Macroeconomics Study Guides
Site: | Saylor Academy |
Course: | ECON102: Principles of Macroeconomics |
Book: | Macroeconomics Study Guides |
Printed by: | Guest user |
Date: | Saturday, September 30, 2023, 11:00 PM |
Description
Keep the following two comprehensive study guides handy throughout your macroeconomics course study. They provide brief oulines for many of the major macroeconomics topics studied in this course and can help prepare you for your final economics exams.
AP Macroeconomics Study Guide
Source: Charles Feng, https://web.archive.org/web/20150404015746/http://jsher.myclassupdates.com/sitebuildercontent/sitebuilderfiles/feng.pdf
This work is licensed under a Creative Commons Attribution-NonCommercial-NoDerivatives 2.5 License.
I. Basic Economic Concepts
Economic Goals |
1. Economic growth - produce more and better goods and services 2. Full employment - suitable jobs for all citizens who are willing and able to work 3. Economic efficiency - achieve the maximum production using available resources 4. Price-level stability - avoid large fluctuations in the price level (inflation + deflation) 5. Economic freedom - businesses, workers, consumers have a high degree of freedom in economic activities 6. Equitable distribution of income - try to minimize gap between rich and poor 7. Economic security - provide for those who are not able to earn sufficient income 8. Balance of trade - try to seek a trade balance with the rest of the world |
---|---|
Basic Economic Problem |
1. Society's material wants, that is, the material wants of its citizens and institutions, are virtually unlimited and insatiable. 2. Economic resources - the means of producing goods and services-are limited or scarce.
|
Types of resources |
Land - all natural resources usable in the production process Capital - all manufactured aids to production (tools, machinery, equipment, and factory, storage, transportation, and distribution facilities used in producing goods and services Labor - physical and mental talents of individuals available and usable in producing goods and services Entrepreneurial ability - the entrepreneur 1) takes the initiative in combining the other resources to produce a good or service. 2) makes basic business-policy decisions, 3) is an innovator, and 4) is a risk bearer. |
Factors of production |
Several objectives must be satisfied to reach full production: 1) Full employment - use all available resources 2) Full production - use resources efficiently (productive efficiency - production in least costly way, allocative efficiency - production of goods and services most wanted by society) |
Production Possibilities Curve |
The production possibilities curve represents the combinations of maximum output that can be reached in the economy. It is a frontier because it shows the limit of output. Anything under the curve is attainable, but involves inefficient use of resources. Anything outside the curve is unattainable with current resources. Usually, the curve is some type of consumer goods versus some type of capital goods. Each point on the curve represents a maximum output of the two goods. Different points on the curve mean different production combinations of the two goods. The curve bows outwards because of the Law of Increasing Opportunity Cost, which states that the amount of a good which has to be sacrificed for each additional unit of another good is more than was sacrificed for the previous unit. The rationale for this law is that some economic resources are not completely adaptable to alternative uses, so the resources will yield less of one product. Shifts in this curve can be caused by increases in resource supplies or advances in technology. Also, if an economy favors "future goods" (technology; etc.), the curve will shift faster because of more economic growth. |
Determinants for Production |
One must compare marginal benefits and marginal costs to determine the best or optimal output mix on the Production Possibilities Curve. |
II. Basic Economic Measurements
III. Economic Models
IV. Economic Policies
V. Alternative Theories/Approaches
VI. International Aspects of the Economy
Comparative Advantage |
When it's cheaper for one nation to produce something than another. For example, if two products on the production possibilities curve are coffee and wheat, and the United States needs to spend 2 coffees to make a wheat, while Brazil only needs to spend 1.5 coffees, Brazil has a comparative advantage over the US in wheat (because it's relatively cheaper to make) and the US has a comparative advantage over Brazil in coffee. |
Terms of Trade |
The price of a good or service (the amount of one good or service which must be given up to obtain one unit of another good or service). |
Exchange rates |
Flexible exchange-rate system: rates at which national currencies are exchanged for one another are determined by demand and supply and in which no government intervention occurs. Fixed exchange-rate system: governments determine rates at which currencies are exchanged and make necessary adjustments in their economies to ensure that these rates continue. |
Appreciation/depreciation of money |
When the currency depreciates, then American goods seem cheaper to foreigners, so they will buy more, increasing exports, and making the trade balance "more favorable". Likewise, when the currency appreciates, American goods seem more expensive to foreigners, and foreign goods seem cheaper to Americans, so imports increase and the trade balance becomes "less favorable". |
Fiscal/Monetary policy |
Fiscal Expansionary policy → higher domestic interest rate → increased foreign demand for dollars → dollar appreciates → net exports decline → balance of trade becomes less "favorable" Contractionary policy → lower domestic interest rate → decreased foreign demand for dollars → dollar depreciates → net exports increase → balance of trade becomes more "favorable" Monetary Easy money policy → decreased foreign demand for dollars → dollar depreciates net exports increase → balance of trade becomes more "favorable" Tight money policy → increased foreign demand for dollars → dollar appreciates → net exports decrease → balance of trade becomes less "favorable" |
Favorable/unfavorable trade balances |
If exports exceed imports, you get a trade surplus which is considered a "favorable balance of trade". If imports exceed exports, you get a trade deficit which is considered an "unfavorable balance of trade". A "favorable" balance of trade is not entirely good, however. We cannot buy as much foreign goods now (since our dollar is worth less) so foreign companies don't get as much business from us. However, when foreign prices rise, Americans turn to American companies to buy things from, helping American companies make more money. Likewise, a "unfavorable" balance of trade isn't entirely bad either. Since our dollar has grown in value, we can buy more foreign goods, so foreign companies get more money. However, because of cheaper foreign goods, American companies won't get as much business (or they have to lower prices), so they don't get as much money. |
VII. AD/AS Graph
Aggregate Demand Shifters |
These cause shifts in aggregate demand: |
Aggregate Supply Shifters |
These cause shifts in aggregate supply:
|
AS Curve ranges |
Horizontal range - includes only real levels of output which are substantially less than full-employment output. A change in real output in this range won't affect price level at all. Vertical range - economy has already reached its full-capacity real output. Any increase in the price level at this range won't affect real output at all. Intermediate range - an expansion of real output is accompanied by a rising price level. The full-employment output is found in this range. |
Principles of Macroeconomics Lecture Notes
Read both sets of lecture notes. Use these notes as a review of the material covered in Unit 1 and Unit 2 in preparation for Unit 3.
