3 - AGENDA \u2022 what determines the economy\u2019s total output\/income \u2022 how are the prices of the factors of production are determined \u2022 how is total

# 3 - AGENDA u2022 what determines the economyu2019s total...

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AGENDA what determines the economy’s total output/income?how are the prices of the factors of production are determined?how is total income is distributed across factors?A Supply/Demand model of the macroeconomy.
Outline of model Assume a closed economy , market-clearing model, where NX=0 (we will relax this assumption later on). Supply side factor markets (supply, demand, price) determination of output/income Demand side determinants of C, I, and G Equilibrium goods market loanable funds market (financial market)
The production function: Y = F(K,L) shows how much output ( Y ) the economy can produce from K units of capital and L units of labor reflects the economy’s level of technology exhibits constant returns to scale
Returns to scale: A reviewInitially Y1= F(K1,L1Scale all inputs up by the same factor z>1K2 = zK1 and L2 = (e.g., if z= 2, then all inputs are doubled)What happens to output, Y2= F (K2,L2 ) : zL 1 )? 1 1 zY 1
Returns to scale: An Example constant returns to scale for any z > 0 ( , ) F K L KL ( , ) ( )( ) F zK zL zK zL z KL 2 z KL 2 z KL ( , ) z F K L
QUIZ: Returns to Scale Determine whether each of these production functions has constant, decreasing, or increasing returns to scale: (a) (b) ( , ) F K L K L ( , ) K F K L L 2
QUIZ: Answers, part (a) constant returns to scale for any z > 0 ( , ) K F K L L 2 ( ) ( , ) zK F zK zL zL 2 z K zL 2 2 K z L 2 ( , ) z F K L
QUIZ: Answers, part (b) constant returns to scale for any z > 0 ( , ) F K L K L ( , ) F zK zL zK zL ( ) z K L ( , ) z F K L
Assumptions 1. Technology is fixed. 2. The economy’s supplies of capital and labor are fixed at and K K L L
, L K
Notation W = nominal wage R = nominal rental rate P = price of output W / P = real wage (measured in units of output) R / P = real rental rate W = nominal wage R = nominal rental rate P = price of output W / P = real wage (measured in units of output) R / P = real rental rate