econ2102_lecture1 econ2102 lecture unsw

7/17/11

1

Econ2102 Professor James Morley

Lecture 1

Class Outline

•  Some administra>ve details •  Some “big picture” issues of Intermediate Macro

•  The Basic Neoclassical Model of Aggregate Produc>on

•  Readings: Jones Chapters 1-‐4 •  Next >me: Jones Chapter 5

Econ 2102

•  Lecturer-‐in-‐charge: Professor James Morley •  Room 434, ASB •  Phone No: 9385 3366 •  Email: [email protected] •  Consulta>on Times – Fridays 1:00-‐3:30 pm •  Course website on Blackboard

Learning and Assessment

•  Textbook: Macroeconomics 2nd Edi>on, Charles I. Jones, Norton Press – Do readings before class!

•  Lectures – Complement, not subs>tute for textbook

•  Tutorials – Apply concepts from textbook and lectures

•  Problem Sets and Final Exam – Problem Sets due on 8/8 and 19/9

7/17/11

2

What is Macroeconomics?

•  Macroeconomics is the study of aggregate economic phenomena: – Long-‐Run Economic Growth –  Infla>on – The Business Cycle

How do macroeconomists explain these phenomena?

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

•  Observa>on and Theory •  Models and Predic>on •  In Intermediate Macro, we focus on models

Why focus on models?

•  Models make the assump>ons and predic>ons of theories precise, allowing us to beger evaluate compe>ng theories

•  This allows us to beger understand the poten>al and limita>ons of different 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 limita>ons

•  We will consider how macroeconomists develop and extend their models

•  We will also consider advanced theories of Long-‐Run Infla>on, Consump>on, Investment, and Exchange Rate Determina>on

7/17/11

3

The Structure of Models The Key Dis>nc>on

•  The dis>nc>on between exogenous and endogenous variables is fundamental

•  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

Long-‐Run Growth

•  Measured as an increase in Real GDP Per Capita •  Despite flaws, Real GDP Per Capita s>ll captures bulk of varia>on in standards of living across countries and across >me

•  The Neoclassical Aggregate Produc>on Func>on 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 produc>on to explain economic growth over >me

7/17/11

4

Chapter 4 – A Model of Produc>on •  In this chapter, we learn: –  how to set up and solve a macroeconomic model. –  how a produc>on func>on can help us understand differences in per capita GDP across countries.

–  the rela>ve importance of capital per person versus total factor produc>vity in accoun>ng for these differences.

–  the relevance of “returns to scale” and “diminishing marginal products.”

–  how to look at economic data through the lens of a macroeconomic model.

The Basic Neoclassical Model of Aggregate Produc>on

•  Consider a single, closed economy, with only one consump>on good.

Setting Up the Model

•  A certain number of laborers make the consump>on good.

•  A certain number of machines are used to produce the good.

•  Variables with a bar are parameters. •  A produc>on func>on tells how much output can be produced given any number of inputs, laborers, and machines.

7/17/11

5

CHAPTER 4 A Model of Produc>on

•  is a produc>vity parameter. •  A higher value of it mean firms can produce more, all else equal

•  The Cobb-‐Douglas produc2on func2on is the par>cular produc>on func>on that takes the form of

•  We assume = 1/3.


•  A produc>on func>on exhibits constant returns to scale if doubling each input exactly doubles output.

•  If the exponents on the inputs sum to 1, the func>on has constant returns to scale.

•  If the exponents on the inputs sum to more than 1, the func>on has increasing returns to scale.

•  If the exponents on the inputs sum to less than 1, the func>on has decreasing returns to scale.


•  The standard replica2on argument implies that a firm can build an iden>cal factory, hire iden>cal workers and capital, and can exactly double produc>on.

•  The standard replica>on argument implies constant returns to scale.

Allocating Resources

•  Firms choose the amount of capital and labor to use in produc>on by maximizing profits: output minus costs.

•  The rental rate of capital and the wage rate are taken as given under perfect compe>>on.

•  The price of the output is normalized to one.


7/17/11

6


•  The good that is chosen to express all prices is the numéraire.

•  The solu>on to the firm’s maximiza>on problem is to hire capital un>l the marginal product of labor exactly equals the rental rate and to hire labor un>l the marginal product of labor exactly equals the wage rate.

•  The marginal product of capital (MPK) is the extra amount of output that is produced when one unit of capital is added, holding all other inputs constant.


•  If the produc>on func>on has constant returns to scale in capital and labor, it will exhibit decreasing returns to scale in capital alone.

•  In a Cobb-‐Douglas produc>on func>on, the marginal product of an input is equal to the product of the factor’s exponent >mes the average amount that each unit of the factor produces.

•  The marginal product of labor (MPL) is the extra amount of output that is produced when one un>l of labor is added, holding all other inputs constant.


Solving the Model: General Equilibrium

•  The model has five equa>ons and five endogenous variables: – output –  the amount of capital –  the amount of labor –  the wage –  the rental price of capital


7/17/11

7


•  The five equa>ons are as follows: –  The produc>on func>on. –  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 are the produc>vity parameter, and the exogenous supplies of capital and labor.



