econ 202 midterm 1

ECON 202 MIDTERM 1

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Introduction

Who am I?Nam Ho, 4A Honours Economics

Agenda

1. The Science of Macroeconomics. Macroeconomics in Practice

2. The Data of Macroeconomics3. National Income, The Long-Run Closed

Economy4. The Long-Run Open Economy

Note: Money and Inflation will be covered intermittently as it differs greatly across sections

Part 1The Science of Macroeconomics.

Macroeconomics in Practice

What is Macroeconomics

• Macroeconomics is the study of the overall economy

• Macroeconomic research is mainly focused around:– Real GDP and the business cycle– Inflation– Unemployment

Macroeconomic Models

• Creates simplified versions of the economy in order to:– Show relationships between variables– Explain movements in the economy– Formulate policies to prevent recessions and other

negative shocks to the economy

• Are these models realistic?

Macroeconomic Models

• Two types of variables– Exogenous – input variables determined outside

the model– Endogenous – output variables generated within

the model

Exogenous Input Model Endogenous Output

Macroeconomic Models

• Example: Given a model in which the unemployment rate will be determined. The model uses the following equation:

u = f(K, L, S) = 2K + 4L - Su = unemployment rateK = aggregate level of capitalL = aggregate level of labourS = aggregate level of savingsWhich variables are exogenous and which are endogenous?

Macroeconomic Models

• Answer:– Exogenous: K, L, S– Endogenous: u

Why?u is a function of K, L, and S. Therefore, in the way

that we have our model specified, K, L, and S are the external (exogenous) inputs to our model while u is the determined (endogenous) variable.

Other Important Terms

• Market clearing – we say that a market clears when an equilibrium point is achieved such that supply is equal to demand

• Sticky prices – the idea that prices do not chang very quickly or easily, they respond sluggishly to changes in the economy

• Flexible prices – the idea that prices adjust quickly in response to movements in the economy in order for markets to clear

Other Important Terms

• Application of sticky and flexible prices.Short-run (sticky prices) – prices do not adjust quickly to clear markets. This creates to the potential for shortages and surpluses.

Long-run (flexible prices) – prices adjust until markets clear and stability is achieved

Part 2The Data of Macroeconomics

Before We Begin

• Stock vs. FlowsStock – an accumulated quantity at a point in timeExamples: Aggregate level of labour or capital

Flows – an amount per an amount of timeExamples: GDP, yearly government expenditure

GDP

• Gross Domestic Product (GDP)Multiple Definitions1. Total expenditure on domestically-produced

goods and services2. Total income earned by domestically located

factors of production3. The current market value of all final goods and

services newly produced in an economy

GDP

• Fundamental identity of national income accountingTotal Production = Total Expenditure = Total Income

• Does GDP capture all that goes on in an economy? No!– The underground economy– Non-commercial goods and services– Intangible factors such as life expectancy,

environmental cleanliness, or leisure time

GDP

• Value-added – the incremental value generated by a firm relative to its input

Example: Company A harvests logs of wood and sells them to Company B for $100. Company B then turns the wood into hockey sticks and sell them to consumers for $250.

How much GDP is generated? What is the value-added by Company B?

GDP

Answer:$250 of GDP is generated. Only final goods contribute to GDP, intermediate goods are not.

Company B’s value-added is$250 – $100 = $150

GDP

Additional Notes on Final Goods• Capital goods (goods that are used in the

production of other goods, E.g an assembly machine) count as final goods

• Unsold inventory investment count as GDP

GDP

Components of GDPY – Total Output (GDP)C – ConsumptionI – InvestmentG – Government ExpenditureEX – ExportsIM – Imports

Y = C + I + G + (EX – IM)

GDP

NX = Net exportsNX = EX – IM

Y = C + I + G + NX

Note: Exports and imports are also occasionally written as simply X and M

GDP

• Consumption – the total value of all goods and services. These include:– Durable goods– Nondurable goods– Services

