affected by changes in the real interest rate A higher real interest rate reduces autonomous spending by reducing exports X98I x r as well as by reducing investment 1 x r Chapter 10 6 Final Candidate From the Real Interest Rate to the Change in Exports Exchange Rate Exports as a Function as a Function of gear the Interest Rate Real ofthe EXChange Rate X0 nge Holding Foreign Exchange gigglggng gn Rate Interest Rates and R t a e Speculators39 r4 reduces the real exch nge rate Feal Interest Rate Ex orts gt An increase in the and reduces domestic real gross exports interest rate Legend A change in the real interest rate has larger effects on aggregate demand than those through investment alone a change in the real interest rate changes the exchange rate and thus changes net exports as well Why does a higher domestic interest rate reduce exports A higher real interest rate makes investing in the home country more attractive foreign exchange speculators try to take advantage of this opportunity to earn higher returns by shifting their portfolio holdings to include more home currencydenominated assets This increase in demand for home currencydenominated assets and decrease in demand for foreign currency denominated assets drives down the exchange rate which is the value of foreign currency A lower value of foreign currency makes exports more expensive to foreigners their currency buys less here because it is less valuable It diminishes their ability to purchase exports Since exports are a part of autonomous spending a rise in the real interest rate diminishes autonomous spending through this channel as well Thus a change in interest rates has a bigger effect on output than one would think from the effect of interest rates on investment alone Chapter 10 7 Final Candidate The IS Curve If we put the two interest rate terms in the equation for autonomous spending together A C0 10 G XfoXge0 X erf I Xge gtltr We see that a onepercentagepoint increase in interest rates reduces autonomous spending by an amount II X98 By how much does a change in the interest rate change equilibrium real GDP The effect will be equal to the interest sensitivity of autonomous spending II X98 times the multiplier This relationship between the level of the real interest rate and the equilibrium level of real GDP has a name that was coined by economist John Hicks more than 60 years ago the quotIS curvequot where IS stands for quotInvestmentSaving curve Chapter 10 8 Final Candidate The IS Curve IncomeExpenditure Diagram Expenditure Aggregate Demand income product GDP Autonomous Spending urve Interest Rate Autonomous Spending National income product GDP Legend For each possible value of the real interest rate there is a different level of autonomous spending For each level of autonomous spending the income eXpenditure process generates a different equilibrium level of real GDP The IS curve tells us what equilibrium level of real GDP corresponds to each possible value of the real interest rate The algebra of the IS curve is straightforward if a little crowded and complicated We start from the formula for autonomous spending in terms of the factors underlying aggregate demand Chapter 10 9 Final Candidate AC0IOGXfoX 80 X erf IXgegtltr Then we divide the determinants of autonomous spending into i those that don t depend on the interest rate and ii those that do calling the rst set of determinants baseline autonomous spending or A0 A0 C0 10 6 XfoXge0 Jgerf 14140 1 Jg8gtltr We recall from the incomeexpenditure analysis that real GDP is equal to autonomous spending A divided by one minus the MPE A l MPE Replacing A with its components we see that real GDP Y is AD 17 Y r l MPE l MPE This equation can be expanded if we want to express the MPE and the baseline level of autonomous spending A0 in terms of the underlying model parameters and policy variables C0 10 G Xfo Jgeo Jg8rf I Jg8 Y 1 Cy1 t IMy 1 Cy1 t 1Myxr Chapter 10 10 Final Candidate The IS Curve Real Interest Rate r r ngr Slope 1O1tMy Equilibrium Real GDP Legend The position of the IS curve summarizes all the determinants of equilibrium real GDP and how the level of equilibrium real GDP shifts in response to shifts in the interest rate The slope of the IS curve depends on three factors all clearly Visible in its algebraic expression 1 IS slope WJ XIr X8r The position of the IS curve depends on the baseline level of autonomous spending A0 times the multiplier llMPE A0 C0 10 6 Xfo Jgeo Jgerf l MPE 1 Cy1 t 1My Chapter 10 11 Final Candidate A Change in Fiscal Policy and the Position of the IS Curve Real Interest Rate r An increase in government purchases shifts the IS curve to the r ht Equilibrium Real GDP Legend Practically any shift in policy or in the economic environment will change the position of the IS curve In this case an increase in government purchases shifts the IS curve to the right Economic Fluctuations in the United States the IS Curve as a Lens How useful is the IS curve in understanding economic uctuations in the Us over the past generation or so If we plot on a graph the points corresponding to the longterm real interest rate and output relative to potential attained by the Us economy since 1960 we see that the economy has been all over the mapior at least all over the diagram Yet we can make sense of what has happened using shifts in and along the IS curve That in fact is what the IS curve is for It is a useful tool that is why we have spent so many pages developing it In the next four sections we will apply the IS curve to gain insight into business cycle uctuations in each of the past four decades The I960s The 1960s saw a substantial rightward shift in the IS curve Increased optimism on the part of businesses the KennedyJohnson cut in income taxes and the extra government Chapter 10 Final Candidate expenditures needed to ght the Vietnam War all increased aggregate demand The IS curve rightward by perhaps ve percent of potential output in the 1960s The IS Curve in the 1960s 5 Shifting Out and Moving Along the IS Curve in the 19605 4 3 2 Real Interest Rate Previous Veal 1 0 61 1969 Early 19505 Late 196C 5 Is Curve IS Curve 96 98 100 102 104 106 108 Output Relative to Potential Legend The Vietnam War the KennedyJohnson taX cut and an increase in business optimism about the future all shifted the IS curve to the right between the start of the 1960s and the second half of the decade The late 1960s also saw a movement downward and to the right along the IS curve as real interest rates declined In large part real interest rates declined by accident The Federal Reserve did not fully gauge the amount by which in ation was rising Rising in ation increased the gap between the nominal interest rates directly controlled by Chapter 10 13 Final Candidate monetary policy and the real interest rates that determine aggregate demand the Federal Reserve did not recognize this as it was happening and thus allowed real interest rates to drift downward The Late I970s The second half ofthe 1970s saw the level of real GDP in the Us signi cantly below the level of potential output From 1977 to 1979 the Us economy moved down and to the right along the IS curve However the expansion of output toward potential was accompanied by unexpectedly high and rising in ation This rise in in ation was further fueled by a supply shock the sudden rise in oil prices triggered by the Iranian Revolution 1979 saw a sudden shift in Federal Reserve policy when Paul Volcker became Chair of the Federal Reserve replacing G William Miller Under Miller fighting in ation had been a relatively low priority Under Volcker fighting in ation became the highest priority of all The Federal Reserve raised annual real interest rates stepbystep from 1979 to 1982 up to nearly five percent The increase in real interest rates moved the economy up and to the left along the endofthel970s position of the IS curve the unemployment rate reached nearly ten percent in 1982 and real GDP fell to only 91 percent of the economy39s potential output Chapter 10 14 Final Candidate Moving Along the IS Curve Moving Along the IS Curve at the End of the 19705 5 1982 4 0 031980 M IS Curve 2 Real Interest Rate Previous Fear 1 0 90 92 94 96 98 100 102 Output Relative to Potential Legend Sharp rises in real interest rates at the end of the 1970s after Paul Volcker became Chair of the Federal Reserve pushed the Us economy up and to the right along the IS curve The I980s The election of Ronald Reagan in 1980 was followed by a massive scal expansion Military spending was increased and income taxes were cut in a series of steps that became effective between 1982 and 1985 The result of these increases in government purchases and cuts in taxes was an enormous government deficit and an outward shift in Chapter 10 15 Final Candidate the IS curve A simultaneous increase in investor optimism triggered by falling in ation combined with the government s scal stimulus to shift the IS curve outward relative to potential output by at least 12 percent The IS Curve in the Mid 1980s Shifting the IS Curve Out in the Early 19805 10 8 E y In 3 E 9 Mid 19805 I 6 IS Curve 5 a 2 II E a 4 1 an Early 19805 2 IS Curve 90 92 94 96 98 100 Output Relative to Potential Legend The Reagan budget de cits of the 1980s shifted the economy39s IS curve the right The Federal Reserve responded to this outward shift in the IS curve by raising real interest rates It sought in the first half of the 1980s to ensure that the success it had achieved in reducing in ation did not unravel The Federal Reserve feared that a rapid return of real GDP to potential GDP would put upward pressure on in ation once more Chapter 10 16 Final Candidate Hence the rise in real interest rates to make sure that the large Reaganera fiscal expansion did not have too large an effect The IS Curve in the Late 1980s Moving Along the IS Curve in the 19805 9 8 Late 19805 IS Curve 7 6 5 Real Interest Rate Previous VealI 1990 4 3 96 97 98 99 100 101 102 Output Relative to Potential Legend With the in ation of the 1970s broken and no longer a threat the Federal Reserve gradually reduced interest rates in the late 1980s As it reduced interest rates the economy moved down and to the right