•  A solu>on to the model is called an equilibrium.

•  A general equilibrium is the solu>on to the model when more than a single market clears.

•  A solu>on to the model is a new set of equa>ons that express the five unknowns in terms of the parameters and exogenous variables.


7/17/11

8

CHAPTER 4 A Model of Produc>on CHAPTER 4 A Model of Produc>on

•  In this model, the solu>on implies firms employ all the supplied capital and labor in the economy, the produc>on func>on is evaluated with the given supply of inputs, and the wage and rental rate are the MPL and MPK evaluated with Y, K, and L in equilibrium.

Interpreting the Solution

•  If an economy is endowed with more machines or people, it will produce more.

•  The equilibrium wage is propor>onal to output per worker and the equilibrium rental rate is propor>onal to output per capital.


•  Two-‐thirds of produc>on is paid to labor and one-‐third of produc>on is paid to capital.

•  The factor shares are the payments to labor and capital and are equal to the exponents on the input in the Cobb-‐Douglas func>on.

•  The one-‐third and two-‐thirds division of factor shares holds true in United States empirical evidence.

7/17/11

9


•  Because all income is paid to capital or labor, there is zero profit in the economy, which verifies the assump>on of perfect compe>>on and verifies that produc>on equals spending equals income.

Analyzing the Production Model

•  Note that per capita means per person, while per worker means per member of the labor force.

•  In this model, the two are equal. •  We can perform a change of variables to define output per capita (y) and capital per person (k).



•  Output per person equals the produc>vity parameter >mes capital per person raised to the one-‐third power.

•  Note that doubling capital per person less than doubles output per person because the exponent on the input is less than one.


•  an important lesson about what makes a country rich or poor: Output per person is higher if the produc>vity parameter is higher or if the amount of capital per person is higher.

7/17/11

10

Comparing Models with Data

•  The model is a simplifica>on of reality, so we must verify whether it fits the data well.


The Empirical Fit of the Production Model

•  Development accoun2ng is the use of a model to explain differences in incomes across countries.

•  If we set the produc>vity parameter to 1, then output per person equals capital per person raised to the one-‐third power.



•  Diminishing returns to capital implies that countries with a low amount of capital have a high MPK but countries with a lot of capital cannot raise GDP per capita by much through the accumula>on of more capital.

•  If the produc>vity parameter is 1, the model over-‐predicts GDP per capita.

•  Magnitudes are predicted incorrectly and several rich countries are even richer than they should be.


7/17/11

11


Productivity Differences: Improving the Fit of the Model

•  The produc>vity parameter, , measures how efficiently countries are using their factor inputs and is oqen called total factor produc>vity (TFP).

•  If TFP is no longer equal to 1, we can obtain a beger fit of the model.


•  However, data on TFP is not collected. Nonetheless, it can be calculated because we have data on output and capital per person.

•  Thus because TFP is calculated assuming that the model holds, TFP is referred to as the “residual.”

•  A lower level of TFP implies that for any given level of capital per person, workers produce less output than a country with higher TFP.

7/17/11

12



•  Differences in capital per person explains about one-‐third of the difference in output per person between the richest and poorest countries, while TFP explains the remaining two-‐thirds.

•  Thus, rich countries are rich because they have more capital per person, but more importantly, they use labor and capital more efficiently.

7/17/11

13

Understanding TFP Differences

•  Why are some countries more efficient at using capital and labor?


Human Capital

•  Human capital is the stock of skills that individuals accumulate to make them more produc>ve (for example, educa>on).

•  Returns to educa>on are the value of the increase in wages from addi>onal schooling.

•  Differences in Human capital helps predict some of the large differences in TFP.


Technology

•  Richer countries may use more modern and thus more efficient technologies than poor countries.


Institutions

•  Even if human capital and technologies are beger in rich countries, why do they have these advantages?

•  Ins>tu>ons refer to property rights, the rule of law, government systems, and contract enforcement, among many other items.

•  Well-‐defined ins>tu>ons and laws create a climate for economic growth that is much beger than an environment with corrupt and uncertain ins>tu>ons.


7/17/11

14

Evaluating the Production Model

•  Per capita GDP is higher if capital per person is higher and if factors are used more efficiently.

•  Constant returns to scale imply that output per person can be wrigen as a func>on 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.


•  In the absence of TFP, differences the produc>on model incorrectly predicts differences in income.

•  Addi>onally, the model does not provide an answer as to why countries have different TFP levels.

•  I.e., it has a limited ability to predict “out of sample”

Policy Implications?

•  Should policymakers focus on capital accumula>on as a way to close the gap between rich and poor countries?

•  Or should they focus on Human capital and/or ins>tu>ons?


Summary •  The basic neoclassical model of aggregate produc>on suggests the level of economic development depends on the endowment of capital

•  However, varia>on in capital across countries only explains about 1/3 of the the varia>on in economic development

•  TFP “explains” the rest of the varia>on •  Economic research suggests that TFP can be related to the level of Human Capital and to Ins>tu>ons

•  Next >me: capital accumula>on and economic growth (the Solow-‐Swan Model)


econ2102_lecture1 econ2102 lecture unsw

Documents