Topic 2 (National Income / Chapter 3)

Set of flashcards based on key concepts from the lecture notes.

What is the fundamental principle that determines how firms decide to hire labor in Topic 2?

In Topic 2, firms determine labor hiring decisions based on profit maximization. They will hire labor as long as the additional output generated by an extra unit of labor (its marginal product) is at least equal to its real cost.

State the profit-maximization condition for labor demand in real terms (equation).

The profit-maximization condition for labor demand in real terms is given by the equation: MPL = W/P.

In the equation MPL = W/P, what does MPL specifically represent for the firm?

MPL represents the Marginal Product of Labor. This is the additional output (in physical units) that a firm produces when it hires one more unit of labor, holding all other inputs constant.

In the equation MPL = W/P, what does the term W/P specifically represent for the firm?

W/P represents the Real Wage. It is the cost of hiring one unit of labor measured in terms of units of output, determined by the nominal wage (W) divided by the price level (P).

Why is the real wage (W/P) more relevant than the nominal wage (W) for a firm's labor hiring decisions?

The real wage (W/P) is more relevant because firms ultimately care about their profits in terms of goods and services. The real wage accurately reflects the true cost of labor in terms of the output the firm sells, which they compare to the additional output (MPL) generated.

State the profit-maximization condition for labor demand in nominal terms (equation).

The profit-maximization condition for labor demand in nominal terms is given by the equation: MPL \times P = W.

In the equation MPL \times P = W, what does the term MPL \times P represent?

The term MPL \times P represents the Marginal Revenue Product of Labor. This is the additional revenue (in nominal currency) a firm earns from selling the extra output produced by hiring one more unit of labor.

If a firm observes that its MPL > W/P, what action should it take with regard to labor hiring to maximize profits?

If MPL > W/P, it means the additional output from an extra worker is greater than the real cost of that worker. The firm should hire more labor to increase profits until MPL = W/P.

If a firm observes that its MPK < R/P, what action should it take with regard to capital demand to maximize profits?

If MPK < R/P, it means the additional output from an extra unit of capital is less than the real cost of that capital. The firm should reduce its capital stock (or not invest in new capital) to increase profits until MPK = R/P.

What is the fundamental principle that determines how firms decide to acquire capital in Topic 2?

In Topic 2, firms determine capital acquisition decisions based on profit maximization. They will acquire capital as long as the additional output generated by an extra unit of capital (its marginal product) is at least equal to its real rental cost.

State the profit-maximization condition for capital demand in real terms (equation).

The profit-maximization condition for capital demand in real terms is given by the equation: MPK = R/P.

In the equation MPK = R/P, what does MPK specifically represent for the firm?

MPK represents the Marginal Product of Capital. This is the additional output (in physical units) that a firm produces when it uses one more unit of capital, holding all other inputs constant.

In the equation MPK = R/P, what does the term R/P specifically represent for the firm?

R/P represents the Real Rental Rate of Capital. It is the cost of renting one unit of capital measured in terms of units of output, determined by the nominal rental rate (R) divided by the price level (P).

State the profit-maximization condition for capital demand in nominal terms (equation).

The profit-maximization condition for capital demand in nominal terms is given by the equation: MPK \times P = R.

In the equation MPK \times P = R, what does the term MPK \times P represent?

The term MPK \times P represents the Marginal Revenue Product of Capital. This is the additional revenue (in nominal currency) a firm earns from selling the extra output produced by using one more unit of capital.

State the production function equation that determines total output in Topic 2's classical model.

The production function equation is: Y = F(A,K,L). This equation shows that total output (Y) is a function of technology (A), capital (K), and labor (L).

In the production function Y = F(A,K,L), identify the specific meaning of Y for the economy.

Y represents the total output (or total income/GDP) of the economy. In Topic 2, Y is considered fixed at its full-employment level due to exogenous factors.

In the production function Y = F(A,K,L), what does F() represent?

F() represents the functional relationship or the prevailing technology that transforms inputs (A, K, L) into total output. It shows how efficiently inputs are combined to produce goods and services.

What do A, K, and L specifically represent in the production function Y = F(A,K,L)?

A represents technology, K represents the capital stock (e.g., factories, machines), and L represents the labor force (total hours worked or number of workers available).

What key assumption about the factors of production (A, K, L) is made in Topic 2's classical model regarding output (Y)?

In Topic 2's classical model, the factors of production (A, K, L) are assumed to be fully utilized and exogenous/taken as given. This implies that the economy operates at its full-employment production capacity, leading to a fixed level of total output (Y).