along its IS Curve As in ation remained low throughout the mid and late 1980s Federal Reserve policymakers gained confidence They became increasingly optimistic that higher real GDP levels relative to potential would not reignite in ation Between 1985 and 1980 Chapter 10 17 Final Candidate successive stepbystep reductions in real interest rates carried the US economy back to full employment and carried it down and to the right along the IS curve The I990s to be updated every year within editions The principal maker of economic policy since the late 1980s has been Federal Reserve Chair Alan vr quot01mquot Fr 39 J and 39 J by three 39 presidents Reagan Bush and Clinton Federal Reserve Chair Alan Greenspan also is somewhat of a rr paradox a Federal Reserve Chair whom all trust to be a ferocious in ation ghter yet one whoiin the policies that he has chosenihas frequently seemed willing to risk higher in ation in order to achieve higher economic growth or to avoid a recession Immediately after taking office Alan Greenspan faced a challenge the sudden stock market crash of October 1987 How large an effect would this crash have on aggregate demand What would it do to investment spending How much of a leftward shift in the IS curve would be generated by the sudden change in investors expectations about the future that triggered the stock market crash No one knew If the crash turned out to be the harbinger of a large leftward shift in the IS curve then an unchanging monetary policy would lead to a significant recession So the Alan Greenspanled FOMC lowered interest rates and expanded the monetary base hoping that this shift in monetary policy would offset any leftward shift in the IS curve and avoid a recession In point of fact the stock market crash of 1987 had next to no effect on investment spending or aggregate demand Economists have still not come up with a convincing story for why its effects were so small The two years after 1987 saw higher output relative to potential and lower unemployment rates The years between 1987 and 1990 did not see real interest rates risingas they usually do in the latter stages of an expansionbut real interest rates that were stable or falling As the unemployment rate fell in ation accelerated The economy moved up and to the left along the Phillips curve 1988 and 1989 saw in ation move up from three percent to four percent The Federal Reserve found that it had successfully avoided any chance of a big recession in 1988 in the aftermath of the stock market crash but only at the price of letting in ation rise above four percent per year In the second half of 1990 there came a sudden leftward shift in the IS curve the Iraqi invasion of Kuwait served as a trigger for Chapter 10 18 Final Candidate rms to reduce investment as they waited to see whether the world economy was about to experience another longrun upward spike in oil prices The US economy slid into recession at the end of 1990 The Federal Reserve worried about the upward creep in in ation in the late 1980s took no steps to reduce real interest rates as the economy slid into recession FiThe Recession of 1990 1992 The 19908 5 1997 4 3 2 Late 19805 IS Curve ca 1992 IS Curve Flee Interest Rate Previous Veal0 1 0 95 96 97 98 99 100 101 102 103 104 Output Relative to Potential Legend A sharp inward shift in the IS curve triggered a recession at the beginning of the 1990s Chapter 10 19 Final Candidate During the recession in ation fell to two and a half percent Unemployment rose to a peak of 76 percentiin the late spring of 1992 just in time to be salient for the 1992 presidential election Recovery began in mid1992 Soon thereafter Federal Reserve Chair Alan Greenspan made another decision to risk higher in ation in order to accomplish other goals 1993 saw Greenspan signal that if Congress and the president took signi cant steps to reduce the budget de cit then the Federal Reserve would try as best as it could to maintain lower interest ratesa shift in the policy miX that would keep the target level of production and employment unchanged but that with lower interest rates would promise higher investment and faster productivity growth an quotinvestmentled recoveryquot This time the gamble turned out extremely well As scal policy tightened in 1994 and beyond interest rates remained signi cantly lower than they had been in the 1980s even though output recovered to potential Moreover this time there was no signi cant acceleration of in ation even though by the end of the decade of the 1990s unemployment had fallen to the lowest level in a generation Chapter 3 1 Final Lecture Notes Chapter 3 Thinking Like an Economist J Bradford DeLong httpeconl6lberkeleyedu delongeconberkeleyedu Understanding Macroeconomics In away learning an 39 quot 39 J39 39r like 39 is similar to learning a new language or being initiated into a club Economists way of thinking allows us to see the economy more sharply and clearly than before Of course it can also cause us to miss certain relationships that are hard to quantify or hard to think of as purchases and sales that is why economics is not the only social science and we need sociologists political scientists historians psychologists and anthropologists as well In this chapter we will survey the intellectual landmarks of economists39 system of thought in order to help you orient yourself in the mental landscape of macroeconomics Economics Is It a Science If you are coming to economics from a background in the natural sciences you probably expect economics to be something like a natural science only less so To the extent that it works it works more or less like chemistry though it does not work as well Economic theories are unsettled and poorly described Economists predictions are often wrong If you hold these opinions you are halfright While economics is a science it is not a natural science It is a social science Its subject is not electrons or elements but human beings people and how they behave This subject matter has several important consequences Some of them make economics easier than a natural science some of them make economics harder than a natural science and some of them just make it different First because economics is a social science debates within economics last a lot longer and are much less likely to end in a clear consensus than in the natural sciences The major reason is that different people have different Views of what makes a free a good a just or a wellordered society They look for an economy that harmonizes with their Chapter 3 2 Final vision of what a society should be They ignore or explain away facts that turn out to be inconvenient for their particular political views People are after all only human Economists try to approach the objectivity that characterizes most work in the natural sciences After all what is is and what is not is not Even if wishful thinking or predispositions contaminate the results of a single study later studies can correct the error But economists never approach the unanimity with which physicists embraced the theory of relativity chemists embraced the oxygen theory of combustion and biologists rejected the Lamarckian inheritance of acquired characteristics Biology departments do not have Lamarckians Chemistry departments do not have phlogistonists But economics departments do have a wide variety of points of view and schools of thought Second the fact that economics is about people means that economists cannot ethically undertake largescale experiments Economists cannot set up special situations in which potential sources of disturbance are reduced to a minimum then observe what happens and generalize from the results of the experiment where sources of disturbance are absent to what happens in the world where sources of disturbance are common Thus the experimental method the driver of rapid progress in many of the natural sciences is lacking in economics This aw makes economics harder to do and it makes economists conclusions much more tentative and subject to dispute Third the subjects economists studypeoplehave minds of their own They observe what is going on around them plan for the future and take steps to avoid future consequences that they foresee and fear will be unpleasant At times they simply do what they want just because they feel like doing it Thus in economists analyses the present often depends not just on the past but on the future as wellor rather on what people expect the future to be Box 31 presents one example ofthis it describes how people s expectations of the future and particularly their fear that there might be a depression contributed to the coming of the Great Depression of the 1930s This third wrinkle makes economics in some sense very hard Natural scientists can always assume the arrow of causality points from the past to the future In economics people s expectations of the future means that the arrow of causality often points the other way from the anticipated future back to the present Expectations and the Coming of the Great Depression An important example of how people s expectations can change the course of economic events comes from the stock market crash of 1929 The crash changed what Americans expected about the future of the economy and the shifts in spending caused by these changes in expectations played a key role in causing the greatest economic depression in American history the Great Depression Chapter 3 3 Final On October 29 l929the price of shares traded on the New York Stock Exchange suffered their largest oneday percentage drop in history Stock values bounced back a bit initially but by the end of the week they were down by more than a quarter see Figure 31 Gloom fell over Wall Street Many people had lost a lot ofmoney The Stock Market 1928 1932 If 300 SampP 500 2000 Nomlnal Index 39 1941 43 1000 1 000 J 1928 1929 1930 1931 1932 At that time stock ownership was con ned to the rich Middleclass Americans owned little stock Nonetheless the crash affected their perceptions of the economy bad times were coming Because people expected the economic future to be dimmer many cut back on spending especially on bigticket consumer durables The 1920s had been the first decade