"Introduction to Macro Data" covers:
- Gross Domestic Product (GDP)
- What is Gross Domestic Product and how we measure it? Why is this measure important?
- What are the definitions of the major expenditure components?
- What are the trends in these components over time?
- Inflation
- What is the difference between 'Real' and 'Nominal' variables?
- How is inflation measured?
- Interest Rate
- How is inflation measured?
- Why do we care about Inflation?
- Unemployment
- How is Unemployment measured?
- Why do we care about Unemployment?
"Supply Side of the Macro Economy" covers:
- Production Function
- Labor Market
- Labor Demand
- Labor Supply
- Equilibrium Wages and Employment
Source: Veronica Guirrieri, https://learn.saylor.org/pluginfile.php/31405/mod_folder/content/0/ECON102%20-%20Intro%20to%20Macro%20Data%20by%20Veronica%20Guerrieri.pdf?forcedownload=1 This work is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 License.
Introduction to Macro Data
Goals and Outline of Topic 1
- Gross Domestic Product (GDP)
- What is Gross Domestic Product and how we measure it? Why is this measure important?
- What are the definitions of the major expenditure components?
- What are the trends in these components over time? - Inflation
- What is the difference between 'Real' and 'Nominal' variables?
- How is inflation measured? - Interest Rate
- How is inflation measured?
- Why do we care about Inflation? - Unemployment
- How is Unemployment measured?
- Why do we care about Unemployment?
PART I: GDP
Gross Domestic Product (GDP)
- GDP is a measure of output!
- Why Do We Care?
Because output is highly correlated (at certain times) with things we care about (standard of living, wages, unemployment, inflation, budget and trade deficits, value of currency, etc…)
- Formal Definition:
GDP is the Market Value of all Final Goods and Services Newly Produced on Domestic Soil During a Given Time Period (different than GNP)
Three ways of measuring GDP
- Production Method: Measure the Value Added summed across all firms (value added = sale price less cost of raw materials)
- Income Method: Labor Income (wages/salary) + Capital Income (rent, interest, dividends, profits)+ Government Income (taxes)
- Expenditure Method: Spending by consumers (C) + Spending by businesses (I) + Spending by government (G) + Net Spending by foreign sector (NX)
- Fundamental identity of national income account:
total production = total income = total expenditure
A simple example of how GDP is measured
Orange Inc Transactions |
|
Wagos paid to Orange Inc employees |
$15,000 |
Taxes paid to government |
5,000 |
Revenue received from sale of oranges |
35,000 |
• Oranges sold to public |
10,000 |
• Oranges sold to Juice Inc |
25,000 |
Juice Inc Transactions |
|
Wagos paid to Juice Inc employees |
$10,000 |
Taxes paid to government |
2,000 |
Oranges purchased from Orange Inc |
25,000 |
Revenue received from sale of orange juice |
40,000 |
What is the total value (in dollars) of the economic activity generated by these 2 firms?
Production Method (value added: sales – intermediate good): 35K + (40K– 25K) = 50K
Income Method (Wages + Profits + Taxes) = 15K + 10K + 15K + 3K + 5K + 2K = 50K
Expenditure approach (expenditure by final users): 10K + 40K = 50K
"Production" Equals "Expenditure"
- GDP (for us Y) is a measure of Market Production!
Market value = how much you have to spend to buy - What is produced in the market has to show up as being purchased or held by some economic agent;
- Who are the economic agents we will consider on the expenditure side?
- Consumers (refer to expenditure of consumers as "consumption")
- Businesses (refer to expenditure of firms as "investment")
- Governments (refer to expenditures of governments as "government spending")
- Foreign Sector (refer to expenditures of foreign sector as "net exports")
- For us, we will predominantly spend our time working with the Expenditure Approach:
Back to a Simple Example
- I produce oranges and I can potentially:
- sell them to some domestic customer (Consumption)
- sell them to some business (Investment)
- keep them in my stock room as inventory (Investment)
- sell them to the city of Boston for their shelters (Government spending)
- sell them to some foreign customer (Net Export)
Defining the Expenditure Components
- Consumption (C):
- The Sum of Durables, Non-Durables and Services Purchased Domestically by NonBusinesses and Non-Governments (ie, individual consumers).
