Macro Midterm 2

Economic Growth

Increase in an economy’s production of good and services that is concentrated primarily on human welfare

How is Economic Growth Measured?

Change in Real GDP per Capita

History of Economic growth

Pre Industrial Revolution, most of the world was constantly on subsistence. Explosion of Global Real GDP in last 250 years thanks to new innovations

Mathematics for calculating growth rate

Nominal GDP Growth - Inflation = Real GDP

Real GDP Growth - Population Growth= Estimated Per Capita GDP Growth

RUle of 70

Time taken for a nation’s economy to double. 70/x percent growth rate

Traditional Growth Theory

Focused on resources as determinants for economic growth — mainly physical capital

Types of resources

Land, Labor, Capital

What is Traditional Growth Theory also known as?

Solow Growth Model

Solow I Growth Model Production Function

Real GDP = Y = F(inputs) = F(resources) = F(Land, Labor, Capital)

Why does Solow Growth Model focus on capital?

1. Investments in capital and economic growth are highly correlated

2. High income nations have more capital goods than poorer nations and their success is attributed to those goods

Marginal Product

Additional output created by employing one extra unit of a variable input (such as labor or capital) while keeping all other inputs constant

Marginal Product of Capital Formula

Change in Real GDP/Change in Capital

Diminishing Marginal Product

Idea that marginal product of any input falls as the quantity of its input rises

Solow I.

What is its function?

What does its aggregate production funciton look like?

Function that primarily focuses on capital.

Aggreate produciton function is a curve where output progressively flattens out as more input (capital) is added

Key Assumption about Solow Growth I Model

Capital goods are expected to diminishing returns. Each additonal unit if capital provides less extra output that the previous one

Two Implications of Solow I

1. Steady State: Condition in an economy where there is no new net investment. There is no longer an incentive to build more capital, if no investment there is no change in capital (K) and no growth.

2. Convergence: Income levels across the naiton convergence as they approach their steady states. Rich nations with lots of captial slow down and as they slow down, poorer nations not have room to grow

Emperical Problems of Solow I Growth

• Wealthy nations are continuing to grow and don’t share a steady state

• Poorer nations are not closing the gap and continue not to do so

• Misisng component of technology

Solow II Model

Focus on technological innovations as another growth source

Technology

How does new technology impact production function?

New techniques or methods that enable production of more valuble output per unit of input.

Shifts production funcition outward

Production function for Solow II

Y = A(Technology) * F(Land, Labor Capital)

Key assumptions about Solow II (3)

• Rich countries can sustain growth because they have better technological innovations

• Assumptioness about the randomness of technology and why they occur

• Technology develops exogenously (external factors) and are. unrelated to internal economic conditions —> randomness

Policies based on Solow

Aid that supplies loans directly for capital and technology

• Infrastructure Edition

• Factories

• Healthcare

Problems of Solow Growth Model

• Many policies have not had effects in third world countries

• Adding capital may increase a production function, but in real life nation’s don’t always use their resources efficiently to produce at the max level of their production funciton

Modern Growth Theory

• Idea that economic growth is endogenous and the individual decisions people make matter and influence economic growth — institutions matter

What are institutions

Significant practices, relationships, or organizations in a society

Four key components of institutions

1. Frame decision making environment

2. Define acceptable behavior

3. Affect the costs and benefits

4. Determine incentives for society

Modern Growth Theory Production Function

Y = A * F (Resources, Institutions)

Growth fostering institutions and their precipitating effects

Growth fostering instituitons → Creative incentives —> Lead to more investment, education, innovation —> economic growth is natural —> country utilizes maximum amount of resources in PPF

Modern growth theory believes that to get sustained growth you need what?

Institutions that provide the proper incentives

When did original Macroeconomic concepts originate from?

The Great Depression

AD-AS Model — what does it show?

Model that we use to study short run fluctuatins in the economy and its effects into the long run

Aggregae Demand

What is it?
What does the curve look like?