in which consumer credit had been widely available to finance purchases of cars refrigerators stoves and washing machines With the economic future uncertain spending on consumer durables collapsed It made sense to borrow to buy a consumer durable only if you were confident that you could make the payments and pay off the loan If you thought the economic future might be bad you had a powerful incentive to avoid debt And in the short run the easiest way to avoid debt is to not to purchase large consumer durables on credit You can probably guess what happened in the months after the crash Most people simply stopped buying bigticket items like cars and furniture This massive drop in demand reduced new orders for goods The drop in output generated layoffs in many industries Even though most people39s incomes had not yet changed their expectations of their future income had Chapter 3 4 Final The drop in demand produced by this shift in expectations helped bring on what people feared and put America on the path to The Great Depression The Great Depression happened in large part because people expected something bad to happen Without that pessimistic shift in expectations triggered by the crash of 1929 there would have been Great Depression In spite of the political complications the nonexperimental nature and the peculiar problems of cause and effect in economics the discipline remains a quantitative science Most of the relationships that economists study come quantified Thus economics makes heavy use of arithmetic and algebra while political science sociology and most of history do not Economics makes heavy use of arithmetic to measure economic variables of interest Moreover economists use mathematical models to relate these variables The American economy is complex 130 million workers 10 million firms and 90 million households buying and selling 24 trillion worth of goods and services a year Economists must simplify it To understand this complex phenomenon they restrict their attention to a very few behavioral relationshipscauseandeffect links between economic quantitiesand a handful of equilibrium conditionsthat is conditions that must be satisfied for economic activity to be stable and for supply and demand to be in balance They attempt to cappture these behavioral relationships and equilibrium conditions in simple algebraic equations and geometric diagrams Then they try to apply their equations and graphs to the real world while hoping that their simplifications have not made the model a distorted and faulty guide to how the real world economy works Economists call this process of reducing the complexity and variation of the realworld economy into a handful of equations building a model Using these to understand what is going on in the complex realworld economy has been a fruitful intellectual strategy But modelbulding tends to focus on those variables and relationships that fit easily into the algebraic model It overlooks other factors The Circular Flow of Economic Activity When economists speak of the quotcircular owquot of economic activity they have a definite picture in mind They see patems of spending income and production as liquid owing through various sets of pipes In this extended metaphor categories of agents in the economy all businesses or the government or all householdsare the pools into and out of which the uid of purchasing power ie money ows Thus economists think of economic activitythe pattern of production and spending in the economyas a circular ow of purchasing power through the economy This circular ow metaphor allows them confidently to predict that changes in one part of the Chapter 3 5 Final economy will affect the whole and in what ways It allows them to simplify economic behavior to understand the entire set of decisions taken by different agents in different parts of the economy by thinking of a few typical decisions taken by abstract representative agents Income production and expenditure can be measured at three different points in the circular ow Economists measure GDP at the point where consumers exporters the government and firms that are making investments purchases goods and services from businesses This measurement is real GDP or total output It is the total economywide production of goods and services It is the quotexpenditure sidequot measure of the circular ow Economists also measure the level of economic activity at the point in the circular ow where businesses pay households for the factors of production Businesses need labor capital and natural resources all factors of production owned directly or indirectly by households When businesses buy them they provide households with incomes This measurement is called total income or national income It is the quotincome sidequot measure of the circular ow Third economists measure the level of economic activity at the point where households decide how to use their income How much do they save How much do they pay in taxes How much do they spend on consumption goods This measure of the circular ow of economic activity is the quotuses of incomequot measure The measure used most often is the expenditureside measure the Gross Domestic Product produced by firms and demanded by purchasers It is estimated by counting up the four components of spending and sales consumption government purchases investment and net exports If we compare the expenditureside measure of GDP with the incomeside or usesofincomeside measure we will find that aside from differences created by different accounting conventions they are equal see Box 32 They are equal because the circular ow principle is designed into the National Income and Product Accounts NIPA Every expenditure on a final good or service is accounted for as a payment to a business Every dollar payment that ows into a business is then accounted for as paid out to somebody It can be paid out as incomewages fringe benefits profits Chapter 3 6 Final interest or rent or as an expenditure on goods or services of another business that then in its turn purchases factors of production What if you want to withdraw your income from the circular ow Suppose for instance you simply take the dollar bills you receive and use them to buy something old and precious from another householda bar of gold say And suppose you keep the bar of gold in your basement Doesn39t that break the circular ow The answer is that it does not You no longer have your income but the household that you bought the gold bar from does That household will then either spend it on consumption goods save it or have it taxed away What if you decided to hide the dollar bills themselves in your basement Doesn t that break the circular ow The answer is that it does not The Bureau of Engraving and Printing will notice that the total number of dollar bills circulating in the economy has dropped It will print up more dollar bills and hand them to the Treasury The government will spend these extra dollar bills and so replace the ones you have hidden The net effect would be the same as if you had saved that portion of your income by loaning it out to the government and had bought a Treasury bond There are only two differences between buying a Treasury bond and your basement storage scheme The first is that you have a stack of dollar bills in your basement rather than a piece of paper with the words quotTreasury bondquot written on it The second is that the government does not pay interest on the dollar bills stacked in your basement but it does pay interest on its bonds In the circular ow diagram you have saved this portion of your income and you have saved it in a relatively pointless way by making the government an interestfree loan Markets Economists often speak as if all economic activity took place in the great openair marketplaces of medieval merchant cities Contracts between workers and bosses are made in the labor market All the borrowing of money from and the depositing of money into banks take place in the money market Supply and demand balance in the goods market Indeed in the market squares of preindustrial trading cities you could survey the buyers and sellers and form a good idea of what was being sold for how much In using the openair markets of centuries past as a metaphor for the complex processes of matching and exchange that take place in today39s modern industrial economy economists are assuming that information travels fast enough and that buyers and sellers Chapter 3 7 Final are well informed enough that prevailing prices and quantities are as if we actually could walk around the perimeter of the marketplace and examine all buyers and sellers in an hour In most cases this will be a good intellectual bet to make But some times for example in situations of socalled structural unemployment it may not be Eq u i i bri u m Economists spend most of their time searching for the state of equilibrium a point or points of balance at which some economic quantity is neither rising nor falling The dominant metaphor is of an oldfashioned scale whose two pans are in balance This search for equilibrium is an attempt to simplify the problem Economis questions are much easier to analyze if we can identify points of rest where pressures for economic quantities to rise and fall are evenly balanced Once the potential points of rest have been identi ed economists can gure out how fast economic forces will push the economy to those points of equilibrium This search for points of equilibrium followed by an analysis of the speed of adjustment to equilibrium is the most common way of proceeding in any economic analysis Do not however forget that this pattern of thought is merely an aid to understanding economic theories and principles They are not the theories and principles themselves the theories and principles in turn are just aids to understanding the reality they are not themselves the reality Graphs and Equations In the seventeenth century the French philosopher and mathematician Rene Descartes spent much of his life demonstrating that graphs and equations are two different representations of the same reality Specifically an algebraic equation relating two variables can also be represented as