Δk = s*f(k) - (δ + n + a)k
Population Growth (n)
=> if s,n,a and f(k) similar, countries should converge to the same steady state
not true, because if any of those variables vary across countries, convergence steady state different
countries with different production functions converge to different steady states
+ Ms -> + P -> domestic goods + expensive for foreign market -> - demand for domestic currency -> - S
Capital Accumulation
Causes of Economic Growth
Technological Progress (a)
Others: Human Capital, Public Infrastructure, and Institutions
output per labour ratio -> Y/L = y
Intensive Form
capital per labour ratio -> K/L = k
constant returns to scale
Properties
marginal product of labor and capital diminishing
F(K,L) or F(A,K,L) Formula
Output (Y) Production Function
Capital Stock (K)
Labour (L)
Variables
Population Growth (n)
Depreciation Rate (δ)
Technological Progress (a)
capital stock increases at the same rate as the sum of n, a and delta Definition
Capital Widening Line
(δ + n + a)k Formula
in this model savings = investment
Definition
savings schedule is the portion of capital stock invested in the economy Savings Schedule
trade balance ( records goods and services)
s*f(k) Formula
Components net unilateral transfers (ex. gifts/donations)
point where savings schedule = capital widening line
Defining and Determining international income (X-Z)
Δk=0
Current Account CA = - FA
Y/AL -> 0
X - Z = Y - (C + I + G) = CA
K/AL -> 0 Formulas/Identities
Steady State Balance of Payments CA > 0 => net lender => appreciation of currency
Y/L -> a
Variables' Growth Rate CA < 0 => net borrower => depreciation of currency
K/L -> a
direct investment
Y -> (a + n)
Non-Official portfolio investment
K -> (a + n) Financial Account
Solow Model other investment
steady state level of capital/labor ratio (k) that maximizes consumption for a given economy Definition
Official reserve assets -> conducted by CB
take derivative of f(k) and make it equal to the slope of capital widening line Golden Rule Steady State
How to Find It? Hours Worked vs Leisure Time combination chosen that maxizes utility given individual budget constraint
MPK = f'(k') = (δ + n + a)
every hour worked allows higher consumption => more labour supplied
- consumption today = + savings today => + consumptionin the long run Substitution Effect
Dynamic Efficient Consumption-Leisure Trade Off s > i => + w -> + LS
booming economy
Dynamic Efficiency and Inefficiency same amount of hours worked yield higher consumption => less labour supplied
+ consumption today = - savings today => + consumption in the long run Income Effect
Dynamic Inefficient i > i => + w -> - LS
contracting economy
average # hours/worker x total labour force
output per labor ratio(Y/L) has grown at sustained rate 1. Yes Definition
s > i, because as wage increases more people join labour force
capital per labor ratio (K/L) has grown at sustained rate 2. Yes
Labour Supply 1. upward sloping
capital to output ratio (K/Y) has been stable
3. Yes Properties 2. aggregate labour supply less steep than individual labour supply
both grow at n+a rate
Kaldor Facts 3. homogenous -> assumed equal productivity and undistinguished job type
real interest rate (r) has been stable
4. Yes profit = p*F(K,L) - WL
stable because depreciation rate stable
WL -> nominal wage
labor and capital receive constant shares of total income 5. Yes Profit Maximizing Companies
MPL -> F'(L)
there are wide differences in the growth rate of productivity across countries 6. No Labour Demand highest profit when MPL = real wage
assumption: all countries have the same production function w = W/p
Real Wage
Unconditional Convergence Hypothesis real wage is nominal wage adjusted to inflation
Unconditional and Conditional Convergence Ls = L + U
Conditional Convergence Hypothesis Labour Market Equilibrium Ld = Ls
different levels of output per capita and effective labour
Voluntary Unemployment workers choose not to work, even though there are jobs available
technological progress endogenous to model
constant MPK Labour Markets Involuntary Unemployment
result of firms paying higher wages than equilibrium wages
more labour supply than demand
no steady state possible Properties
consequence of job creation and job destruction
K/L and Y/L constantly growing Frictional Unemployment
can be lowered by + efficient matching process
Δy/y = sA- (δ + n)
AK Model Unemployment involuntary unemployment caused by wage rigidities
linear Structural Unemployment
Ls > Ld
Y = AK Production function
s: % of work force losing jobs over a period of time
Y/L = K/L
Separation and Job Finding Rate f: % of unemployed who find a job over a period of time
sAK = savings Savings Schedule
Û = sL - fU
(δ + n)k Capital Widening Line