- Includes Haircuts (services), Refrigerators (durables), and Apples (non-durables).
- Does Not Include Purchases of New Housing.
- Investment (I):
- The Sum of Durables, Non-Durables and Services Purchased Domestically by Businesses
- Includes Business and Residential Structures, Equipment and Inventory Investment
- Land purchases are NOT counted as part of GDP (land is not produced!!)
- Stock purchases are NOT counted as part of GDP (stock transactions do NOT represent production – they are saving!)
There is a difference between financial and economic investment!!!!!!!
- Government Spending (G): Goods and Services Purchased by the domestic government.
- For the U.S., 2/3 of this is at the state level (police and fire protection, school teachers, snow plowing) and 1/3 is at the federal level (President, Post Office, Missiles).
- NOTE: Welfare and Social Security are NOT Government Spending. These are Transfer Payments. Nothing is Produced in this Case.
- Net Exports (NX): Exports (X) - Imports (IM);
- Exports: The Amount of Domestically Produced Goods Sold on Foreign Soil
- Imports: The Amount of Goods Produced on Foreign Soil Purchased Domestically.
More on Expenditure Components
- Only include expenditures for goods that are "produced".
- If I give $10 to a movie theater to watch a movie, it is counted as expenditure.
- If I give $10 to my friend for a birthday present, it is not counted as expenditure.
- If I give $10 to the ATM machine to put in my savings account, it is not counted as expenditure.
- The second example would be considered a "transfer" (once I give $10 to my friend, he can go to the movies if he wants to – once that $10 is spent, it will show up in GDP).
- "Transfers" are defined as the exchange of economic resources from one economic agent to another when no goods or services are exchanged.
- The third example is considered "saving" (I am delaying expenditure until the future). Once I spend the $10 in the future, it will show up in GDP.
Examples of Expenditure Method
- How would these transactions be counted as part of 2008 U.S. GDP Calculation?
(Assume the production/transaction took place in 2008 if not otherwise specified)
- I purchase a $500 Swiss watch.
- I receive $200 unemployment check from the state government.
- The city of Chicago spends $1 million this year repairing its streets.
- US steel purchases a new $10 million steel rolling machine for its factory.
- Ford Motor Company purchases $10 worth of steel for building fenders.
- I buy a 1998 Ford Escort from a Dealer.
- I buy a plot of land for $100,000.
- I pay a local accountant $175 for her help in filling in my taxes.
- A U.S. travel agent is paid $1000 for services rendered to U.S. customers while in Tokyo for a year.
Preview: Accounting vs Economics
- Macroeconomics studies the determinants of Y (= aggregate supply) and C+I+G+NX (aggregate demand), and shows how, in equilibrium, prices/wages/interest rates/exchange rates have to adjust such that AS = AD.
- Classic economics believes prices/wages move immediately to attain equilibrium.
- Keynesian economics sticky prices/wages give rise to unemployment and an active role to monetary policy.
- With this basic setup we can understand how changes in the determinants of aggregate demand and supply affect growth and prices in an economy.
What GDP Is Not!
- GDP is not, or never claims to be, an absolute measure of well-being!
- Size effects: But even GDP per capita is not a perfect measure of welfare
- Ideally, what we would like to measure is quality of one's life:
- Present discounted value of utility from one's own consumption and leisure and that of one's loved ones.
More on What GDP Is Not!
- GDP Does Not Measure:
- Non-Market Activity (home production, leisure, black market activity)
- Environmental Quality/Natural Resource Depletion
- Life Expectancy and Health
- Income Distribution
- Crime/Safety
Defining Saving
The saving of any economic unit is its current income minus its current needs
For simplicity, I abstract from business saving (things like retained earnings and depreciation). For those interested, see the text.
A Look at Actual U.S. Household Saving Rates: 1970 – 2008
Defining Saving (continued)
• Includes Federal, State and Local Saving
PART II: Inflation
Real versus Nominal variables
- Using current market values allows summing different types of goods and services, but how to compare variables over time?
Production today 20 computers 20 bicycles |
Production tomorrow 20 computers 20 bicycles |
- If prices of computers and bicycles double between today and tomorrow, the current market value of GDP (i.e., nominal GDP) also doubles. However, the amount of physical production remains unchanged.
- What's wrong? Nominal GDP today is expressed in terms of dollars of today and nominal GDP tomorrow is expressed in terms of dollars of tomorrow. If there is inflation, the purchasing power of the dollar has changed over time.
- By looking at the current market value of goods changes over time, you can't tell whether this change reflects changes in the goods produced or in their prices. That is why we need to look at the "real" GDP or at constant prices.
Prices and Inflation
- To compare the market value of output over time, we need to know how does the purchasing power of 1$ change over time. For that we need a price index.
- How Are Prices Measured?
