Macroeconomics Midterm Flashcards
80%
Value of Each Growth Theory
1. Classical theory reminds us that our physical resources are limited, and we need technological advances to grow.
1. Neoclassical theory emphasizes diminishing returns to capital which means we need technological advances to grow.
1. Endogenous growth theory tries to explain productivity or technological growth within the model (endogenously).
1. New growth theory emphasizes the capacity of human resources to innovate at a pace that offsets diminishing returns.
Classical Growth Theory: Assumptions+Implications+Limitations
Main Idea: subsistence level contains population growth
Assumptions
- diminishing marginal returns to inputs
- population growth responds to income levels ( IE, increased output leads to increased population growth )
- fixed nature of natural resources, subsistence level of real GDP & wage
Predictions:
- When real GDP per capita rises above subsistence level a population explosion will bring it back down to subsistence level
- As population grows real wage falls until it hits subsistence level where population+economic growth stop
Implications
- we will always return to a subsisting ( just being able to survive) level of living as the population will grow in response to increases in GDP till GDP per capita returns to subsistence, must contain population
Limitations
- doesn’t take into account the increase in technology, which minimizes DMR, allows the rate of output to outstrip population growth and allow for higher stadnerds of living
- Importance of Labor: Mathluthisan-labor is beneficial up to a limit → (China’s Growth didn’t drive incomes back down to subsistence levels) → Solow-refute
- Inaccurate determination of total wages, didn’t consider how trade unions & demand impacts wages
Neoclassical Growth Theory: Assumptions+Implications+Limitations
Basic Idea: tech advance as key driver of growing long-term living standards, savings & investment super important, eventually output growth will only be driven by population growth until a shock occurs, c k y are constants determined by kSS
assumptions
- A,n,s,d is exogenous
- the economy is closed, and there are no government expenses
- tech affects economic growth+k growth not vice versa
- output produced annually is invest in new capital or in replacing depreciated capital (It), uninvested part of output is consumed by population (Ct)
- there are diminishing marginal returns to facts of production& constant returns to scale
limitations
- A is exogenous when it is affected by human & physical capital, wealth orR&D or technology
- not all forms of capital exhibit diminishing marginal returns
Implications
- there is a conditional convergence of K/L ratio amongst state. Rich countries will grow K slower than poor countries until, eventually, every country will reach a steady state with similar levels of K/L. The condition is that these countries demonstrate similar Saving rate
- factors affecting long-run standard of living, how rate of economic growth evolves over time
Endogenous Growth Theory: Assumptions+Implications+Limitations
Key Difference b/w Solow:
- economic growth is generated internally through endogenous forces (A is endogenous derived from model in terms of s,H, R&D not given or constant) & attacks assumption of diminishing marginal return of capital as capital used properly will increasingly increasing return k
- No steady state if graphs never intersect
Derivation:
1. Sn=sAK=sY
2. K_t+1=K_t+I-dK
I=K+K net investment+depreciation
3. sAK=K+K
k=changeK/K=changeY/Y=sA-d since gy=gk
assumptions
- technology (A) generated from within the economyso production function is not diminishing but constant (alpha>=1) y=Ak, MPK=A, dA/dk=Constant Marginal Return
- number of workers remains constantso growth in output/capital per labor equal
- closed economyimplications
- The growth of a country depends on rates of savings and investmentsg_Kss=g_A=g_RD+g_I=S
- the growth rate of output per worker = growth rate of output. Therefore, there are no diminishing returns to capital. Instead, MPK depends on technology levels, not K stock
- there are increased returns to scale in investments in human capital and private sector R$D ( this lasts because the private sector is motivated by growth)
Implication:
- Constant Determinants of Economic growth rate depends on savings rate, investment (R&D-generated by increasing K & offsets any tendency for MPK to decrease), Human capital not only exogenous productivity growth
Increasing returns to scale from capital investment in knowledge industries (edu, health, telecomm.)
