Macro Econ Final Study Guide PDF

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1 Fouts Madeline Fouts Manuel Lancastre Macro Economics Spring 2019 Macro Economics Final Study Guide (Ch. 10-13 and Ch. 19-20) Chapter 10-13 and Chapter 19-20 Chapter 10. - Economic Growth Factors of Growth - Growth – steady increase in aggregate output over time - Logarithmic scale – scale used to measure GDP on a vertical axis o Has the same proportional increase in a variable - There was decrease in output during the Great Depression, post war recession, and recent recession of 2010 Measure the standard of living - Standard of living – reason we care about growth and the variable to consider is output per person rather than output itself - How do you compare output per person across different countries when there are different currencies? o You use the exchange rate, but can’t really use it because  Exchange rates vary a lot, so it would seem like standard of living is increasing and decreasing a lot  Prices of basic good differ per country and the level of consumption is different  the lower a country’s output per person, the lower the prices of food and basic services Purchasing Power Parity - Adjusted real GDP numbers across time or across countries - When comparing rich vs. poor countries difference will be large - What matter’s for people’s welfare is their consumption rather than their income - In production side should be interested in output per worker per hour worked - A higher standard of living (having more money) leads to happiness Growth Rate in Rich Countries Since 1950 - Force of compounding – output per person has increased tremendously - Policies that stimulate growth can have a large effect on standard of living - Levels of output per person have converged (become closer) over time – the countries that were behind grew faster reducing the gap between them o happened for all OECD countries o Growth Rates (in GDP per capita) are extremely relevant, because faster growing countries will reach higher levels of income over time - Small differences in annual growth rates add up to large differences in levels of income over time o 1950 – US had the highest output per person o In 1870 UK was 31% richer than US o Over the period 1870 – 2009, it grew on average by 1.5% per year the U.S grew by 1.8% o BY 2009, the UK was 19% poorer than the U.S

2 Fouts Aggregate Production Function - The relation between aggregate output and the inputs in production o Y= F(K,N)  Y is aggregate output  K is capital (sum of all machines, plants, office buildings)  N is labor (number of workers in the economy) - State of technology affect these 2 variables – more advanced technology means more productivity – same amount of people can produce more outputs

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Returns to Scale - Constant returns to scale - If N and K double then output will double as well  2Y= F(2K, 2N) Decreasing returns to scale – increases in capital or labor lead to smaller increases in output

Output per Worker and Capital Per Worker - Set x= 1/N - Y/N = F(K/N, N/N)  (K/N, 1)  output per worker is a function of capital per worker o K/N - capital per worker which is equal to k o Y/N – output per worker which is equal to y Sources of Growth - Capital accumulation - Increases in y can come from increases in k o This alone cannot sustain growth because it requires larger and larger levels of capital per worker and economy at some point will be unwilling to save that amount and then output per workers will stop growing o Higher saving rate cannot permanently increase the growth rate of output, but it can sustain a higher level of output  two economies will grow at same rate but one will have a higher level of output than the other - Technological process - Increases in y can come from improvements in the state of technology that shift production function F and lead to more output per worker given capital per worker o In the long run, an economy that sustains a higher rate of technological process will eventually overtake all other economies  Narrow def of tech: fundamental and applied research, role of paten laws, role of education and training  Broader def: how economy is organized, role of governments

