Intro

Question 1

What are the components of an economic model?

Answer 1

Parameters (inputs fixed over time), exogenous variables (inputs that can change over time), and endogenous variable (output of the model)

Question 2

What do you need to keep track of for each model?

Answer 2

Variables (endogenous? exogenous?) and parameters, and assumptions (reasonable? necessary?)

Question 3

What is market clearing?

Answer 3

The assumption that prices are flexible and adjust to equilibrium supply and demand which is usually true in the long run but in the short run prices are often sticky, taking time to respond to supply and demand imbalances

Question 4

What are national accounting and national income accounting?

Answer 4

National accounting keeps track of the state of an economy at a given time, the changes over time, and the differences between countries
National income accounting is the method of aggregating the production of diverse goods into a single measure of overall economic activity

Question 5

What are the three equivalent definitions of GDP?

Answer 5

Production: total market value (price sold for) of domestically produced final goods and services (ready for consumption) in a period, final value is the sum of value added at each stage of production (value of output - value of input)
Expenditure: total expenditure on domestically produced fInal goods and services in a period
Income: total income earned by domestically located factors of production in a period

Question 6

What is the relationship between national income and national output?

Answer 6

They are the same

Question 7

How is production equal to expenditure equal to income?

Answer 7

In every transaction the buyer’s expenditure becomes the seller’s income so the sum of expenditures equals the sum of income

Question 8

What is the national income accounting identity?

Answer 8

Y = C + I + G + NX
Y: national income
C: value of all goods and services bought by households
I: spending on capital or goods for future use (includes business fixed investment like spending on plant and equipment, residential fixed investment which is consumer or landlord spending on housing units, and inventory investment which is changes in the value of a firm’s inventory)
G: all government spending on goods and services excluding transfer payments
NX: value of total exports minus value of total imports EX - IM

Question 9

What are the approximate shares of national income going to capital and labour?

Answer 9

About two thirds to labour and a third to capital

Question 10

What are some issues with GDP?

Answer 10

Doesn’t include home production, goods or services transacted outside of markets or in black/underground markets, used good transactions, housing services, government transfer payments
Doesn’t consider well-being, changes in environmental resources, inequality
Not well equipped to consider intangible assets, globalisation, the digital economy, the sharing economy, or the gig economy

Question 11

What is the difference between nominal and real GDP?

Answer 11

Nominal GDP measures final values at current prices, real GDP measures actual quantities
nominal GDP = price level * real GDP

Question 12

What is the GDP Deflator?

Answer 12

Nominal GDP / Real GDP

Question 13

What are the indices used to measure price level changes?

Answer 13

Laspreyes: calculates changes in real GDP using initial year prices
Paasche: calculates changes using final year prices
Fisher: average of Laspreyes and Paasche indeces over the given period

Question 14

How is Real Chained-Weighted Data calculated?

Answer 14

The Fisher index is applied year on year

Question 15

What is the inflation rate?

Answer 15

The rate at which prices change over time = ∆P/P = π
P = general price level in the economy

Question 16

What are the measures of inflation?

Answer 16

GDP Deflator
CPI: measures the prices of a typical basket of goods
HICP: harmonised index of consumer prices used as an overall measure for EU countries

Question 17

What are the main differences between CPI and GDP deflator?

Answer 17

Capital goods are included in GDP deflator but not CPI
Prices of imported consumer goods are included in CPI but not GDP deflator
The CPI basket is fixed but the GDP deflator does not measure a fixed set of goods

Question 18

How is GDP compared across countries?

Answer 18

Nominal GDP is analysed alongside exchange rates, usually by converting GDPs into a common currency and then multiplying by the ratio of prices

Question 19

Which parts of the circular flow model are relevant to LR supply?

Answer 19

Firms —(factor payments)—> Markets for FOPs —(income)—> Households

Question 20

What are the assumptions for the long run production model?

Answer 20

There is a single closed economy
Markets clear and prices are flexible
Only one good is consumed/produced

Question 21

What variables are involved in a production function F?

Answer 21

Y: output
K: capital used in production
L: labour used in production
A: productivity parameter

Question 22

What is MPL and MPK?

Answer 22

Marginal Product of Labour = F(K, L + 1) - F(K, L) = ∂F/∂L
Marginal Product of Capital = F(K + 1, L) - F(K, L) = ∂F/∂K

Question 23

What are the assumptions for the neoclassical production function?

Answer 23

Constant returns to scale
Cobb-Douglas Production Function

Question 24

What are constant, increasing, and decreasing returns to scale?

Answer 24

Y = F(K, L)
CRS: F(tK, tL) = tY for t > 0
IRS: F(tK, tL) > tY for t > 1
DRS: F(tK, tL) < tY for t > 1

Question 25

What are diminishing marginal returns?

Answer 25

As more of one factor is input while the other remains constant, its marginal product decreases

Question 26

How can diminishing returns be shown graphically?

Answer 26

On a graph of Y against L a plot of F(K bar, L) would have a decreasing (plateauing) slope showing that MPL (gradient) decreases as L increases
Same idea for Y against K

Question 27

What is the production function used in the neoclassical model?

Answer 27

A Cobb-Douglas function:
Y = AK^aL^1-a
0 < a < 1
Can verify that CRS holds, and MPL & MPK are positive but diminishing in L and K respectively

Question 28

What are the neoclassical assumptions for the FOP markets?

Answer 28

Supply of factors (K, L) is fixed
Demand for factors is determined by firm demands on K and L for production inputs
Firms are perfectly competitive (small, price takers, profit maximising)

Question 29

How does a firm decide the quantity of inputs in the neoclassical model?

