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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 CD Production Function: • A production function: Y = AF(K, L)
(1• A CD production function: Y = A KL(1 )
C Y L=1 (Total
Output) Y= AKαL1α
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 CD 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 TwoPeriod Model
TwoPresentvalue 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 agedependent
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
steadystate 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*=(1s)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 longrun 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 longrun level effect, not a long
run growth effect. k Higher the population growth rate, the lower is longrun 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
• Simpleminded 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 ruleofthumb for setting the Fed Funds rate:
rule ofi = + 0.02 + 0.5y +0.5(  T) Where longterm neutrality comes in
long • Mildly countercyclical monetary policy over
the business cycle
Where shortterm nonneutrality 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 quartertoquarter 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* Posttax cut income
C1* y1 y1 + ΔT s’ < s
k*’ Pretax 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 Costbenefit, political equilibrium
Cost Costbenefit, 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 steadystate deficit
steady • In a growing economy, keep Debt/GDP
constant
This implied a steadystate 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 countercyclical behavior of variables,
Pro counterLeadlag relations
Lead Demandinitiated (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
Consumptionsmoothing 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 $s is – S r • BOP add to zero!
BOP “balance”
balance”
balances generally means official
rw • A very important identity is: S p I G TR T NX INT Priv.
Savings Inv. Budget Deficit CA Surplus I
S, I
SI = NX < 0
S, I 41 42 7
7 Exchange Rates Flexible Exchange Rate • enom, e Flexible exchange rate (nominal) determination: In the formulae it is fc/$
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
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This note was uploaded on 03/02/2010 for the course BUAD 350 taught by Professor Safarzadeh during the Spring '07 term at USC.
 Spring '07
 Safarzadeh
 Inflation

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