Lecture02_note - Macroeconomics II Lecture 2 Classical...

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Unformatted text preview: Macroeconomics II Lecture 2 Classical theory: the close economy in the long run Macroeconomics Instructor: Vu Pham Hai Dang, Ph.D. University of Economics and Business - VNU In this chapter, you will learn… what determines the economy’s total output/income how the prices of the factors of production are determined how total income is distributed what determines the demand for goods and services how equilibrium in the goods market is achieved LECTURE 2 Close economy in the long run slide 1 Classical Theory, Long Run This theory assumes that the economy automatically ensures that supply equals demand for every commodity Supply and demand are made equal by fastacting prices that quickly close the gap between supply and demand whenever there is one LECTURE 2 Close economy in the long run slide 2 1 Macroeconomics II Outline of model A closed economy, market-clearing model 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 LECTURE 2 Close economy in the long run slide 3 Factors of production K = capital: tools, machines, and structures used in production L = l b labor: the physical and mental efforts of workers These are exogenous variables. LECTURE 2 Close economy in the long run slide 4 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 LECTURE 2 Close economy in the long run slide 5 2 Macroeconomics II Returns to scale: A review Initially Y1 = F (K1 , L1 ) Scale all inputs by the same factor z: K2 = zK1 and L2 = zL1 (e.g., (e g if z = 1.25, then all inputs are increased by 25%) 1 25 What happens to output, Y2 = F (K2, L2 )? If constant returns to scale, If increasing returns to scale, If decreasing returns to scale, LECTURE 2 Close economy in the long run slide 7 Example 1 F (K , L) KL F (zK , zL) (zK )(zL) z 2KL z 2 KL z KL z F (K , L) LECTURE 2 constant returns to scale for any z > 0 Close economy in the long run slide 8 Now you try… Determine whether constant, decreasing, or increasing returns to scale for each of these production functions: 2 (a) ( ) F (K , L) K L (b) F (K , L) K L LECTURE 2 Close economy in the long run slide 11 3 Macroeconomics II Assumptions of the model 1. Technology is fixed. 2. The economy’s supplies of capital and labor are known to be K K LECTURE 2 and LL Close economy in the long run slide 14 Determining GDP Output is determined by the fixed factor supplies and the fixed state of technology: Y F (K , L) LECTURE 2 Close economy in the long run slide 15 The distribution of national income determined by factor prices, which are the prices per unit that firms pay for the factors of production wage = rental rate = LECTURE 2 Close economy in the long run slide 16 4 Macroeconomics II Notation W = nominal wage of labor R = nominal rental rate of capital P = price of output (Y) W /P = real wage (measured in units of output) R /P = real rental rate LECTURE 2 Close economy in the long run slide 17 How factor prices are determined Factor prices are determined by supply and demand in factor markets. Recall: Supply of each factor is fixed. What about demand? LECTURE 2 Close economy in the long run slide 18 Demand for labor Assume markets are competitive: each firm takes W, R, and P as given. Basic idea: A firm hires each unit of labor if the cost does not exceed the benefit. cost = benefit = LECTURE 2 Close economy in the long run slide 19 5 Macroeconomics II Marginal product of labor (MPL ) definition: The extra output the firm can produce using an additional unit of labor (holding other inputs fixed): MPL = LECTURE 2 Close economy in the long run slide 20 Marginal Product of Labor MPL = F (K, L +1) – F (K, L) If F (K, L) = K0.3 L0.7, and if K and L are known, then MPL can be calculated by substitution. For the Cobb-Douglas production function F (K, L) = Kα L1- α, it can be shown that: MPL = Once again, if α, K and L are known, then MPL can be calculated. LECTURE 2 Close economy in the long run slide 21 Exercise: Compute & graph MPL a. Determine MPL at each value of L. b. Graph the production function. c. Graph the MPL curve with MPL on the vertical axis and L on the horizontal axis. LECTURE 2 Close economy in the long run L 0 1 2 3 4 5 6 7 8 9 10 Y 0 10 19 27 34 40 45 49 52 54 55 MPL n.a. ? ? 8 ? ? ? ? ? ? ? slide 22 6 Macroeconomics II Fig 3-3: MPL and the production function Y output F (K , L ) 1 MPL As more labor is added, MPL MPL 1 MPL Slope of the production function equals MPL 1 L labor LECTURE 2 Close economy in the long run slide 25 Diminishing marginal returns As a factor input is increased, its marginal product falls (other things equal). Intuition: Suppose L while holding K fixed fewer machines per worker lower worker productivity LECTURE 2 Close economy in the long run slide 26 Check your understanding: Which of these production functions have diminishing marginal returns to labor? a) F (K , L) 2K 15L b) F (K , L) KL c) F (K , L) 2 K 15 L LECTURE 2 Close economy in the long run slide 27 7 Macroeconomics II Exercise (part 2) L 0 1 2 3 4 5 6 7 8 9 10 Suppose W/P = 6. d. If L = 3, should firm hire more or less labor? Why? e. e If L = 7, should firm hire more 7 or less labor? Why? LECTURE 2 Y MPL 0 n.a. 10 10 19 9 27 8 34 7 40 6 45 5 49 4 52 3 54 2 55 1 Close economy in the long run slide 28 Figure 3-4: MPL and