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MACROECONOMICS

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MACROECONOMICS

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    1. The material in this chapter is the basis of much of the remaining material in this book. So, the time your students spend mastering this material will pay dividends throughout the semester. The 7th edition contains a new FYI box on the financial system and the crisis of 2008. I’ve added slides corresponding to this material. The material in this chapter is the basis of much of the remaining material in this book. So, the time your students spend mastering this material will pay dividends throughout the semester.

    2. In this chapter, you will learn: what determines the economy’s total output/income how the prices of the factors of production are determined how total income is distributed what determines the demand for goods and services how equilibrium in the goods market is achieved

    3. 3 Outline of model A closed economy, market-clearing model Supply side factor markets (supply, demand, price) determination of output/income Demand side determinants of C, I, and G Equilibrium goods market loanable funds market It’s useful for students to keep in mind the “big picture” as they learn the individual components of the model in the following slides. It’s useful for students to keep in mind the “big picture” as they learn the individual components of the model in the following slides.

    4. 4 Factors of production K = capital: tools, machines, and structures used in production L = labor: the physical and mental efforts of workers In the simple model of this chapter, we think of capital as plant & equipment. In the real world, capital also includes inventories and residential housing, as discussed in Chapter 2. Students may have learned in their principles course that “land” or “land and natural resources” is an additional factor of production. In macro, we mainly focus on labor and capital, though. So, to keep our model simple, we usually omit land as a factor of production, as we can learn a lot about the macroeconomy despite the omission of land. In the simple model of this chapter, we think of capital as plant & equipment. In the real world, capital also includes inventories and residential housing, as discussed in Chapter 2. Students may have learned in their principles course that “land” or “land and natural resources” is an additional factor of production. In macro, we mainly focus on labor and capital, though. So, to keep our model simple, we usually omit land as a factor of production, as we can learn a lot about the macroeconomy despite the omission of land.

    5. 5 The production function: Y = F(K,L) shows how much output (Y ) the economy can produce from K units of capital and L units of labor reflects the economy’s level of technology exhibits constant returns to scale

    6. 6 Returns to scale: A review Initially Y1 = F (K1 , L1 ) Scale all inputs by the same factor z: K2 = zK1 and L2 = zL1 (e.g., if z = 1.2, then all inputs are increased by 20%) What happens to output, Y2 = F (K2, L2 )? If constant returns to scale, Y2 = zY1 If increasing returns to scale, Y2 > zY1 If decreasing returns to scale, Y2 < zY1 This review includes 7 slides. If you’d like to shorten this chapter, you might consider skipping a few of these slides. This review includes 7 slides. If you’d like to shorten this chapter, you might consider skipping a few of these slides.

    7. 7 Returns to scale: Example 1

    8. 8 Returns to scale: Example 2

    9. 9 Returns to scale: Example 3

    10. 10 Assumptions Technology is fixed. The economy’s supplies of capital and labor are fixed at Emphasize that “K” and “L” (without bars on top) are variables - they can take on various magnitudes. On the other hand, “Kbar” and “Lbar” are specific values of these variables. Hence, “K = Kbar” means that the variable K equals the specific amount Kbar. Regarding the assumptions: In chapters 7 and 8 (the Economic Growth chapters), we will relax these assumptions: K and L will grow in response to investment and population growth, respectively, and the level of technology will increase over time. Emphasize that “K” and “L” (without bars on top) are variables - they can take on various magnitudes. On the other hand, “Kbar” and “Lbar” are specific values of these variables. Hence, “K = Kbar” means that the variable K equals the specific amount Kbar. Regarding the assumptions: In chapters 7 and 8 (the Economic Growth chapters), we will relax these assumptions: K and L will grow in response to investment and population growth, respectively, and the level of technology will increase over time.

    11. 11 Determining GDP Output is determined by the fixed factor supplies and the fixed state of technology: Again, emphasize that “F(Kbar,Lbar)” means we are evaluating the function at a particular combination of capital and labor. The resulting value of output is called “Ybar”. Again, emphasize that “F(Kbar,Lbar)” means we are evaluating the function at a particular combination of capital and labor. The resulting value of output is called “Ybar”.

