ECO1019 Principles of Macroeconomics Lecture and Textbook Notes PDF

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Warning: TT: undefined function: 32 Lecture 1 – Introduction and Measurement Macroeconomics: an Overview Microeconomics – the study of how individual households and firms make decisions and how they interact with one another in markets Macroeconomics is the study of the economy as a whole. It examin...

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ECO1019: Principles of Macroeconomics

Dimitra Petropoulou

Lecture 1 – Introduction and Measurement Macroeconomics: an Overview Microeconomics – the study of how individual households and firms make decisions and how they interact with one another in markets Macroeconomics is the study of the economy as a whole. It examines the aggregate behaviour of the economy – how the actions of all individuals & firms interact to produce a particular economy-wide level of economic performance. What is Macroeconomics? • Models built to explain macroeconomic phenomena • The important phenomena are long-run growth and business cycles • Approach in this course is to build up macroeconomic analysis from microeconomic principles • Explore policy implications of the models Macroeconomics: an Overview 1. Micro-foundations: every macro model has consumers and firms that interact in the economy, set of goods that consumers wish to consume, consumer preferences, technology available to produce goods, resource available 2. Consumers and firms optimize: they do their best given the constraints they face. 3. (Competitive) equilibrium: firms and consumers are price takers, hence a situation in which the price of each good is such that demand equals supply 4. Now we can run thought experiments using this little model. First experiments to check that matches data. Then experiments to answer questions to which we don’t know the answer. • Macroeconomics: how does it work? o We use models (mathematical simplifications of macroeconomic relationships, assumptions are crucial, don’t need to be realistic) o We aggregate (one labour market, one market for G & S, one asset market, etc.)… o But the micro-foundations have to be right o We rely on data to develop and test theories about how the economy works • Macroeconomics tries to answer questions such as the following: o Why is average income high in some countries and low in others? What causes growth? – Growth o Why does economic activity fluctuate? Can we do something about it, i.e. reduce amplitude and duration of recessions? – Business cycles o Inflation, unemployment and credit o Do govt macroeconomic policies improve/worsen economic performance? Fiscal, monetary policy as well as a financial market regulation The basic structure of a macroeconomic model is a description of the following features: 1. The consumers and firms that interact in the economy 2. The set of goods that consumers wish to consume 3. Consumers’ preferences over goods 4. The technology available to firms for producing goods 5. The resources available • Main concept used in macroeconomic models is competitive equilibrium ©Shankary Ravichelvam 2017

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ECO1019: Principles of Macroeconomics

Dimitra Petropoulou

o Competitive equilibrium – equilibrium in which firms and households are assumed to be price-takers, and market prices are such that the quantity supplied equals the quantity demanded in each market in the economy Gross Domestic Product • Economists and policymakers monitor the performance of the overall economy by looking at GDP Gross Domestic Product (GDP) – the total market value of all final goods/services produced within a country in a given period of time • GDP (Y) is the sum of Consumption (C, total purchases), Investment (I), Government Purchases (G) and Net Exports (NX) • This is called the income-expenditure identity Y = C + I + G + NX • GDP: real vs nominal, levels vs. growth, per capita Per Capita Real GDP (in 2005 dollars) for the US, 19002011 • Looking at data over a long period of time oversees the fluctuations in the short term • Real GDP could be increasing because of an ! in output/inflation • WWII – big govt investment in industries, hence GDP ! a lot • If technological change !, allows us to ! production • Per Capita Real GDP – measure of the average level of income for a citizen • Two unusual, though key, events in the figure are the Great Depression, when there was a large reduction in living standards for the average American, and World War II, when GDP per capita output increased greatly Percentage Deviations from Trend in Per Capita Real GDP • Trend is growth theory • Fluctuations of the trend (why it is below/above it) • The Great Depression and WWII represent extremely large deviations from trend relative to post-WWII business cycle activity and business cycles before the Great Depression o Production lead to a big spike in WWII – destruction of resources Measuring GDP • GDP measured using: o 1. Product Approach o 2. Expenditure approach o 3. Income Approach – includes salaries • Should all give the same number (up to measurement errors) Product approach – determines GDP as the sum of value added to goods/services in production across all productive units in the economy Expenditure approach – determines GDP as total spending on all final goods/services production in the economy ©Shankary Ravichelvam 2017

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ECO1019: Principles of Macroeconomics

Dimitra Petropoulou

Income approach – determines GDP as the sum of all incomes received by economic agents contribution to production National Income Accounting Example Fictional Island Economy • Coconut producer – produces 10 million coconuts and sells them at $2 each o Revenue = 2 x 10 = $20 million o Pays $5mil to workers (who are also the consumers) o Pays $1.5mil in taxes to govt • Coconut is an intermediate good (input) and a final consumption good • Restaurant – buys 6mil coconuts o Coconuts used for cooking coconut soup o Sells $30mil of soup o Paid $12mil for coconuts o Pays $4mil in wages o Pays $3mil in taxes to govt o After tax profits = total revenue – wages – interest – cost of intermediate inputs – taxes • Government – collects taxes, $4.5mil from producers & $1mil from consumers o Uses revenue to pay wages to army • Consumers – get wages, interest income, profits o Pays taxes

GDP using the Product Approach • • 1. 2. 3.