a curve drawn on a graph Each of the variables in the equation can be thought of as one of the axes of the graph The set of points whose x axis value is the first variable and whose yaxis value is the secondithat is the set of points for which the equation holdsimakes up the line or a curve on the graph That line or curve is the equation see Figure 35 Thus the solution to a set of two equations is that point on the graph where the two curves that represent the equations intersect Moreover you can just as easily move back in the other direction by thinking of a curve in terms of the equation that generates it Today economists make very extensive use of these ideas from Rene Descartes s analytic geometry Just after the end of World War 11 Professor Paul Samuelson of MIT discovered that many of his students were much more comfortable manipulating diagrams than solving algebraic equations With diagrams they could see what is going on in a hypothetical economy Thinking of how a particular curve would shift was often easier than thinking of the consequences of changing the value of the constant term in an equation Chapter 3 8 Final If you nd analytic geometry easy and intuitive then Samuelson s intellectual innovation will make 39 more quot 39 to you D 39 39 39 relationships become curves that shift about on a graph Conditions of economic equilibrium become dots where curves describing two behavioral relationships cross and thus both behavioral relationships are satis ed Changes in the state of the economy become movements of a dot Understanding economic theories and arguments becomes as simple as moving lines and curves around on a graph and looking for the place where the correct two curves intersect And solving systems of equations becomes easy as does changing the presuppositions of the problem and noting the results If you are not comfortable with analytic geometry then you need to nd other tools to help you think like an economist Remember that the graphs are merely tools to aid your understanding If they don39t then you need to concentrate on understanding and manipulating the algebra or at understanding and using the verbal descriptions of a problem Use whatever method feels most comfortable grab hold of what makes most sense and recognize that all three are ways of reaching the same conclusions Building Models The American economy is complex 130 million workers 10 million rms and 90 million households all producing 85 trillion worth of goods and services a year Economists have placed the intellectual bet that the best way to understand this complexity is to simplify Restrict the problem to a very few behavioral relationships causeandeffect links between two sets of economic quantities Look at only a handful of equilibrium conditionsconditions that must be satis ed for economic activity to remain stable Capture these few behavioral relationships and equilibrium conditions in simple algebraic equations and use diagrams to represent those equations See how the mathematical system made up of those equations behaves Then apply them back to the real world and hope that the quanti ying and simplifying have not made the model a bad approximation to reality Economists call this process of focus and analysis quotbuilding a modelquot Simpli cation is the essence of modelbuilding Economists use simple models for two reasons First no one really understands excessively complicated models and model is of little use if economists cannot understand the logic behind a model39s prediction Second the predictions generated by simple models are nearly as good as the ones generated by more complex models While the economic models used by the Federal Reserve or the Congressional Budget Of ce are more complicated than the models presented in this textbook at the bottom they are clearly cousins of the models used here You may have heard that economics is more of an art than a science This means that the rules for effective and useful modelbuildingfor omitting unnecessary detail and Chapter 3 9 Final complexity while retaining the necessary and important relationshipsare nowhere written down In this important respect economists tend to learn by doing or by example But there are fundamental steps that almost every successful construction of a macroeconomic model follows They include the use of representative agents a focus on opportunity costs in understanding agents decisions and careful attention to the effect of people s expectations on events Excel File PopGrowth XlS Population Growth in the Solow Growth Model The Basic Idea Over time population and L the number of workers increases That means that this year s k the stock of capital per worker will change due to THREE effects 1 investment 7 k will grow as more machines are added 2 depreciation 7 k will fall as machines wear out and are thrown away 3 population growth 7 k will fall as there are more workers upon which to spread machines around The sheets US Population and US Civilian LF contain data on pop growth rates These sheets show the following facts to remember US population has grown at 13 per year from 1900 to 1998 US civilian labor force has grown at 165 per year from 1947 to 1999 We39ll follow Mankiw to keep it simple and assume both W171 grow at 1 Mankiw captures the three in uences on changes in capital per worker in one single equation Aksy78nk Obviously the n stands for the rate of growth of population but how does the math work How is this equation derived No Population Growth Model First let s do the n0 case The total capital stock in period t1 is equal to the total capital stock in the previous period plus the amount of output devoted to investment minus the amount of capital used up in production In the language of mathematics that s Kt1 K1 1 SY 6K1 Now let s divide the entire equation by the number of workers in period t1 K 21 L 5 Si 45g Lt1 Ltl Ltl 1 Since there s no population growth Lt1Lt so we can simply replace the L1H values on the righthandside with L LzZlkAeWBDdoc Page 1 of6 L 1 Then we can apply the K L k and YL y substitutions km k syt Skt Since the change in k Ak is equal to km k we have Ak syt 5kt The equation above describes how capital per worker changes In the steady state the change in capital per worker must be zero so Ak syt 5kt 0 is the familiar steadystate condition we used for the simple KAcc model Adding Population Growth Now what happens when L is growing at a constant rate n We return to the starting point Km K sYt 5K1 Now let s diVide the entire equation by the number of workers in period t1 K 21 L L Si 5A 1 Lt1 Ltl Ltl If we assume constant population growth that equals constant labor force growth we have Lt11nLt Like Mankiw says if n1 per year then 150 million workers in one year will lead to 101 150 1515 million the next year and 101 1515 or 153015 million the year after that So we can simply replace the LM values on the righthandside with 1nLt Kt 1 Kt Y K s 5 LH1 1nLt 1nLt 1nLt Then we can apply the K L k and YL y substitution LzZlkAeWBDdoc Page 2 of6 l s 5 11 7 kt Y 39 kt 1n 1n 1n We can t simply do quotthe change in k Ak is equal to km ktquot because ofthat pesky l1n We ve got to get rid of it How Let s collect the k terms on the righthandside k l7 L lk 171n 11n 1nJ 3 3971 5739 km 1nyzL 1nJICz Here comes the really tricky part We know we want a k term so that we can do the Ak move so we add and subtract 1 from inside the brackets like this s l7 ln 1 57l k 71ny L171n1nlk Then we multiply through and recombine terms in the numerator keeping careful track of the signs 7 s l7lnl 57 km 7 1nYt 7 ktL 1n J 7 s l7n 57l km 7 1nYt 7 ktL1ncht 7 s 7n57 km 7 1nYt t L1nchz Now that we39ve got the k term on the righthandside we can subtract it from the lefthandside in order to get Ak yt 7n57k ln L1nl S You have to admit we re pretty close to Ak syt 8nkt How do we get the rest of the way Well it turns out that strictly speaking we don39t What we do is note that at the steadystate the 1n term disappears because Ak 0 at the steady state LzZlkAeWBDdoc Page 3 of6 When Ak 0 the sy and n5k terms will equal each other and multiplying both sides by 1n will cancel out the 1n terms Or if you multiply both sides of Ak by 1n then set 1n Ak 0 it s clear that the 1n term will vanish The upshot of the argument above is that when we solve for the steadystate solution we can safely ignore the 1n term and treat the equilibrium condition as simply syt 8nkt 0 However if we want to get the correct time path of the system the 1n term does matter The Excel sheet PopGrovrtb gets it exactly right Mankiw39s Presentation The algebra presented above may confuse or enlighten you It is certainly cumbersome and boring Mankiw simply avoids it Footnote 6 p 98 says quotAfter a bit of manipulation this produces the equation in the textquot It looks like he remains faithful to his goal quotto offer the clearest most uptodate most accessible course in macroeconomics in the fewest words possiblequot LzZlkAeWBDdoc Page 4 of6 Finding the Steadv State Equilibrium Solution Having explained the derivation of the syt 8nkt 0 equilibrium condition we can now nd the initial steady state solution to the model A variety of options are available Numerical Methods PopGrowth sheet Years button The old reliableiwatch the time path and see where it settles down Excel Solver a new strategy Algebra Same as before except now there s an n term oating around Suppose y fk Aka with A l and a 12 then at the steady state we39d have s l n5 my39l1nlk 0 sy n5k 0 sJk n5k s k W2 S IJk n5 s2 mmk S mm z39 Sz n5 S 6 l Sm Comparing Numerical Methodsiare the answers the same LzZlkAeWBDdoc Page 5 of6 Finding the Golden Rule Level of the Savings Rate Numerical Methods Notice hoW you can use the constraint to force Solver to nd the savings rate that maximizes cquot subject to being in the steady state Comparative Statics Numerical Methods 1 Time Path based methods The clunkiest is i 751315 sgnrqucw mm W 0m 0mm El They both suffer from the fact that you have to make sure you39ve driven Ak close enough to zero Even numbers like 0002345 may yield a k that is quotfar away m k Their advantage is that you can see the time path The Comparative Statics Wizard 2 Solver based