    12. 12 The distribution of national income determined by factor prices, the prices per unit firms pay for the factors of production wage = price of L rental rate = price of K Recall from chapter 2: the value of output equals the value of income. The income is paid to the workers, capital owners, land owners, and so forth. We now explore a simple theory of income distribution. Recall from chapter 2: the value of output equals the value of income. The income is paid to the workers, capital owners, land owners, and so forth. We now explore a simple theory of income distribution.

    13. 13 Notation W = nominal wage R = nominal rental rate P = price of output W /P = real wage (measured in units of output) R /P = real rental rate It might be worthwhile to refresh students’ memory about nominal and real variables. The nominal wage & rental rate are measured in currency units. The real wage is measured in units of output. To see this, suppose W = $10/hour and P = $2 per unit of output. Then, W/P = ($10/hour) / ($2/unit of output) = 5 units of output per hour of work. It’s true, the firm is paying the workers in money units, not in units of output. But, the real wage is the purchasing power of the wage - the amount of stuff that workers can buy with their wage. It might be worthwhile to refresh students’ memory about nominal and real variables. The nominal wage & rental rate are measured in currency units. The real wage is measured in units of output. To see this, suppose W = $10/hour and P = $2 per unit of output. Then, W/P = ($10/hour) / ($2/unit of output) = 5 units of output per hour of work. It’s true, the firm is paying the workers in money units, not in units of output. But, the real wage is the purchasing power of the wage - the amount of stuff that workers can buy with their wage.

    14. 14 How factor prices are determined Factor prices are determined by supply and demand in factor markets. Recall: Supply of each factor is fixed. What about demand? Since the distribution of income depends on factor prices, we need to see how factor prices are determined. Each factor’s price is determined by supply and demand in a market for that factor. For instance, supply and demand for labor determine the wage. Since the distribution of income depends on factor prices, we need to see how factor prices are determined. Each factor’s price is determined by supply and demand in a market for that factor. For instance, supply and demand for labor determine the wage.

    15. 15 Demand for labor Assume markets are competitive: each firm takes W, R, and P as given. Basic idea: A firm hires each unit of labor if the cost does not exceed the benefit. cost = real wage benefit = marginal product of labor

    16. 16 Marginal product of labor (MPL ) definition: The extra output the firm can produce using an additional unit of labor (holding other inputs fixed): MPL = F (K, L +1) – F (K, L)

    17. 17 MPL and the production function (Figure 3-3 on p.52) It’s straightforward to see that the MPL = the prod function’s slope: The definition of the slope of a curve is the amount the curve rises when you move one unit to the right. On this graph, moving one unit to the right simply means using one additional unit of labor. The amount the curve rises is the amount by which output increases: the MPL.(Figure 3-3 on p.52) It’s straightforward to see that the MPL = the prod function’s slope: The definition of the slope of a curve is the amount the curve rises when you move one unit to the right. On this graph, moving one unit to the right simply means using one additional unit of labor. The amount the curve rises is the amount by which output increases: the MPL.

    18. 18 Diminishing marginal returns As a factor input is increased, its marginal product falls (other things equal). Intuition: Suppose ?L while holding K fixed ? fewer machines per worker ? lower worker productivity Tell class: Many production functions have this property. This slide introduces some short-hand notation that will appear throughout the PowerPoint presentations of the remaining chapters: The up and down arrows mean increase and decrease, respectively. The symbol “?” means “causes” or “leads to.” Hence, the text after “Intuition” should be read as follows: “An increase in labor while holding capital fixed causes there to be fewer machines per worker, which causes lower productivity.” Many instructors use this type of short-hand (or something very similar), and it’s much easier and quicker for students to write down in their notes. Tell class: Many production functions have this property. This slide introduces some short-hand notation that will appear throughout the PowerPoint presentations of the remaining chapters: The up and down arrows mean increase and decrease, respectively. The symbol “?” means “causes” or “leads to.” Hence, the text after “Intuition” should be read as follows: “An increase in labor while holding capital fixed causes there to be fewer machines per worker, which causes lower productivity.” Many instructors use this type of short-hand (or something very similar), and it’s much easier and quicker for students to write down in their notes.

