Topic 2 Flashcards
5 assumptions of the LR closed economy model?
- firms maximise profits
- households maximise utility
- technology is fixed
- Say’s law
- markets always clear
What is Say’s law?
Supply determines output and creates demand
Why is Y fixed?
K and L are exogenous, tf Y=F(K,L) is also fixed
What determines national income then?
NI is determined by factor prices (per unit prices of FofP)
Up to what point do firms demand labour and capital?
Until cost=benefit
real wage/rent=marginal product of factor
What is A in cobb-douglas production function?
Total factor productivity
Profit function for a competitive firm?
Profit = PY-WL-RK
where P=price of output, Y=output, W=wage, R=price of capital
tf optimisation problem - see solving it in notes
See and learn graph units of output vs Q. of labour
now
What does the distribution of national income state? (2)
1) No excess profits (all income goes to K or L)
2) Split is based on how marginal products change as L and K vary
What does the neoclasscial theory of income distribution state?
It states that each input factor is paid it’s marginal product
Given: Y=AK^(1-v)L^(v), what share of income will go to labour and what will go to capital?
Labour gets ‘v’, capital gets ‘(1-v)’
tf labour and capital’s share of income over time is roughly constant
LEARN PROOF IN NOTES!
Property of cobb-douglas PF?
As marginal product falls, factor use increases at the same rate
Note
Since capital is more concentrated than labour, and private capital is increasing, inequality too can be argued to be increasing since people are born with labour but not with capital (SEE TRENDS IN ACCUMULATION SLIDE!)
also technological progress -> increase demand for skilled workers tf increasing gap between pay rates of skilled and unskilled workers
What is the life cycle model?
Model that assumes individuals try to smooth consumption levels over time
Note
Government spending and taxes in this model are taken as exogenous variables
What is consumption roughly as a percentage of GDP in developed countries?
50-60%
What does this model assume regarding consumption?
Assumes it depends only on current income which takes into account any taxes paid (assumes most families cannot adopt complex lifetime approach to financial constraints)
2 equations for consumption based on different tax types?
1) C=b(Y-T) where b=MPC, T=taxes
2) C=bY(1-t) where t=avg. rate of tax on income
Why do we allow MPC to vary over time?
To capture LT decisions
See consumption function (C vs (Y-T))
now
What is the slope of the consumption function if:
1) taxes are fixed
2) taxes depend on income?
1) slope=MPC
2) slope=MPC(1-t)
Why does consumption become less (milder slope) when taxes depend on income?
Because if slope=MPC(1-t), and both MPC and (1-t) are less than 1 then the final result will be smaller than either MPC or (1-t) was before tf less consumption
Rough investment levels as a percent of GDP for Europe and China?
Europe roughly 17-20%
China roughly 40-50%
How do firms make decisions on investments?
They compare the rate of return on investing in projects with the opportunity cost of that money (ie. the real interest rate)
(households either invest in firms or put money in bank to gain r)
Investment function r vs I and why?
downward sloping, because as the real interest rate falls, the level of investment that delivers a rate of return equal to or larger than r increases
Define nominal interest rate?
The return on investment in money terms
Define real interest rate?
The return on investment in terms of what goods we can buy
See example
in notes
See slides for how example leads to fisher equation and learn it
now
What is government expenditure in Europe roughly?
15-20% of GDP
See and learn macroeconomic equilibrium equations for a closed economy. How is equilibrium in demand and supply determined?
Since r is the only endogenous variable in the model, it adjusts to bring demand and supply into equilibrium in goods market
What is the market clearing assumption?
at any given instant, buyers can buy all that they want & sellers can sell all they want at the going price
See market for loanable funds in notes
now
How can we tell that the goods market is in equilibrium when the loanable funds market is in equilibrium?
If LFM is in eq.: S=I tf Y-C-G=I
tf Y=C+G+I
Briefly explain the Reagan deficits of the 1980s?
Reagan introduced policies to:
1) increase defense spending tf rise in G
2) big tax cuts tf fall in T
both of these policies reduce national saving (see slides for full explanation)
3 reasons households may save more?
increase in r, poor health, increase in number of children
If theres an increase in investment demand and this leads to an increase in the interest rate…?
this may lead to more saving from households tf can say S(r)
What does r vs S,I look like when S(r)?
see graph (S(r) upward sloping)
What outlook does LR policy take with this model?
to increase prosperity you need to increase institutional structure tf more efficiency tf higher utility (positive supply side shocks)
3 policy areas to improve labour markets?
improve legislation
improve institutional structures
improve human capital and skills
3 policy areas to improve G&S markets?
enhance competitiveness
improve market structures
innovation
3 policy areas to improve financial and capital markets?
increase stability
regulate corporate behaviour
internationalisation
4 impacts of an ageing population (Supply side)?
- smaller labour force (shift labour supply left)
- increase in retirement age (labour supply right)
- productivity effects (could rise or fall)
- could have effects on demand for specific services (eg. hospitals and gyms)
see and learn diagrams that go with these in notes
3 demand side effects of an ageing population?
- fall (or rise) in savings, increase pensions expenditure
- changes to gov. expenditure and taxes
- new products and investment in new areas
read last few slides on this for full explanation
