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Review_Final_AAP - Measurement • GDP definitions 3...

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Unformatted text preview: Measurement • GDP definitions 3 alternative ways to get to GDP GDP Review • Measurement of inflation CPI measure the overall price changes Hold quantities constant to benchmark year • Real GDP measurement Hold prices at benchmark year, calculate the overall increase in the quantities of things BUAD 350 1 2 Production -1 C-D Production Function: • A production function: Y = AF(K, L) (1• A C-D production function: Y = A KL(1- ) C- Y L=1 (Total Output) Y= AKαL1-α Y K=1 Often specialized it to: Y = A K0.3L0.7 Increases with A (proportionally) Increases with K and L (less than proportionally) K MPK (Marginal Product of Capital) • Marginal products of K and L Slope of the production function Product of Labor) Extra Output MPL with L, and MPL with K and A MPL MPK with K, and MPK with L and A MPK L MPL (Marginal L=1 Slope of Above Function K K=1 L Note: Recall that the slope of a concave function is decreasing 3 Cost of Capital Production -2 • In equilibrium • A C-D production function: C K MPL 1 A L 4 R/P = r + 1 L MPK A K and of course r = R/P - • Equilibrium: • If f is the marginal tax rate for firms’ marginal firms’ profits, then the “required” MPK is required” r MPK 1 f MPL is the demand for labor, MPL = W/P MPL and Labor Supplied = Labor Demanded Labor MPK is the demand for capital, MPK = R/P MPK and Savings = Investment Y = C + I + G + NX NX 5 6 1 1 Labor Supply Labor Supply • The substitution effect: w labor supply • The income effect: w y labor supply We assume the substitution effect dominates The aggregate supply of labor increases with the real wage rate w Labor supply decreases with weatlh Shocks in the Labor Markets • Classical equilibrium: LD = LS • Short run U at business cycle frequencies is called cyclical unemployment cyclical When economy is booming, U is < natural rate In a recession U is > natural rate 7 8 Consumption -1 The Two-Period Model TwoPresent-value Budget Constraint (PVBC): • The consumer budget constraints in a 22period world (S >=< 0): C1 + C2/(1+r) = Y1 + Y2/(1+r) C1 = Y1 - S, C2 = (1 + r) S + Y2 can be condensed into a single intertemporal intertemporal constraint: PV(C) = PV(Y) C1 C2 (1+r)Y1 + Y2 C2 Y Y1 2 1 r 1 r Wasting resources at this point • This constraint, combined with utilityutilitymaximizing behavior by consumers, results in consumption choices C1, C2 C1 >=< Y1 , C2 >=< Y2 Y2 Save everything today & consume only tomorrow. * Can’t afford this point * Consume your income every period Y1 Y1 + Y2/(1+r) C1 Borrow to the limit & consume everything today 9 Consumption -2 10 Consumption • This can only be done if consumers are able to borrow and lend in the capital markets • Consumption depends on the present value present of income It doesn’t matter if the higher income is in the doesn’ first or second period Consumption Choice • The consumer tends to smooth consumption smooth She spreads consumption relatively evenly over both period, regardless of the income profile 11 12 2 2 Consumption -3 • Savings (like labor supply) are influenced by Consumption The substitution effect: r S , and by The income effect: r y S We assume the substitution effect dominates • Lifecycle model Ricardian Equivalence Saving is age-dependent age- • The permanent income hypothesis Permanent Income is the PV of all future income PV + current financial assets Ct t PV Et Future Incomet 13 Growth -1 Substitution Effect Dominant • The per capita production function is y = A f(k), where y = Y/L, k = K/L • Since Inv = Sav, i = s y = s A f(k) Inv Sav Capital accumulation is, k = s A f(k) - k and the steady state is when s A f(k*) = k* • If population grows at the rate n, then the steady-state is: s A f(k*) = ( + n)k* steady• At the Golden Rule s = , which maximizes permanent sustainable consumption (of increase in ‘r’) C2 (with Flatter indifference curve causes Substitution Effect to dominate: S when r . (What we assume) in r) C2*’ (1+r)Y1 + Y2 C2* Y2 C1*’ Y1 C1* Y1 + Y2/(1+ r) C1 (with S 14 in r) S’ 15 Growth -2 Graphs 2 and 3 Together 4. 