Methods Use the Comparative Statics Wizard to have Solver properly constrained nd steady state solutions given a set of values of an exogenous varia e Analytical Methods Wgebra and Calculus Take the derivative of the reducedform and evaluate it Comparing Methodsiare the answers the same LZZIkAeWBDdoc Page 6 of6 Chapter 8 1 Final Lecture Notes Chapter 8 Money Prices and Inflation J Bradford DeLong M o ney Newspaper and television commentators devote a lot of attention to in ation In ation disrupts the economy in a number of different ways Moreover even when in ation is absent fear that it will emerge has a powerful effect on the economy The actions of economic policymaking agencies like the Federal Reserve are tightly constrained by fear that certain courses of action will lead to in ation The US experienced an episode of relatively mild in ationprices rising at between five and ten percent per yea in the 1970s Although relatively mild that in ation was large enough to cause significant economic and political trauma Avoiding a repeat of the in ation of the 1970s remains a major goal of economic policy even today a quarter century later Many countries have experienced in ations that are not mild In Russia in 1998 the price level rose at a rate of 60 percent per year In Germany in 1923 prices rose at a rate of 60 percent per week Socalled hyperin ations have been seen in many other countries in this century from Argentina to Ukraine from Hungary to China They are extremely destructive They in ict severe damage on the ability of money to grease the wheels of the social mechanism of exchange that is the market economy The system of prices and market exchange breaks down and production can fall to a small fraction of potential output chapter 8 2 Inflation in the United States 19511994 l4 o 7 CPIVU 12 10 5 6 4 2 0 1950 H950 1970 HMS 1990 Legend All measures ofprice changes show aburst of in ation in the US in the 705 Sumce 2000 Economic Repurtufthe Przszdzm Washington GPO The power to analyze real variables without ever referring to the price level is a special feature ofthe fullemployment exibleprice model ofthe economy Economists call this 39 39 39 39 quot or the 39 A A 39 39 39 39 aiiaine also hear economists speak ofthis as the property that quotmoneyquot is neutral orthat quotmoneyquot is avezlna covering that does not a ect the shape of the face underneath real L like the price level You will 11 pl L 4 39 L de ationin Fquot wonh doing for two rea on First 39 quot l Chapter 8 3 Final contrast the conclusions of future chapters Second whenever we look over relatively long spans of timedecades perhapswages and prices are effectively exible they do have time to move in response to shocks and the exibleprice assumption is a fruitful and useful one Money Liquid Wealth That Can Be Spent When normal people use the word quotmoneyquot they may mean a number of things quotMoneyquot may be used as a synonym for wealth when we say quotshe has a lot of moneyquot we mean that she is wealthy quotMoneyquot may be used as a synonym for income when we say quothe makes a lot of moneyquot we mean that he has a high income When an economist uses the word quotmoneyquot however he or she means something different To an economist quotmoneyquot is wealth that is held in a readilyspendable form Money is that kind of wealth that you can use immediately to buy things because others will accept it as payment Today the economy39s stock of money is made up of Coin and currency that are transferred by handing the cash over to the seller which almost everyone will accept as payment for goods and services Checking account balances that are transferred by writing a check which most people will accept as payment for goods and services Other assetslike savings account balancesthat can be turned into cash or demand deposits nearly instantaneously risklessly and costlessly Why do economists adopt this special definition of money I do not know Giving normal household words special definitions is probably a bad thing to do It causes confusion and mistunderstanding Yet economists do so for not only quotmoneyquot but also for terms like quotinvestmen quot and utility Whether assets that can be quickly and cheaply turned into cash like savings account balances money market mutual funds liquid Treasury securities and so on are included in the money stock is a matter of taste and judgment At what level of cost and inconvenience is an asset no longer quotreadily spendablequot There is no clear hard bright line unambiguous answer Thus economists have a number of different measures of the money stockiidentified by symbols like H M1 M2 M3 and Leach of which draws Chapter 8 4 Final the line around a different set of assets that it counts as wealth readily enough spent to be quotmoneyquot The Usefulness of Money Try to imagine a barter economy an economy without the social convention of money In our world all you need to carry out a market transactionwhether you want to buy or sell some good or serviceis to either have money if you want to buy or for the purchaser to have money if you want to sell In a barter economy market exchange would require the socalled coincidence of wants You would have to have physically in your possession some good or service that they wanted and they would have to have in their possession some good or service that you wanted As Figure 82 shows nding consumption goods to satisfy the coincidence of wants would get remarkably complicated remarkably quickly Without money an extraordinary amount of time and energy would be spent simply arranging the goods one needed to trade Chapter 8 5 Final Coincidence of Wants Farmer w nts A MN A needs to eat Mover A wants to read novel Writer Barber wa llS C Carpenter Legend Without money how is the carpenter to persuade the farmer to give him corn when the farmer wants a haircut but doesn39t need fumiturewhich the cook wants How is the mover going to persuade the cook to feed him when the cook doesn39t need the moving truckthe writer does With money all can sell what they have for cash and have con dence that they can then turn around and use the cash to buy what they need Units of Account There is one other feature worth noting The same assets that serve as the most common form of readilyspendable purchasing power also serve us as units of account Dollars or euros or yen are not only what we use to settle transactions but also what we use to quote prices to one another At some times and places the function of money as a medium of Chapter 8 6 Final exchange and of money as a unit of account have been separated but today they almost invariabley go together This is a potential cause of trouble Anything that alters the real value of the domestic money in terms of its purchasing power over goods and services will also alter the real terms of those existing contracts that use the money as the unit of account The effect of changes in the price level on contracts that have used the domestic money as a unit of account is a principal source of the social costs of in ation and de ation The effect of changes in the exchange rate on contracts that have used foreign monies as units of account is a principal source of the social costs of currency crises The Quantity Theory of Money People have a demand for money just as they have a demand for any other good They want to hold a certain amount of wealth in the form of readilyspendable purchasing power because the stuff is useful The more money in your portfolio the easier it is to buy things Too little money makes living one s life pointlessly difficult You have to waste time running to the bank for extra cash or waste energy and time liquidating pieces of your portfolio before you can carry out your normal daily transactions On the other hand you don t want to have too much of your wealth in the form of readily spendable purchasing power Cash sitting in your pocket is not earning interest at the bank Wealth you will not want to spend for five years could earn a higher return as a certi cate of deposit or invested in the stock market than sitting in your checking account Reasons for and Opponunity Cost of Holding Money Expensive Wealth in Needed because you readily to make lose interest spendable transactions and profits form go smoothly Chapter 8 7 Final Legend As with every other economic decision the amount of wealth households and businesses wish to hold in the readilyspendable form of money depends on bene ts of holding money and the opportunity costithe lost interest and profitsiof doing so The theory that the only important determinant of the demand for money is the ow of spending is called the quantity theory of money It is summarized in either the Cambridge England moneydemand function 1 M gtltPgtltY V or in the American quantity equation M X V P X Y In either form of the quantity theory P X Y represents the total nominal ow of spending For each dollar of spending on goods and services households want to hold lV dollars worth of money The parameter Via constant or perhaps growing slowly and predictably trend in this section of the chapter onlyilater on things become more complicated is the velocity of money The velocity of money is a measure of how quotfastquot money moves through the economy how many times a year the average unit of money shows up in someone39s income and is then used in to buy a nal good or service that counts in GDP Thus if we know real GDP Y the velocity of money V and the money stock M we can calculate that the price level is 124ij Should the price level be momentarily higher than the quantity equation predicts households and businesses will notice that they have less wealth in the form of readily spendable purchasing power than they wish They will cut back on purchases for a little Chapter 8 8 Final while to build up their liquidity As they cut back on purchases sellers will note that demand is weak and cut their prices so the price level will fall Example Calculating the Price Level from the Quantity Equation It is straightforward to use the quantity theory of money P XM Y to calculate the price level For example in the third quarter of 1998 real GDP in chained 1992 dollars