Macroeconomics Powerpoint

7/28/2019 Macroeconomics Powerpoint

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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 0


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C H A P T E R 3

The Economy in the Long Run:The Classical Market Clearing ModelLearning object ives

Understand that the difference between the long run andthe very long run.

Understand that over the long run, all factors ofproduction are fully employed.

Understand that in the Classical model equilibrium outputdepends on equilibrium labour use.

Understand that the demand for goods and services isbased on spending by the various sectors of theeconomy.

Understand that in the long run Classical model, the pricelevel is determined by the level of money supply.

PowerPoint slides prepared by Marc PrudHomme, University of OttawaCopyright 2005 McGraw-Hill Ryerson Ltd.


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The Supply of Goods and Services

o Output is assumed produced through a production

function, which combines factors of production:

o K: capital

o N: labour

1) Y = AF(K , N)

o A : Level of technology (or productivity)

o Cobb-Douglas Production function:

2) Y= AKN1 -

o : capitals share of income

o 1 - : labours share of incomeo Canadas production function:

3) Y= AK0.3 N0.7

C

hapter3:TheEc

onomyintheLongRun

General Form of the Production Function


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Changes in Factor ProductivityBOX

3-1Percent Change in Total Factor Productivity, 1976-2002


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o Two Assumptions:o A is ignored

o Ignore effects of capital change on full employment

output

o

The amount of output produced depends on theamount of labour input.

o In 2002: Y= 18.7 x (949.90.3) N0.7

C

hapter3:TheEconomyintheLongRun

Production Function in the Long Run

Y = F(K,N) (5)


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Outp

ut,Y(billionso

f1997dollars)

Labour, N(millions)0 5.0 10.0

C


Figure 3-1: Production Function with Fixed Capital and Technology

5 more units

of labour

286.1 more units

of output

A458.0

B

744.1

0

300.0

600.0

900.0

1200.0

Theproduct ion

funct ion

relates th e

amount of

outpu t that can

be produced

using v ar ious

amounts of the

labour input ,

hold ing c api tal

an dtechnology

constant .


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o Marginal Product of Labour (MPN): Theamount that output increases for eachadditional unit increase in labour input.

o Diminishing Marginal Product of Labour:

As labour use increases, the amount of

extra output that is gained from anincrease in labour input becomes smaller.

Marginal Product of Labour and Labour DemandC



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M

arginalProduct

Labour

MPN

N

MPN

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Figure 3-2: Marginal Product of Labour Curve

The MPN curve is

downward

sloping , as each

addi t ional uni t of

labour contr ibutes

less to o utput

than the previousunit did . This is

cal led the

dimin ish ing

marg inal produc t

of labou r.


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o Marginal Cost of Labour (W): The amount paid bythe firm for an extra unit of output orThe nominalwage that must be paid to the extra unit of labourthat must be hired.

o Marginal benefit to the firm (or the value of themarginal product): The value of the additional unitof output that is produced by the additional unitof labour.

W = MPNx P (7)w = MPN (8)

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Figure 3-3: Demand for Labour Curve

RE

ALWAGE,M

PN

Labour

W

N

ND

Thedemand for

labour cu rveis

der ived from the

con di t ion that the

marg inal produ ct

of labour equals

the real wage. It is

downward sloping

due to the

dimin ish ing-

returns property

of the product ion

funct ion.

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o Marginal benefit of working: The marginal benefitof working an extra hour is measured by howmuch this extra hour of work will increaseconsumption. The marginal benefit of working anextra hour is measured by the real wage.

o Marginal cost of working: The marginal cost ofworking an extra hour is that the worker mustgive up other activities, which economists call

Leisure.Workers will supply labour up to thepoint where the marginal benefit from an extrahour of work, measured by the real wage, equalsthe marginal cost of giving up an extra hour ofleisure.

The Supply of Labour Chapter3:TheEconomyintheLon

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REALWAGE,M

PN

Labour

W

N

NSThelabour

supply curveis

upward s lop ing,

ref lect ing th e

assumpt ion that

the high er realwage wi l l induc e

workers to g ive

up more leisure

and work more

hours .

C


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Figure 3-4: Labour Supply Curve


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o Full employment: Occurs when all members ofthe labour force are employed; individuals notworking are not in the labour force and thereforeare not counted as being unemployed.

Equilibrium in the Labour Market Chapter3:TheEconomyintheLon

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Y* = F(K,N*) (9)


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R

EALWAGE,MPN

Labour

W

N

NS

ND

W*

N*

Given that the

real wage m oves

quick ly to

ensure constant

market

equi l ibr ium, the

equi l ibr ium

amount of

emplo yment, N*,

represents ful l

employment in

the labou r

market .

C


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Figure 3-5: Labour Supply Curve


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PRICELEVEL

OUTPUT

P

YY*

In the long run ,

fu l l employment

output d epends

only on the

product ion

funct ion and is

independent ofthe pric e level.

Therefore, the

AS curve is

vert ical at the

level of ful l

employment

output .