    19. 19 MPL and the demand for labor It’s easy to see that the MPL curve is the firm’s L demand curve. Let L* be the value of L such that MPL = W/P. Suppose L < L*. Then, benefit of hiring one more worker (MPL) exceeds cost (W/P), so firm can increase profits by hiring one more worker. Instead, suppose L > L*. Then, the benefit of the last worker hired (MPL) is less than the cost (W/P), so firm should reduce labor to increase its profits. When L = L*, then firm cannot increase its profits either by raising or lowering L. Hence, firm hires L to the point where MPL = W/P. This establishes that the MPL curve is the firm’s labor demand curve. It’s easy to see that the MPL curve is the firm’s L demand curve. Let L* be the value of L such that MPL = W/P. Suppose L < L*. Then, benefit of hiring one more worker (MPL) exceeds cost (W/P), so firm can increase profits by hiring one more worker. Instead, suppose L > L*. Then, the benefit of the last worker hired (MPL) is less than the cost (W/P), so firm should reduce labor to increase its profits. When L = L*, then firm cannot increase its profits either by raising or lowering L. Hence, firm hires L to the point where MPL = W/P. This establishes that the MPL curve is the firm’s labor demand curve.

    20. 20 The equilibrium real wage The labor supply curve is vertical: We are assuming that the economy has a fixed quantity of labor, Lbar, regardless of whether the real wage is high or low. Combining this labor supply curve with the demand curve we’ve developed in previous slides shows how the real wage is determined. The labor supply curve is vertical: We are assuming that the economy has a fixed quantity of labor, Lbar, regardless of whether the real wage is high or low. Combining this labor supply curve with the demand curve we’ve developed in previous slides shows how the real wage is determined.

    21. 21 Determining the rental rate We have just seen that MPL = W/P. The same logic shows that MPK = R/P: diminishing returns to capital: MPK ? as K ? The MPK curve is the firm’s demand curve for renting capital. Firms maximize profits by choosing K such that MPK = R/P. In our model, it’s easiest to think of firms renting capital from households (the owners of all factors of production). R/P is the real cost of renting a unit of K for one period of time. In the real world, of course, many firms own some of their capital. But, for such a firm, the market rental rate is the opportunity cost of using its own capital instead of renting it to another firm. Hence, R/P is the relevant “price” in firms’ capital demand decisions, whether firms own their capital or rent it. In our model, it’s easiest to think of firms renting capital from households (the owners of all factors of production). R/P is the real cost of renting a unit of K for one period of time. In the real world, of course, many firms own some of their capital. But, for such a firm, the market rental rate is the opportunity cost of using its own capital instead of renting it to another firm. Hence, R/P is the relevant “price” in firms’ capital demand decisions, whether firms own their capital or rent it.

    22. 22 The equilibrium real rental rate The previous slide used the same logic behind the labor demand curve to assert that the capital demand curve is the same as the downward-sloping MPK curve. The supply of capital is fixed (by assumption), so the supply curve is vertical. The real rental rate (R/P) is determined by the intersection of the two curves. The previous slide used the same logic behind the labor demand curve to assert that the capital demand curve is the same as the downward-sloping MPK curve. The supply of capital is fixed (by assumption), so the supply curve is vertical. The real rental rate (R/P) is determined by the intersection of the two curves.

    23. 23 The Neoclassical Theory of Distribution states that each factor input is paid its marginal product a good starting point for thinking about income distribution

    24. 24 How income is distributed to L and K total labor income = The last equation follows from Euler’s theorem, discussed in text on p. 55. The last equation follows from Euler’s theorem, discussed in text on p. 55.

    25. The ratio of labor income to total income in the U.S., 1960-2007 This graph appears in the textbook as Figure 3-5 on p.59. Source: www.bea.govThis graph appears in the textbook as Figure 3-5 on p.59. Source: www.bea.gov

    26. 26 The Cobb-Douglas Production Function The Cobb-Douglas production function has constant factor shares: a = capital’s share of total income: capital income = MPK x K = a Y labor income = MPL x L = (1 – a )Y The Cobb-Douglas production function is: where A represents the level of technology.

    27. 27 The Cobb-Douglas Production Function Each factor’s marginal product is proportional to its average product: These formulas can be derived with basic calculus and algebra. These formulas can be derived with basic calculus and algebra.