GDP

• Investment – the total value of goods and services purchased for future use. These include:– Business investment (E.g. Spending to build

factories or purchase machinery)– Residential investment (Spending on housing,

including rent gathered by landlords)– Inventory investment (Increases in inventories

held by firms in the economy)

GDP

• Government expenditure – spending by the government on goods and services. This includes:– Government consumption– Government investment

• Transfer payments between government institutions do not count

GDP

• Net Exports = Exports – Imports• Exports are the locally produced goods and

services consumed in foreign markets• Imports are goods and services produced in

foreign nations that are consumed locally• Net Exports is also known as the trade balance

Nominal GDP vs. Real GDP

• Nominal GDP is a measure of total output using current price levels

• Real GDP is a measure of total output comparatively using the price level of the base year

• The price level of the base year is always 1

Nominal GDP vs. Real GDP

• Real GDP = Nominal GDP / Price Level

• GDP Deflator = 100 x Nominal GDP / Real GDPNotice that Price Level = 100 x GDP Deflator

• The price level of the base year is always 1Alternatively, we can say the GDP deflator in the base year is 100.

Nominal GDP vs. Real GDP

• Example: Let the base year (year 0) have a GDP of 100. In year 1, the price level increased to 1.06 and nominal GDP was 110. In year 2, the price level was 1.1 and nominal GDP was 115. What is the real GDP for each year? What is the GDP deflator for each year?

Nominal GDP vs. Real GDP

• Answer:

Real GDP GDP DeflatorY0 = 100 / 1 = 100 Y0 = 1 x 100 = 100Y1 = 110 / 1.06 = 103.77Y1 = 1.06 x 100 = 106Y2 = 115 / 1.10 = 104.55Y2 = 1.10 x 100 = 110

Year Nominal GDP

Price Level Real GDP GDP Deflator

0 100 1.00 100 1001 110 1.06 103.77 1062 115 1.10 104.55 110

Inflation

• Inflation is the growth rate of prices

The inflation rate (π) can be measured as:πt = (Pt+1 – Pt)/Pt

πt = inflation for period t Pt+1 = price at time t+1 Pt = price at time t

Unemployment

• Employed - people with jobs• Unemployed – people without jobs and are looking for jobs• Not in the labour force – people without jobs who are not

looking for employment

• Labour Force = # of Employed + # of Unemployed• Unemployment Rate = # of Unemployed / # of Employed • Labour Force Participation Rate = Labour Force / Adult Pop.• Employment Ratio = # of Employed / Adult Pop.

• Note: The adult population consists of all citizens age 16 or older

Interest Rates

• Interest rates represent the cost of borrowing• Nominal interest rate (i) – the return in dollars that a

lender receives on a loan• Real interest rate (r) – the increase in purchasing

power that the lender receives on a loan

• The Fisher Effect: r = i – πe

πe = expected inflation

Part 3National Income, The Long-Run

Closed Economy

The Closed Economy

1. Supply Side: Capital and Labour2. Demand Side: Consumption, Investment and

Government3. Loanable Funds: Borrowers, Savers, and

Interest Rates

Supply Side (Closed)

• Factors of Production– Capital (K): The input provided by machines, tools,

and other utilities

– Labour (L): The input provided by workers in the economy

Supply Side (Closed)

• The Production FunctionY = F(K,L)

• Typical Cobb-Douglas Production FunctionY = A(Kα)(L(1- α))

A = Level of technologyα = share of income dedicated to capital

Supply Side (Closed)

• The share of income dedicated to each factor is based on their prices (factor prices)

• The price of capital is expressed through the rental rate

• The price of labour is expressed through the wage rate

Supply Side (Closed)

• Like interest rates and GDP, we have nominal and real factor prices

W = nominal wage rateR = nominal rental rateP = price levelW/P = w = real wage rateR/P = r = real rental rate

• Firms will employ these factors to the point that each additional unit’s cost is equal to the benefit (marginal product)

Supply Side (Closed)

• Marginal Product of Capital (MPK)MPK = F(K+1,L) – F(K,L)