The total demand for all final goods and services (GDP) in an economy

“The spending side of economy”

Curve is downward sloping

Why does the AD curve slope downward

1. Wealth Effect: Change in price level affects people’s real wealth and this leads to changes in their quantity of aggregate demand. Increase in price level -→ decrease real wealth —> Lower spending

2. Interest Rate Effect: When price levels rise, people need more money for transactions and can’t save less, which decreases supply in LFM and drives interest rates up. Higher interest rates lowers investment spending and Quantity of Aggregate Demand

3. International Trade Effect: When price levels fall, country’s goods become relatively cheaper than another, which increases exports and decreases imports —> net exports increase —> AD increases

What causes shifts in Aggregate Demand

1. Changes in C + I + G + NX

   1. If any of these change, it affects AD

2. Consumer Confidence

   1. Increasing consumer confidence allows people to spend more (Consumption part of CIGNX increase)

AD — Consumption Shifts — what are they related too?

1. Expected future income: If people feel more financially secure, they are willing to spend more now —> Consumption Increases

2. Changes in real wealth: If real wealth increases due to NON change in price level (Housing or Stock increase) it shifts AD

3. Taxes: Taxes affect disposable income. Tax Increase —> shift left. Tax Decrease —> Shift Right

AD—Investment shifts — what are they related too?

1. Business Firm Confidence: If businesses are confident —> firms expect higher profits —> mre likely to build factories —> I increases —> AD shifts right

2. Interest Rates: If interest rates decrease —> borrowing is cheaper and happens more —> Firms are able to borrow and invest more —> AD shifts right

3. Quantity of Money: If money supply increases —> interest rates fall —> investmetn increases —> more firm investments —> AD shifts right

AD-Goverment Shifts

When the goverment spends more money on goods and servces such as building infrastructure, funding programs, hiring workers

AD-Net Exports Shifts

1. Increase in Foreign Income: When foreigners have more income, they have more money to spend on US domestic goods —> AD shifts right

2. Value of the dollar in terms of other currencies: If currency depreciates and becomes weaker, foreigners are more likely to buy our goods —> shift AD

Aggregate Supply

The total supply of all final goods and services (Real GDP) in an economy

Difference between Long Run and Short Run

Short Run: Period of time in which some prices have not yet adjusted

Long Run: Period of time sufficient for all prices to adjust

Why is there a short run and long run AS curve
What happens if prices go up for each?

Input prices take longer to adjust than output prices (sticky prices).

• If prics go up in SR, expansion and output go directly up

• If prices go up in LR, quantity supplied isn’t affected as it resets by then

SRAS

Upward sloping curve that represents changing price levels with Real GDP

LRAS

A vertical line that represents the limmit at full employment output (Y*) of an economy

Cause for shift in LRAS

Change in full employment output due to changes in Resources, Technology, or Institutions

What happens when LRAS Shifts

1. Economic growth or decline

2. SRAS also shifts with LRAS

Causes for shift in SRAS

1. Changes in wages and other sticky prices

2. Short run supply shocks (temporary exogenous events that change producion costs)

What happens when SRAS shifts

1. Change in how much firms are willing to produce at every price level

2. Doesn’t mean LRAS shifts as well

3. AD does not shifts to match

AD-AS Equillibrium

1. Where LRAS, SRAS, and AD all interset

2. Economy is pushing toward this point

3. Y* = Y

4. U* = U

Economic Viewpoints

1. Classical Economics

2. Keynesian Economics

3. Modern Economics

Classical Economics

• History

• What was its main idea

• Key Assumption

• Implications

• What should our main focus be

• The dominant approach to macroeconomics before the Great Depression

• Prices adjust to move markets to equillibrium rather quickly

• Because all prices are flexible —> No sticky prices —> No SRAS, just LRAS

• No Big Economic Contractions, Economy is inherently stable

• Our main focus should in increasing Aggregate Supply

Keynesian Economics

• History

• What was its main idea

• Key Assumption

• Implications

• What should our main focus be

• Great Depression hits and John Maynard Keynes publishes a book

• Some prices are sticky and take awhile to adjust

• Sticky prices are caused by things like money illlusion and long-term wage contracts

