topic 4.3

topic 4.3

ANALYZING THE PRODUCTION MODEL

Back to the original question: why are some countries so much richer than others?

We need to convert to per capita terms

define

y = Y/L
k = K/L

then in equilibrium

y* = A.k1/3

so output per capita increases with

• a higher "productivity parameter"
• higher per capita capital

The Empirical Fit of the Model

Figure 4.5 shows that the model overpredicts the wealth of the poorest countries (setting A = 1)

How can we fix this poor fit? What about decreasing the capital exponent? The problem is that 1/3 is capital's share of output - it was not chosen arbitrarily.

An alternative is to allow A to vary.

We shall call A total factor productivity.

We allow TFP to vary for each country in such a way as to make the predicted and actual Y match.

TFP is a residual, a measure of our ignorance.

TFP "explains" two-thirds of GDP while capital per person explains one-third.

Ideally we would measure TFP compnents directly, then we could have a true test of the model.

TFP is a measure of using capital and labor efficiently. What explains differences in TFP?

1. Human Capital

Accumulated skills that make people more productive.

Education is easy to measure and does partly explain TFP.

2. Technology

We will get this later.

Institutions

Mancur Olson pointed out the natural experiments of Korea, Germany, China. (JEP 1996).

Institutions include rules, such as "rule of law". Property rights, contracts.

More research on institutions is needed.

topic 4.1

Topic 4.1

A MODEL OF PRODUCTION


Consider a closed economy with a production function

Y = F(K,L) = A.K1/3.L2/3

A = productivity parameter
K = capital
L = labor

this production function uses a Cobb-Douglas form (Y = Ka.Y1-a)

this function generates constant returns to scale (since a + (1-a) = 1)

F(2K,2L) = 2.F(K,L)

if a + (1-a) <> 1 we have increasing returns to scale

how should capital and labor be allocated to maximize profit?

assuming this is the production function for a single firm acting competitively, and setting thr price of the good to 1

max(over K and L)

profit = A.F(k,L) - r.K - w.L

we get results for L and K


these results make sense:

as w increases the firm decreases L
as Y increases the firm increases L

What the firm is doing is to adjust L and K to match marginal productivities with the values of r and w. r and w are taken as given by the individual firm.

The macro level determination of r and w can be illustrated by two diagrams that show equilibrium in the markets for L and K.

As a consequence of the Cobb-Douglas formulation the total output is absorbed by the returns to labor and capital.

w*L* + r*K* = Y*

topic 3

topic 3

LONG-RUN ECONOMIC GROWTH

Sustained increases in standards of living are a relatively recent phenomenon.

The chart by Angus Maddison shows this.

Most of the world is richer than in 1960. Today about 600 million fall below $5US/day instead of 4 billion in 1960. Growth in Chaina and India ccounted for 40 per cent of the world population and a lot of the decrease in poverty.

The rule of 70 illustrates how small changes in growth rates have major effects on growth.

Under a 2 per cent growth rate income will quadruple in 70 years. Under a 3 per cent growth rate it will increase eight times in 70 years.

Some countries have consist growth, other periods of high growth, and some have plateaued out or even negative growth.

Some properties of grwoth rates:

if z = x/y then gz = gx - gy
if z = x.y then gz = gx +gy
if z = xa then gz = a.gx


yt =y0(1 +g)t where y is growth and g is the rate of growth.

An Example of a Growth Model

Yt = AtKt(1/3)Lt(2/3)

Yt = growth
At = technology
Kt = capital
Lt = labor


g(Yt) = g(At) + 1/3.g(Kt) + 2/3g(lt)

where g(.) is the growth rate

Growth has costs

• environment
• inequality

Robert Lucas stimulated growth research with his lectures on economic growth. (JME, 1988)

topic 2

topic 2

MEASURING THE MACROECONOMY

Gross domestic product:
the market value of all final goods and services produced in a country over a certain time

Alternative approachs to measuring GDP are the expenditure and income methods

production = expenditure = income
(for a closed economy)

Economic profits:
zero economic profit is the profit earned in perfect competition sufficient that firms do not enter or leave an industry ("normal profit")

The expenditure approach to GDP

Y = C + I + G + NX

NX is also called the "trade balance"

Since 1950 C has increased as a percentage of GDP, leading to a negative trade balance

1939-45 was exceptional because of war spending

Capital

GDP is limited as a measure because it does a poor job ofmeasuring improvements in quality (like the quality of health care)

Nominal and real GDP

GDP deflator
CPI

There are alternative methods of calculating indexes of inflation:

Laspeyres index uses initial prices
Paasche index uses final prices
Chain weighting (the Fisher index) is intermediate between the other two

Comparing economic performance between countries is difficult

topic 1

topic 1

INTRODUCTION TO MACROECONOMICS

1.1 Macroeconomics studies the way in which market interactions determine overall economic activity.

The main economic phenomena we study are:

• growth
• inflation
• business cycles

Modern macroeconomics is based on modelling the behavior the behavior of individual economic agents (households and firms) and then extending the analysis to reach conclusions about the macroeconomy. This is why macroeconomics requires a base of microeconomics.

The division between microeconomics and macroeconomics is somewhat artificial. Until the 1930s there was no separate field of macroeconomics.

1.2 How macroeconomics studies questions.

The ideal is to follow the scientific method, with facts/observations informing theory. In practice this is more difficult than is the case with microeconomics because the power of econometrics is weak.

One of the most interesting areas of macroeconomics is experiments. Experiments allow control of extraneous influences.

A standard outline of the approach is:

• document facts ("empirical regularities")
• develop a model
• compare predictions with original facts ("calibration")
• use the model to make testable predictions

Economic models use some general terms:

• parameter
• exogenous variable
• endogenous variable
• "experiment" means different things to different people

Macroeconomists commonly use "experiment" to mean changing parameters in a model and then observing the effect on endogenous variables.

1.3 Overview

The long-run is amazing - living standards have increased enormously.

Output often deviates from long-run potential output. This is the short-run business cycle.

To convert dollar ("nominal") GDP into "real" terms we need to measure inflation.

"Open economy macroeconomics" is the extension of closed economy macroeconomics to the international economy.