the demand for labor Units of output Each firm hires labor up to the point where MPL = W/P. Real wage MPL, Labor demand Units of labor, L Quantity of labor demanded LECTURE 2 Close economy in the long run slide 29 Fig 3-2: The equilibrium real wage Units of output Labor supply equilibrium real wage L LECTURE 2 The real wage adjusts to equate labor demand with supply. MPL, Labor demand Units of labor, L Close economy in the long run slide 30 8 Macroeconomics II Calculating the Real Wage We saw earlier, that if the production function is known, and if K and L are known, then MPL can be calculated. As W/P = MPL the real wage can also be MPL, calculated. The total real income of labor is W/P × L, this can also be calculated. LECTURE 2 Close economy in the long run slide 31 Calculating the Real Wage For the Cobb-Douglas production function F (K, L) = Kα L1-α, LECTURE 2 Close economy in the long run slide 32 Determining the rental rate We have just seen that MPL = W/P. The same logic shows that MPK = R/P : diminishing returns to capital: MPK as K The MPK curve is the firm’s demand curve firm s for renting capital. Firms maximize profits by choosing K such that MPK = R/P . LECTURE 2 Close economy in the long run slide 33 9 Macroeconomics II The equilibrium real rental rate Units of output Supply of capital equilibrium R/P K LECTURE 2 The real rental rate adjusts to equate demand for capital with supply. MPK, demand for capital Units of capital, K Close economy in the long run slide 34 Calculating the Real Rental If the production function is known, and if K and L are known, then MPK can be calculated. As R/P = MPK, the real rental rate can also be calculated. calculated As the total real income of capital is R/P × K, this can also be calculated. LECTURE 2 Close economy in the long run slide 35 Calculating the Real Rental For the Cobb-Douglas production function F (K, L) = Kα L1-α, LECTURE 2 Close economy in the long run slide 36 10 Macroeconomics II The Neoclassical Theory of Distribution Our theory of the distribution of total income between labor and capital is called the neoclassical theory of distribution It states that each factor input is paid its marginal product LECTURE 2 Close economy in the long run slide 37 How income is distributed: total labor income = total capital income = If production function has constant returns to scale, then LECTURE 2 Close economy in the long run slide 38 The Cobb-Douglas Production Function The Cobb-Douglas production function has constant factor shares: = capital’s share of total income: capital income = labor income = The Cobb-Douglas production function is: Y AK L1 where A represents the level of technology. LECTURE 2 Close economy in the long run slide 40 11 Macroeconomics II The Cobb-Douglas Production Function Each factor’s marginal product is proportional to its average product: LECTURE 2 Close economy in the long run slide 41 Demand for goods & services Components of aggregate demand: C = consumer demand for g & s I = demand for investment g & s G = government demand for g & s (closed economy: no NX ) LECTURE 2 Close economy in the long run slide 43 Consumption, C def: Disposable income is total income minus total taxes: Y – T. Consumption function: C = C (Y – T ) Shows that (Y – T ) C ( def: Marginal propensity to consume (MPC) is the increase in C caused by a one-unit increase in disposable income. LECTURE 2 Close economy in the long run slide 44 12 Macroeconomics II Consumption Function: Example Assume C (Y – T ) = 10 + 0.8 × (Y – T ) We saw earlier that if K, L, and the production function are known, then Y can be calculated. Therefore, If T, which is an exogenous variable, is known and if the consumption function is known, then C can be calculated. LECTURE 2 Close economy in the long run slide 45 Figure 3-6: The consumption function C C (Y –T ) MPC 1 The slope of the consumption function is the MPC. Y–T LECTURE 2 Close economy in the long run slide 47 Investment, I The investment function is I = I (r ), where r denotes the real interest rate, the nominal interest rate corrected for inflation. The real interest rate is the cost of borrowing the opportunity cost of using one’s own funds to finance investment spending. So, r I LECTURE 2 Close economy in the long run slide 48 13 Macroeconomics II The investment function r Spending on investment goods depends negatively on the real interest rate. I (r ) I LECTURE 2 Close economy in the long run slide 50 Government spending, G G = govt spending on goods and services. G excludes transfer payments (e.g., social security benefits, unemployment insurance benefits). benefits) Assume government spending and total taxes are exogenous: G G LECTURE 2 and T T Close economy in the long run slide 51 The market for goods & services Aggregate demand: Aggregate supply: Equilibrium: The real interest rate adjusts to equate demand with supply. LECTURE 2 Close economy in the long run slide 52 14 Macroeconomics II The loanable funds market A simple supply-demand model of the financial system. One asset: “loanable funds” demand for funds: investment supply of funds: saving “price” of funds: real interest rate LECTURE 2 Close economy in the long run slide 53 Demand for funds: Investment The demand for loanable funds… comes from investment: Firms borrow to finance spending on plant & equipment, new office