• Marginal Product of Labour (MPL)MPL = F(K,L+1) – F(K,L)

• For those with a math background, the marginal product is the first derivate with respect to the given factor

Supply Side (Closed)

• Diminishing marginal productivity – as the amount of a certain input increases, holding all other inputs constant, the added benefit of each additional unit decreases

Intuitive explanation – If you buy more computers without hiring more employees, you reach a point where there isn’t enough labour available to properly use all the capital

Production Function of LY

output

Llabour

Supply Side (Closed)

MPL, Labor demand

Labor supply

L

Labor supply

MPL, Labor demand

equilibrium real wage

Supply Side (Closed)

MPL, Labor demand

Labor supply

L

Supply ofcapital

MPK, Demand for capital

equilibrium rental

Supply Side (Closed)

• Conclusions:MPK = R/P = rMPL = W/P = w

Expenditure on capital = MPK x K = rKExpenditure on labour = MPL x L = wLTotal Expenditure = rK + wL = YExpenditure = Output

Supply Side (Closed)

• Alternatively, recall that α = share of income dedicated to capital

MPK x K = rK = αYY = rK/ αMPL x L = wL = (1 – α)YY = wL/(1 – α)

Supply Side (Closed)

• Also recall that Y = A(Kα)(L(1- α))

A(Kα)(L(1- α)) = rK/ α (from previous slide) α A(Kα - 1)(L(1 - α)) = r = MPK

A(Kα)(L(1- α)) = wL/(1 – α)(1 – α) A(Kα)(L(- α)) = w = MPL

Supply Side (Closed)

• Key FormulasY = A(Kα)(L(1- α))

Y = rK + wL

MPK = r = R/PMPL = w = W/P

Supply Side (Closed)

• Example: An economy has a nominal wage rate of $8 and a nominal rental rate of $6. The price level is 2. At these prices, the economy employ 5 units of labour and 3 units of capital. Calculate the MPK, MPL, and output.

Supply Side (Closed)

Answer:MPK = R/P = 6/2 = 3 = rMPL = W/P = 8/2 = 4 = r

Y = rK + wLY = 3(3) + 4(5)Y = 29

Demand Side (Closed)

• Components: C, I, and G

• This is a Closed economy so NX = 0

• Note: The upcoming section has some differences between textbooks, please refer to the section that corresponds to your professor

Demand Side (Closed)

• Consumption for Vaughan’s Class:Consumption is a function of output (Y), taxes (T) and the marginal propensity to consume (MPC)

C = C(Y – T)When (Y – T) C

Demand Side (Closed)

• Consumption for DeJuan’s Class:Consumption is a function of output (Y), taxes (T) and the marginal propensity to consume (MPC) but is also a minimum level known as autonomous consumption

C = C-bar + C(Y – T)When (Y – T) C

Demand Side (Closed)

• InvestmentI = I(r)

Investment is a function of interest rates (r)

When r I This is because, when interest rates rise, people prefer to borrow so they can earn the higher rate rather than borrow to invest in capital

Demand Side (Closed)

• Government spending is typically an exogenous variable

• The government creates its own budget for spending and uses taxes as income

• Balanced budget: G = T• Deficit: G > T• Surplus: G < T

Demand Side (Closed)

Aggregate Demand =C(Y – T) + I(r) + G (Vaughan’s class) orC-bar + C(Y – T) + I(r) + G (DeJuan’s class)

Aggregate Supply = Y = F(K,L)

EquilibriumY = C(Y – T) + I(r) + G (Vaughan’s class) Y = C-bar + C(Y – T) + I(r) + G (DeJuan’s class)

Demand Side (Closed)

Y = C(Y – T) + I(r) + G (Vaughan’s class) Y = C-bar + C(Y – T) + I(r) + G (DeJuan’s class)

Exogenous variables = Y, C, G

The only endogenous variable is I!

