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What explains the dierences in standards of living across countries and across Bme?

Econ2102 Professor James Morley

Lecture 1

CHAPTER 1 IntroducBon to Macroeconomics

Class Outline
Some administraBve maLers Big picture issues in Macroeconomics The Basic Neoclassical Model of Aggregate ProducBon Readings: Jones Chapters 1-4 Next Bme: Jones Chapter 5

Econ 2102
Lecturer-in-charge: Professor James Morley Oce: ASB 434 Phone No: 9385 3366 Email: james.morley@unsw.edu.au ConsultaBon Times Wednesdays 1:00-3:30 Course website on Blackboard

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Tutor Details
Paul Vamvouklis
Email: paul.vamvouklis@hotmail.com

Learning and Assessment

Textbook
Macroeconomics 2nd EdiBon, Charles I. Jones, Norton Press

Yiyuan (Edward) Xie

Email: yiyuan.xie@unsw.edu.au

Lectures
Complement, not subsBtute for textbook

Xiao Chun Xu (tutor-in-charge)

Email: xiaochun.xu@unsw.edu.au

Tutorials
Problem sets apply concepts from textbook and lectures

Assignments and Final Exam

Assignments due on 13/8 and 24/9

What is Macroeconomics?
Macroeconomics is the study of aggregate economic phenomena:
Long-Run Economic Growth InaBon The Business Cycle

How do macroeconomists explain these phenomena?

Measurement (see Chapter 2):
Real GDP CPI The Unemployment Rate

ObservaBon and Theory Models and PredicBon In Macro 2, we focus on models

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Why focus on models?

Models make the assumpBons and predicBons of theories precise Allows for beLer evaluaBon of compeBng theories BeLer understanding of the potenBal and limitaBons of dierent policies to achieve desirable outcomes for macro phenomena

Intermediate Macro
We will study two key models that macroeconomists actually use
Solow-Swan Model of long-run economic growth New Keynesian Model of business cycles

We will explore why the models are so widely applied, but also consider their limitaBons We will consider how macroeconomists develop and extend their models We will also consider advanced theories of Long- Run InaBon, ConsumpBon, Investment, and Exchange Rate DeterminaBon

The Structure of Models

The Key DisBncBon

The disBncBon between exogenous and endogenous variables is key to understanding models Avoid confusion by specifying which is which Exogenous variables are not being explained by the model, while endogenous variables are A model provides the mechanism by which the endogenous variables are determined by the exogenous variables

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Topic 1: Long-Run Growth

Measured as an increase in Real GDP Per Capita Despite aws, Real GDP Per Capita sBll captures bulk of variaBon in standards of living across countries and across Bme The Neoclassical Aggregate ProducBon FuncBon is the basis for a simple model of the level of Real GDP Per Capita across countries The Solow-Swan Model extends the basic Neoclassical model of aggregate producBon to explain economic growth over Bme

Chapter 4 A Model of ProducBon

In this chapter, we learn:
how to set up and solve a macroeconomic model. how a producBon funcBon can help us understand dierences in per capita GDP across countries. the relaBve importance of capital per person versus total factor producBvity in accounBng for these dierences. the relevance of returns to scale and diminishing marginal products. how to look at economic data through the lens of a macroeconomic model.

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The Basic Neoclassical Model of Aggregate ProducBon

Consider a single, closed economy, with only one consumpBon good.

Setting Up the Model

A certain number of inputs are used in the producBon of the good Inputs
Labor (L) Capital (K)

ProducBon funcBon
Shows how much output (Y) can be produced given any number of inputs

Others variables with a bar are parameters. ProducBon funcBon:

The Cobb-Douglas producBon funcBon is the parBcular producBon funcBon that takes the form of
Assumed to be 1/3. Explained later.

Output

Productivity parameter

Inputs

A producBon funcBon exhibits constant returns to scale if doubling each input exactly doubles output.

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Returns to Scale Comparison

Find the sum of exponents on the inputs

Standard replicaBon argument

A rm can build an idenBcal factory, hire idenBcal workers, double producBon stocks, and can exactly double producBon. Implies constant returns to scale.

Result the function has constant returns to scale the function has increasing returns to scale the function has decreasing returns to scale

sum to 1

sum to more than 1

sum to less than 1

Allocating Resources

The marginal product of labor (MPL)

The addiBonal output that is produced when one unit of labor is added, holding all other inputs constant.

The marginal product of capital (MPK)

Firm chooses inputs to maximize profit Rental rate of capital Wage rate

The addiBonal output that is produced when one unit of capital is added, holding all other inputs constant.

The rental rate and wage rate are taken as given under perfect compeBBon. For simplicity, the price of the output is normalized to one.

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The soluBon is to use the following hiring rules: Hire capital unBl the MPK = r Hire labor unBl MPL = w

If the producBon funcBon has constant returns to scale in capital and labor, it will exhibit decreasing returns to scale in capital alone.