GDP = sum of value added in each sector Value added = value of production – intermediate goods Sum of value added to goods/services across all productive units in the economy Coconut producer à no intermediate goods, so $20mil is value added Restaurant à total revenues – coconuts used in production = $30mil - $12mil = $18mil Govt à defence is not sold in the market so not clear what is the value

©Shankary Ravichelvam 2017

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ECO1019: Principles of Macroeconomics

Dimitra Petropoulou

Ø We use the cost of the inputs to produce it as the value – we only use labour here so value added is $5.5mil Ø Assume money that govt receives is valued

GDP using the Expenditure Approach GDP = C + I + G + NX 1. No investment, no exports, no imports 2. Consumers à spend $8mil (4mil x $2) on coconuts and $30mil in restaurants, so C = $38mil 3. Govt à Again, expenditure = costs = $5.5mil

GDP using the Income Approach GDP = sum of all income received by economic agents contributing to production • We add up all income received by economic agents contributing to production, adding depreciation (value of productive capital that wears out in the year) because we take it out when we calculate profits • So à wages, profits, net interest, rental income, corporate profits, indirect business taxes 1. Wages - $14.5mil 2. After tax profits - $24mil 3. Interest income - $0.5mil 4. Taxes paid by producers (govt income) - $4.5mil

Problems in Measuring GDP • Economic activity in the underground economy cannot be measured directly – this activity might me measured indirectly by accounting for the use of currency o Black markets • Govt production is difficult to measure, as the output is typically not sold in the market o Defence services • Even if we use it as a proxy for aggregate economic welfare, GDP doesn’t take into account the income distribution • It leaves out all non-market activities – work at home etc. ©Shankary Ravichelvam 2017

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ECO1019: Principles of Macroeconomics

Dimitra Petropoulou

GDP statistics only measure transactions reported to the govt o \ GDP always under reports • GDP is supposed to be a measure of well-being/standard of living – not a great indicator of this GDP and GNP Gross National Product (GNP) – the value of output produced by domestic factors of production, regardless of whether the production takes place inside the country’s border • Income produced by a plant in Vietnam owned by a firm resident in UK – included in GNP but not in GDP • Income produced by a plant in Cambridge owned by a Korean firm – included in GDP but not in GNP GNP = GDP + NFP • NFP – net factor payments from abroad Nominal and Real GDP and Price Indices Price index – weighted average of a set of observed prices that gives a measure of the price level • Price indices allow us to measure the inflation rate – the rate of change in the price level • A measure of the inflation rate allows us to determine how much of an ! in GDP is nominal and how much is real Calculating Nominal GDP • Orange prices have doubled in the second year •

Nominal GDP has doubled which would lead you to believe that the value of GDP has doubled but this isn’t the case since inflation has also influenced GDP o Quantities and prices might be moving at the same time – can be misleading and actually lead to inflation Calculating Real GDP • Real GDP – depends what year we consider as the base year! o One of the methods used in Economic Data Analysis • Year 2 –Take quantities from the second year but keep the prices constant – another method used to workout real GDP • Nominal GDP will overstate the picture, which is why real GDP is a better measurement to use •

©Shankary Ravichelvam 2017

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ECO1019: Principles of Macroeconomics

Dimitra Petropoulou

Valuing production today with prices last year

Chain weighted gc = √(𝑔$ × 𝑔& ) (Fisher Index) Nominal GDP (black line) and Chain-weighted Real GDP (coloured line) • Nominal increases rapidly but real GDP increases more steadily o The point where the graphs cross is the base year

Measure of the price level • On the one hand, CPI is representative of household spending but the basket of goods is forever evolving but in the short run it keeps it constant • Prices don’t increase uniformly or increase at a constant rate • Basket of goods always changes – CPI ignores this o Assumes that people on average stick with same basket of goods à here the CPI ignores the substitution effect, and overestimates inflation • There can be substantial differences between the two – CPI includes only goods purchased by consumers, and quantities are fixed at base year ()*+,-./012 Implicit GDP price deflator = / × /100 34-./012 ©Shankary Ravichelvam 2017

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ECO1019: Principles of Macroeconomics

