Economics-Chapter21(18) - Economics Chapter 21 Lecture...

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Economics Chapter 21: Lecture: Three types of economic actors: Firms use inputs to produce output Consumers provide input, consume, save Government taxes, transfers and “consumes” → interact in: markets for inputs/production factors, markets for goods and services, financial markets Exogenous variables: taxes, government expenditure, production technology and supply of production factors Endogenous variables: output production, private consumption, investment Production with flexible prices: Economic output determined by firms (Assumption 1: Firms are price takers) → What determines firm's output decision? Price, Input costs, Production technology Production Technology: If firm uses L units of labor, produces F(L) units of output → Marginal product of labor MPL: Output increases for “small” increases in labor input → MPL(L)=F'(L) Assumption 2: MPL strictly decreasing in L Firms' goal: Maximize profits by using “right” amount of labor → Profits of using L units of labor given output price P and wage W is P x F(L) – WL → employ L* units of labor so that MPL(L*)=W/P → Labor demand determined by real wage W/P (=marginal productivity of labor) Assumption 3: Labor supply fixed at L If real wages fully flexible, equilibrium in labor market requires MPL(L )=W*/P → If wages are fully flexible, output only determined by input supplies and production technology Potential output=F(L )=Y → does not depend on prices/nominal variables Consumption: Consumers' nominal income is P x Y, where P is the price for each unit of output Should consumption depend on nominal (PY) or real income (Y)? Nominal income determines amount of money you can spend Real income gives your purchasing power Also need to subtract taxes to get disposable income Y – T (Opportunity cost of consumption = neglected) The consumption function relates private consumption to disposable income: C(Y T ) = C + c(Y T ) C =autonomous consumption c=marginal propensity to consume MPC Investment: Invest today to increase productive capabilities and consumption possibilities tomorrow Key determinant of investment demand: Opportunity cost of using money to finance investments Opportunity cost 1: Nominal interest rate → Investment demand decreases in I Opportunity cost 2: Real interest rate → investment demand decreases in r Our analysis so far: Y ≡ Y due to flexible prices in the long-run G ≡ G and T ≡ T since we take government‘s actions as exogenous C ≡ C(Y T ) = C + c(Y T ) determined from real disposable income I = I(r) since investment demand depends (negatively) on real interest rate
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