- Price Indexes measure the cost of a fixed 'basket' of goods over time
(weights are usually fixed or slowly moving)
- Inflation rate = % change in P, where P is the general price level
Prices and Inflation
- GDP Deflator (one prominent price index):
- Another prominent price index is the CPI (consumer price index) – measures price changes of consumer goods. BLS surveys over 80,000 goods per month in different locations around the country.
- I will often use the CPI as our measure of a price index in this class.
Using Prices to distinguish between Nominal and Real Variables
- Nominal GDP is output valued at Current Prices
- Comparing Nominal GDPs over time can become problematic
- Confuses changes in Output (production) with changes in prices
- Real GDP is output valued at some Constant Level of Prices (prices in a base year).
- Growth in Real GDP:
or (approximately)
Example of Price Index Calculations
Veronica's Basket of Goods (goods I produce in my world)
|
2000 |
2008 |
||||
Q |
P |
Y |
Q |
P |
Y |
|
Books |
10 |
1.00 |
10.00 |
20 |
2.00 |
40.00 |
Wine |
15 |
3.00 |
45.00 |
20 |
4.00 |
80.00 |
Clothes |
50 |
0.50 |
25.00 |
40 |
1.00 |
40.00 |
Y(2000) = 80.00 (10 + 45 + 25)
Y(2008) = 160.00 (40 + 80 + 40)
Nominal GDP went up by 100%!
Compute GDP Deflator for Veronica's World (with 2000 as Base Year)
|
2000 |
2008 |
||||
Q |
P |
Y |
Q |
P |
Y |
|
Books |
10 |
1.00 |
10.00 |
20 |
2.00 |
40.00 |
Wine |
15 |
3.00 |
45.00 |
20 |
4.00 |
80.00 |
Clothes |
50 |
0.50 |
25.00 |
40 |
1.00 |
40.00 |
Current Output at Current Prices: 160.00
Current Output at Base Year Prices: 100.00 (1*20 + 3*20 +0.50*40)
GDP Deflator for 2000 = 1.00 (Price Index in the Base Year ALWAYS = 1)
GDP Deflator for 2008 = 1.60
Inflation Rate Between 2000 and 2008 = 60%
What is real GDP growth between 2000 and 2008 in Veronica's World? 40% (approx).
What is real GDP growth between 2000 and 2008 in Veronica's World? 25% (actual)
Notes on Price Indexes
- Need to Pick a Basket of Goods (cannot measure all prices)
- 'Ideal/Representative' Basket of Goods Change Over Time
- Invention (Computers, Cell Phones, VCRs, DVDs).
- Quality Improvements (Anti-Lock Brakes)
- Criticisms of Price Indices:
- Part of the Change in Prices Represents a Change in Quality - Actually, not measuring the same goods in your basket over time.
- Technology advances drive down the price of 'same' goods over time
- Substitution of goods in reaction to prices changes
- Arbitrary choice of the goods (Housing included in US CPI not in EU CPI)
- How do we account for "sales"?
- Boskin Report Concludes that CPI Overstates Inflation by 1.1% per year (quality adjustment/substitution bias)
- Overstating Inflation means understated Real GDP increases - makes it appear that the U.S. Economy has Grown Slower Over Time. (Same for Stock Market, Housing Prices, Wages - any Nominal Measure)
- Measures to Get Around Problems with CPI - Chain Weighting
- Read Box 2.2 in the Text to get a sense of chain weighting
Focus on Real Variables
- Which is better: Real or Nominal?
- In this class, we will focus on the 'Real'! We are trying to measure changes in production, expenditures, income, standard of livings, etc. We will separately focus on the changes in prices.
- From now on, both in the analytical portions and the data portions of the course, we will assume everything is real unless otherwise told.
PART III: Interest Rate
Interest Rates
= the nominal interest rate between periods 0 and 1
(the nominal return on the asset)
= the expected inflation rate between periods 0 and 1
= the expected real interest rate between periods 0 and 1
Definitions
where and
are the actual real interest rate and inflation
Interest Rate Notes
- The Formula given is approximate. The approximation is less accurate the higher the levels of inflation and nominal interest rates. The exact formula is
- Central Banks are very interested in
since it may affect the savings decisions of households and definitely affects the investment decisions of firms. The press talks about Central Banks setting
, but the Central Banks are really trying to set
.
- 3 easy ways of measuring expected inflation:
- Recent actual inflation.
- Survey of forecasters.
- Interest rate spread on nominal vs. inflation-indexed securities (WSJ)
Why We Care About Inflation?
- Note: We will have a whole lecture on this later in the course
- Inflation is Unpredictable
- Indexing Costs (even if you know the inflation rate - you have to deal with it).
- Menu Costs (have to go and re-price everything)
- Shoe-Leather Costs (you want to hold less cash - have to go to the bank more often).
- Caveat: There may be some benefits to small inflation rates - more on this later.
- An Example of how inflation can affect real returns.
- Suppose we agree that a real rate of 0.05 over the next year is fair.
- borrowing rate, salary growth rate, etc.
- Suppose we also agree that expected inflation over the next year is 0.07.