Current year CPI =

Dimitra Petropoulou

7)89/): /;-84 /?-,9+9+48/-9 /@?==4,9/A=+@48 7)89/): /;-84/?-,9+9+48 /-9/;-84 / -1 à can even look at shrinking population ©Shankary Ravichelvam 2017

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ECO1019: Principles of Macroeconomics

Dimitra Petropoulou

• Population = workers = quantity of employment (everybody works, just for simplicity) Consumption-Savings Behaviour • Consumers are assumed to save a constant fraction s of their income for the future, consuming the rest o Why do we need savings in this model? à because S = I • No government (G=0) – assumption • Savings = Investment • Investment à ! capital stock • No G, and thus no net exports Representative Firm’s Production Function • •

F = production function à when we combine capital and labour, we yield production Z = parameter à it scales up and down production à it is TECHNOLOGY o Z is outside the function, to keep it simple

Properties of the Firm’s Production Function 1. Output ! with increases in labour input or capital input 2. MP for capital and labour are positive (the amount of extra output) • Mathematically – the slope (derivative) of the production function with respect to that factor • Marginal Product (MP) – MP of a FoP is the addition output that can be produced with one additional unit of that factor input, holding constant the quantities of the other factor inputs • NB: We are going to assume that the MP is diminishing Production Function, Fixing the Quantity of Labour and varying the Quantity of Capital • Every time we make an investment and get more capital, the next additional investment will yield a smaller ! in capital à DIMINISHING RETURNS o Thus, there is some optimal level of investment ©Shankary Ravichelvam 2017

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ECO1019: Principles of Macroeconomics

Dimitra Petropoulou

Marginal Product of Labour Schedule for the Representative Firm 3. The marginal product of labour ¯ as the labour input ! • If I invest in my economy and invest in capital stock, labour becomes more productive • K is fixed, Nd is the labour input, the more input you have the more output you get o However, gradient ¯ - output is ! at a decreasing rate o More labour we have the lower the marginal product (diagram on the right)

4. The marginal product of labour ! as the quantity of the capital input ! • Everyone gets more productive at the same time with more capital

©Shankary Ravichelvam 2017

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ECO1019: Principles of Macroeconomics

Dimitra Petropoulou

In conclusion: 1. Output ! with ! in either the labour input/capital input 2. The MPL ¯ as labour input ! 3. The marginal product of capital ¯ as the capital input ! 4. The marginal product of labour ! as the quantity of the capital input ! 5. Constant returns to scale – if I double my inputs, I double my outputs Constant Returns to Scale Constant returns to scale implies: • GDP per capita = GDP/population • If we know that it has constant returns to scale, then it will work by no matter what we divide it by • K/N – capital-labour ratio, an economy with high capital-labour ratio is a “capital-rich” country The Per-Worker Production Function 𝑦 = 𝑧𝑓(𝑘) • Instead of it Y and K, it’s y and k (all we did is divide it by a constant)

©Shankary Ravichelvam 2017

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ECO1019: Principles of Macroeconomics

Dimitra Petropoulou

Evolution of the Capital Stock – FUNDAMENTAL • Future capital equals the capital remaining after depreciation, plus current investment

K = current capital stock; K’ = future capital stock d = depreciation rate We have current capital (K) o Capital in the next period, will be the one we started with, minus the depreciation rate (fraction of capital stock will wear/tear/depreciate) plus new capital coming in through investment o Every year, depreciation is taking away from capital stock while investment adds to capital • Investment is financed by saving Income-Expenditure Identity • The income expenditure identity holds as an equilibrium condition • G=0, NX=0 𝑌 =𝐶+𝐼 ⟹ 𝑌−𝐶 = 𝑆 = 𝐼 • This tells you S=I o The income-expenditure identity in the economy is simply Y = C + I Equilibrium • Let’s combine what we know: 𝐾 C = (1 − 𝑑)𝐾 + 𝐼 ⇒ 𝐾 C = ( 1 − 𝑑) 𝐾 + 𝑆 ⇒ 𝐾 C = (1 − 𝑑) 𝐾 + 𝑠𝑌 ⇒ 𝐾 C = (1 − 𝑑)𝐾 + 𝑠𝑧𝐹 (𝐾, 𝑁) • In equilibrium, future capital equals total savings (=I) plus what remains of current K • I can be substituted for S since they are equal o Savings in the economy is fraction of income, so we can substitute further • Let’s rewrite in per-worker form: 𝐾 C = (1 − 𝑑)𝐾 + 𝑠𝑧𝐹 (𝐾, 𝑁) 𝐾C 𝐾 𝐹 (𝐾, 𝑁) ⇒ = (1 − 𝑑) + 𝑠𝑧 𝑁 𝑁 𝑁 • • •