was equal to 7566 billion the M1 measure of the money stock was equal to 1072 billion and the velocity of money was equal to 7964 Therefore 7964 K897 556 In the third quarter of 1998 the price level was equal to 11284 of its 1992 level which works out to an average rate of in ation of about 214 per year from 1992 to 1998 Xl072 11284 Had velocity grown an additional 10 between 1992 and 1998 the price level would have grown an additional 10 as well if the money stock and real GDP were unchanged from their historical values Had the money stock growth by an additional 10 between 1992 and 1998 the price level would have grown by an additional 10 as well if velocity and real GDP were unchanged from their historical values And had real GDP grown by an additional 10 between 1992 and 1998 this would have reduced the 1998 price level by 10 relative to its historical value if velocity and the money stock were unchanged from their historical values In the United States the Federal Reserve the nation39s central bank determines the money stock That is the basic task of monetary policy the determination of the money stock The central bank directly determines the monetary base the sum of currency in circulation and of deposits at the Federal Reserve s twelve branches When the central bank wants to reduce the monetary base it sells shortterm government bonds and accepts currency or deposits at its regional branches as payment The currency is then removed Chapter 8 9 Final from circulation and stored in a basement somewhere the deposits it receives as payment are then erased from its books Thus the monetary base declines When the Federal Reserve wants to increase the monetary base it buys shortterm government bonds paying for them with currency or by crediting the seller with a deposit at the Federal Reserve These transactions are called open market operations because the Federal Reserve buys or sells bonds on the open market The procedures that govern when and how the Us central bank the Federal Reserve undertakes these transactions are decided at periodic meetings of the Federal Reserve Open Market Committee F OM C Open Market Operations To Increase the Monetary Base To Decrease the Monetary Base sells bond for cash Ibuxs bonds for cash Federal Reserve Federal Reserve Legend The Federal Reserve controls the money supply through open market operations purchases and sales of bonds on the open market A purchase of bonds increases the economy s money stock A sale of bonds sucks cash out of the economy and reduces the money stock The Federal Reserve directly controls the monetary base The other measures of the money stock are determined by the interaction of the monetary base with the banking sector Banks accept checking and savings account deposits They loan out the purchasing power deposited in the bank earn interest and provide the depositor with a claim to wealth in readilyspendable form But central banks limit commercial banks ability to accept deposits Central banks require that commercial banks redeposit at the Federal Reserve a certain proportion of their total deposits Financial institutions also find it prudent to hold extra liquid reserves in case an unexpectedly large number of depositors seek to withdraw their money There is nothing worse for a nancial institution than for it to be unable to meet its depositors demands for money Thus as Chapter 8 10 Final Box 82 shows broader measures of the money stock are larger than but limited in their growth by the size of the monetary base the regulatory reserve requirements imposed on banks and other nancial institutions and nancial institutions39 extremely powerful incentive never to get caught without the cash to satisfy depositors demands In this chapter and if truth be told in later chapters too these subjects are given short shrift in this book but are explored in great depth in Money and Banking textbooks Details Different De nitions of the Money Stock The different definitions of the money stock all draw the line separating money from notmoney in different places Economists definition of money considers any wealth held in the form of readilyspendable purchasing power to be money But ready spendability is to some degree at least a thing found in the eye of the beholder The narrowest definition of moneyicalled H for HighPowered Money or sometimes B for Monetary Base iincludes only cash and deposits at branches of the Federal Reserve The assets that make up the monetary base are special because only they can serve as reserves to satisfy the Federal Reserve s requirement that institutions that accept deposits also maintain funds to cover any emergency spike in withdrawals The narrowest commonlyused definition of money is Ml which consists of currency plus checkingaccount deposits travelers checks and any other deposits where the depositor can demand his or her money back and get it instantaneously from the bank Almost anyone will accept Mltype money as a means of payment for almost any purchase M2 adds to M1 wealth held in the form of savings accounts wealth held in relatively small term deposits and money held in money market mutual funds Some of the money included in M2 cannot be spent without paying a penalty for early withdrawal Moreover if the bank wishes it has the legal right to delay your withdrawal for a period of time M2type money is a little bit less spendable than Mltype money There are still broader definitions of money One of the broadest is M3 which includes large term deposits and institutional moneymarket fund balances Still Chapter 8 11 Final larger is L which includes savings bonds and Treasury bills But a large chunk of these assets are not readily spendable by any stretch Have you ever tried to buy something with a savings bond or a Treasury bill The quantity equation new leads immediately to an equation for the in ation rate TD the proportional rateof change of the price level if you recall our rule from Chapter 2 about how to calculate the proportional growth rates of products or quotients Put simply the proportional growth rate of a product is the sum of the growth rates of the terms multiplied together the proportional growth rate of a quotient is the difference between the growth rates of the individual terms Thus in ation velocity growth rate money growth rate real GDP growth rate To write this relationship in more compact form use a lowercase m and a lowercase v for the proportional growth rates of the money stock and velocity and use a lowercase y for the growth rate of real GDP Then Tcmvy If the proportional growth rate of real GDP is 4 per year the velocity of money V increases at a proportional rate of 2 per year and the money stock M grows at 5 per year then 7c5243 The in ation rate is three percent per year The Interest Rate and Money Demand Representing the velocity of money as a constant or slowlymoving steady trend is misleading In the real world in ation is not always proportional to money growth Chapter 8 12 Final For example in the 1980s in the United States both in ation and the velocity of money fell sharply but money growth in the 1980s was as fast as in the 1970s In ation fell even though money growth did not In the first half of the 1990s there were further rapid declines in velocity which meant that even relatively high money growth did not trigger accelerating in ation The second half of the 1990s saw equally rapid increases in velocity and so nominal money supply growth had to dip well below zero in order to keep in ation from rising Economic theory suggests that money demand should be inversely related to the nominal interest rate which is the sum of the real interest rate and the current in ation rate The cash in your purse or wallet does not earn interest Your checking account balances earn little or no interest as well As a result their purchasing power over real goods and services erodes at the rate of in ation The expected real return on keeping your money in readily spendable form is 7756 the negative of the expected in ation rate By contrast were you to take a dollar out of your checking account and invest it its real return would be the real interest rate r The difference between the rate of return on money balances and the rate of return on other assets is the opportunity cost of holding money This opportunity cost is the sum of the in ation rate Tie and the real interest rate r that is the nominal interest rate i The higher is this opportunity cost of holding money the lower is the demand for money balances as Figure 88 shows Economic theory thus tells us that the velocity of money will be a function like VVL XIKxrn2 where VL is the financial technologydriven trend in the velocity of money and V0 Vir te captures the dependence of the demand for money on the nominal interest rate The higher is the nominal interest rate i r7c the higher is the velocity function V and the lower is the demand for money Such a function for velocity means that the demand for nominal money balances is Because the level of money demand depends on the current rate of in ation we need to keep track of two equations to determine the behavior of money prices and in ation The first comes directly from the money demand function and is the equation for the price level Chapter 8 13 Final PXY Mf V XIIXr7c The second comes from the rate of change of the demand for money If in ation is constant and the proportional rate of change of the velocity trend is V then as before Tcmv y Thus if the rate of growth of the money stock is 6 per year the velocity trend is l per year and real GDP growth is 4 per year then in ation is 3 per year Now suppose that the rate of growth of the money stock suddenly increases permanently from 6 per year to 10 per year When the economy settles down the new in ation rate will be 4 per year higher7 instead of 3 per year But at an in ation rate of 7 per year the opportunity cost of holding money was higher If the real interest rate is stable at 3 per year then the opportunity cost of holding money has just jumped from 6 to 10 per year Chapter 8 14 Final Effects of an Increase in Money Growth Price Level In ation Rate Money Growth Rate rn nominal interest rate Price Level Time