C


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Figure 3-6: Classical Supply Curve

S


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The Demand for Goods and Services

o Rate of time preference: The rate at which you arewilling to give up consumption today if you arecompensated by increased consumption in thefuture.

o Rate of interest: Return on an investmentmeasured in dollars of constant value; roughlyequal to the difference between the nominalinterest rate and the rate of inflation.

o Private savings (SP): Saving by individuals, byfamilies, and by firms; saving by everyone otherthan government.

Consumption and Savings Chapter3:TheEconomyintheLon

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RealInterestRat

e

Savings

r

S

SP

Thesav ings

curveshows the

amount

consum ers are

wil l ing to save

for each real

interest rate.

Chapter3:TheEconomyintheLon

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Figure 3-7: Savings Curve

The curve

s lopes upward,

as we assume

that an

increased return

on savings (the

real rate of

interest) makes

current

consumpt ion

less attract ive.


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RealinterestRate

Investment

r

I

I

The desire of a

f i rm to bui ld

mo re machin ery

and equipm ent,

which is

investmentspending,

depends

negat ively o n

the real rate of

interest.


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Figure 3-8: Investment Demand Curve


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o Consumers by their savings are suppliers of funds andbusinesses by their borrowing are demanders of funds.

Equilibrium: Saving Equals Investment

o Equilibrium: Savings equals Investment.

o (10)Y = C + I + Gis the national income identity

o (11)Y - C - G = I o (12)YD = Y + TR - TA

o (13)(YD - C) +(TA - TR - G) = I

o S= SP+ SG= I

o TA - TR - Gis government saving


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ro

Io = So


RealInteres

tRate

Savings, Investment

r

S, I

S

For aggregate

demand

equi l ibr ium, tota l

savings equals

investment.

Total saving s is

compo sed ofpr ivate sector

savings and

government

savings in terms

of the bud getary

surplus or

defici t .I


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Figure 3-9: Savings and Investment


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ro

Io= So

r1

I1= S1


RealInterest

Rate

Savings

r

S

When the

government

runs a budget

def ic i t ,

government

sav ings is

negative. The S

curve curveshi f ts to the left .

The result is that

the governm ent

bud get defic i t

causes a higher

real interest rate

and lower tota l

savings.I

S

S


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Figure 3-10: Effects of a Government Budget Deficit


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Figure 3-11: Effects of the Canadian Budget Deficits, 1972-2002


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The Money Stock, the Price Level, and the Inflation Rate

o Money is a medium of exchange as seen by the quantity equation:

o (14)MV = PT

o M: Money supply (Money stock)

o V: Velocity of circulationo P: Average price of all transactions

o T: All the real transactions in the economy

o PT: Number of dollars exchanged per period

o

(15)V = PT/Mo V: measures the speed with which money circulates in the

economy.

Money Chapter3:TheEconomyintheLon

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o Using Yas a proxy forT

Money (contd)

o The demand for money is expressed in terms ofreal money

o The supply for money is expressed in terms of

real money and is determined by the centralbank


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MV P (15)

DM

P kY (16)

M

P= kY (17)


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o In equilibrium

o IfV= 1/k and Vis constant

o The Quantity Theory of Moneypredicts


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Money (contd)

M1

k

= P (15)

MV = PY (20)

M =P (21)


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o The Quantity Theory of Moneyin dynamic terms

Money Growth and Inflation

o Because velocity is assumed constant andbecause real income changes only due tochanges in the production process

Chapter3:TheEco

nomyintheLon

gRun%M = %P (23)

%M +%V = %P +%Y (22)


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Chapter3:TheEco

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Figure 3-12: Rate of Growth of Money and the Inflation Rate, 1880-2000 (Decade

Averages)


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o The Real Rate of Interesto (24)r = i -o (25)i = r +

o

In the long run, the inflation rate has twocomponents:o Real return (r):your ability to purchase goods and

services

o Inflation rate (): Compensation for the change inpurchasing power.

o The Fisher Effect: A long run increase in theinflation rate will increase the nominal interestrate, so that the real interest rate will not changedue to inflation.

The Real Rate of Interest in the Long Run Chapter3:TheEco

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Chapter Summary

In the long run, the Classical model states that all factorsof production are fully employed and that prices areflexible.

The Classical model has three ingredients: supply ofgoods and services, demand for goods and services, andthe quantity theory of money.

Aggregate supply is determined by the productionfunction.

Labour demand depends on the marginal product oflabour, the supply depends on workers choosingbetween work and leisure.

Aggregate demand determines the allocation of incomeamong consumption, investment, government spending,and next export spending.

Chapter3:TheEco

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Chapter Summary (contd)

Consumers choose between current consumption andsavings.

Government savings is measured by the budgetary deficitor surplus.

In equilibrium, total savings equals investment.

In the long run, the quantity theory of money predicts thatthe price level is determined by the level of the stock ofmoney.

In the long run, changes in the nominal money stock haveno real effect on variables.

The Fisher effect states that a change in the inflation ratewill bring about a change in the nominal interest rate inthe long run.

Chapter3:TheEco

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The End

Chapter3:TheEco

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