Answer 29

P - unit price, R - rental rate of capital, W - worker wage
Firm maximises profit ∏ = PF(K, L) - RK - WL so they increase inputs until extra revenue equals extra costs, i.e. ∆∏ = 0
Added profit from a marginal worker is the added revenue minus the added cost so ∆∏ = PMPL - W so firm hires where PMPL = W i.e. MPL = W/P
Similarly capital is hired until MPK = R/P

Question 30

What are the variables in the neoclassical model?

Answer 30

Endogenous: Y, K, L, W/P (real wage), R/P (real rental rate of capital)
Parameters: productivity parameter A, production function parameter a (alpha)
Exogenous: supply of K, supply of L

Question 31

What is a solution and a general equilibrium for the neoclassical model?

Answer 31

Solution (or equilibrium): new set of equations that express the 5 unknowns in terms of the parameters and exogenous variables
General equilibrium: solution where more than a single market clears

Question 32

How do you graphically represent the equilibrium rental rate and wage?

Answer 32

R against K, vertical line for supply at K bar, decreasing line for MPK = demand for capital, showing that the real rental rate adjusts to equate demand and supply for capital (thanks to flexible prices)
Similar for W against L

Question 33

What is the solution to the neoclassical model?

Answer 33

(K without a star means K bar, same for L)
K* = K
L* = L
Y* = AK^aL^1-a
(R/P)* = MPK = aAK^a-1L^1-a = aY/K
(W/P)* = MPL = (1-a)AK^aL^-a = (1-a)Y/L

Question 34

What are the shares of income for capital and labour in the solution to the neoclassical model?

Answer 34

Capital’s income = (R/P)K = aY*
Labour’s income = (W/P)L = (1-a)Y*

Question 35

What are some implications of the solution to the neoclassical model?

Answer 35

An increase in K or L increases Y
The equilibrium wage is proportional to output per worker
The equilibrium rental rate is proportional to output per unit capital

Question 36

What is the economic and accounting profit for the firm in the neoclassical model?

Answer 36

Economic profit = Y - MPLL - MPKK = 0 since Euler’s theorem shows that if F has CRS then Y = F(K, L) = MPLL + MPKK
Perfect competition implies that economic profit = 0
Accounting profit = economic profit + MPK*K

Question 37

What does the neoclassical production model predict about output per person?

Answer 37

Denoting output per capita as y and capital per person as k gives:
k* = K/L, y* = Y/L = A(k*)^a
The resulting prediction is that output per person in equilibrium depends on productivity (A or TFP) and capital per person k

Question 38

What can be said about applying the neoclassical model to income differences between countries?

Answer 38

Assuming the same TFP across countries leads the model to predict much smaller income differences despite variations in capital per person but this is because of the model’s strong diminishing returns to capital per person
The model fits better if a different TFP is found for each country however it can only be determined as a residual based on output and capital per person
About 3/4 of income difference between richest and poorest countries can be explained by TFP

Question 39

What does the neoclassical model of aggregate demand analyse?

Answer 39

Where demand for the expenditure Y (result of production model) which is treated as constant (written Y bar) comes from

Question 40

How is consumption treated in the neoclassical aggregate demand model?

Answer 40

As an increasing function of disposable income: C = C(Y - T)

Question 41

What is MPC?

Answer 41

Marginal Propensity to Consume = increase in consumption from an additional unit of disposable income = derivative or slope of consumption function (can plot C against Y-T)

Question 42

What are investments and how does the neoclassical investment function look?

Answer 42

Investments are purchases that add to a firm’s/household’s capital stock
Investment I = I(r) is a decreasing function of r = real interest rate = nominal interest rate corrected for inflation = cost of borrowing = opportunity cost of using one’s own funds to finance investment spending

Question 43

What are the variables in the neoclassical aggregate demand model?

Answer 43

Exogenous: G, T

Question 44

What is the equilibrium in the goods market?

Answer 44

When aggregate demand C(Y - T) + I(r) + G equals aggregate demand Y = F(K, L) so Y = C(Y - T) + I(r) + G

Question 45

What does the real interest rate do in the goods market equilibrium?

Answer 45

Adjusts to equate demanded output with supplied output

Question 46

What is the loanable funds market?

Answer 46

A simple supply-demand model of the financial system with loanable funds as the one asset, demand = I(r), supply = savings S = public saving + private saving = (T - G) + (Y - T - C(Y - T)) = Y - C(Y - T) - G (all vars with bars), and the price of funds being the real interest rate

Question 47

What does the graph of the loanable funds market look like?

Answer 47

Plots r against S, I
Savings S bar = Y bar - C(Y bar - T bar) - G bar is a vertical line
I(r) is a downward sloping straight line

Question 48

How do the equilibria for the loanable funds market and the goods market compare?

Answer 48

Loanable funds: Y - C - G = I
Goods market: Y = C + I + G
These are the same

Question 49

How can comparative statics be carried out on the loanable funds market?

Answer 49

The savings curve can be shifted by changes to public saving (affected by fiscal policy which changes G and T) and private saving (preferences changing or tax laws that affect saving changing)
If G increases, S decreases so the S curve shifts left which leaves lower investment at a higher interest rate (this is crowding out)
The I curve can also shift (e.g. due to innovation which requires firms to invest more or investment tax credits) which would change the interest rate in the same direction but as S is fixed the equilibrium level of investment doesn’t change, however S can also be treated as an increasing function of r which would mean shifts in the I curve do change equilibrium investment