    28. 28 Labor productivity and wages Theory: wages depend on labor productivity U.S. data: The table shows the average annual rates of productivity and real wage growth in each time period. Source: Economic Report of the President 2008 http://www.gpoaccess.gov/eop/tables08.html and US Department of Commerce http://www.bls.gov/news.release/prod2.t02.htm The table shows the average annual rates of productivity and real wage growth in each time period. Source: Economic Report of the President 2008 http://www.gpoaccess.gov/eop/tables08.html and US Department of Commerce http://www.bls.gov/news.release/prod2.t02.htm

    29. 29 Outline of model A closed economy, market-clearing model Supply side factor markets (supply, demand, price) determination of output/income Demand side determinants of C, I, and G Equilibrium goods market loanable funds market We’ve now completed the supply side of the model. We’ve now completed the supply side of the model.

    30. 30 Demand for goods & services Components of aggregate demand: C = consumer demand for g & s I = demand for investment goods G = government demand for g & s (closed economy: no NX ) “g & s” is short for “goods & services”“g & s” is short for “goods & services”

    31. 31 Consumption, C def: Disposable income is total income minus total taxes: Y – T. Consumption function: C = C (Y – T ) Shows that ?(Y – T ) ? ?C def: Marginal propensity to consume (MPC) is the change in C when disposable income increases by one dollar. Again, we are using the short-hand notation that will appear throughout the remaining PowerPoints: ?X ? ?Y means “an increase in X causes a decrease in Y.” Please feel free to edit slides if you wish to substitute other notation. Again, we are using the short-hand notation that will appear throughout the remaining PowerPoints: ?X ? ?Y means “an increase in X causes a decrease in Y.” Please feel free to edit slides if you wish to substitute other notation.

    32. 32 The consumption function

    33. 33 Investment, I The investment function is I = I (r ), where r denotes the real interest rate, the nominal interest rate corrected for inflation. The real interest rate is the cost of borrowing the opportunity cost of using one’s own funds to finance investment spending So, ?r ? ?I

    34. 34 The investment function

    35. 35 Government spending, G G = govt spending on goods and services. G excludes transfer payments (e.g., social security benefits, unemployment insurance benefits). Assume government spending and total taxes are exogenous: It might be useful to remind students of the meaning of the terms “exogenous” and “transfer payments.” It might be useful to remind students of the meaning of the terms “exogenous” and “transfer payments.”

    36. 36 The market for goods & services Aggregate demand: Aggregate supply: Equilibrium: The real interest rate adjusts to equate demand with supply. In the equation for the equilibrium condition, note that the real interest rate is the only variable that doesn’t have a “bar” over it – it’s the only endogenous variable in the equation, and it adjusts to equate the demand and supply in the goods market. When the full slide is showing, before you advance to the next one, you might want to note that the interest rate is important in financial markets as well, so we will next develop a simple model of the financial system. In the equation for the equilibrium condition, note that the real interest rate is the only variable that doesn’t have a “bar” over it – it’s the only endogenous variable in the equation, and it adjusts to equate the demand and supply in the goods market. When the full slide is showing, before you advance to the next one, you might want to note that the interest rate is important in financial markets as well, so we will next develop a simple model of the financial system.

    37. 37 The loanable funds market A simple supply-demand model of the financial system. One asset: “loanable funds” demand for funds: investment supply of funds: saving “price” of funds: real interest rate

    38. 38 Demand for funds: Investment The demand for loanable funds… comes from investment: Firms borrow to finance spending on plant & equipment, new office buildings, etc. Consumers borrow to buy new houses. depends negatively on r, the “price” of loanable funds (cost of borrowing).

    39. 39 Loanable funds demand curve

    40. 40 Supply of funds: Saving The supply of loanable funds comes from saving: Households use their saving to make bank deposits, purchase bonds and other assets. These funds become available to firms to borrow to finance investment spending. The government may also contribute to saving if it does not spend all the tax revenue it receives.