Which variables, including factors of production and fiscal policy tools, are considered exogenous or taken as given in Topic 2's classical model?

In Topic 2's classical model, technology (A), capital stock (K), labor force (L), government purchases (G), and taxes (T) are all considered exogenous or taken as given. They are not determined within the model but affect its outcomes.

Does a change in fiscal policy (e.g., in G or T) cause a change in total output (Y) in Topic 2's classical model? Explain.

No, a change in fiscal policy (e.g., in G or T) does not cause a change in total output (Y) in Topic 2's classical model. This is because output (Y) is determined by the fixed (exogenous) factors of production (A, K, L) at its full-employment level. Fiscal policy primarily affects the composition of aggregate demand, not the total supply of goods and services.

Why is total output (Y) considered fixed at its full-employment level in Topic 2's classical model?

Total output (Y) is fixed at its full-employment level in Topic 2's classical model because it assumes that markets (including labor and capital) clear perfectly, factors of production (A, K, L) are fully utilized, and prices are flexible. This means there are no unemployed resources due to insufficient demand.

State the extended goods market equilibrium equation in Topic 2, equating total output with the sum of consumption, investment, and government purchases.

The goods market equilibrium equation is: Y = F(A,K,L) = C(Y-T) + I(r) + G. This shows that total output (supply) equals the sum of consumption (C), investment (I), and government purchases (G).

Detail the initial shock of immigration in the labor market within Topic 2's framework.

The initial shock of immigration is an increase in the labor supply (L \uparrow). This means there are more workers available in the economy to be employed.

How does immigration (L \uparrow) affect the marginal product of labor (MPL) in Topic 2's model, given fixed capital and technology?

With capital (K) and technology (A) held constant, an increase in labor supply (L \uparrow) leads to a decrease in the marginal product of labor (MPL \downarrow). This illustrates the principle of diminishing returns to labor: each additional worker has less capital to work with, thus contributing less to total output.

How does the change in MPL (from immigration) affect real wages (W/P) in Topic 2's model?

Since real wages (W/P) are determined by the MPL, a decrease in the marginal product of labor (MPL \downarrow) due to immigration leads to a decrease in real wages (W/P \downarrow). Firms will only hire more workers if the real wage falls to match their lower productivity.

How does immigration (L \uparrow) also affect the marginal product of capital (MPK) and subsequently the real rental rate (R/P)?

An increase in labor (L \uparrow) makes existing capital more productive because each unit of capital now has more labor to work with. This increases the marginal product of capital (MPK \uparrow), leading to an increase in the real rental rate of capital (R/P \uparrow), as capital becomes more valuable.

Describe the initial shock of an earthquake on the capital stock within Topic 2's model.

The initial shock of an earthquake is a decrease in the capital stock (K \downarrow). This means there are fewer machines, factories, and infrastructure available for production.

How does a decrease in capital (K \downarrow) due to an earthquake affect the MPK and consequently the real rental rate (R/P)?

A decrease in capital (K \downarrow) makes the remaining capital relatively scarcer and more productive compared to the fixed labor supply. This leads to an increase in the marginal product of capital (MPK \uparrow), which in turn causes the real rental rate (R/P) to increase (R/P \uparrow).

How does a decrease in capital (K \downarrow) due to an earthquake also affect the MPL and consequently real wages (W/P)?

A decrease in capital (K \downarrow) means each unit of labor now has less capital to work with. This reduces the productivity of labor, leading to a decrease in the marginal product of labor (MPL \downarrow), which then causes real wages (W/P) to decrease (W/P \downarrow).

Describe the initial shock of a positive technology change (A \uparrow) on productivity.

A positive technology change (A \uparrow) fundamentally means that firms can produce more output with the same inputs, or the same output with fewer inputs. This generally implies an increase in the productivity of both labor and capital.

How does a positive technology shock (A \uparrow) affect both MPL and MPK?

A positive technology shock (A \uparrow) generally makes all factors of production more productive. Therefore, it leads to an increase in both the marginal product of labor (MPL \uparrow) and the marginal product of capital (MPK \uparrow).

How does the increase in MPL and MPK (due to a technology shock) affect real wages (W/P) and the real rental rate (R/P)?

Since real wages are determined by MPL, and the real rental rate by MPK, an increase in both (MPL \uparrow and MPK \uparrow) due to a technology shock leads to an increase in both real wages (W/P \uparrow) and the real rental rate (R/P \uparrow).

Consider a scenario where both nominal wages (W) and the price level (P) double simultaneously. What is the resulting impact on the real wage (W/P)?