3 Fouts Chapter 11 – Saving, Capital, Accumulation, and Output Interactions between Output and Capital - Saving rate – ratio of saving to GDP (averages 17% in US) o Increase in the savings rate leads to higher growth for some time - Output in the long run depends on 2 things o Amount of capital determines amount produced o Amount produced determines amount saved and amount of capital accumulated Output on Investment - 3 assumptions o Closed economy so I=S+(T-G) o Assume public saving (T-G) is equal to 0 so I=S o Assume Private Saving is proportional to income so S=Y where  is the saving rate  Richer countries do not have higher saving rate than lower countries - Relationship between investment and output – I = Y  the higher the output the higher the saving rate and the higher the investment Flow or Stock - Flow: investment, depreciation - Stock: Capital Investment on Capital Accumulation - Capital depreciates at  - Evolution of capital stock is Kt+1 = (1-)Kt + It - Now replace I with its definition from above and divide by N  Kt+1/N = (1-)Kt/N + sY/N - Kt+1/N - Kt/N = sY/N - Kt/N  from the savings side see how output determines capital accumulation o Change in capital stock per worker, is equal to savings per worker minus depreciation Dynamics of Capital and Output - Change in capital per worker depends on o Investment per worker: level of cap determines output per worker and output per worker determines the savings per worker and thus investment per worker o Depreciation per worker: capital stock per worker determines the amount of depreciation per worker - If investment > depreciation then capital per worker is positive and increases - If investment < depreciation then capital per worker is negative and decreases Y/N = f(K/N) Solow Model in Steady State - I is lower than Y by a factor of saving rate (s) o Investment per worker increases with capital per worker -

Depreciation per worker increases in proportion to capital per worker Change in capital per worker is the difference between I per worker and  per worker Steady state – state in which output per worker and capital per worker are no longer changing

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sf(K*/N) = (K*/N)  savings just covers depreciation Y*/N = f(K*/N)

Know how to derive this – look in notes

How does the savings rate affect the growth rate of output per worker? - Has no effect on the long run growth rate out output per worker which is equal to zero  Growth rate of output is equal to zero no matter the savings rate - determines the level of output per worker in the long run - Higher savings rate = higher output per worker - Increase in savings rate will lead to a higher growth rate of output per worker for some time not permanently  comes to end when economy reaches new steady state The Saving Rate and Consumption - Governments affect savings through varying public savings and through private saving taxes - Increase in savings comes initially with an equal decrease in consumption - Golden rule level of capital – the level of capital associated with the value of the saving rate that yields the highest level of consumption in steady state o savings is equal to 0, Y/N and K/N = 0 o s between 0 and SG higher savings leads to higher K/N, and C/N and Y/N o s above SG still higher K/N and Y/N but lower C/N because output more than offset by increase in  o if S = 1 then no room for C cause all money goes to  Physical vs. Human Capital - human capital: the set of skills of the workers in the economy - increase in human capital has been as large as increase in physical capital - New production function: Y/N = f(K/N, H/N) Human Capital, Physical Capital, and Output - Y/N depends on how much society saves and how much it spends on education - Education is partially consumption and partly investment - Spending on education includes cost and opportunity cost - Depreciation of physical capital is likely to be higher than depreciation of human capital Returns of Education - Returns to education by looking at wages of identical individuals who attended different levels of schooling  they earn differently suggesting that the market evaluates the level of education - Annual returns to education declines as years of education accumulate o Grades 1-4: 13.4% return o Grades 5-8: 10.1% return o Grades higher than 8: 6.8% return - An individual with 10 years of education has 1*1.134 4*1.1014*1.0672 = 2.77 times the wage of an uneducated individual College Premium in the US

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The college premium has fluctuated during 1940-2008 Two theories explain the sharp rise in the college premium since 1980: o Globalization – increase in the demand for US skilled workers o Skilled based technical change – computers skilled workers increase productivity Several theories aimed to explain the relation between education and income per capita o Education makes the worker more productive o More educated individuals can deal better with change o Externalities

Endogenous Growth - Countries that save more or spend more on education will achieve higher level of output per worker in the steady state - Models of endogenous growth – models that generate steady state growth without technological progress

Chapter 12 – Technological Process and Growth - Technological process has many dimensions o Lead to larger quantities of output for given quantities K,L o Lead to better, new, variety of products - State of technology – variable that tells us how much output can be produced from given K,L - Y=F(K,AL) where AL is effective worker o Technological process reduces the number of workers needed to produce a given amount o Increases the output that can be produced with a given amount of workers - Output per affective workers Y/AN = f(K/AN) Interactions between output and capital with Tech change - GN = Population growth rate - GA = growth rate of output per worker - GA + GN = growth rate of effective worker and growth of output - I = K + (gA+gn)K = Investment needed to maintain a given level of capital