- We should then set the nominal return equal to
Borrowers/Firms are better off
Lenders/Workers worse off
People/Firms Don't Like the Uncertainty
PART IV: Unemployment
Measuring Unemployment
- Standardized Unemployment Rate:
Labor Force = #Employed + #Unemployed but Looking Unemployment Rate = # Unemployed but Looking/Labor Force
This is the definition used in most countries, including the U.S.
Types of Unemployment
- Frictional Unemployment: Result of Matching Behavior between Firms and Workers.
- Structural Unemployment: Result of Mismatch of Skills and Employer Needs + Industry/Product structural change
- Cyclical Unemployment: Result of Output being below full-employment
- Is Zero Unemployment a Reasonable Policy Goal?
– No! Frictional and Structural Unemployment may be desirable (unavoidable).
Why We Care About Unemployment
- Depreciation of Human Capital
- Productive Extranalities
- Social Extranalities
- Individual Self Worth
PART V: Preview of the model
The Mechanics of The Course (1)
The Demand Side
- The aggregate demand (AD) curve represents the expenditure (demand) side of the economy.
- Aggregate demand curve will relate price changes with changes in 'real' expenditures.
- Demand side of the economy will be the expenditure side of the economy!
- We will prove later in the course that the AD curve slopes down (take my word for it now). As prices increase, aggregate demand in the economy will fall.
The AD Curve: Graphical Representation
Let Y = Real GDP
Let P = the aggregate price level (measured by some price index)

The AD curve does not need to slope down linearly - it could have some curvature. We draw it linearly for simplicity.
The AD curve only shifts when C, I, G, or NX changes.
The Mechanics of The Course (2)
The Supply Side
- The aggregate supply (AS) curve represents the production (supply) side of the economy. The supply side of the economy is determined by firm production.
- Aggregate supply curve relates price changes with changes in production.
- The focus of next week's lecture will be on the aggregate production function for the economy.
Y = f(inputs in the economy; land, labor, machines, oil, etc)
- We will prove later in the course that the short run AS curve slopes upward (take my word again!). As prices increase, aggregate production in the economy will rise.
The AS Curve: Graphical Representations
Let Y = Real GDP
Let P = the aggregate price level (measured by some price index)
The short run AS curve is not linearly sloped. We usually draw it linearly for simplicity. In the real world, the SRAS curve is flatter at lower levels of GDP.
The AS curve only shifts when the price of factors of production change (things like oil prices, wages, and such) or the means of production change (technology) – wait for next week!
LONG RUN: Potential Output (Y*)
- Potential Output (Y*) is going to be the level of output in the economy where the economy is in long run equilibrium. In other words, if no shocks hit the economy, the economy will stay at Y* (or it will gravitate towards Y*).
(ok, that definition is kind of technical, what does Y* really mean?)
- Think of it this way, Y* is the level of economic activity that the economy was designed to sustain:
- People are working the 'right' amount given labor market conditions (not working too much, not working too little),
- Machines are working the right amount given profit maximizing conditions (not working too much, not working too little)
- We will formalize this (and all concepts) as the course progresses.
Macroeconomic Equilibriums
- Short run equilibrium: AD = AS
- Long run equilibrium: AD = AS = Y* (economy at its potential level)
- Formal definition of "recession": Y < Y*.
- Formal definition of "expansion": Y > Y*
- Note: Y* is not static – it evolves over time (as does AD and AS).
We are going to eventually model a "three equation dynamic system".
Short run equilibrium: AD equals short run AS (SRAS)
What does that mean? What is produced is equal to what is purchased (total expenditures).
Long run equilibrium: AD equals short run AS at the potential level of output
(Long run AS curve - Y* = LRAS)
What does that mean? What is produced is equal to what is purchased and what is produced is equal to the sustainable level of production.
How are these equilibriums ensured? prices in the economy adjust (price level, interest rates, wages).
Business Cycles vs. Economic Growth
- Business cycle analysis focuses on high frequency movements of Y
- Why do we have recessions? Why do we have periods of economic expansions?
- High frequency macroeconomic analysis focus on quarters, years, maybe a decade
- Economic growth analysis focuses on the evolution of Y* over time.
- Typically focus is on low frequency macroeconomic analysis (decades, centuries)
Demand Shocks
The relationship between inflation and output when aggregate demand shifts: Suppose we are in long run equilibrium at point (a) (AD = SRAS = LRAS)
If the economy receives a negative aggregate demand shock, short run equilibrium will move from point (a) to point (b). Output will fall (from Y* to Y'). Prices will fall (from P to P').
If the economy receives a negative aggregate demand shock short run equilibrium If the economy receives a negative aggregate demand shock, short run equilibrium will move from point (a) to point (b). Output will fall (from Y* to Y’). Prices will fall
(from P to P’).
Demand shocks cause prices and output to move in the same direction. (You should be able to illustrate a positive demand shock)
Supply Shocks
The relationship between inflation and output when aggregate supply shifts: Suppose we are in long run equilibrium at point (a) (AD = SRAS = LRAS)
If the economy receives a negative short run aggregate supply shock, short run equilibrium will move from point (a) to point (c). Output will fall (from Y* to Y''). Prices will rise (from P to P'').