    41. 41 Types of saving private saving = (Y – T ) – C public saving = T – G national saving, S = private saving + public saving = (Y –T ) – C + T – G = Y – C – G After showing definition of private saving, - give the interpretation of the equation: private saving is disposable income minus consumption spending - explain why private saving is part of the supply of loanable funds: Suppose a person earns $50,000/year, pays $10,000 in taxes, and spends $35,000 on goods and services. There’s $5000 remaining. What happens to that $5000? The person might use it to buy stocks or bonds, or she might put it in her savings account or money market deposit account. In all of these cases, this $5000 becomes part of the supply of loanable funds in the financial system. After displaying public saving, explain the equation’s interpretation: public saving is tax revenue minus government spending. Notice the analogy to private saving – both concepts represent income less spending: for the private household, income is (Y-T) and spending is C. For the government, income is T and spending is G. After showing definition of private saving, - give the interpretation of the equation: private saving is disposable income minus consumption spending - explain why private saving is part of the supply of loanable funds: Suppose a person earns $50,000/year, pays $10,000 in taxes, and spends $35,000 on goods and services. There’s $5000 remaining. What happens to that $5000? The person might use it to buy stocks or bonds, or she might put it in her savings account or money market deposit account. In all of these cases, this $5000 becomes part of the supply of loanable funds in the financial system. After displaying public saving, explain the equation’s interpretation: public saving is tax revenue minus government spending. Notice the analogy to private saving – both concepts represent income less spending: for the private household, income is (Y-T) and spending is C. For the government, income is T and spending is G.

    42. 42 Notation: ? = change in a variable For any variable X, ?X = “the change in X ” ? is the Greek (uppercase) letter Delta The Delta notation will be used throughout the text, so it would be very helpful if your students started getting accustomed to it now. If your students have taken a semester of calculus, tell them that ?X is (practically) the same thing as dX (if ?X is small). Furthermore, some basic rules from calculus apply here with ?s: The derivative of a sum is the sum of the derivatives: ?(X+Y) = ?X + ?Y The product rule: ?XY = (?X)(Y) + (X)(?Y) In fact, you can derive the two arithmetic tricks for working with percentage changes presented in chapter 2. Just take the preceding expression for the product rule and divide through by XY to get (?XY)/XY = ?X/X + ?Y/Y, the first of the two arithmetic tricks. The Delta notation will be used throughout the text, so it would be very helpful if your students started getting accustomed to it now. If your students have taken a semester of calculus, tell them that ?X is (practically) the same thing as dX (if ?X is small). Furthermore, some basic rules from calculus apply here with ?s: The derivative of a sum is the sum of the derivatives: ?(X+Y) = ?X + ?Y The product rule: ?XY = (?X)(Y) + (X)(?Y) In fact, you can derive the two arithmetic tricks for working with percentage changes presented in chapter 2. Just take the preceding expression for the product rule and divide through by XY to get (?XY)/XY = ?X/X + ?Y/Y, the first of the two arithmetic tricks.

    43. 43 Budget surpluses and deficits If T > G, budget surplus = (T – G ) = public saving. If T < G, budget deficit = (G – T ) and public saving is negative. If T = G , “balanced budget,” public saving = 0. The U.S. government finances its deficit by issuing Treasury bonds – i.e., borrowing.

    44. U.S. Federal Government Surplus/Deficit, 1940-2007 Notes: 1. The huge deficit in the early 1940s was due to WW2. Wars are expensive. 2. The budget is closed to balanced in the ’50s and ’60s, and begins a downward trend in the ’70s. 3. The early ’80s saw the largest deficits (as % of GDP) of the post-WW2 era, due to the Reagan tax cuts, defense buildup, and growth in entitlement program outlays. 4. The budget begins a positive trend in the early 1990s, and a surplus emerges in the late 1990s. There are several possible explanations for the improvement. First, President Bush (the first one) broke his campaign promise not to raise taxes. Second, the Clinton administration barely squeaked a deficit reduction deal through Congress (with Al Gore casting the tie-breaking vote in the Senate). And third, and probably most important, there was a swelling of tax revenues due to the surge in economic growth and the stock market boom. (A stock market boom leads to large capital gains, which leads to large revenues from the capital gains tax.) 5. The budget swings to deficit again in 2001, due to the Bush tax cuts and a recession. 6. Recently, the budget deficit has reached all-time highs, when measured in current dollars. As a percentage of GDP, though, the deficit does not seem quite as worrisome relative to the time period captured in this graph. That could change due to the expensive stimulus package and bailouts enacted in 2008-2009. Source of data: U.S. Department of Commerce, Bureau of Economic Analysis. Notes: 1. The huge deficit in the early 1940s was due to WW2. Wars are expensive. 2. The budget is closed to balanced in the ’50s and ’60s, and begins a downward trend in the ’70s. 3. The early ’80s saw the largest deficits (as % of GDP) of the post-WW2 era, due to the Reagan tax cuts, defense buildup, and growth in entitlement program outlays. 4. The budget begins a positive trend in the early 1990s, and a surplus emerges in the late 1990s. There are several possible explanations for the improvement. First, President Bush (the first one) broke his campaign promise not to raise taxes. Second, the Clinton administration barely squeaked a deficit reduction deal through Congress (with Al Gore casting the tie-breaking vote in the Senate). And third, and probably most important, there was a swelling of tax revenues due to the surge in economic growth and the stock market boom. (A stock market boom leads to large capital gains, which leads to large revenues from the capital gains tax.) 5. The budget swings to deficit again in 2001, due to the Bush tax cuts and a recession. 6. Recently, the budget deficit has reached all-time highs, when measured in current dollars. As a percentage of GDP, though, the deficit does not seem quite as worrisome relative to the time period captured in this graph. That could change due to the expensive stimulus package and bailouts enacted in 2008-2009. Source of data: U.S. Department of Commerce, Bureau of Economic Analysis.