Know how to derive this – look in notes

Dynamics of Capital and Output - In the steady state, Y is growing at same rate as (K/AL) so the ratio between the two is constant - In the steady state, Y grows at the rate of technological progress - L is growing at the rate of population growth (G l) and K and Y are growing at the rate equal to the sum of population growth and rate of technological progress  balanced growth - In the steady state, the growth rate of Y depends only on the rate of population growth and the rate of technological process o An increase in the population growth rate will case an increase in the state-state growth rate of capital The Determinants of Technological Process - Research and development (R&D) - Firms spend on R&D to create profit because by increasing it firms are increasing the probability it will discover a new product - Fertility – how R&D spending translates into new ideas o A reduction in fertility research will most likely cause a decrease in the rate of technological process - Appropriability – the extent to which firms benefit from the results of their own

6 Fouts Management, Innovation, and Imitation - Poorer countries are further from technology frontier and grow by imitating rather than innovating  example China Institutions, technological Process and Growth - Low protection of property rights is associated with a low GDP per person - Protection of property rights means good political system where those in charge cannot expropriate or seize the property of the citizens o Means good judicial system o Means laws against insider trading o Means clearly written and well-enforced patents The Facts of Growth Revisited - If high growth reflects high balanced growth, Y/N should be growing at a rate equal to the rate of tech progress - If high growth reflects instead the adjustment to higher level of K/AL growth rate of Y/L exceeds the rate of tech progress - Growth rate of US between 1985 and 2014 was 1.7% - An increase in the savings rate will cause an increase in output per effective worker Where Does China’s growth come from? - China has transferred labor from the countryside where productivity is low to industries and services with higher productivity - High rate of growth of output from China came from E – a increase in tech progress and an increasing in the saving rate - China has imported the technology of more technologically advanced countries - Average growth rate of China is 10%

Chapter 13 – Technological Progress: The Short, the Medium, and the Long Run Productivity, Output and Unemployment in the Short Run - Production function Y= AL  assume output is only produced using labor - Increase in A represent technological progress and output per worker - N = Y/A o Employment is equal to output/productivity - In short run level of output Y=Y(C-T) + I(r + x, Y) + G and r=r o Output depends on demand (C+I+G) and consumption depends on disposable income o Investment depends on borrowing rate which equals policy rate plus a risk premium - Increased international trade means increase in foreign competition which means many firms have to reorganize and downsize  this increases uncertainty and reduces consumption so IS shifts left - By raising expected output growth and expected profits, IS shifts right - % change in E = % change in Y - % change in A - In short run, higher output growth leads to higher productivity growth - Sometimes increases in productivity lead to increases in output sufficient to maintain or even increase employment in the short run. Sometimes they do not and then unemployment increases Learn what shifts IS curves each way Productivity and the Natural Rate of Unemployment

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Technological unemployment – resurfaces when unemployment is high Technocracy movement – argued that high unemployment came from the introduction of machinery and that things would only get worse if technological progress were allowed to continue

Summary - Short run – there is no relation between movements in productivity growth ad movement in unemployment - Medium run – if there is inverse relationship between productivity growth and unemployment o Lower productivity growth leads to higher unemployment Technological Progress, Churning, and Inequality - Creative destruction – when new goods are developed making old ones obsolete - One main factor in wage inequality is technological change - Main factor behind increase in the wage inequality is the increase in demand from higher skilled workers - Relative supply of children who have higher education is increasing but not enough to match the increase in relative demand

Chapter 19 – Output, the Interest Rate, and the Exchange Rate Equilibrium in the Goods Market - Y = C(Y-T) + I(Y,r) + G – IM(Y, e)/e + X(Y*,e) - NX(Y,Y*,e) = X(Y*,e) – IM(Y, e)/e - An increase in the exchange rate leads to a shift in demand towards foreign goods and therefore a decrease in net exports which decreases demand for domestic goods and therefore a decrease in output - e = EP/P* - a decrease in the nominal exchange rate (depreciation) lead to a decrease in the real exchange rate Equilibrium in the Financial Markets - people have a choice between domestic and foreign bonds - Interest parity condition - that both foreign and domestic bonds have the same rate of return - Left is return in domestic currency holding domestic bonds, right is return of holding domestic bonds in terms of foreign currency

