Makro chapter 1-7

Chapter 1: Introduction

1. What should we ask ourselves when using an economic model?

   • What are the key relationships and assumptions in the model?

   • How well does the model simplify and represent real-world economic behavior?

   • What are the limitations and potential biases of the model?

2. What is the difference between endogenous and exogenous variables?

   • Endogenous variables are determined within the model (e.g., production and consumption).

   • Exogenous variables are set outside the model and taken as given (e.g., government spending).

3. What is the difference between nominal and real GDP?

   • Nominal GDP measures output using current prices.

   • Real GDP adjusts nominal GDP for inflation, measuring output using constant prices.

4. What are some measures of inflation? How are they measured?

   • Consumer Price Index (CPI): Tracks the average change in prices paid by consumers.

   • GDP Deflator: Measures price changes for all goods and services included in GDP.

   • Producer Price Index (PPI): Measures price changes from the perspective of producers.

5. What’s the difference between GDP per capita and GDP per capita adjusted by PPP?

   • GDP per capita: Economic output per person, not accounting for cost-of-living differences.

   • PPP-adjusted GDP per capita: Accounts for differences in price levels across countries, reflecting purchasing power.

Chapter 2: Production, Prices, and Distribution of Income

1. What are the properties of a production function? Why do they matter?

   • Properties include diminishing returns, constant returns to scale, and substitutability of inputs. They determine how inputs like labor and capital affect output.

2. Why is the Cobb-Douglas production function a good fit for our analysis?

   • It reflects real-world properties like constant returns to scale and diminishing marginal productivity of inputs, and its simplicity makes it practical.

3. What does the demand for a product depend on in a monopolistic competition setup?

   • Price elasticity, consumer preferences, and competitors’ pricing strategies.

4. How does one compute the price elasticity of demand?

   • By the formula:

5. How do firms formulate a profit maximization problem?

   • Firms maximize profits by setting marginal cost equal to marginal revenue and choosing optimal input levels.

6. Relate the price elasticity to the price mark-up.

   • Mark-up = . Higher elasticity leads to a lower mark-up.

7. What determines the price level and real wage?

   • The price level depends on production costs, mark-ups, and market conditions. The real wage is determined by productivity and labor market dynamics.

8. How is the natural level of production determined?

   • By the intersection of aggregate supply and aggregate demand when the economy is at full employment.

Chapter 3: Interest Rates and Investment

1. What are the definitions of nominal and real interest rates? How are they related?

   • Nominal interest rate: Observed rate without adjusting for inflation.

   • Real interest rate: Nominal rate adjusted for inflation:

2. How could nominal interest rates be negative?

   • Through policies like quantitative easing or high demand for secure assets.

3. Why should we care about investment?

   • It drives capital accumulation, economic growth, and future production capacity.

4. How does one obtain the desired level of capital stock?

   • By equating the marginal product of capital to the real interest rate.

5. What are its determinants?

   • Real interest rate, depreciation rate, technological progress, and savings rate.

6. What’s the difference between investment in the long- and short-run?

   • Long-run: Focuses on optimal capital stock.

   • Short-run: Driven by expectations, economic shocks, and current profitability.

7. Why is investment more volatile than output?

   • It reacts strongly to changes in interest rates, business confidence, and external shocks.

8. What happens when we cannot adjust the level of capital stock freely?

   • Firms face inefficiencies, production constraints, and economic instability.

Chapter 4: Consumption and the Natural Rate of Interest

1. What is the difference between and ?

   • : Intertemporal utility over multiple periods.

   • : Single-period utility.

2. How do we derive the lifetime budget constraint in a 2-period model?

   • By equating the present value of income to the present value of consumption:

3. What does the slope represent?

   • The slope of the budget constraint is , showing the trade-off between current and future consumption.

4. How do we mathematically obtain the slope of the indifference curve, and what does it represent?

   • , representing the marginal rate of substitution between periods.

5. What happens to consumption when the real interest rate decreases?

   • Consumption in the current period increases due to lower saving incentives.

6. What about if the patience parameter decreases?

   • Consumption shifts to earlier periods.