Supply shocks cause prices and output to move in opposite directions. (You should be able to illustrate a positive supply shock)
Reinterpreting the Business Cycle Data 1970-2001
1970 recession: |
Inflation increasing at start of recession! |
1981 recession: |
Dramatic decrease in inflation at start of recession |
1990 recession: |
Little increase in inflation/but low level of inflation (demand shock: fall in consumer confidence/oil price increase) |
Rapid growth in mid 1990s: |
No inflation (supply shock: IT revolution) |
2001 recession: |
No inflation (demand shock: over confidence by firms: inventory adjustment) |
Current recession: |
Inflation first up and then down (supply shock: oil price increase + demand sock: credit crunch + confidence loss) |
The Supply Side of the Economy
Goals of Topic 2
Introduce the Supply Side of the Macro Economy:
- Production Function
- Labor Market:
- Labor Demand
- Labor Supply
- Equilibrium Wages and Employment
Source: Veronica Guirrieri, https://learn.saylor.org/pluginfile.php/31405/mod_folder/content/0/ECON102%20-%20The%20Supply%20Side%20of%20the%20Economy%20%20by%20Veronica%20Guerreiri.pdf?forcedownload=1 This work is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 License.
Production Function
The Production Function
- GDP (Y) is produced with capital (K) and labor (N):
= an index of efficiency in the use of inputs (technology)
- Sometimes, I will modify the production function as follows:
- Realistic Example is a Cobb Douglas function for F(.):
Measurement
- Y is GDP (it is measured in dollars). As noted above, we want to measure Y in "real" terms.<<you should know what this means from lecture 2>>.
- For our Cobb Douglas production function, N is measured in number of workers and K in dollars:
– K often is measured as the replacement cost of capital
– N often is measured in number of workers
- N can also be measured using
total hours worked = number of workers × hours per worker - Wage differentials can help to measure "effective labor supply", taking into account "skill" differentials.
N.B.: sometimes we will use N to denote total population (e.g. income per capitaY/N)
Graphical Representation 1
- Hold A and N constant (at levels A* and N*)
- Graph Y as a function of K
1. As K increases Y increases (the curve is upward-sloping)
2. As K increases the marginal increase in production decreases (the curve becomes flatter as K increases)
Graphical Representation 2
- Hold A and K constant (at levels A* and K*)
- Graph Y as a function of N
1. As N increases Y increases (the curve is upward-sloping)
2. As N increases the marginal increase in production decreases (the curve becomes flatter as N increases)
Aggregate Production Function: Fact 1
1. Constant Returns to Scale
Aggregate Production Function: Fact 2
2. Diminishing Returns to N and K
Cobb-Douglas:
Fixing A and K, MPN falls when N increases
Fixing A and N, MPK falls when K increases
Aggregate Production Function: Fact 3
3. Complementarities between A, K and N
FACT 3: The higher the level of capital (or technology), the higher the marginal product of labor (and symmetrically for capital!)
Cobb-Douglas:
Increasing A or K, increases MPN
Increasing A or N, increases MPK
Aggregate Production Function: Fact 4
4. Elasticities and Income Shares
- Elasticity is the percentage increase in Y (dependent variable) resulting from a
1% increase in X (independent variable), everything else constant
FACT 4: Labor Elasticity ~.7
Capital Elasticity ~.3
Cobb-Douglas:
- Share of labor income out of total GDP is about 70%
Share of capital income out of total GDP is about 30%
Two Notions of Productivity
Driven by A and K/N
Basically TFP is a 'catch-all' for anything that effects output other than K and N.
- Workweek of labor and capital
- Quality of labor and capital
- Regulation
- Infrastructure
- Specialization
- R&D, Innovation
- Strategy (Entrepreneurial methods/new management techniques)
- Some of the above tend to make TFP procyclical (capital utilization)
(Definition of Procyclical: Variable increases when Y is high, decreases when Y is low)
Simple examples (in words)
- Technology: "It costs FedEx $2.40 to track a package for a customer who calls by phone, but only $0.04 for one who visits its website", says Rob Carter, the firm's technology boss.
- Technology: "Airline kiosks reduce costs of boarding to less than a third".
- Management: Southwest’s oil hedging. Estimated oil price paid by SW: $31. United: $56.
- Infrastructure: Imagine what it takes to buy intermediate inputs from a different region with roads like in Nigeria.
Measure of Labor productivity
Productivity Levels
United States = 100
Country | GDP per capita |
Labour productivity |
||||
---|---|---|---|---|---|---|
Per person employed |
Per hour worked |
|||||
1995 | 2003 | 1995 | 2003 | 1995 | 2003 | |
United States |
100 | 100 | 100 | 100 | 100 | 100 |
Euro area |
72 | 70 | 84 | 77 | 95 | 89 |
Germany |
77 |
70 | 81 | 73 | 97 | 90 |
France | 75 | 74 | 83 | 88 | 108 | 107 |
Italy | 75 | 70 |
93 | 80 | 104 | 88 |
Spain | 57 | 62 | 78 | 73 | 83 | 75 |
Netherlands | 78 | 78 | 80 | 73 | 107 |
98 |
Belgium | 78 | 76 | 98 | 92 | 111 | 106 |
Austria | 84 | 79 | 81 | 74 |
98 | 87 |
Greece | 47 |
52 | 64 | 70 | 61 | 64 |
Portugal | 47 | 49 | 47 | 49 |
47 | 51 |
Finland | 69 | 72 | 81 | 76 | 87 | 80 |
Ireland | 64 | 87 | 86 |
92 | 86 | 99 |
Japan |
81 | 74 | 82 | 69 | 71 | 69 |
United Kingdom |
72 | 77 | 76 | 79 | 81 | 83 |
Canada | 80 | 87 | 89 | 86 | 92 | 86 |
Sweden | 77 | 75 |
70 | 71 | 80 | 86 |
Denmark | 81 | 80 | 76 | 75 | 92 | 89 |
Norway | 86 | 96 | 84 | 92 | 110 | 123 |
Iceland | 81 | 76 | 83 | 74 | 84 | 73 |
The Labor Market
Part I: Labor Demand
- In a competitive market, a firm can sell as much Y as it wants at the going
- price p, and can hire as much N as it wants at the going wage w.
