Long-Run Economic Growth

REVIEW QUESTIONS

1.What is a production function? What are some factors that can cause a nation's production function to shift over time? What do you have to know besides an economy's production function to know how much output the economy can produce?

Production function tells us the amount of output that can be produced with any given quantity of capital and labor. Factors that may cause a nations production function to shift overtime would be holding labor fixed (relationship between output and capital) and holding capital fixed (relationship between output and labor) either case the production function slopes upward, meaning a greater use of capital or labor leads to more output. In order to estimate how much output the economy can produce you'll need besides the economy's production function the supply shock it consists of a shift of production function, which implies a change in the amount of output that can be produced with given amounts of capital and labor.

2.. The production function slopes upward, but its slope declines from left to right. Give an economic interpretation of each of these properties of the production function.

The production function slopes upward from left to right. The slope of the production function reveals that, as the capital stock increases, more output can be produced. The marginal product of capital declines as the capital stock is increased. Because the marginal product of capital is the slope of the production function, the slope of the production function decreases as the capital stock is increased. The tendency for the marginal product of capital to decline as the amount of capital in use increases is called the diminishing marginal productivity of capital.

5. What is the MPN curve? How is the MPN curve related to the production function? How is it related to labor demand?

An MPN curve, marginal product of labor, is the extra output that can be produced when labor increases by one unit, with capital held constant. It can be measured as the slope of the production function relating output to labor falls as employment rises, Implying that labor also diminishes marginal productivity. It relates to labor demand because the labor demand curve is identical to the MPN curve, this is because an increase in the real wage causes firms to demand less labor, the labor demand curve slopes downward.

6. Use the concepts of income effect and substitution effect to explain why a temporary increase in the real wage increases the amount of labor supplied, but a permanent increase in the real wage may decrease the quantity of labor supplied.

Under the substitution effect, a temporary increase in real wage will cause workers to supply more labor in response to a higher reward for their work. But in the long term, the income effect come to scene; this is that as workers are becoming wealthier, they would be able to afford additional leisure time and the labor supply would decrease.

8. Define full-employment output. How is full-employment output affected by an increase in labor supply? By a beneficial supply shock?

Full-employment output, sometimes called potential output, is the level of output that firms in the economy supply when wages and prices have fully adjusted. Equivalently, full-employment output is the level of output supplied when aggregate employment equals its full employment level. As the labor supply increase and the economy continues being at full-employment, the output produced by the full-employment will also increase. When a beneficial supply shock occurs, the same quantity of full-employed people will be able to produce more output due to the shock, mostly cause by technological changes among others.

9. Why is the classical model of the labor market discussed in this chapter not very useful for studying unemployment?

The classical model of the labor market is based on the assumption that the real wage adjusts reasonably quickly to equate labor supply and labor demand.

12. What is frictional unemployment? Why is a certain amount of frictional unemployment probably necessary in a well-functioning economy?

Frictional unemployment is the one that arises as workers search for suitable jobs and firms search for suitable workers. In other words frictional unemployment arises from matching workers with jobs. A certain amount is necessary because not every job is adequate for everybody, people have to take their time to find the job in which they will be more productive and in which they Y = AK0.3N0.7.

14. Define the natural rate of unemployment and cyclical unemployment. What does negative cyclical unemployment mean?

The natural rate of unemployment is the rate of unemployment that prevails when output and employment are at their full-employment levels. The natural rate of unemployment reflects unemployment owing to frictional and structural causes. Meanwhile cyclical unemployment is the difference between the actual rate of unemployment and the natural rate of unemployment. Specifically, cyclical unemployment = u – u, where u is the actual unemployment rate and u is the natural rate. Negative cyclical unemployment is when output and employment exceed full-employment levels.

15. What is Okun’s law? If the unemployment rate increases by 2 percentage points between this year and next year, by how much will output change during the same period? Assume that the natural unemployment rate and full-employment output are constant.

Okun’s law is a law that states that the gap between an economy’s full employment output and its actual level of output increases by 2 percentage points for each percentage point the unemployment rate increases. If the unemployment rate increases by 2 percentage points between this year and next year it would be 4% increase.

ANALYTICAL PROBLEMS

2. How would each of the following affect the current level of full-employment output? Explain.

a. A large number of immigrants enter the country.

This means that the supply of labor will increase, increasing output and the number of people employed.

b. Energy supplies become depleted.

Output will decrease since energy is a necessity.

c. New teaching techniques improve the educational performance of high school seniors.

Since education is favorable for the development of technology and productivity, output will increase in the long term.

d. A new law mandates the shutdown of some unsafe forms of capital.

Output will decrease since sources of jobs and output development are being closed.

3. During the 1980s and 1990s the average rate of unemployment in Europe was high. Some economists claimed that this rate was in part the result of “real- wage rigidity,” a situation in which unions kept real wages above their market-clearing levels.

a. Accepting for the sake of argument that real wages were too high in Europe in the 1980s and 1990s, show how this situation would lead to unemployment (a situation where people who would like to work at the going wage cannot find jobs).

b.         What is the effect of real-wage rigidity on the output actually supplied by firms, relative to the output they would supply if there were no real-wage rigidity?

