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The classical model of economics
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Economics 122aFall 2012
Agenda for next two classes:
1. The classical macro model 2. How economists measure
output/income
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Some announcements• Course is limited to those on course list on web page plus
juniors (appeals are under consideration and should be decided early next week).
• There will be an optional section on logs and math review next Friday.
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The great chasm of macroeconomics
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Classical macro:- perfect markets
-rational individuals
- flexible wages and prices
- full employment
Keynesian macro:- imperfect competition
-bounded rationality
- sticky wages and prices
- unemployment
This is our topic for today:
classical approach
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Basics of Static Classical Model: Production Theory
Classical production model. The basic model is simplest representation of the classical approach. When dynamized, it becomes the neoclassical growth model.
Factor markets: capital and labor inputs (K and L)One sector for output (Y).Aggregate production function (for real GDP, Y)What is a production function? Recipe for combining
inputs into outputs for given technology.(1) Y = F( K, L)
Standard assumptions: positive marginal product (PMP), diminishing returns (DR), constant returns to scale (CRTS):CRTS: mY = F( mK, mL)PMP: ∂Y/∂K>0; ∂Y/∂L>0DR: ∂2Y/∂K2<0; ∂2Y/∂L2<0
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Production function for popovers
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Courtesy of Florence Kling Harding , Twentieth Century Cookbook, 1921
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Potential Output
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Potential output. With exogenous labor force (LF), inherited capital (K) , unemployment at the NAIRU (u*), this gives potential output (Yp):(2) Yp = F[K, (1-u*)LF]
Potential output critical for unemployment theory and growth theory and for medium and long-run forecasts.
u* = Jones “long-run or natural rate of unemployment” = non-accelerating inflation rate of unemployment
(NAIRU) = unemployment rate at which inflation neither rises
or falls = lowest sustainable rate of unemployment = around 5-6 percent today
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Real GDP over the cycle
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12,000
12,500
13,000
13,500
14,000
14,500
15,000
2004 2005 2006 2007 2008 2009 2010 2011 2012
Real GDP (Actual)Real Potential GDP
Rea
l GD
P (b
illion
s of
200
5 $)
Large GDP “gap”
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Example: Cobb-Douglas production function
Very important production function: Cobb-Douglas (log linear)F( K, L) = AKαL1-α
Properties:MPL = ∂[AKαL1-α]/∂L=(1-α)AKαL1-α /L = (1-α)Y/L = (1-α) x APL(and similarly for MPK)
F( K, L) = 1.5L1-.5
L YMPL (discrete)
MPL (continuous/ derivative)
0.00 0.00 na1.00
1.00 1.00 0.500.41
2.00 1.41 0.350.32
3.00 1.73 0.290.27
4.00 2.00 0.25
0.00.20.40.60.81.01.21.41.61.82.0
0 0.5 1 1.5
Y, M
PL
Labor inputs (L)
Y
MPL
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Factor Markets
Factor markets: capital and labor inputs (K and L):- Capital inherited from past investments- Labor inputs exogenous (from biology, health, customs,
pharma)Real wage rate: = W/P = MPL = ∂Y/∂L = ∂[F( K, L)]/∂L (see Fig.
1)
Real rental rate on capital (like apartment rental as $ per month):
= R/P = MPK = ∂Y/∂K = ∂[F( K, L)]/∂KNational income = labor income + capital income = WL + RK
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Distribution with the Cobb-Douglas production function
National incomeY = MPL x L + MPK x K = L[(1-α)Y/L] +K[αY/K ] = Y (exhaustion of product theorem)
Shares of capital and labor:share of K = RK/Y = (αY/K ) x (K/Y) = constant = α
Why do economists like Cobb-Douglas? See next slides on historical data on factor shares.
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Incomes in the National Income Accounts
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Share, 2001 National income 93.9 13,359
Compensation of employees 51.1 8,295 62.1%Proprietors' income 14.1 1,157 8.7%Rental income of persons 6.2 410 3.1% Corporate profits after tax 9.3 1,448 10.8%Net interest and misc 4.6 527 3.9%Taxes on production and imports 6.8 1,098 8.2%
2011
Table 1.12. National Income by Type of Income[Billions of dollars]Bureau of Economic AnalysisLast Revised on: August 29, 2012
1929
Source: U.S. Bureau of Economic Analysis (www.bea.gov)
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Near-constancy of labor’s share of national income
0%
10%
20%
30%
40%
50%
60%
70%
80%
1929 1939 1949 1959 1969 1979 1989 1999 2009
Share of compensation
Share of wages
?
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Other sources of national income
-5%
0%
5%
10%
15%
20%19
2919
3219
3519
3819
4119
4419
4719
5019
5319
5619
5919
6219
6519
6819
7119
7419
7719
8019
8319
8619
8919
9219
9519
9820
0120
0420
0720
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Interest Proprietors Rental Corporate profits
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Applications of static neoclassical model
Impact of immigration: problem setImpact of foreign investment:
• Assume that foreign firms build a factory in US. What is effect in simple neoclassical model?
• Answer: Same as immigration, but reverse the factors.Impact of government debt: later in course
• What is the effect of a growing government debt?• Slightly more complicated, but might crowd out capital
stock. This then reduces output. Note effects on wages and rentals.
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What are the macroeconomic effects of
immigration?
Alfred Stieglitz
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L
W/P
MPL
Real wages and MPL: graphics
L*
(W/P)*
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L
W/P
MPL
Effect of immigration
L*
(W/P)1
(W/P)2
E1
E2
Assume immigrants are perfect substitutes for LResults:1. Wage rate falls.2. Output and national
income rise.3. Capital income rises.4. More generally, income of
substitutes fall and complements rise.
5. Empirical studies suggest that low-skilled and Hispanic workers are hurt by Mexican immigration.
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National Academy of Sciences study (The New Americans)
“Immigration over the 1980s increased the labor supply of all workers by about 4 percent. On the basis of evidence from the literature on labor demand, this increase could have reduced the wages of all competing native-born workers by about 1 or 2 percent. Meanwhile, noncompeting native-born workers would have seen their wages increase…”
“Based on previous estimates of responses of wages to changes in supply, the supply increase due to immigration lowered the wages of high school dropouts by about 5 percent…”
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What we missed at the end of last lecture…
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International macro
In a world of rapid globalization, international macro becomes increasingly important.
Role of exchange rates, international trade, currencies.
The biggest issues today are:
8. What are “global imbalances?” Why does the US have such a huge current trade deficit while China has such a large surplus? How will these resolve? 9. What is the reason for the Euro crisis? Will the Eurozone fall apart, or evolve closer to a standard fiscal union? Is disaster waiting around the corner?
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So this leads to the biggest question of them all…
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Why study macroeconomics?
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Because you may be the next Ben Bernanke – in charge of rescuing the world economy from the wreckage of some future depression!
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A puzzler for the next classAssume there are two goods (computers and shoes)
Period 1PShoes = Pcomputers = $1Qshoes = Qcomputers = 1Nominal GDP = $2
Period 2Pshoes = 1; Pcomputers = $0.01Qshoes = 1; Qcomputers = 100Nominal GDP = $2
What is the growth of real GDP from period 1 to period 2?
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