Solving the Model: General Equilibrium

The model has ve endogenous variables:
Output (Y) the amount of capital (K) the amount of labor (L) the wage (w) the rental price of capital (r)

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The model has ve equaBons:

The producBon funcBon The rule for hiring capital The rule for hiring labor Supply equals the demand for capital Supply equals the demand for labor

The parameters in the model:

The producBvity parameter The exogenous supplies of capital and labor

A soluBon to the model

A new set of equaBons that express the ve unknowns in terms of the parameters and exogenous variables Called an equilibrium

General equilibrium
SoluBon to the model when more than a single market clears

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In this model
The soluBon implies rms employ all the supplied capital and labor in the economy. The producBon funcBon is evaluated with the given supply of inputs. The wage rate is the MPL evaluated at the equilibrium values of Y, K, and L. The rental rate is the MPK evaluated at the equilibrium values of Y, K, and L.

Interpreting the Solution

If an economy is endowed with more machines or people, it will produce more. The equilibrium wage is proporBonal to output per worker.
Output per worker = (Y/L)

In many countries, empirical evidence shows:

Two-thirds of producBon is paid to labor. One-third of producBon is paid to capital. The factor shares of the payments are equal to the exponents on the inputs in the Cobb-Douglas funcBon.

The equilibrium rental rate is proporBonal to output per capital.

Output per capital = (Y/K)

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In the model, all income is paid to capital or labor.

Results in zero prot in the economy This veries the assumpBon of perfect compeBBon. Also veries that producBon equals spending equals income.

Analyzing the ProducBon Model

Per capita = per person Per worker = per member of the labor force.
In this model, the two are equal.

We can perform a change of variables to dene output per capita (y) and capital per person (k).

Output per person equals the producBvity parameter Bmes capital per person raised to the one-third power.

What makes a country rich or poor? Output per person is higher if the producBvity parameter is higher or if the amount of capital per person is higher.
What can you infer about the value of the producBvity parameter or the amount of capital in poor countries?

Output per person Productivity parameter

Capital per person

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Comparing Models with Data

The model is a simplicaBon of reality, so we must verify whether it ts the data well.

The Empirical Fit of the Production Model

Development accounBng:
The use of a model to explain dierences in incomes across countries.

Set productivity parameter = 1

CHAPTER 4 A Model of ProducBon

Diminishing returns to capital implies that:

Countries with low K will have a high MPK Countries with a lot of K will have a low MPK, and cannot raise GDP per capita by much through more capital accumulaBon

If the producBvity parameter is 1, the model overpredicts GDP per capita.

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Productivity Differences: Improving the Fit of the Model

The producBvity parameter measures how eciently countries are using their factor inputs. Oren called total factor producBvity (TFP) If TFP is no longer equal to 1, we can obtain a beLer t of the model.

However, data on TFP is not collected.

It can be calculated because we have data on output and capital per person. TFP is referred to as the residual.

A lower level of TFP

Implies that workers produce less output for any given level of capital per person

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Output dierences between the richest and poorest countries?

Dierences in capital per person explain about one-third of the dierence. TFP explains the remaining two-thirds.

Thus, rich countries are rich because:

They have more capital per person. More importantly, they use labor and capital more eciently.

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Understanding TFP Differences

Why are some countries more ecient at using capital and labor?

Human Capital
Human capital is the stock of skills that individuals accumulate to make them more producBve (for example, educaBon). Returns to educaBon are the value of the increase in wages from addiBonal schooling. Dierences in Human capital helps predict some of the large dierences in TFP.

CHAPTER 4 A Model of ProducBon

CHAPTER 4 A Model of ProducBon

Technology
Richer countries may use more modern and thus more ecient technologies than poor countries.

Institutions
Even if human capital and technologies are beLer in rich countries, why do they have these advantages? InsBtuBons refer to property rights, the rule of law, government systems, and contract enforcement, among many other items. Well-dened insBtuBons and laws create a climate for economic growth that is much beLer than an environment with corrupt and uncertain insBtuBons.
CHAPTER 4 A Model of ProducBon

CHAPTER 4 A Model of ProducBon

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Evaluating the Production Model

Per capita GDP is higher if capital per person is higher and if factors are used more eciently. Constant returns to scale imply that output per person can be wriLen as a funcBon of capital per person. Capital per person is subject to diminishing returns and the diminishing returns are very strong because the exponent is much less than one.
CHAPTER 4 A Model of ProducBon

In the absence of varying TFP, the producBon model incorrectly predicts dierences in income. AddiBonally, the model does not provide an answer as to why countries have dierent TFP levels. I.e., it has a limited ability to predict out of sample

CHAPTER 4 A Model of ProducBon

Policy Implications?
Should policymakers focus on capital accumulaBon as a way to close the gap between rich and poor countries? Or should they focus on Human capital and/or insBtuBons?

Summary
The basic neoclassical model of aggregate producBon suggests the level of economic development depends on the endowment of capital However, variaBon in capital across countries only explains about 1/3 of the the variaBon in economic development TFP explains the rest of the variaBon Economic research suggests that TFP can be related to the level of Human Capital and to InsBtuBons Next Bme: capital accumulaBon and economic growth (the Solow-Swan Model)
CHAPTER 4 A Model of ProducBon

CHAPTER 4 A Model of ProducBon

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