u = U/Ls
sum of final sales Unemployment Rate
Un = s/(s+f) -> equilibrium unemployment rate
sum of value added ( sale - cost) Measuring GDP
average (mix)
sum of factor incomes (wages + land, interest, dividends, profit + taxes)
hard-line (wage oriented) flatter indifference curve
GDPt = Pto*Qto + Pta*Qta Nominal and Real GDP Labour Unions
Nominal GDP jobs-first (job oriented) very steep indifference curve
uses a reference year price and the current year price
insiders vs outsiders
GDPr = Po*Qo + Po*Qa
Real GDP prevent employers to depress wages
uses a fixed price point, only measures change in quantity produced minimum wage
Wage Regulation protects poor and uneducated from exploitation
measures price of output relative to price in base year
Wage Rigidity
Definition and Formula min w > equilibrium w => unemployment
GDP deflator = nominal GDP/real GDP
employers actively choose to pay higher wages then equilibrium
growth rate of GDP deflator
Inflation Rate - labour turn-over
Δ(%)GDP deflator = Δ(%)GDPn - Δ(%)GDPr GDP Deflator The Fundamentals of Economic Growth Efficiency Wages - moral hazard
different measure of inflation increases productivity
+ self-selection
only measures good and services consumed, including imported ones Consumer Price Index
+ health, + nutrition
Pl = Pt'Qb' + Pt"Qb"/Pb'Qb' + Pb"Qb"
total wealth = total consumption
G => government spending Y = C+ I + G + X - Z Wealth wealth = C1 + C2/(1+r) = Y1 + Y2/(1+r)
Y=C+S+T through saving and borrowing, income profile does not constrain consumption
S-I => private sector, savings - investment Components of GDP preferences constraint to budget line
Intertemporal Budget Constraint
T-G => government budget Y = S-I + T-G = X-Z Why Save or Borrow? price of saving/borrowing (r)
X-Z => exports - imports future income expectations/needs
measured at a specific point in time Stock Variables Macroeconomics Midterm Content given available information, individuals make correct forecasts
Rational Expectations Hypothesis
measured over a given period of time (ex. yearly) Stock vs Flow Variables assuming no uncertainty => perfect foresight
Flow Variables
GDP = flow variable production function: Y = ÂF(K,L)
medium of exchange Profitability of Investment opportunity cost: (1+r)K
store of value Functions of Money labour and technological progress constant
Investment V = K - F(K)/(1+r)
unit of account
Present Value of Profit from Investment if V > 0 => F(K) > (1+r)K => investment profitable
no intrinsic value
Fiat V > 0 => + wealth => wealth = V+ Y1 + Y2/(1+r)
(paper currency)
Types of Money Optimal Investment when "flipped" F(K) tangent to budget line
intrinsic value
Commodity G1 + G2/(1+rg) = T1 + T2/(1+rg)
(petroleum, gold coins)
Borrowing, Lending, and Budget Constraints Government's Intertemporal Budget Constraint T-G < 0 => primary deficit
Reserve Requirements
T-G > 0 => primary surplus
Open Market Operations M0s is controlled by CB Money Supply
Interbank Rate (C1 + G1) + (C2+G2)/(1+r) = Y1 + Y2/(1+r)
+ Md => - i
Consolidated Budget Constraint C1 + G1 > Y1 and C2+G2 < Y2 => CA1 deficit and CA2 surplus
Md = k(i)PY Budget Constraint of a Nation C1 + G1 < Y1 and C2+G2 > Y2 => CA1 surplus and CA2 deficit
- Md => + i
Money Demand when countries don't pay back external debt
i = interbank interest rate
In the short run, k depends on i, cost of money foreign lending/investment stops
Md = M0s* = i*
External Debt Default international investors fear debt default + exports and - imports to compensate
Money Market
CB sets i* or M0s* constant Money Market Equilibrium severe recession
Ms = kPY results in rescheduling, partial default, complete default
money growth = inflation + real GDP growth Equal Interest Rates C1 + C2/(1+r) = (Y1-G1) + (Y2-G2)/(1+r) + (r-rg)(G1-T1)/(1+r)
Consolidated Budget Constraint
ΔM = Δ P + Δ Y Different Interest Rates C1 + C2/(1+r) = (Y1-G1) + (Y2-G2)/(1+r)
Money Growth
+ Ms = + inflation and/or + real GDP taxation pattern does not affect household's consumption
Definition
Inflation = ΔM - Δ Y implies households save when government borrows
+ Md => + M0s and i constant rg not = r
Increase in GDP: CB's Options Ricardian Equivalence
+ Md => + i and M0s constant distortionary taxation
Failures
increase in Ms is fully absorbed by inflation growth as real GDP is constant credit constraints
Neutrality of Money
guarantees countries don't get richer by printing money individuals don't live long enough to incorporate gov. budget constraint
Properties of Money
In the long run, nominal variables don't affect real variables affected by individual preferences and lifetime wealth
Dichotomy Principle Intertemporal Optimal Consumption