- Facing w and p, a profit maximizing firm hires N to the point where
(the benefit from an additional worker, in terms of additional output, must equal the cost of hiring him). <<This is straight from micro>>
Why? MPN is decreasing in N, hence:
- If MPN> w/p then the firm can increase profits by increasing N.
- If MPN< w/p then the firm can increase profits by decreasing N.
The Labor Demand Curve
Notes on the Labor Demand Curve
- For the moment keep A and K constant.
- Caveat: Who says that there is a demand for more Y?
- Need to look at the demand side of economy (next lectures).
Part II: Labor Supply
- Labor Supply Ns Results from Individual Optimization Decisions
- Households compare benefits of working (additional lifetime resources) with cost of working (forgone leisure + effort)
- How much labor an household will choose to supply as the real wage (before taxes) wp varies?
- 2 effects:
- Substitution effect: higher real wage means higher reward to working, hence you want to work more!
- Income effect: higher real wage means you are richer, hence you need to work less to consume the same goods!
Refresh your memory from Micro!
- Think of an agent who gets utility from consuming apples and bananas
- From the utility maximization problem you get
- If P(apples) increases:
- Substitution effect: you want to increase MU(apples)/ MU(bananas). By the law of diminishing marginal utility you need to consume less apples and more bananas! You subsitute away from apples towards bananas
- Income effect: you spend more for the apples that you buy, so you are poorer. You will consume less apples AND bananas!
From Micro to Macro
- The two goods that the household can consume are now consumption (C) and leisure (L)
- The budget constraint is
for simplicity) with
. Then we can write a static version of the maximization problem as:
- If W/P increases:
- Substitution effect: you want to increase
. By the law of diminishing marginal utility you need to subsitute away from leisure towards consumption goods. Then you need to work more!
- Income effect: you have higher wages, so you are richer. You will consume more C and L. To consume more L, you need to work less!
Back to the Labor Supply
- In reality the household problem is not static. Define
, that determines the household income. life time resources, that determines the household income.
- For simplicity to graph the Labor Supply we separate income and substitution effects by separating PVLR from the current real wage w/p effects by separating PVLR from the current real wage w/p.
- PVLR represents the income effect and w/p the substitution effect.
- SHORTCUT: if w/p increases permanently PVLR increases as well, BUT if w/p increases temporarily only, then PVLR increases just a tiny bit so that we assume that
does not change!
The Labor Supply Curve
- Factors Affecting Labor Supply
- The Real Wage (w/p)
- The Household's Present Value of Lifetime Resources (PVLR)
- The Marginal Tax Rate on Labor Income(tn)
- The Marginal Tax Rate on Consumption (tc)
- Value of Leisure (reservation wage) - non-'work' status (VL)
- The Working Age Population (pop)
- Labor Supply (Ns) shows the relationship between real wages and hours worked holding everything else constant (included (PVLR)!)
The Labor Supply Curve: Substitution Effect
The Labor Supply Curve: Income effect
What affects the Labor Supply?
- The Real Wage - HOLDING PVLR fixed: A higher w/p encourages individuals to substitute away from leisure toward work (leisure becomes more expensive). This is a substitution effect.
<<This is why the labor supply curve slopes upwards>>
- Estimating this substitution effect is difficult since PVLR is not easily held constant. Estimates range from 0 - 2 (For a 1% increase in after-tax w/p holding PVLR fixed, labor supply either increases between 0% and 2%). Very Wide Range – little consensus.
- A higher PVLR induces individuals to work less (lower Ns
) for a given after-tax wage, allowing them to enjoy more leisure (If leisure is preferred to work – as I get richer, I can afford to work less). <<This is represented by a shift of the supply curve >>
- PVLR is net of taxes and non-work governmental transfers and inclusive of all other transfers.
- Marginal tax rate on labor income- Should have same substitution effect as the before tax real wage. Studies of the 1986 U.S. Tax Reform found that only high-earning married women worked more in response to lower marginal income tax rates. income tax rates.
- Marginal tax rate on consumption - see above
- Value of Leisure - If leisure/no-work becomes more/less attractive, households will work less/more (think about welfare programs, child care,…)
- Working Age Population: Usually defined as 16-64 (includes changes in Labor Force Participation Rates)
Recap on Labor Supply
- Substitution Effect:
- This is why Labor Supply Curve Slopes Upward
- Income Effect
– For a given after-tax wage, higher PVLR decreases (Ns).