Money Growth Rate In ation Rate Time Relative level of money demand a er the acceleration of money growth Relative level of money demand before the acceleration of money growth Mva PXY Relative Money Demand Lrn Chapter 8 15 Final Legend An increase in the rate of growth of the money stock leads to an immediate jump in the price level to a stepup of the in ation rate and to a fall in the quantity of money demanded as a fraction of nominal GDP A higher opportunity cost of holding money will raise the velocity of money If the money stock and real GDP remain fixed this increase in the velocity of money will cause the price level to jump suddenly and discontinuously as is shown in Figure 89 By how much will the price level jump It depends on how sensitive money demand is to changes in the nominal interest rate The more sensitive is money demand to the nominal interest rate the larger will be the sudden jump in the price level Thus in the exibleprice macroeconomy a change in the rate of growth of the money stock not only changes the longrun in ation rate it also causes an immediate jump in the price level at the moment that households and businesses become aware that the rate of money growth has changed The Costs of Inflation In ation does have costs but they are subtle For the most part the costs of moderate in ation appear to be relatively small smaller than one would guess given the strength of today39s political consensus that price stability is a very desirable goal The Costs of Moderate Expected Inflation The costs of expected in ation are especially small Expected in ation raises the nominal interest rate which you will recall is equal to the real interest rate plus the rate of in ation Since the nominal interest rate is the opportunity cost of holding money balances when the nominal interest rate is high you devote more time and energy to managing your cash balances From the viewpoint of the economy as a whole this extra time and energy is just wasted Nothing useful is produced and valuable resources that could be used to add to output or simply spent enjoying yourself are used up Chapter 8 16 Final Expected in ation wastes time and energy in other ways as well Firms nd that they must spend resources changing their prices not because of any change in their business but simply because of in ation Households nd that it is harder to gure out what is a good and what is a bad buy as in ation pushes prices away from what they had perceived normal prices to be The most serious costs of expected in ation surely come from the fact that our tax laws are not designed to deal well with in ation Lots of productive activities are penalized and lots of unproductive ones rewarded simply because of the interaction of in ation with the tax system The fact that debt interest is treated as a cost means that in times of high in ation it is arti cially cheap to nance businesses by issuing bonds are borrowing at the bank and so businesses adopt debtheavy capital structures that may make the economy more vulnerable to nancial crises and certainly increase the amount of resources wasted paying bankruptcy lawyers as businesses with lots of debt tend to go bankrupt relatively easily Nevertheless when the rate of in ation is lowiperhaps when in ation less than ten percent per year probably when in ation is less than ve percent per year and certainly when n ation is less than two percent per yearthese costs are too small to worry about because they are counterbalanced by bene ts Suppose the central bank wishes to push the real interest rate below zero in some economic crisis It cannot do so unless there is some in ation in the economy because nominal interest rates cannot be less than zero and the real interest rate is the difference between the nominal interest rate and the 39 I I in ation rate Many and p J greatly harmed if worker wages are clearly and unambiguously cut A small amount of 39 have r 39 A that worker morale is in ation may then grease the wheels of the labor market allowing for wage adustment without the damaging effect on morale of explicit wage cuts The Costs of Moderate Unexpected Inflation Unexpected in ation does have signi cant and worrisome costs for unexpected in ation redistributes wealth from creditors to debtors Creditors receive much less purchasing power than they had anticipated if a loan falls due during a time of signi cant in ation Debtors nd the payments they must make much less burdensome if they borrow over a period of signi cant in ation The process works in reverse as well if in ation is less than had been expected creditors receive a windfall and debtors go bankrupt Most people are averse to risk We buy re insurance after all People who are averse to risk Chapter 8 17 Final dislike uncertainty and unpredictabilityand unexpected in ation certainly creates uncertainty and unpredictability Yet perhaps these economic costs of moderate unexpected in ation are relatively low Why don t debtors and creditors want to insure themselves against in ation risk by indexing their contracts and using some alternative more stable unit of account In economies with high and variable in ation we do see such indexation The fact that we do not in countries with moderate and low in ation suggests that the costs of in ation to individual debtors and creditors though perhaps not to society as a whole must be relatively low On the other hand there is a powerful political argument that the costs of moderate in ation are high Voters do not like moderate in ation The 1970s saw government after government in the industrialized world voted out of of ce Polls showed that voters interpreted rising rates of in ation as signs that political parties in power were incompetent at managing the economy Since the end of the 1970s no major political party in the industrialized world has dared run on a platform of less price stability and more in ation Hyperinflation and Its Costs We can see the costs of in ation mount to economydestroying levels during episodes of socalled hyperin ation when in ation rises to more than 20 percent per month Hyperin ations arise when governments attempt to obtain extra revenue by printing money and overestimate how much they can raise For some governments printing money is an important source of revenue Most governments tax their citizens or borrow from people who think that the government will pay them back But if a government nds that it does not have the administrative reach to increase its explicit tax take and that no one will lend to it it can simply print money and use the bills hot off the press to purchase goods and services Where do the resourcesthe power to buy goods and servicesthat the government acquires by printing money come from The answer is that a government that nances its spending by printing money is actually nancing its spending by levying a tax on holdings of cash Suppose I have 500 in cash in my pocket when the government Chapter 8 18 Final suddenly announces it has printed up enough extra dollar bills to double the economy s cash supply With Y and V unchanged doubling the money supply doubles the price level The 500 in my pocket will buy only as much after the govemment s money printing spree as 250 would have bought before It is as if the government levied a special onetime 50 tax on cash holdings The In ation Tax and have 500 billion in cash and reserves W the government prints an extra 500 billion in cash 50 the price level doubles and so household and where did the other 250 business cash and reserves loses half its real billion in real purchasing power value it39s now worth only 250 billion in go The government now has preinflation terms ithas raised it through the quotinflation taxquot V 2 Legend The in ation tax is a way for the government to get command over goods and services just as much as is any other tax Those who pay the in ation tax are those who hold assets that lose value in the event of in ation Where did the 250 real dollars in my pocket go The government has them it now has 500 newlyprinted dollars even if each of them is worth half a prein ation dollar in real terms Clearly printing money can be easier than imposing a 50 explicit tax To collect an explicit tax a government needs need an entire wealthtracking moneycollecting and compliancemonitoring bureaucracy To print money all the government needs is a Chapter 8 19 Final printing press some ink some paper and a working connection to the electric power grid Almost everyone agrees that this in ation taxnalso called seigniorage because the right to coin money was originally a right reserved to certain feudal lords certain seigneursnis a bad policy One of the first principles of public nance is that taxes should be broad based and lie relatively lightly on economic activity The in ation taX is a heavy taX on a narrow base of economic activity the activity of holding money Moreover the in ation taX is a heavy taX on one small slice of moneyholding cash and deposits at the central bank Other components of the money stockyour checking account sayare not a potential source of purchasing power for the government through the in ation taX Suppose that you deposited your money in your checking account and the bank then took that purchasing power and used it to buy an office building If the price level doubles you have lost half the real value of your checking account yes But the gainer in real terms is not the government The gainer in real terms is the bank that now finds the value of the office building it owns to be twice as large relative to the value of the money it owes to its depositors is not only a bad taX but in its operation it disrupts the rest of the financial system as well For these reasons the in ation taX is only resorted to by a government that is falling apart and lacks the administrative capacity to raise money in any other way Even so such a government usually finds out afterwards that the costs of the in ation taX and hyperin ation outweigh the benefits Eventually prices rise so rapidly that the monetary system breaks down People would rather deal with each other in barter terms than use a form of cash whose value is shrinking measurably every