limitations
- technological advancement is limitless ( exponential). This is not necessarily true
- does not take into account market failures generated by externalities. ( growth of technology leads to pollution, leads to a decrease in productivity)
New Growth Theory: Assumptions+Implications+Limitations
Basic Idea: Long run growth (y=real GDP per capita) grow because of choices that people make in the pursuit of profit and growth can persist indefinitely a perpetual motion machine
Assumptions
- Knowledge is not subject to diminishing returns
- Discovery result from choices, brings profit if patented or else is a public capital good, competition destroys profit & knowledge is not subject to DMR as increasing its stock makes L & K more productive (increases MPK+MPL)t
- Graph + Sala Table
implication
- real GDP per person grows because of choices that people make in the pursuit of profit, and that growth can persist indefinitely
- growth is a perpetual motion machine. Innovation -> new and better products and techniques -> better jobs and more leisure time -> higher standard of living -> want for an even higher standard of living ( choices in pursuit of self-interest) -> innovation
limitations
- New growth theory assumes that knowledge and innovation generate increasing or constant returns to scale, meaning that the more an economy invests in R&D or human capital, the higher the returns. However, in reality, diminishing returns to knowledge and innovation might occur. Not all investments in education or R&D lead to groundbreaking innovations, and knowledge may not always spill over efficiently to the entire economy.
- it is challenging to measure knowledge, human capital, or the effects of innovation.
- there are so many different things you could quantify as the determinants of growth, including (the environment, politics, civil liberties, etc)
Marcoeconomics + Usage + Issues Addressed
- A top-down study of the structure, nature, performance and course of national economies as a whole and of the policies that governments use to try to affect it
- Analytical tool used to craft economic & fiscal policy more applicable to everyday life, while microeconomics is used by investors for investment decisions
- Issues Addressed: effects of being an open economy and government policies on economic performance as well as factors that determine/cause a nation’s long-run economic growth, fluctuations in economic activity, unemployment, rising prices
What do Macroeconomists do? How do they analyze economic policy?
What do Macroeconomists do?
* Forecast (short run, longrun too unpredictable) & analysis to determine if and what action should be taken
* Research (theoretical & empirical) to make general statements of how economy works depending on assumptions, applicability, testability, results
* Data Development: data used to assess state of economy now and future, effects of policies and test theories
* Comparative Static Experiments: changing one variable all other factors remaining constant and observe how macroeconomic model responds to the shock
How is economic policy analyzed?Disagreements can arise with normative analysis (ex. Efficiency vs Equality, We can grow vs Should we grow)
Positive (objective/what will it do/consequences) no judgment
Normative (subjective/is it desirable/should it be used) analysis, requires value judgements
Comparative Static Analysis: comparing old vs new equilibrium in models
2 Key Approaches to Macroeconomics
Great depression classical failed, stagflation classical comeback
Classical: economy work well on its own, hands off, invisible hand - free mkts & individuals will work in oneself interest, naturally optimize
* P+W adjust rapidly to get to equilibrium (supply=demand) and are signals that coordinate people’s actions
* Gov should have limited role in economy
Keynesians: economy takes time to adjust, short-term consequences & affects government should intervene to make transition smoother and less costly
* P+W sticky, adjust slowly (especially in one direction) so mkt remain out of equilibrium for long periods and persistent unemployment occurs
* Gov should intervene to restore full employment, to guide economy to best outcome
**Common Ground of Approaches: **
* 3 Mkts: goods, assets, labor
* Long Run: P+W perfectly flexible
* Short Run: Classical P+W flexible, Keynesian P+W slow to adjust
* Money is neutral long & short term: monetary policy doesn’t work
Long-Run Economic Growth/Living Standards + Key Determinants
Business Cycle + Relation with inflation & unemployment rate
Draw Graph
Long-Run Economic Growth: labor & prices are variable sustained expansion of production function/ possibilities/real GDP over a given period foundation for socioeconomic development, rich nations have extended periods of rapid economic growth, while poor nations have never or was offset by decline
- Measured by change in real GDP per capita/output per labor (g_y), generally increases when
(1) Population Incr. more labor/workers (L)
(2) Average Labor Productivity Incr.more output produced per unit of labor input (A–>MPL) - Y=LaborxMPL, constant k, MPL driven by A
- Different growth models emphasize different factors.
Business Cycles: not economic growth, short-run contractions & expansions of economic activity, labor+prices are fixed
* Recession/depression (Unemployment rate rises, hard times, major political concern), expansion/recovery (Unemployment rate falls), peak, trough
How to calculate rate of growth? Find rate of growth of total output
log+derivative %Y=%L+%MPL
Unemployment Rate
* Unemployment Rate: doesn’t work, but who was available & actively sought work in the previous 4-6 weeks, percentage of labor force unemployed not a perfect definition
* Cyclical + Natural(Frictional+Structural)
* Can never reach zero even at peak of business cycle (no cyclical) due to frictional (job searching) and structural (wage/skill change) unemployment.