- Evidence:
– Weak Consensus is that, with equal (%) increase in PVLR and after-tax wage, (Ns)falls (income effect dominates)
Part III: Labor Market Equilibrium
Temporary Increase in A
Permanent Increase in A
N* < N" → Here income effect is dominated!
Can Technological Progress destroy jobs?
Facts:
A N w/p are trending up over time A, N, w/p are trending up over time.
N/pop is trending down (except in U.S. since 1980).
Higher A countries have higher w/p and lower N/pop.
Implications:
Adjusting for pop, higher A goes with lower N.
Higher A reduces Nd and destroys jobs? - NO! Labor Demand Increases.
Higher A increases PVLR and reduces Ns.It is Labor Supply that falls
What happened to US Wage inequality?
Differential shift of A on different skill markets
Permanent Increase in pop
Population and Jobs
Temporary vs Permanent Increase in Taxes (tc or tn)
Temporary Increase in Taxes (tc or tn)
After tax wage SHIFTS the supply curve!!
Permanent Increase in Taxes (tc or tn)
Income effect can dominate or not! Try the other case
Labor Market Equilibrium (Long Run)
- We define Long Run Equilibrium in macroeconomics as occurring when the labor market clears.
- At N*, labor demand = labor supply. So, by definition, all workers who want a job (the suppliers) are able to find a firm looking for a worker (the demanders).
Long run equilibrium is characterized by zero cyclical unemployment!
- It is an equilibrium such that there is no incentive for real wages to change at N*
Real wages have 2 components: nominal wages (w) and the price level (p).
Long Run Aggregate Supply
- Suppose prices (p) increase. What happens in the labor market?
- In terms of equilibrium, nothing happens!
- Increasing prices have no effect on labor demand (A and K do not change).
- Increasing prices have no effect on labor supply (taxes, population, etc. do not change).
- You may ask "Doesn't PVLR change when prices increase???" No!
- As long as nominal wages adjust, real wages will be unchanged when p increases.
- The % change in prices will be matched exactly by the % change in nominal wages – real wages will not change (so PVLR will not change).
- No effect on labor supply.
- Key: Because real wages will not change, changes in prices will have NO effect on the labor market (.e., it will have no effect on N).*
- Conclusion: Changing prices will have NO effect on Y* (since N* is constant).
Long Run Aggregate Supply curve
- If labor market clears, changes in prices will lead to equal changes in nominal wages.
As a result, there will be no change in N* and hence no change in Y*.
- Leads to a vertical LRAS curve. Prices do not affect production in the long run!
What shifts Y*? (the LRAS)
- Anything that affects the labor market will affect Y*!
- If N* increases, Y* will shift to the right.
- If N* decreases, Y* will shift to the left.
- Summary: Y* will shift right if:
- A increases
- K increases
- population increases
- labor income taxes fall (and income effect is small relative to substitution effect)
- labor income taxes rise (and income effect is large relative to substitution effect)
Take out
- In the long run – when labor markets clear.
– Supply side of economy (labor market, K, A, other inputs like oil) determines output.
– Demand side of economy (C+I+G+NX) will determine prices.
- In the short run – when labor markets do not clear:
– Demand and Supply jointly determine prices and output.
– Three outstanding issues (we will get to them soon):
- What determines demand?
- When is the labor market NOT in equilibrium?
- What does the supply curve look like when labor market doesn't clear?
Preview: Disequilibrium in Labor Markets
- When do we get cyclical unemployment in our models? So far NO unemployment! We need some frictions
in the labor market to get cyclical unemployment.
- Cyclical unemployment occurs when labor demand is smaller than labor supply at current wages (one story: nominal wages do not adjust to clear the labor market).
- Cyclical unemployment occurs only in disequilibrium!
Trends in Actual (Standardized) Unemployment Rates
1994 |
1996 |
1998 |
2000 |
2001 |
2002 |
2004 |
2007 |
200802 |
|
Britain |
9.6 |
8.2 |
6.3 |
5.5 |
5.0 |
5.1 |
4.7 |
5.3 |
5.4 |
Japan |
2.9 |
3.4 |
4.1 |
4.7 |
5.0 |
5.4 |
4.7 |
3.9 |
4.0 |
USA |
6.1 |
5.4 |
4.5 |
4.0 |
4.8 |
6.0 |
5.5 |
4.6 |
5.3 |
France |
12.3 |
12.4 |
11.7 |
9.5 |
8.5 |
8.9 |
9.6 |
8.3 |
7.7 |
Germany |
8.4 |
8.9 |
9.4 |
7.9 |
7.7 |
8.7 |
9.5 |
8.4 |
7.4 |
Spain |
24.1 |
22.1 |
18.3 |
14.1 |
10.6 |
11.3 |
10.9 |
8.3 |
10.6 |
Poland |
18.5 |
19.8 |
18.8 |
9.6 |
7.3 |
Why is Unemployment So High In Europe?
- High labor income tax rates (tn)
- Firing restrictions
- Centralized wage setting
- High minimum wages
- Powerful unions and insiders
- Generous unemployment benefits