day GDP starts to fall as the economy begins to lose the benefits of the division of labor In the end the government finds that its currency is next to worthless It runs the printing presses faster and faster and yet finds that the money it prints buys less and less At the end of the German hyperin ation of the 1920s one trillion marks were needed to buy what one mark had bought less than ten years before Chapter 6 1 Final Lecture Notes Chapter 6 Building Blocks of the FlexiblePrice Model J Bradford DeLong httpeconl6lberkeleyedu delongeconberkeleyedu In the past two chapters we have looked at longrun growthiat how the economy develops and evolves over periods as long as generations In this chapter we shift our point of view and take instead a snapshot view of the economy looking at it over such a short period that its productive resources will be fixed The key questions we will seek to answer are 1 What determines the equilibrium level of real GDP Y 2 What economic forces keep real GDP Y at its equilibrium level 3 What determines the composition of real GDPithat is the division of production and spending between consumption goods C investment goods I government purchases G and net exports NX To answer the first two questions we will assume that wages and prices are sufficiently exible that markets clearithat every buyer finds a willing seller and every seller finds a willing buyer This exibleprice assumption means most importantly that supply equals demand in the labor market no firms wishing to hire workers are left unsatisfied and no workers who are willing to work are left unemployed This type of analysis is a full employment analysis In answering the third question what determines the composition of spending we will be assembling the building blocks for he analysis of the following chapter In Chapter 7 we will put these building blocks together and show in detail how the answers to the three key questions are consistent and what are the economic forces that ensure that a exible price economy reaches and stays at its equilibrium Chapter 6 2 Final Potential Output and Real Wages In the exibleprice model of the macroeconomy to be developed in this section two sets of factors determine the levels of potential and actual output and of real wages the production function and the balance of supply and demand in the labor market The Production Function Chapter 4 introduced the production function the rule that tells us how much the economy can produce given its available productive resources In the CobbDouglas form of the production function we learned potential output Y is determined by l the size of the labor force L 2 the economy39s capital stock K 3 the efficiency of labor E and 4 a parameter 0L that tells us how fast returns to investment diminish The production function tells us that potential output is Y K L E 1 The assumption in this chapter that wages and prices are exible was commonly made by the socalled classical economists who wrote back before World War 11 Thus this assumption is also called the classical assumption The classical assumption guarantees that markets workithat prices adjust rapidly to eliminate gaps between the quantities demanded and the quantities supplied Thus no businesses find their inventories of unsold goods piling up Thus there is full employment everyone who wants a job at the market clearing level of wages can get a job and every business that wants to hire a worker at the marketclearing level of wages can hire a worker And because there is full employment actual output is equal to potential output there is no gap between the economy s productive potential and the level of output the economy does produce The classical assumption made in this section means that this section is devoted to full employment exibleprice macroeconomics The exibleprice assumption it is not always a good one Experience has shown that a market economy does not always work well and does not always produce full employment So while the exibleprice assumption is key in this section starting in Section III we will drop it and make instead the Keynesian assumption that wages and prices are sticky see Table 61 Chapter 6 3 Final If the classical exibleprice assumption is not always a good one to make why make it It is a good assumption if wages and prices are relatively exible and have enough time to adjust in order to balance supply and demand The classical assumption simplifies the analysis of several issues making how the macroeconomy works easier to grasp In general it is better to start with the simpler cases before looking at more complicated ones Moreover the way an economy if the exibleprice assumption held provides a useful baseline against which to assess economic performance Nevertheless we must remember that this section presents only one model of the economy the classical model The Keynesian stickyprice model behaves very differently in a number of ways The Labor Market Economists try to suppress every detail and difference that does not matter to the overall result in order to simplify the analysis and focus it on the key important factors that count Because differences between businesses will not matter let s think about an economy with K typicalidenticalcompetitive firms each of which owns one unit of the economy39s capital stock Each of these typical competitive firms hires L workers and each firm pays each worker the same wage W Each firm sells Y units of its product at a perunit price P The typical firm does not control either the wages it must pay or the prices it receives those are determined by the market The firm tries to make as much money as it can The typical firm s profits are simply its revenues minus its costs and its only costs are the wages it pays to workers Therefore Pro ts Revenues Costs ProfitsPXYWXL To figure out how many workers to hire the firm follows two simple rules 1 Hire workers to boost output 2 Stop hiring when the extra revenue from the output produced by the last worker hired just equals his or her wage Chapter 6 4 Final The value of the output produced by the last worker hired is the product price P times the marginal product of labor MPL The cost of hiring the last worker is his or her wage W The rm will keep hiring until PXMPLW0 The marginal product of labor is the difference between what the rm can produce with its current labor force L m and what it would produce if it hired one more worker see Figure 62 MPL F1 Lf 1 F1 L m The MPL for the CobbDouglas production function is MPL K gtltE L m 1 K gtltE L m 1 Again we take how much the rm would produce if it hired one more worker and subtract how it produces now with its current labor force Since the rm has only one um um unit of capital we can rewrite this equation as MPL l XEI L 1 0c l gtltE1 Lfm1 0c rm 2 Eliot Hm 1170c L rm lroc The term inside the brackets looks like the rateofgrowth of a variable growing by one unit the rm s labor force L m and then raised to a power the term lOL We have a standard ruleofthumb look back in Chapter 2 at Box 23 Useful Mathematical Tools for dealing with such a situation The proportional growth rate of a variable raised to a power is the proportional growth rate of the variable multiplied by the power to which the variable is raised This tells us that the term inside the brackets is L m 1 L m1 1 0Lgtlt l L So the MPL is 1 0LE1 MPL a L m Chapter 6 5 Final There is nothing deep in this math Indeed the CobbDouglas function was carefully tweaked so that it would yield such simple forms for quantities like the MPL That is why economists use it so often If the CobbDouglas production function produced more complicated expressions we would not use it The firm hires workers up to the point where the product price times the marginal product of labor equals to the wage P xMPL W 0 Substituting for the MPL in this equation we get 1 CL E P x W L m Next we rearrange this equation to see that the typical firm s demand for workers is L OOEIroc WP Because there are K firms in the whole economy total economywide employment is equal to K times the typical firm s demand for labor 10 Xx LK1 ocE WP What is the labor supply The answer is simple it is the number of workers who want to work The labor market will be in equilibrium when firms39 total demand for workers is equal to the labor force Can the labor market not be in equilibrium if wages and prices are exible Think about what would happen if supply were not equal to demand Suppose there are more workers than firms wish to hire at current wages and prices Then some of the unemployed will underbid their employed fellow workers offer to take their jobs and work for less Those workers who are employed will respond by offering to accept lower wages to keep their Chapter 6 6 Final jobs The wage W will decline relative to the price level P and the real wage WP will fall As the real wage falls rms will hire more workers Suppose rms want to hire more workers than there are people in the labor force Some rms will try to bid workers away from other rms by offering higher wages The real wage WP will rise As the real wage rises employers will reduce the quantity of labor they demand Thus in equilibrium labor demand Ld will equal the labor force L see Figure 64 1 0LElrot Xx WP Labor demand is equal to the labor force when the real wage WP is W K a Y 1 0LEquot l OL P lt gt L lt gt L and each of the K rms in the economy employs LK workers As long as wages and LL K prices are exible enough for this adjustment process to work the economy will remain at full employment Note that a full employment economy is not necessarily the best or even a good economy The real incomes of those who don t own chunks of the capital stock are their real wages WP lOL X YL IfOL is large their real incomes will be small and social welfare may be low When the labor market is in equilibrium the typical rm produces a level of output equal to Y m 1 E17 L KY Because there are K rms total output Y is simply K times the typical rm s output Y K X Y m production function analysis This is the same potential output Y in the CobbDouglas form of the Y K x 1 K gtlt1 E1 L K K E1 L1 10 LEW Y
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