buildings, etc. Consumers borrow to buy new houses. depends negatively on r, the “price” of loanable funds (cost of borrowing). LECTURE 2 Close economy in the long run slide 54 Loanable funds demand curve r The investment curve is also the demand curve for loanable funds. I (r ) I LECTURE 2 Close economy in the long run slide 55 15 Macroeconomics II Supply of funds: Saving The supply of loanable funds comes from saving: Households The government LECTURE 2 Close economy in the long run slide 56 Types of saving private saving = public saving = national saving, S = private saving + public saving LECTURE 2 Close economy in the long run slide 57 Saving If K, L, and the production function are known, then Y can be calculated. If T and the consumption function are also known, known then C can be calculated calculated. Finally, if G, which is exogenous, is known, then S = Y – C – G can be calculated. LECTURE 2 Close economy in the long run slide 58 16 Macroeconomics II Notation: = change in a variable For any variable X, X = “the change in X ” is the Greek (uppercase) letter Delta Examples: If L = 1 and K = 0 th Y = MPL d 0, then MPL. More generally, if K = 0, then MPL Y . L (YT ) = Y T , so C = MPC (Y T ) = MPC Y MPC T LECTURE 2 Close economy in the long run slide 59 EXERCISE: Calculate the change in saving Suppose MPC = 0.8 and MPL = 20. For each of the following, compute S : a. G = 100 b. T = 100 c. Y = 100 d. L = 10 LECTURE 2 Close economy in the long run slide 60 Loanable funds supply curve r S Y C (Y T ) G National saving does not depend on r, so the supply curve is vertical. S, I LECTURE 2 Close economy in the long run slide 65 17 Macroeconomics II Loanable funds market equilibrium r S Y C (Y T ) G Equilibrium real interest rate I (r ) Equilibrium level of investment LECTURE 2 S, I Close economy in the long run slide 66 Equilibrium in the Loanable Funds Market Recall: Equilibrium in the goods market requires Y = C + I + G . Therefore, Y – C – G = I. Therefore, S = I. This condition determines the real interest rate. LECTURE 2 Close economy in the long run slide 67 Investment and Interest Rate We saw earlier how S can be calculated. S = I means that investment can be calculated. If, further, the investment function is known to be, say, I = 100 – 8 × r, then I = 100 – 8 × r can be used to calculate r. LECTURE 2 Close economy in the long run slide 68 18 Macroeconomics II The special role of r r adjusts to equilibrate the goods market and the loanable funds market simultaneously: If L.F. market is in equilibrium, then Y–C–G =I Add (C +G ) to both sides to get Y = C + I + G (goods market eq’m) Thus, LECTURE 2 Eq’m in L.F. market Eq’m in goods market Close economy in the long run slide 69 Mastering the loanable funds model Things that shift the saving curve public saving: private saving: LECTURE 2 Close economy in the long run slide 71 CASE STUDY: VIETNAM 2002-2009 1. The decrease in the deficit increses saving… 2. which 2 …which causes the real interest rate to fall… r S 2 r1 r2 3. …which increases the level of investment. LECTURE 2 S1 Close economy in the long run I (r ) I1 I2 S, I slide 75 19 Macroeconomics II CASE STUDY: VIETNAM variable 2002-05 2006-09 T–G –4.9 –4.78 S 19.5 21.1 4.05 r I 1.05 22.3 28.2 T–G, S, and I are expressed as a percent of GDP All figures are averages over the 4-year period. LECTURE 2 Close economy in the long run slide 76 Mastering the loanable funds model, continued Things that shift the investment curve LECTURE 2 Close economy in the long run slide 78 An increase in investment demand r …raises the interest rate. r2 S An increase in desired investment… r1 But the equilibrium level of investment cannot increase because the supply of loanable funds is fixed. LECTURE 2 Close economy in the long run I1 I2 S, I slide 79 20 Macroeconomics II A Jump in Consumption If there is a boom in realestate prices or in the stock market, people feel wealthier. They feel a reduced need to save. Therefore, C CA CB There is a jump in consumption How will this affect the market Y–T for loanable funds? LECTURE 2 Close economy in the long run slide 80 Saving and the interest rate Why might saving depend on r ? How would the results of an increase in investment demand be different? Would r rise as much? ? Would the equilibrium value of I change? LECTURE 2 Close economy in the long run slide 81 Summary Total output is determined by the economy’s quantities of capital and labor the level of technology Competitive firms hire each factor until its marginal product equals its price. If the production function has constant returns to scale, then labor income plus capital income equals total income (output). LECTURE 2 Close economy in the long run slide 83 21 Macroeconomics II Summary A closed economy’s output is used for consumption investment government spending The real interest rate adjusts to equate the demand for and supply of goods and services loanable funds LECTURE 2 Close economy in the long run slide 84 Summary A decrease in national saving causes the interest rate to rise and investment to fall. An increase in investment demand causes the interest rate to rise, but does not affect the rise equilibrium level of investment if the supply of loanable funds is fixed. LECTURE 2 Close economy in the long run slide 85 22 ...
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