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Macroeconomics > Real economy in the long run > Flashcards

Real economy in the long run Flashcards

1
Q

What agents are present in the circular flow of income?

A

Households, firms and the government.

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2
Q

What markets are present in the circular flow of income?

A

Financial market, factors of production market and market for goods and services

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3
Q

What is the classical model?

A
  • Economic thought that dominated the 20th century
  • Assumes market clears on its own accord
  • Assumes firms maximise profit and households maximise utility.
  • It represents the long run equilibrium
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4
Q

What are the factors of production and how is this represented in equation form?

A

Labour and capital

Y= f(N,K)

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5
Q

what is the equation for profit?

A

Profit=total revenue-total cost
Total revenue= output X price= pY
Total cost= (rental price of capital X amount of capital) + (number of workers X wages)

Profit= pf(N,K)-NW-KR

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6
Q

How is profit maximised?

A

By choosing values of each factor of factor of production so that its marginal benefit is equal to its marginal cost

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7
Q

What is the profit maximising amount of workers?

A

When the revenue from additional output from hiring one extra worker equates to wages of said worker:
Additional revenue= cost of labour
MPN*P=W
So profit maximising output is set to where marginal product of labour is equal to real wage
MPN= W/P

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8
Q

What is diminishing marginal product?

A

The phenomenon where increasing a factor of production such as labour or capital decreases the marginal product over time.

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9
Q

What is the profit maximising amount of capital?

A

When the revenue gained from one additional unit of capital is equal to the cost of capital:
additional revenue from one unit of capital= rental cost of capital
MPK*P= R
so MPL is set so it equals to real rental price of capital

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10
Q

What is the equation for economic profit? rearrange this for Y

A

This is in terms of output
Economic profit= Y-(MPNW)-(MPKR)
Y=Economic profit- (MPNW)-(MPKR)

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11
Q

Under profit maximisation what is the wage per worker and rent per capital?

A

Wage per worker is MPN and rent per capital is MPK.

Each factor of production earns its own marginal product.

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12
Q

Under what conditions are there no economic profits?

A

-Profit maximisation
-Constant returns to scale
-Competition
This means there is no money left after factors of producton are paid- this is called Euler’s thereom

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13
Q

Using the economic profits equation, explain why under profit maximisation there are 0 economic profits.

A

Economic profit is basically total revenue- costs expressed in terms of output. Y is revenue it terms of total output and costs are wages multiplied by the number of workers and rental costs multiplied by the number of capital, which is MPNN and MPKK which basically gives total output from labour and total output from capital. Since output is a function of labour and capital, output can only come from these two factors which means Y=MPNN+MPKK, so economic profit= Y- MPNN-MPKK=0

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14
Q

In real life how is it possible that there are no economic profits?

A

We make the assumption in the classical model that there are three agents: labourers, owners of capital and owners of firms. However in real life owners of capital are often owners of firms. Economic profit and return to capital (rental price of capital) are often lumped together.
Accounting profit= Economic profit + MPK*K. This means profit does exist but mainly comes from returns to capital.

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15
Q

How was the Cobb- Douglas production function created and what is it ?

A

An economist realised that income from labour and capital grow at almost the same rate. This seemed impossible as factors of output earn their own marginal product so how can they grow at the same rate? however this is solved with the cobb-douglas function:
F(N,K)= AK^αN^1-α

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16
Q

According to the cobb douglas function what is MPN?

A

MPN=1-αAK^αN-α

17
Q

According to the cobb douglas function what is MPK?

A

MPK= αAK^α-1N^1-α

18
Q

How can we prove the Cobb douglas function has constant return to scale?

A

-Multiply labour and capital by z

19
Q

What are the assumptions for consumption in this model?

A

The consumer only lives for one period so consumption is dependant on current disposable income rather than past savings or income

20
Q

What is MPC

A

The marginal propensity to consume. How income changes when disposable income is increased by £1

21
Q

What is the formula for consumption

A

C=b(Y-t) where b is MPC and y-t is disposable income

22
Q

What is the relationship between consumption and disposable income?

A

When disposable income increases so too does consumption.

23
Q

What is investment dependant on ?

A

The real interest rate which is just the nominal interest rate corrected for inflation (nominal interest - price inflation)

24
Q

When will a firm invest in a project?

A

When the real return of the project is greater than the opportunity cps which is represented by the real interest rate on financial assets. So when real interest rates are low the higher the percentage of real returns as high or higher than the real interest rate

25
Q

What is the relationship between real interest rate and investment ?

A

The higher the real interest rate the smaller the amount of investments. This is because of the opportunity cost outweighs a lot of real return from projects and also because high real interest rate means high prices of loans.

26
Q

What are transfer payments and give an example?

A

Transfer of the government’s revenue from tax to people to use for consumption e.g. Pip, jsa and pensions

27
Q

How would you describe tax and government expenditure in relation to the model?

A

They are exogenous (fixed outside the model)

28
Q

How can you tell whether the government is running a budget deficit or surplus and when are they likely to happen?

A

Deficit: usually occurring in recessions and occurs when T-G0

29
Q

How are deficits funded?

A

Through government bonds (when government sells shares to the public for money which they will then buy back plus interest) and money printing

30
Q

What is the formula for output/ income?

A

Y=C+I+G
Y=b(Y-T)+I(r)+G
Y=b(Y-T)+I(r)+G
This means we can see that we can evaluate I.

31
Q

What’s the formula for savings?

A

S=Y-T-C+T-G
S=Y-C-G
S=I

32
Q

How can we relate savings to real interest rate?

A 
We inverse the investment function to solve for r. so r=I^-1.S
e.g is I(r)=d-er
d-er=S
d=S+er
d-S/e=r

Macroeconomics (7 decks)

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