    45. U.S. Federal Government Debt, Fiscal Years 1940-2010 A later chapter will give more details, but for now, tell students that the government finances its deficits by borrowing from the public. (This borrowing takes the form of selling Treasury bonds). Persistent deficits over time imply persistent borrowing, which causes the debt to increase. After WW2, occasional budget surpluses allowed the government to retire some of its WW2 debt; also, normal economic growth increased the denominator of the debt-to-GDP ratio. Starting in the early 1980s, corresponding to the beginning of huge and persistent deficits, we see a huge increase in the debt-to-GDP ratio, from 32% in 1981 to 66% in 1995. In the mid 1990s, budget surpluses and rapid growth started to reduce the debt-to-GDP ratio, but it started rising again in 2001 due to the economic slowdown, the Bush tax cuts, and higher spending (Afghanistan & Iraq, war on terrorism, 2002 airline bailout, etc). The current financial crisis / recession will surely boost the debt ratio, as revenues have fallen while outlays (the stimulus package, bailouts) have sharply increased. The data shown end in 2007, and we are just beginning to see a rise in the debt ratio that will surely accelerate through 2010 and perhaps beyond. The “pop-up” box highlights perhaps the most obvious cost of a large federal debt: interest payments. Students are often shocked to learn how much extra we are paying in taxes just to service the debt; if it weren’t for the debt, we’d either pay much lower taxes, or have a lot of revenue available for other purposes, like financial aid for college students, AIDS and cancer research, national defense, Social Security reform, etc. Source of data: U.S. Dept of Commerce Bureau of Economic Analysis. A later chapter will give more details, but for now, tell students that the government finances its deficits by borrowing from the public. (This borrowing takes the form of selling Treasury bonds). Persistent deficits over time imply persistent borrowing, which causes the debt to increase. After WW2, occasional budget surpluses allowed the government to retire some of its WW2 debt; also, normal economic growth increased the denominator of the debt-to-GDP ratio. Starting in the early 1980s, corresponding to the beginning of huge and persistent deficits, we see a huge increase in the debt-to-GDP ratio, from 32% in 1981 to 66% in 1995. In the mid 1990s, budget surpluses and rapid growth started to reduce the debt-to-GDP ratio, but it started rising again in 2001 due to the economic slowdown, the Bush tax cuts, and higher spending (Afghanistan & Iraq, war on terrorism, 2002 airline bailout, etc). The current financial crisis / recession will surely boost the debt ratio, as revenues have fallen while outlays (the stimulus package, bailouts) have sharply increased. The data shown end in 2007, and we are just beginning to see a rise in the debt ratio that will surely accelerate through 2010 and perhaps beyond. The “pop-up” box highlights perhaps the most obvious cost of a large federal debt: interest payments. Students are often shocked to learn how much extra we are paying in taxes just to service the debt; if it weren’t for the debt, we’d either pay much lower taxes, or have a lot of revenue available for other purposes, like financial aid for college students, AIDS and cancer research, national defense, Social Security reform, etc. Source of data: U.S. Dept of Commerce Bureau of Economic Analysis.

    46. 46 Loanable funds supply curve At the end of this chapter, we will briefly consider how things would be different if Consumption (and therefore Saving) were allowed to depend on the interest rate. For now, though, they do not. At the end of this chapter, we will briefly consider how things would be different if Consumption (and therefore Saving) were allowed to depend on the interest rate. For now, though, they do not.