Tells us that the current exchange rate depends on domestic interest rate, foreign interest rate, and expected future exchange rate o Increase in domestic interest rate leads to increase in exchange rate o Increase in foreign interest rate leads to a decrease in the exchange rate o Increase in expected future exchange rate leads to an increase in the current exchange rate

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An appreciation today leads to an expected depreciation in the future because the exchange rate is expected to be the same An increase in the domestic interest rate relative to the foreign interest rate leads to an appreciation Changes in i* and E bar will shift the curve

Putting Goods and Financial Market Together

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Increase in interest rate now has 2 affects o Closed economy: Direct on investment  higher interest rate leads to a decrease in investment, a decrease in the demand for domestic goods, a decrease in output o Only present in the open economy: effect on exchange rate  higher interest rate leads to increase in exchange rate which leads to a decrease in net exports, and therefore to a decrease in the demand for domestic goods and decrease in output  They both decrease Y

Effects of Monetary Policy in an Open Economy (pg 399) - Increase domestic interest rate o LM shifts up, IS does not shift, leads to an appreciation o In monetary policy works through 2 channels in closed economy: on spending, and on the effect of interest rate on the exchange rate and effect of the exchange rate on exports and imports o work in same direction  decrease in demand and output Effects of Fiscal Policy in an Open Economy (pg 401) - change in government spending (increase in budget deficit) o if Y was below potential, then increase in G moves output towards potential but not above so IS shifts to right, LM curve does not shift and neither does exchange rate - if G increases and interest rate increases o exchange rate will appreciate o net exports decrease cause output goes up, increasing imports and there is an appreciation Monetary Contraction and Fiscal Expansion: the United States in Early 1980s - the early 1980s saw sharp changes in US monetary and fiscal policy - Under Paul Volcker, the Fed Embarked on a program of monetary contraction to reduce the inflation rate - Ronald Reagan was elected in 1980 on a platform of decreases in taxation and the role of government in economic activity o Tax rates were cut, leading to decreased tax revenue, but spending was not, so the budget deficit increased steadily - The effects of the monetary contraction and fiscal expansion were in line with the predictions of the Mundell-Fleming Model o From 1980-1982, the economy was dominated by the effects of monetary contraction: sharp increases in interest rates leading to dollar appreciation and recession (with ambiguous effects on trade balance)

Know how to draw – look in notes

Know how to draw – look in notes

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From 1982 onwards, the effect of the fiscal expansion dominated: the strong growth, high interest rates, further dollar appreciation (increasing the trade deficit). The Twin deficits (budget deficit and trade deficit) became a big issue

Fixed Exchange Rates Pegs, Crawling Pegs, Bands, The EMS, and the Euro - Peg their currency to the dollar – when countries maintain a fixed exchange rate in terms of foreign currency - Decrease in an exchange create under a regime of fixed exchange rates is called a devaluation - Crawling pet –moving to an exchange rate target slowly o These countries typically have inflation rates higher than the US inflation rate  if they peg their currency to the US dollar there would be a steady real appreciation and their goods would be uncompetitive - EMS (European Monetary System) - determined the movements of exchange rates within the European Union from 1978 and 1998 o In the Ems, member countries agreed to maintain their exchange rate relative to the other currencies in the system within narrow limits or bands around a central parity – a given value for the exchange rate - Beginning on Jan 1, 1999, a number of those European countries adopted a common currency, the Euro Monetary Policy when Exchange Rate is fixed - In a fixed exchange rate and perfect capital mobility, the domestic interest rate must be equal to the foreign interest rate (1+i*) = (1+i) - They countries give up monetary policy Fiscal Policy when the Exchan...