allows nominal and real variables to be analysed separately change in income (temporary or permanent) affects consumption
# foreign currency units/ one domestic units Borrower: consumes + today through loans, and - tomorrow
Nominal Exchange Rate (S)
if R$3.5 = 1 euro => S = 3.5 Lender: consumes - today, past savings increase consumption tomorrow
relative price of goods across countries, ajusted to domestic and foreign inflation + income today => save a portion to reach + consumption tomorrow
sigma = s(P/P*) Temporary:
+ income tomorrow => borrow today to consume + in both periods
+ σ (appreciation) => + S or P > P* => - X and + Z
Income Change:
Real Exchange Rate (sigma) equal change in income in both periods
- σ (depreciation) => - S or P < P* => + X and - Z Permanent:
implies permanent increase or decrease in consumption
Δ σ = Δ S + Δ P - Δ P*
Consumption Smoothing Irrespective of time in which income changes, consumption behavior stays the same
do not convert foreign price to domestic currency
consumption only changes if wealth changes
+ S -> appreciation (domestic currency worth more) Consumption Random Walk of Consumption Theory
Appreciation vs Depreciation Excahnge Rates changes in consumption should be unpredictable
- S -> depreciation (domestic currency worth less)
heavy fluctuations of income in a lifetime are compensated by saving and borrowing, making
amount of goods affordable with one unit of currency Life Cycle Hypothesis consumption smoothing 
P -> domestic inflation Purchasing Power implies permanent income hypothesis (Yp)
P* -> foreign inflation
Money, Exchange Rates Keynes Idea assumed consumption was correlated to disposable income
decrease in nominal exchange rate offsets increase in inflation wealth is more volatile
Relative Purchasing Power Parity Determinants of Consumption
Consumption more correlated to disposable income wealth is more difficult to measure
countries with high inflation have currencies depreciate in the long run credit constraint
Law of One Price: same good should trade at = price in every currency Private Sector Demand + r => - aggregate wealth => - consumption through wealth
1 unit of currency should have same purchasing power in every country Absolute Purchasing Power Parity Real Interest Rates borrowers: - wealth => - consumption today
+r
does not hold in practice (bigmac index) lenders: + consumption today, because IE>SE
monetary base; created by CB if K borrowed, then MC of borrowing
M0 Cost of capital = (1+r)
M0=C+R if K mine, then opportunity cost
Optimal Capital Stock
currency (bills and coins) if - MPK => + K
Highest profits when: MPK=MCK=1+r
bank deposit accounts M1 if + MPK => - K
M1 = C + (1/rr)R Monetary Aggregates Technological Progress Increase causes + slope of F(K)=> + K
M1 + bank savings deposits M2 Higher Interest Rates + r => + costly to invest => - K
larger, fixed term deposits optimal level of capital does not only depend on MPK=MCK
accounts at non-bank institutions M3 Future Value of a Firm
firm's stock prices are the best estimate of the future value of the firm
Investment
+ M2 Tobin's q definition investment as a function of stock prices
controls money and credit conditions Value of firm not = replacement cost of capital there are intangible assets that replacement cost does not take into account
provides currency (C) if q > 1: firms will invest in capital stock
Central Bank Tobin's q
commercial banks' reserves (R)
Formula and Intuition q = market value of firm/replacement cost of K if q < 1: incentive to divest (i.e sell machines)
prevents banks from increasing M1 without limit reserve ratio (rr) if q = 1: ideal
issue demand deposits + r => - q
grant loans (money creation) Factor that affect q technological progress => + q
Commercial Banks
incorporate liquid assets into economy (+ returns, + risk) future expectations of investors
new deposits created when loans are granted
Money Makers
One initial loan triggers succession of loans
Money Multiplier
each following loan will be rr x previous loan
1/rr
D = (1/rr)R
money expansion is always a multiple of reserves
Reserve Multiplier
implies indirect control of CB
+ rr => - M1
reserve ratio stable, however, if
- rr => +M1
Price stability (inflation within 0-2%)
Growth and employment
Objectives
+ growth, employment in short run
+ M1 =>
+ inflation in long run
demands stable Md and money multiplier
Monetary Targeting
hard to define which money aggregate to target
Monetary Policy
target inflation set
if forecasts predict high inflation => + i (CB) Inflation Targeting
if forecasts predict low inflation => - i (CB)
models how CB tries to achieve price and GDP/employment stability
í = natural nominal interest rate = desired i with inflation and Y stable Taylor's Rule
i = í + a(inf - inf') + b(Y-Y'/Y')