* Discouraged Workers (searchers): stop searching, discouraged from lack of success (not counted so UE is underestimated)
* Problem: lost of human capital (damages job prospects) & lost income & production
=#unemployed/#LF=#LF-#E/#LF
Inflation & Deflation & Hyperinflation
- Inflation Rate: percentage incr. in level of prices, money becomes less valuable → more economic activity
- Deflation: decr. in level of prices, money becomes more valuable → less economic activity
- Hyperinflation: extremely high rate of inflation → economic collapse
International Economy Terminology
- International Economy: trade & borrowing relationships can transmit business cycles across nations
- Open Economy: extensive trading & financial relations with other national economies
- Closed Economy: no economic interaction with rest of the world
- Trade Balance: surplus E>I, deficit I>E
- Exports=g+s produced in domestically consumed abroad
- Imports=g+s produced abroad consumed domestically
Macroeconomic Policies
Should a government intervene and how should they? Beware of policy lag, action lag
Fiscal Policy: government spending & taxation
Monetary Policy: central bank’s control of short-term interest rates & money supply
Budget Deficits: excess gov spending over tax collection
Twin Deficit: trade & budget deficit
Economic Theory vs Model vs Aggregation
- Economic Theory: set of ideas about the economy to be organized in a logical framework (capitalism, classical, keynesian, supply+demand, tragedy of commons)
- Economic Model: simplified description of some aspects of the economy (Cobb-Douglas, AD-AS, IS-LM, Solow)
- Aggregation: summing individual economic variables to obtain economy wide totals, ignoring individual mkts
Can average labour productivity fall, even though total output is rising?
Can the unemployment rate rise, even though total output is rising?
- Yes, population increase can produce more total output even if they are less productive/skilled as beginners.
- Yes, tech advancement makes less people more productive and produce more total output
How Do We Measure Current Economic Activity?
GDP+NFP=GNP
Total Production=Total Income=Total Expenditure: approaches are equivalent in theory as mkt value of good=spending on good, spending on good=income earned
-
Value Added Approach (Total Production): measures amount of output produced, excluding output in intermediate stages of production used in production of other goods in same time period.
* Equation: sum(Value Added)=sum(Output-Input)
* Note: capital goods (buildings, machinery, equipment) & inventory investment are final goods
* Problems: not all goods are sold in legal markets, unpaid work (household production), contributions that lack market values (quality, gov services, NGO donations) -
Income Approach (Total Income): measures incomes received by the factors of production (wages, interest, rent, profit), tax forms make this easiest to calculate
* Equation: Y=Total National Income (Wage+Land+Profit+Interest)+NFP+Depreciation+Sales Tax
* Y_D=Y+NFP-T+TR+INT=C+S -
Expenditure Approach (Total Expenditure): measures amount of spending by purchasers of output, most used in theoretical research
* Y=C+I+G+Nx
Explain GDP+NFP=GNP
- Net Factor Payments: domestic income from foreign for domestic factors of production minus foreign income from domestic economy for foreign factors of production (Income from Foreign-Income to Foreign)
- Gross Domestic Product (GDP) is the market value of final goods & services newly produced within a nation during a fixed period of time. Note: domestically owned capital & labor used abroad to produce output/income are not included. Foreign owned capital & labor used domestically to produce output/income are included
- Gross National Product (GNP) is the market value of all final goods newly produced by domestic factors of production (capital, labor) during the current period Note: domestically owned capital & labor used abroad to produce output/income are included. Foreign owned capital & labor used domestically to produce output/income are not included
Balance of Payments
Balance of Payment: measures international money flows, categorizes between country’s residences vs rest of the world, if transaction is a consequence of intl. Trade or investment, or flow is outgoing(-ve) or incoming (+ve)
- Current Account+Financial Account+Capital Account=0
- Current Account=Capital Account
- Credits given=Debts Received
- Movement of product is always balanced out with movement of money/financial asset