Let’s see how this works…

Loanable Funds (Closed)

• The market for loanable funds is comprised of borrowers who need to borrow money for investment and savers who want to lend money to finance later consumption or investment

Demand: BorrowersSupply: LendersPrice: Interest rate

Loanable Funds (Closed)

r

I

I (r )

Loanable Funds (Closed)

• Savings (S) in the closed economy is comprised of:S = Private Saving + Public SavingS = (Y – T – C) + (T – G)S = Y – C – GS = ISaving = Investment

Loanable Funds (Closed)

r

I

I (r )

S = Y – C – G = I

L

Equilibrium interest rate

Equilibrium investment

Closed Economy Example

• Example: Given that the following information pertains to a closed economy, what is savings? How much of it is public and how much of it is private?Y = 100 Tax rate = 0.2G = 30 MPC = 0.6Autonomous Consumption = 0

Loanable Funds (Closed)

• Answer:Public savings = Y – T – CPrivate savings = T - GSavings = Public savings + Private savingsY = 100T = Y(tax rate) = 100(0.2) = 20C = C-bar + C(Y – T) = 0 + 0.6(100 – 20) = 48G = 30

Loanable Funds (Closed)

• Answer (continued):Public savings = Y – T – C= 100 – 20 – 48 = 32Private savings = T – G= 30 – 20 = -10Savings = Public savings + Private savings= 32 + (-10) = 22

Part 4The Long-Run Open Economy

Open Economy

• Two major differences compared to a closed economy:– Spending need not equal output– Saving need not equal investment

Note: We will primarily discussing a small open economy, the descriptor of “small” means that our economy is not large enough to effect global interest rates, it is a price taker

Open Economy

• C = Cd + Cf

• I = Id + If

• G = Gd + Gf

• Y = Cd + Id + Gd + EXY = (C – Cf) + (I – If) + (G – Gf) + EXY = C + I + G + EX – (Cf + If + Gf)Y = C + I + G + EX – IMY = C + I + G + NX

Open Economy

• What happens to savings?Y = C + I + G + NXPrivate Savings = Y – T – CPublic Savings = T – GS = (Y – T – C) + (T – G)S = Y – C – GS = (C + I + G + NX) – C – GS = I + NX

Open Economy

• If S = I + NXRearranging we have S – I = NXThis implies that excess saving that are not invested locally are exported to be consumed or invested elsewhere

If S – I > 0: NX > 0 and we have a trade surplusIf S – I < 0: NX < 0 and we have a trade deficit

Loanable Funds (Open)

r

I

I (r )

Domestic Savings = S

L

World interest rate

I = S - NX

NX

The interest is now exogenous, take as the equilibrium world interest rate

Loanable Funds (Open)

r

I

I (r )

Domestic Savings = S

L

World interest rate

I = S - NX

NX < 0

Loanable Funds (Open

• Conclusion:When rd < rf NX > 0When rd > rf NX < 0

When local interest rates are higher than international rate then investment flows in as internal investors seek to lend at the higher rate, imports increase, and net exports is negative.

Open Economy

• Example: What if local government expenditure and taxes increased (expansionary fiscal policy)?

• The increase in T would decrease local savings• Equilibrium interest rates remain unchanged

because this is a small economy• Net exports will decrease

Open Economy

r

I

I (r )

S2

L

World interest rate

I = S - NX

NX2

S1

L

NX1

Open Economy

• Example: What if international large government expenditure and taxes increased (foreign expansionary fiscal policy)?

• International savings decreases• Equilibrium interest rates increase in response

to the decrease in savings• Net exports will increase

Open Economy

r

I

I (r )

r1

I = S - NX

NX2

S

L

NX1

r2

Open Economy

• Example: What if demand for investment increases?

• Equilibrium interest rates remain unchanged• Net exports will decrease

Open Economy

r

I

I (r )1

r

I = S - NX

NX2

S1

L

NX1I (r )2

Open Economy

• A few key assumptions of this model that may not hold true to reality– Domestic and foreign bonds are perfect

substitutes– Perfect capital mobility, frictionless movement of

money and capital to anywhere in the world

Tne End

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