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Class Outline Econ2102 Professor James Morley

Lecture 1 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: james.morley@unsw.edu.au 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

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What is Macroeconomics?
Macroeconomics is the study of aggregate economic phenomena:
Long-Run Economic Growth Ina>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 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 limita>ons We will consider how macroeconomists develop and extend their models We will also consider advanced theories of Long- Run Ina>on, Consump>on, Investment, and Exchange Rate Determina>on

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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 aws, 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

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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 dierences in per capita GDP across countries. the rela>ve importance of capital per person versus total factor produc>vity in accoun>ng 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.

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.

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is a produc>vity parameter. A higher value of it mean rms 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.

CHAPTER 4 A Model of Produc>on

CHAPTER 4 A Model of Produc>on

The standard replica2on argument implies that a rm 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 prots: 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.

CHAPTER 4 A Model of Produc>on

CHAPTER 4 A Model of Produc>on

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The good that is chosen to express all prices is the numraire. The solu>on to the rms 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 factors 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.

CHAPTER 4 A Model of Produc>on

CHAPTER 4 A Model of Produc>on

Solving the Model: General Equilibrium

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

CHAPTER 4 A Model of Produc>on

CHAPTER 4 A Model of Produc>on

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The ve 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.

CHAPTER 4 A Model of Produc>on

CHAPTER 4 A Model of Produc>on

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 ve unknowns in terms of the parameters and exogenous variables.

CHAPTER 4 A Model of Produc>on

CHAPTER 4 A Model of Produc>on

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In this model, the solu>on implies rms 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.

CHAPTER 4 A Model of Produc>on

CHAPTER 4 A Model of Produc>on

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.

CHAPTER 4 A Model of Produc>on

CHAPTER 4 A Model of Produc>on

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Because all income is paid to capital or labor, there is zero prot in the economy, which veries the assump>on of perfect compe>>on and veries 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 dene output per capita (y) and capital per person (k).

CHAPTER 4 A Model of Produc>on

CHAPTER 4 A Model of Produc>on

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

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.

Note that doubling capital per person less than doubles output per person because the exponent on the input is less than one.
CHAPTER 4 A Model of Produc>on CHAPTER 4 A Model of Produc>on

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Comparing Models with Data

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

The Empirical Fit of the Production Model

Development accoun2ng is the use of a model to explain dierences 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.

CHAPTER 4 A Model of Produc>on

CHAPTER 4 A Model of Produc>on

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.

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CHAPTER 4 A Model of Produc>on

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CHAPTER 4 A Model of Produc>on

CHAPTER 4 A Model of Produc>on

Productivity Differences: Improving the Fit of the Model

The produc>vity parameter, , measures how eciently 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 t 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.

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CHAPTER 4 A Model of Produc>on

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CHAPTER 4 A Model of Produc>on

CHAPTER 4 A Model of Produc>on

Dierences in capital per person explains about one-third of the dierence 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 eciently.

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CHAPTER 4 A Model of Produc>on

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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 produc>ve (for example, educa>on). Returns to educa>on are the value of the increase in wages from addi>onal schooling. Dierences in Human capital helps predict some of the large dierences in TFP.

CHAPTER 4 A Model of Produc>on

CHAPTER 4 A Model of Produc>on

Technology
Richer countries may use more modern and thus more ecient 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-dened 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.
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CHAPTER 4 A Model of Produc>on

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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 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.
CHAPTER 4 A Model of Produc>on

In the absence of TFP, dierences the produc>on model incorrectly predicts dierences in income. Addi>onally, 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 Produc>on

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)
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CHAPTER 4 A Model of Produc>on

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