If both nominal wages (W) and the price level (P) double, the real wage (W/P) remains unchanged. For example, if W goes from 10 to 20 and P from 2 to 4, then W/P remains 5 (10/2 = 5, 20/4 = 5).

Consider a scenario where both the nominal rental rate (R) and the price level (P) double simultaneously. What is the resulting impact on the real rental rate (R/P)?

If both the nominal rental rate (R) and the price level (P) double, the real rental rate (R/P) remains unchanged. The purchasing power of the rental income or cost is preserved.

What specific factors lead to the diminishing marginal product of labor (MPL) in Topic 2's model?

The diminishing marginal product of labor (MPL) arises from holding capital (K) and technology (A) constant while continuously increasing the amount of labor (L) employed. Each additional worker has less capital to work with, thus adding progressively smaller amounts to total output.

State the complete formula for national saving (S) in Topic 2 and explain what each term represents.

The complete formula for national saving (S) is: S = Y - C(Y-T) - G. Here, Y is total output, C(Y-T) is consumption as a function of disposable income (Y-T), and G is government purchases. National saving is what remains of total income after consumption and government purchases.

How is national saving (S) related to the sum of private saving (SP) and public saving (SG)?

National saving (S) is the sum of private saving (SP) and public saving (SG). That is, S = SP + SG.

Define private saving (S_P) using the appropriate terms from the national income identity.

Private saving (SP) is the amount of disposable income (Y-T) that households and firms have left after they have paid for their consumption (C). Its formula is: SP = Y - T - C.

Define public saving (S_G) using government purchases (G) and taxes (T).

Public saving (SG) is the amount of tax revenue (T) that the government has left after it has paid for its own purchases (G). Its formula is: SG = T - G.

What is the formula for a budget deficit?

The formula for a budget deficit is G - T, where G represents government purchases and T represents taxes. A budget deficit occurs when government purchases exceed tax revenue.

What market is crucial for determining the real interest rate (r) and the level of investment (I) in Topic 2?

The market for loanable funds is crucial for determining the equilibrium real interest rate (r) and the level of investment (I) in Topic 2. This market brings together savers (supply) and investors (demand).

Describe the causal chain from an increase in national saving (S \uparrow) to the real interest rate (r) and subsequently to investment (I).

An increase in national saving (S \uparrow) represents an increased supply of loanable funds. This shifts the supply curve in the market for loanable funds to the right. Consequently, the equilibrium real interest rate (r) decreases (r \downarrow), which then encourages firms to undertake more investment projects, leading to an increase in investment (I \uparrow).

What happens to the supply curve for loanable funds when national saving (S) increases?

When national saving (S) increases, the supply curve for loanable funds shifts to the right. This indicates that at every real interest rate, a greater quantity of funds is available for lending.

What effect does a rightward shift in the supply of loanable funds have on the equilibrium real interest rate (r)?

A rightward shift in the supply of loanable funds, due to increased saving, leads to a decrease in the equilibrium real interest rate (r \downarrow). The increased availability of funds drives down the price of borrowing.

Consider a tax increase of ΔT = 100 with a marginal propensity to consume (MPC) of 0.6. Calculate the change in public saving (ΔS_G).

The change in public saving is ΔSG = ΔT - ΔG. Since only taxes change (ΔG=0), ΔSG = ΔT = +100. Thus, public saving increases by 100.

For the same scenario (ΔT = 100, MPC = 0.6), calculate the change in private saving (ΔS_P).

The change in private saving is ΔSP = Δ(Y-T-C). Since Y is fixed (ΔY=0) and ΔC = MPC \times Δ(Y-T) = MPC \times (-ΔT), then ΔSP = -ΔT - (-MPC \times ΔT) = ΔT(MPC-1). With ΔT=100 and MPC=0.6, ΔS_P = 100(0.6-1) = 100(-0.4) = -40. Thus, private saving decreases by 40.

For the same scenario (ΔT = 100, MPC = 0.6), calculate the total change in national saving (ΔS).

The total change in national saving is ΔS = ΔSP + ΔSG. From previous calculations, ΔSP = -40 and ΔSG = +100. So, ΔS = -40 + 100 = +60. Thus, national saving increases by 60.

State the general formula for the change in national saving (ΔS) due to changes in taxes (ΔT) and government purchases (ΔG), as provided in Q6 of the professor's key, including the specific interpretation of ΔG from their notation.

The general formula for the change in national saving (ΔS) is: ΔS = (MPC \times ΔT) + ΔG. In their notation, if government purchases (G) are reduced