Current Account: regular economic activities that crosses borders NFP is usually 0 as foreign income made in Canada against Canadian income made in foreign nation are close to equivalent
* CA=Nx+NFP=D Income from F (export)-F income from D (import)+NFP
* CA=S-I
Capital Account: transactions with financial nature,FA=Foreign CI in Domestic-Domestic CI from Foreign
* Explains why US is still strong: current account vs capital count, more amount of foreign investment into the country than US investment in other countries (ex.US bonds), deficit is financed by other countries
* Current account surplus vs capital account deficit, lending out money to other countries to keep importing goods from them
Gross Capital Flows
=Total Capital Inflows+Total Capital Outflows
Net Government Income + Budget Surplus vs Deficit + Twin Deficit
- T-TR-INT
- Gov Budget Surplus(+ve) T>G+TR+INT
- Deficit(-ve) T<G+TR+INT
- Twin Deficit: Trade and budget deficit, only US can do this because they have a strong currency & army. CAN has it too, will get worse if don’t diversify money flows away from US
Calculate GDP using all 3 approaches
Apple Farm
Wages 15,000
Taxes 5,000
Revenue from Sales 35,000
Public Sales 10,000
Juice Company Sales 25,000
Apple Juice Company
Wages 10,000
Taxes 2000
Apples from Apple Farm 25,000
Revenue from Sales 40,000
Value Added Approach:
Juice: 40,000-25,000=15,000
Apple Farm: 35,000
GDP: 15,000+30,000=50,000
Income Approach:
Wages+Taxes+Profit(Revenue-Cost)
=10,000+15,000+2000+5000+(35,000-15,000-5,000)+(40,000-25,000-2,000-10,000)
=25,000+7000+(15,000+3,000)
=50,000
*All the costs cancel out, GDP is just profit
Expenditure Approach:
=40,000+10,000
=50,000
Wealth + Savings v. Saving + National
Wealth: difference b/w assets & liabilities, stock variable that is measured at a point in time
* National Wealth: country’s domestic physical assets, net foreign assets=foreign assets-foreign liabilities. Changes when value of national savings change (SNational=I+CA)
Saving: flow variable that is measured per unit of time, connect stock variables (ex.Saving→Wealth, Investment→Capital)
Savings: current income minus spending on current needs Savings=Income-Consumption
National Savings: Private Savings + Government Savings=Spvt+Sgov=I+CA=Y-C-G
Private Savings: Spvt=Y+TR+INT-T-C=I+Nx=I+(-Sgov)+CA, ignoring TR, powerful, analyzes whole economy, asked in job interviews & CFA exam
* Private savings used in 3 ways - Investment (I), INT funding government budget deficit (-SGov) and current account balance (CA=X-M)
* Deficit is money goes to unproductive sector instead of investment, risk free government bonds more safe for pvt
* Many assumptions about the economy can be pulled from this express: production-consumption, savings-investment, excess production
Government Savings T-G-TR-INT
Derive Spvt=I+Nx
Y=C+I+G+X-M
Y-T=(C+I+G+X-M)-T
YD-C=I+(G-T)+(X-M)
Spvt=I+(-Sgov)+CA
Key Knowledge to Investment
Nominal return doesn’t account for increasing inflation year by year.
- Nominal GDP
- Real GDP
- GDP Deflator
- CPI
- Rate of Inflation
- FIsher Equation
Nominal GDP vs Real GDP
Nominal GDP (current-dollar GDP): dollar value of an economy’s final output at current market prices
Real GDP (constant-dollar GDP): (quantity only) physical volume of an economy’s final output using the prices of a base year
GDP Deflator vs CPI
GDP Deflator: price index measures overall level of prices of g+s included in GDP, proxy for CPI but less prone to biases
Nominal GDP/Real GDP X100
Consumer Price Index: measures level of prices of a basket of g+s
Value in Given Year/Value in Base Year X100
Similarities: these price indexes measure of avg level of prices and their changes
CPI measures price changes in a specified set of g+s (fixed consumer basket occasionally updated or chain-weighted indexes)
GDP Deflator measures overall level of prices of g+s included in GDP
Fisher Equation + Precise True Formula for Real & Nominal Interest Rate
real interest rate(expectant) ≈ nominal interest rate(current) − inflation rate(pi)
- Rate of Inflation: % rate of increase in a price index per a period of time, rate of return promised by a borrower to a lender 1=P2-P1/P1=ChangeP2/P1
- Real Interest Rate (r) rate at which real value of an asset increases over time
- Nominal Interest Rate (i) rate at which nominal value of an asset increases over time
(1+NR)=(1+RR)(1+pi^exp)
Calculator Real Interest Rate given Nominal Interest Rate 11% & expected inflation rate 8%
(1+NR)=(1+RR)(1+exp)
(1+11%)=(1+RR)(1+8%)
RR=1.111.08-1
RR=2.78%