⇒ •

Now a trick! ⇒

𝐾C = (1 − 𝑑)𝑘 + 𝑠𝑧𝑓 ( 𝑘) 𝑁

𝐾C 𝑁C = (1 − 𝑑)𝑘 + 𝑠𝑧𝑓 (𝑘 ) 𝑁 𝑁C

𝑁C = (1 − 𝑑)𝑘 + 𝑠𝑧𝑓 (𝑘) 𝑁C ⇒ 𝑘′(1 + 𝑛) = (1 − 𝑑)𝑘 + 𝑠𝑧𝑓 (𝑘) The problem with our per-worker form is that it is NOT PER CAPITA à thus we must divide by ‘n’ everywhere o Multiplying and dividing by the same thing does not change the value of our worker, but it allows us to clean out formula o K’/N = future capital per worker ⇒ 𝑘′

•

©Shankary Ravichelvam 2017

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ECO1019: Principles of Macroeconomics

•

•

Dimitra Petropoulou

o Population in the future = (1+n) o We want to know what the capital labour will be in the future as a function of today Rearrange to get: 𝑘 C (1 + 𝑛 ) = (1 − 𝑑)𝑘 + 𝑠𝑧𝑓 (𝑘 ) ( 1 − 𝑑) 𝑘 𝑠𝑧𝑓 (𝑘 ) ⇒ 𝑘C = + 1+𝑛 1+𝑛 Final equation – output is now per capita o The second part of the equation is curved, causing the entire formula to be curved

Determination of the Steady State Quantity of Capital Worker

This blue curve tells us how capital today relates to capital in the future o The 45-degree line – capital today and capital in future are the same à steady state • When we are in the steady-state, we are not growing à y=f(k) à so if k is not changing, then income is not increasing either • There is a stability in the economy à if capital collapses, the dynamics of the economy will cause capital to converge back to steady state • We cannot increase indefinitely à there is an equilibrium level in the economy; if you deviate, you will slowly return to this level Analysis of the steady state • Recall: (1 − 𝑑)𝑘 𝑠𝑧𝑓 ( 𝑘) 𝑘C = + 1+𝑛 1+𝑛 • In the steady state k = k’ = k* ( 1 − 𝑑)𝑘 ∗ 𝑠𝑧𝑓(𝑘 ∗ ) 𝑘∗ = + 1+𝑛 1+𝑛 • Multiply by (1+n) both sides, rearrange and get: •

szf(k*)=(n+d)k*/

• •

Left part of the equation = income multiplied by savings rate (=savings, which equals investment)/ o What is added to capital (curved)/ Right part of the equation = degree of erosion of capital/ o What is taken away from capital (linear)

©Shankary Ravichelvam 2017

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ECO1019: Principles of Macroeconomics

Dimitra Petropoulou

Determination of the Steady State Quantity of Capital per Worker

szf(k*)=(n+d)k*/ •

What happens to Y, K, C in the steady state? 𝑌 𝐶 𝐾 𝑘 = ///////𝑦 = //////𝑐 = 𝑁 𝑁 𝑁

k, y and c constant – so: o K grows at rate n o Y grows at rate n o C grows at rate n • GDP per capita is constant • Population is growing at a rate ‘n’ • If you want to know how fast an economy is going to grow, it will grow as fast of its population growth (if population grows at 3%, then GDP will grow at 3%) à might think that this isn’t very realistic, which it isn’t An Increase in the Savings Rate ‘s’ • In the steady state, an ! in the saving rate s ! capital per worker and real output per capita • In the steady state, there is no effect on the growth rates of aggregate variables • In line with data (investment positively correlated with GDP per capita)! Thought Experiment 1: Model has told us that: 1. If nothing changes, we will converge to steady state 2. If something dramatic happens, we will initially have very high/low growth, and then converge back to steady state •

Effect of an ! in the Savings Rate at Time T • You can use a higher savings rate to jump start you to get a higher income level, but then you will continue to grow at the same rate Steady State Consumption per Worker

©Shankary Ravichelvam 2017

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ECO1019: Principles of Macroeconomics

Dimitra Petropoulou

Savings is a fraction of income o So, if we were to plot income (zf(k*)0, then it would be the same shape but higher • Thus, it must be that the gap between income (Y) and savings (S) = consumption • C =Y– S The Golden Rule Quantity of Capital per Worker •

Question: What is the steady state level of capital that maximises the steady state level of consumption? Maximise w.r.t k*: c*/=/zf(k*)/–/(n+d)k*/ We get c** such that: •

MPK/=/n/+/d/ If population grows at 3%, and capital depreciates at 1%, then the level of marginal capital = 4%/ Countries that save more and invest more are richer • Kgr – golden rule capital per worker • Sgr – golden rule savings rate You can plot the gap between income and savings à If we had a choice, which equilibrium d...