Real wage rigity creates a higher level of unemployment because firms can no longer pay so many jobs. Therefore less people working causes less output.

4. How would each of the following affect Helena Handbasket’s supply of labor?

a. The value of Helena’s home triples in an unexpectedly hot real estate market.

Since she would be wealthier, the income effect will enter to scene, she will be able to afford more leisure and she will reduce her supply of labor and

b. Originally an unskilled worker, Helena acquires skills that give her access to a higher-paying job.

Assume that her preferences about leisure are not affected by the change in jobs.

She would increase her supply of labor in the short-run as stated in the substitution effect, but in the long-run as her wealthy increase, she will decrease it as stated in the income effect.

c. A temporary income tax surcharge raises the percentage of her income that she must pay in taxes, for

the current year only. (Taxes are proportional to income in Helena’s country.)

Since her income will be reduced, she would reduce her supply of labor.

Macroeconomics Review. Please Comment:)

Chapter 1

Microeconomics within Macroeconomics

With in economic, macroeconomics focuses on the broad economic phenomenon.  On the other hand microeconomics is more interested on the individual player and their interactions.  

Aggregation is the process of summing individual economic variables to obtain economy-wide totals.

The international Economy

Open economy: an economy that has extensive trading and financial relationships with other national economies

Closed economy: an economy that does not interact economically with the rest of the world

Trade surplus is when you export more than you import.

Trade deficit is when you import more than you export.

Classical Versus Keynesians

Another cause for disagreement is on who drives the economy.  Does Supply drives Demand (Classical or Keynesian) or vice versa.

The Classical approach builds on “the invisible hand” of the market.  It also assumes the prices will adjust to equilibrium fairly quickly.  Thus, it generally disapproves of government intervention.

The Keynesian approach assumes the prices do not adjust so quickly.  It encourages the intervention of government at times of high unemployment.  It essence it believes that to reach equilibrium the economy will need some help form government.  

Chapter 2

 National Income Accounting: the Measurement of Production, Income and Expenditure

The National Income Accounts are an accounting framework used in measuring current economic activity. 

Three alternative approaches give the same measurements

1.         Product approach: the amount of output produced

2.         Income approach: the incomes generated by production

3.         Expenditure approach: the amount consumed. 

Using the Product Approach:

It measures economic activity by adding the market value of goods produced, excluding any goods used up in intermediate stages of production . 

Using the Income Approach:

The income approach measures economic activity by adding all income received by producers of output, including wages received by workers and profit received by owners of firms.

Using the Expenditure Approach:

The Expenditure Approach measures the activity by adding the amount spent by all ultimate users of output.  This means final product.                                                           

Why the Three Approaches Are Equivalent?

2.Any output produced (product approach) is purchased by someone (expenditure approach) and results in income to someone (income approach) The fundamental identity of national income accounting:total production = total income = total expenditure

They are all measured in the same unit and it is called the Fundamental Identity of national income accounting. 

Gross Domestic Product (GDP)

GDP is the broadest measure of aggregate economic activity.

The Product Approach to Measuring GDP

GDP (gross domestic product) is the market value of final goods and services newly produced within a nation during a fixed period of time

How do we measure the value of each product or service? Market Value: Goods are market at the price that they are sold (market value)

GNP vs. GDP:

GNP is the market value of final goods and services newly produced by domestic factors of production during a period of time.

GDP is the market value of final goods and services newly produced within the domestic territory during a period of time.

Net Factor Payment from Abroad (NFP) is defined as income paid to domestic factors of production by the rest of the world minus income paid to foreign factors of production by domestic economy.  This can be denoted mathematically as:

GDP = GNP – NFP
For countries with high remittances GNP is a more important indicator.

Chapter 3

The Production Function

Factors of production is refer to as inputs to the production process

Productivity how much output is produce for one unit of input.

There are two factors use to determine the amount of output an economy produces: Capital and labor.

Total Factor Productivity is a measure of overall effectiveness with which capital and labor are used.

The Marginal Product of Capital (MPK)

The marginal product of capital is the increase in output produced that results from a one-unit increase in the capital stock.

MPK has two properties:

The MPK is upward sloping

It has a diminishing rate

The property of diminishing rate is called the rate of diminishing marginal productivity. 

The Marginal product of Labor  :The marginal product of labor is the additional output produced by each additional unit of labor and it is nothing more than the slope of the production function.

Supply Shock : Supply shock is a change in an economy’s production function. 

There can be positive or Negative.

Examples are weather (farm), earthquake (fix), statistical analysis in quality control, inventions or innovations, etc…

The Income-Leisure Trade-off

The main goal is to maximize utility function given a budget constraint.

By looking at the marginal cost of labor like the cost of working and extra hour and the marginal benefit of leisure like the benefit of an extra hour of leisure and equating it will provide us with the labor supply.  