7. How does consumption respond to transitory and permanent shocks?

   • Transitory shocks: Temporary changes in consumption.

   • Permanent shocks: Larger, sustained changes.

8. What is a liquidity constraint, and how can it affect MPC?

   • A liquidity constraint limits borrowing, increasing the marginal propensity to consume.

9. What are durable goods? Why are they important for the fluctuations of consumption?

   • Long-lasting goods (e.g., cars). Their purchase is sensitive to economic cycles.

10. What is the definition of the natural rate of interest?

    • The interest rate at which output equals its potential level without causing inflationary pressure.

Chapter 5: Capital Accumulation and Growth

1. Why is economic growth important?

   • It improves living standards, reduces poverty, and increases a nation’s productive capacity.

2. Why is capital per effective worker the key factor to figure out in the Solow model?

   • It determines productivity and output per worker, which drive long-term growth.

3. What is the law of motion for capital per effective worker?

   • Where is capital per effective worker, is the savings rate, is population growth, is technological progress, and is depreciation.

4. Why does converge to a steady state? What is in the steady state?

   • Convergence occurs as investment balances depreciation and growth. In the steady state, capital per effective worker remains constant.

5. What are the properties of the steady state? Which variables are constant, and which are growing?

   • Capital per effective worker and output per effective worker are constant. Total output grows at the rate of population and technological progress.

6. What is absolute and conditional convergence? What is the empirical evidence for these?

   • Absolute convergence suggests all economies converge to the same steady state. Conditional convergence occurs when economies converge, accounting for differing fundamentals. Empirical evidence supports conditional convergence.

7. How does a change in the savings rate affect consumption and output?

   • Higher savings initially increase output and consumption, but excessive saving can reduce consumption in the long run.

8. What is the Golden Rule?

   • The savings rate that maximizes steady-state consumption per worker.

9. Why are some countries richer than others?

   • Differences in savings rates, population growth, technological progress, and institutional factors.

Chapter 6: Wage-Setting and Unemployment

1. What is the equilibrium rate of unemployment?

   • The rate at which the number of job seekers equals the number of vacancies, considering frictions and wage-setting behavior.

2. What determines the natural rate of unemployment?

   • Factors such as job matching efficiency, labor market frictions, and institutional arrangements like minimum wages and unionization.

3. How do wage-setting and price-setting curves interact?

   • The wage-setting curve reflects wage demands based on unemployment, while the price-setting curve reflects firms’ output prices based on costs. Their intersection determines the equilibrium.

4. What causes persistent high unemployment?

   • Causes include skill mismatches, inefficient labor market institutions, and hysteresis (where temporary shocks have lasting effects).

5. What role do unions play in wage-setting?

   • Unions negotiate wages, which can lead to higher wages but may also reduce employment levels if set above market-clearing levels.

6. How does technological change affect unemployment?

   • It can create mismatches in skills, but over time it may increase productivity and job creation in new sectors.

7. What is hysteresis in unemployment?

   • When temporary increases in unemployment lead to a permanently higher natural rate due to skill loss and reduced labor market attachment.

8. How do minimum wages impact unemployment?

   • They can increase unemployment if set above equilibrium wages but may have minimal effects in markets with monopsony power.

Chapter 7: Money and Inflation in the Long Run

1. What determines the long-run rate of inflation?

   • The growth rate of money supply relative to the growth of output.

2. How does money growth explain inflation?

   • By the Quantity Theory of Money: , where increases in (money supply) lead to proportional increases in (price level) if (velocity) and (output) are constant.

3. What are the costs of inflation?

   • Includes shoe-leather costs, menu costs, tax distortions, and uncertainty affecting savings and investment.

4. What is seigniorage?

   • Revenue earned by the government through money creation, effectively a tax on holding money.

5. What is the role of expectations in inflation?

   • Expectations influence wage and price-setting, making it crucial for central banks to manage inflation expectations to stabilize the economy.

6. What is the velocity of money?

   • The rate at which money circulates in the economy, defined as .

7. What happens if money supply grows faster than output?

   • Persistent inflation occurs as more money chases the same amount of goods and services.