16 y • The Golden Rule equilibrium means: y = Af(k) Consumption is maximized for that production function k + n c*=(1-s)y* s x Af(k) ∆ k < 0; Therefore capital with time. savings = s x y* But NOT production More savings means less consumption less MPK = n + ; r = n k ∆k > 0; Therefore capital with time ∆k =0; Capital unchanging (STEADY STATE) 17 18 3 3 Growth -3 Golden Rule • For a CD function: C* 8. (Steady State Consumption) s=1 s=0 Low saving & productive capacity (but eat more of the “small pie”) The higher The higher The higher The higher s sg Golden Rule saving rate – maximizes long-run consumption High saving & productive capacity (but eat a much smaller slice of the “large pie”) sA k* n 1 1 s the higher k* & therefore y* n the lower k* & therefore y* the lower k* & therefore y* A the higher k* & therefore y* • The only way this model delivers continuing growth if for productivity (A) continuing to increase continuously over time 19 20 Change In Savings Rate 6. y Change In Population Growth Rate From s1 to s2 > s1 7. y From n1 to n2 > n1 y = Af(k) y2* y = Af(k) k+n s2 x Af(k) y1* ( + n2)k ( + n1)k s1 x Af(k) s x Af(k) y* k1* k2* k* A change in savings rate is a long-run level effect, not a long run growth effect. k Higher the population growth rate, the lower is long-run per worker income. k*, y*, and savings all increase; what about c*? 21 Money Demand 22 Money Supply –1 • Fractional reserve system: Money demand function • Md / P = L(i, Y) where L is a function that Banks are required to hold a minimum ratio of reserves against Demand Deposits, D, in Y , and in i; Md / P is “real balances” balances” The reserve ratio banks choose is rr, Consumers hold currency, C, and D in some proportion, c This means that if the Fed issues B units of reserves, M will be, 1 c • The price level (CPI) comes from P = M/ L(i, Y) and the inflation rate comes from: P/P = M/M - L(i, Y)/L(i, Y) M B mB c rr m 1 and D will be, B B D c rr 1 c • Currently the single instrument of monetary policy is OMOs P/P = g(supply of M) – g(demand for M) • Quantity Theory: M V = P Y M/M + V/V = P/P + Y/Y 23 24 4 4 Money Supply –2 Money Supply –3 • The Fed is guided by P/P = M/M + V/V - Y/Y to keep inflation low and promote economic growth • Monetary neutrality The Phillips curve • Simple-minded Keynesian Phillips curve: Simple_ _ u u • Rational expectations version Long run (yes: little argument) Short run (probably not) _ u u e A major battleground between Can’t fool people for long; you get the same Can’ unemployment (or worse) and more inflation! Keynesian – interventionists Classical – hands off, let the markets do it 25 26 Good Monetary Policy (cnt.) cnt.) What Is Good Monetary Policy? • • Low but positive inflation target Allow enough money growth for real growth No gain from creating high inflation The “Taylor Rule”: Rule” A rule-of-thumb for setting the Fed Funds rate: rule- ofi = + 0.02 + 0.5y +0.5( - T) Where long-term neutrality comes in long- • Mildly countercyclical monetary policy over the business cycle Where short-term non-neutrality comes in shortnon- where y GDP Y f Yf is full employment GDP The rule targets T inflation (target) • The “Taylor rule” codifies such a policy rule” Y Yf Mildly countercyclical Raises FF rate if Y is above trend & is above T Uses 2% as the real rate It is not a quarter-to-quarter rule! not quarter- to- 27 28 Monetary Equilibrium Fiscal Policy -1 • A useful way to think about how equilibrium is determined: • Macro policy issue: to what extent should government use its spending, taxing, and spending taxing borrowing power to affect economic activity? borrowing • Government purchases, G, clearly affect the equilibrium • Does the method of financing affect the method equilibrium? • The budget deficit is: deficit = outlays - tax revenues Deficit = (G + TR + INT) - T TR INT Saving behavior, population growth, depreciation, and technology determine Y and its growth rate The same real variables determine r real r will not grow with the economy not Y and r constitute the real equilibrium (C, S, I, G) real The Fed determines M and its growth rate That, along with Y and its growth rate, determine P and its growth rate (given the real equilibrium), and e r and e determine the nominal rate; i = r + e 29 30 5 5 Fiscal Policy -2 Fiscal Policy -3 • The burden of debt burden • Ricardian Equivalence Gov takes resources from the economy now but