II.         Real Wages and Labor Supply

The real wage is the about of real income that a worker receives in exchange for giving up a unit of leisure for work.

Substitution effect of a higher real wage is the tendency of workers to supply more labor in response to higher reward for working.

Income effect of a higher real wage is the tendency of workers to supply less labor in response to becoming wealthier. 

Pure Substitution Effect: a One-Day Rise in the Real Wages

A Pure Income Effect: Wining the Lottery

The Substitution Effect and the Income Effect Together: A Long–Term Increase in the real Wage.

Substitution Effect leads to more hours of work.

Income Effect leads to less hours of work.

Labor Supply Curve

Any factor that increases the amount of labor supplied at a given level of w shifts the curve to the right.

Any factor that decreases the amount of labor supplied at a given level of w shifts the curve to the left.

Examples are:Increase in wealth, Expected future wages, Participation rate, Immigration, Working age, Minimum wage

Labor Market Equilibrium

Labor demand = Labor supply The classical model assumes real wages adjust quickly

The full-employment level of employment is achieved after the complete adjustment of wages and prices and equilibrium is reached.

Unemployment

The assumption of the labor market is that all willing workers are able to find jobs at the prevailing market wages, which is unrealistic.

Why There Always Are Unemployed People?

Because of frictional and structural unemployment the unemployment rate is never zero.

a.         Frictional UnemploymentWork and workers are not perfectly suitable: It takes time to find an decent job, and It takes time for a firm to hire a qualified employee.

Frictional unemployment is the unemployment that arises as workers search for suitable jobs and firms search for suitable workers.

b.         Structural Unemployment: Chronically unemployed are those who are unemployed a large part of the time. Structural unemployment is the long term and chronic unemployment that exists even when the economy is not in a recession.

Reasons: Unskilled or low-skill workers often are unable to obtain desirable jobs.

The reallocation of labor from industries that are shrinking, or regions that are depressed, to areas that are growing.

Okun’s Law.

Output and employment commonly move together. The observed relationship between more unemployment and less GDP becomes intuitive, since people who are out of work not only stop producing, but also usually cut back significantly on spending. Also, economic data such as high unemployment and low consumer spending may discourage investment by businesses.

Okun’s law explains how a change in unemployment impacts the economic output.

Left hand side is the percent that output will fall short from full employment output given the cyclical unemployment.

Chapter 4

Desire Consumption (C^d) is defined as the aggregate quantity of goods that households want to consume, given income and other factors that determine households’ economic opportunities.

The consumption-smoothing motive is the desire to have a relatively even pattern of consumption over time.  The rational people will avoid high borrowing or high savings.

The marginal propensity to consume (MPC) is defined as the fraction of additional current income that one consumes in the current period.

Effect of Changes in Expected Future Income

To summarize, an increase in an individual’s expected future income is likely to lead that person to increase current consumption and decrease current saving. 

Effect of Changes in the Real Interest Rate

If interest increases: One should save more, andSpend less
Reason: The reason is because each real dollar of saving in the current year grows to 1+r real dollars next year, and increase in the real interest rate means that each dollar of current saving will have a greater payoff in terms of increased future consumption.  In other words you will be compensated at a high rate!!

The two opposing effects are:

1)The substitution effect of the real interest rate on saving reflects the tendency to reduce current consumption and increase future consumption as the price of current consumption 1+r increases

2)The income effect of the real interest rate on saving reflects the change in current consumption that results when a higher real interest rate makes a consumer richer or poorer

Chapter 5

Balance of Payments Accounting

Balance of payment accounts are the records of a country’s international transactions. 

Any transaction that involves a flow of funds into the US is a credit item for the US and it is entered as a positive. Any transaction that involves a flow of funds out of the US is a debit item for the US and it is entered as a negative.

The Current Account

The current account measures a country’s trade in currently produced goods and services, along with unilateral transfers between countries.

Net unilateral transfers

Net unilateral transfers are payments from one country to another that do not correspond to the purchase of any good, service or asset.

Net unilateral transfers consist of official foreign aid and remittances. This amount is a debit item because funds flow out.

Capital and Financial Accounts Balance is the sum of the capital account balance and the financial account balance; equivalently, the sum of net assets unilaterally transferred into a country and net financial flows into a country.

The Relationship between the Current Account and the Capital and Financial Account

In each period the current account balance and the capital and financial account balance must sum to zero (plus minus an error term). 

CA + KFA = 0

The reason this holds is that every transaction involves a swap of goods, services, or assets between countries. 

Statistical discrepancy is the amount that would have to be added to the sum of the current account and the capital and financial account for this sum to reach its theoretical value of zero.

Saving and Investment in a Small Open Economy

A small open economy is an economy that is too small to affect the world real interest rate. 

The world real interest rate is the real interest rate that prevails in the international capital market, that is, the market in which individuals, business and governments borrow and lend across national borders.

Follow my blog :) Help in E-marketing:)