• SRAS adjusts which is painful for people, economy is inherently unstable as AD moves along AS curve

• Government mus thelp to intervene —> EMpahsize AD shifting

Modern Economics

Synthesize Traditional and Keynesian

Believe some prices are sticky

Emphasize all factors

What does the US populatio pyramid currently look like

Baby boomer surge in 60s

Long life spans

Current low birth rates

Federal Budget

National government’s plan for outlays and revenue

Outlays and types of outlays

Direct spending plus transfer payments

• Mandatory Outlays: Payments that occur automatically each year because of laws already in place

• Discretionary Outlays: Budget items that are adjustable on year-to-year basis

• Interest outlays: Payments made on interest on debt

What is spending side budget mostly comprised of

Mandatory: 60%

Discretionary: 26%

Interest: 14%

Main types of taxes Government raises revenue

Taxes:

Income Taxes -51%

Social Insurance Taxes -33%

Corporate Taxes -9%

Other

What tax system does US use and how does it work

Progressive Income Tax: Tax system in which people get more taxed as their income goes up

Marginal Tax Rate

The tax rate that applies to a person’s next dollar of income

Average Tax Rate

Percentage of total income that is paid on taxes (ATR = T/Y)

How is the difference between Outlays and Revenue expanding

Gap is getting further apart

Budget Deficit, and what government must do when this occurs

When outlays exceed tax revenue; applies to a particular time period

• If there is a deficit, must borrow to make up those difference

Budget Surplus

When tax revenue exceeds total outlays

National Debt

Accumulation of all upaid debts

Why is bigger debt not a super concern for US

Because people instead look at outlays and revenue as relative to country’s GDP

Fiscal Policy and where did it come from

Usage of government spending and taxation to influence the economy

• First made appearance in New Deal which greatly increased governent spending

AD-Focused Fiscal Policy
- History
-What does it do

1. Traditionla Form of Fiscal Policy

2. Change in Government Spending (G) to shift AD diretly

3. Change people’s taxes to shift consumption (C)

Spending Multiplier and Multiplier Effect

When new spending yields higher incomes, this leads to even more spending

Multiplier effect occurs when government spends money but AD shifts more since it encourages people to spend

Marginal Propensity to Consumption

THe portion of new iincome that people spend on consumption

NOT THE SAME AS MARGINAL PROPENSITY TO SAVE

Spending Multiplier

m^s = 1(1-MPC)

Countercyclical Fiscal Policy

Government tries to smooth out the business cycle

• During a recession, we want to increase G and decrease taxes —> Create Budget Deficit

• During expanion, we want to decrease G and increeease taxes —> Create Budget Surplus

Concerns about Demend Side Fiscal Policy

1. Recognition Lag: Recognizing where we are in the business cycle is difficult

2. Implementation Lag: Takes time to implement fiscal policy

3. Impact Lag: How long it tkes for economy to feel full effects

Ways to push back on TIme Lag, what are the two types of lag it counteracts?

Automatic Stabilizers: Government programs that increase G and decrease Taxes automatically when recessioanry conditios exist

• Counts out recognition and implementation lag

Crowding Out

Occurs when government spending reduces private sector investment and consumptoin

• increases in G are offset by decreases in C and I

Mechanism for Crowding Out
And what is net effect on AD

Governenment goes out to spend more moeny → Government must borrow more → shifts the demand for loanable fundds amrket —> real interest goes up —> private investment goes down and consumption icreases

• In net effect on AD, rise in G is partially or fully offset

Supply Side Fiscal Policy

Policy is designed to shift the productive capacity of. economic — they want a long run increase in full employment output

Marginal Tax Rates in relation taxable Income

The components of revenue and marginal tax rates are not independent, increasing/decreasing tax rates will have an effect on the amount of taxalbe income

Laffer Curve

Does LRAS shift affect natural rate of unemployment?

It stays the same

Factors in Supply Side Fiscal Policy

1. Research and Development tax credits

2. Policies that focus on education

3. Lower corporate profit tax rates

4. Lower marginal income tax rates