now borrows to pay for them! If this tricks consumers into thinking their income is high, they will save less and k will grow more slowly! The issue is the empirical relevance of Ricardian equivalence Traditional (Keynesian view) A government tax cut (holding G constant) only rearranges the tax burden, and doesn’t change doesn’ the Present Value of income Private consumption is not affected Private savings increase (they save the tax cut) National savings doesn’t change doesn’ YES! Reduces Nat’l Savings Nat’ Classical view –Ricardo, Barro NO! Private savings adjust; doesn’t matter doesn’ 31 Ricardian View of Deficits Traditional View of Deficits S’ r S PV of Income unchanged with tax cut => C1*, C2* unchanged (Spvt) before tax cut = y1- C1* (Spvt) after tax cut = (y1 + ΔT) – C1* Capital Market Sgovt by $1 Spvt 32 by < $1 => Spvt ↑ by ΔT and Sgovt ↓ by ΔT I => S = Spvt + Sgovt S, I y Solow Model y* y*’ C2 S = Spvt + Sgovt y = Af(k) Optimal Consumption Unchanged C2* (+n)k A s x Af(k) in long run income level & standard of living y2-(1+ r)ΔT s’ x Af(k) k* Post-tax cut income C1* y1 y1 + ΔT s’ < s k*’ Pre-tax cut income y2 C1 S k S’ 33 “Good” Fiscal Policy Good” 34 “Good” Fiscal Policy Good” • Choose an “optimal” level of G and TR optimal” TR • Choose an “optimal” level of G and TR optimal” TR Cost-benefit, political equilibrium Cost- Cost-benefit, political equilibrium Cost- • Steady tax rates • Steady tax rates Lowest marginal rates possible Avoid double taxation Lowest marginal rates possible Avoid double taxation Profit taxes? Profit taxes? Finance deficit fluctuations Finance deficit fluctuations • In a growing economy, keep Debt/GDP constant This implied a steady-state deficit steady- • In a growing economy, keep Debt/GDP constant This implied a steady-state deficit steady- $14T GDP, $9T debt ~64% ratio GDP 2.5% real growth + 2% inflation implies ~ ?? Def? 35 $12T GDP, $7T debt 58% ratio GDP 2.5% real growth + 2% inflation implies ~ $400 Bil. Bil. 36 6 6 Business Cycles –1 Business Cycles –2 • Business cycles: • Keynesian Business Cycle Recurring but irregular fluctuations of RGDP RGDP Recession; boom Features of the Business Cycle: Relative volatility of variables, Pro- or counter-cyclical behavior of variables, Pro- counterLead-lag relations Lead- Demand-initiated (often by the Fed) DemandPrice rigidities impede the establishment of full employment equilibrium In the short run money is not neutral • Prescription: Active government intervention Why stop there? Why not control the economy all the time? See: Commanding Heights Commanding 37 Business Cycles –3 38 Figure 10.03 Small shocks and large cycles • Classical “Real” Business Cycle Real” Supply initiated technology or supply shocks Labor/Leisure substitution in response to real wages Consumption-smoothing cuts down savings ConsumptionIn the short run money is neutral enough Wages and prices are flexible enough • Prescription: No reason for active government intervention Likely to make things worse Government control and regulation slows the economy and reduces productivity growth 39 Balance of Payments 40 Open Economy Macro • Foreign transaction that causes Opening the economy could (and often does) lead to deficit: Inflow of $s is + Outflow of $s is – S r • BOP add to zero! BOP “balance” balance” balances generally means official rw • A very important identity is: S p I G TR T NX INT Priv. Savings Inv. Budget Deficit CA Surplus I S, I S-I = NX < 0 S, I 41 42 7 7 Exchange Rates Flexible Exchange Rate • enom, e Flexible exchange rate (nominal) determination: In the formulae it is fc/$ fc/$ $ appreciation: $1 buys more FC $ depreciation: $1 buys less FC in quality of US goods causes $ to appreciate. S enom enom S • Real FX rate FX e fc / $$ / U .S . Goods For. Goods enom P US PFor U .S . Goods fc / For. Goods enom*´ enom* enom* D´ D • PPP: Pfor = enom PUS (absolute) • PPP: Pfor = *enom PUS (relative --indices) --indices 43 $ 44 Relative PPP (cnt.) cnt.) Fixed Exchange Rate The equation below is an identity: identity Overvaluation Case: e D $ (in foreign exchange market) % e %enom $ For S • Relative PPP is: eofficial %e 0 %enom $ For enom* (Fundamental value of exchange rate) %enom For $ D LDC Currency 45 46 THE END 47 8 8 ...
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