    47. 47 Loanable funds market equilibrium

    48. 48 The special role of r r adjusts to equilibrate the goods market and the loanable funds market simultaneously: If L.F. market in equilibrium, then Y – C – G = I Add (C +G ) to both sides to get Y = C + I + G (goods market eq’m) Thus, This slide establishes that we can use the loanable funds supply/demand diagram to see how the interest rate that clears the goods market is determined. Explain that the symbol ? means each one implies the other. The thing on the left implies the thing on the right, and vice versa. More short-hand: “eq’m” is short for “equilibrium” and “LF” for “loanable funds.”This slide establishes that we can use the loanable funds supply/demand diagram to see how the interest rate that clears the goods market is determined. Explain that the symbol ? means each one implies the other. The thing on the left implies the thing on the right, and vice versa. More short-hand: “eq’m” is short for “equilibrium” and “LF” for “loanable funds.”

    49. 49 Digression: Mastering models To master a model, be sure to know: 1. Which of its variables are endogenous and which are exogenous. 2. For each curve in the diagram, know: a. definition b. intuition for slope c. all the things that can shift the curve 3. Use the model to analyze the effects of each item in 2c. This is good general advice for students. They will learn many models in this course. Many exams include questions requiring students to show how some event shifts a curve, and then use the model to analyze its effect on the endogenous variables. If students methodically follow the steps presented on this slide for each model they learn in this course (and other economics courses), they will likely do better on the exams and get more out of the course. This is good general advice for students. They will learn many models in this course. Many exams include questions requiring students to show how some event shifts a curve, and then use the model to analyze its effect on the endogenous variables. If students methodically follow the steps presented on this slide for each model they learn in this course (and other economics courses), they will likely do better on the exams and get more out of the course.

    50. 50 Mastering the loanable funds model Things that shift the saving curve public saving fiscal policy: changes in G or T private saving preferences tax laws that affect saving 401(k) IRA replace income tax with consumption tax Continuing from the previous slide, let’s look at all the things that affect the S curve. Then, we will pick one of those things and use the model to analyze its effects on the endogenous variables. Then, we’ll do the same for the I curve. Continuing from the previous slide, let’s look at all the things that affect the S curve. Then, we will pick one of those things and use the model to analyze its effects on the endogenous variables. Then, we’ll do the same for the I curve.

    51. 51 CASE STUDY: The Reagan deficits Reagan policies during early 1980s: increases in defense spending: ?G > 0 big tax cuts: ?T < 0 Both policies reduce national saving:

    52. 52 CASE STUDY: The Reagan deficits

    53. 53 Are the data consistent with these results? variable 1970s 1980s T – G –2.2 –3.9 S 19.6 17.4 r 1.1 6.3 I 19.9 19.4 Display the data line by line, noting that it matches the model’s predictions---UNTIL YOU GET TO Investment. The model says that investment should have fallen as much as savings. Ask students why they think it didn’t. Answer: in our closed economy model of chapter 3, the only source of loanable funds is national saving. But the U.S. is actually an open economy. In the face of a fall in national saving (i.e. the domestic supply of loanable funds), firms can finance their investment spending by importing foreign loanable funds. More on this in an upcoming chapter.Display the data line by line, noting that it matches the model’s predictions---UNTIL YOU GET TO Investment. The model says that investment should have fallen as much as savings. Ask students why they think it didn’t. Answer: in our closed economy model of chapter 3, the only source of loanable funds is national saving. But the U.S. is actually an open economy. In the face of a fall in national saving (i.e. the domestic supply of loanable funds), firms can finance their investment spending by importing foreign loanable funds. More on this in an upcoming chapter.

    54. 54 Mastering the loanable funds model, continued Things that shift the investment curve: some technological innovations to take advantage some innovations, firms must buy new investment goods tax laws that affect investment e.g., investment tax credit

    55. 55 An increase in investment demand An increase in desired investment…

    56. 56 Saving and the interest rate Why might saving depend on r ? How would the results of an increase in investment demand be different? Would r rise as much? Would the equilibrium value of I change? Suggestion: Display these questions and give your students 3-4 minutes, working in pairs, to try to find the answers. Then display the analysis on the next slide. Reasons why saving might depend on r: An increase in r makes saving more attractive , increases the reward for postponing consumption Many consumers finance their spending on big-ticket items like cars and furniture, and an increase in r makes such borrowing more expensive. However, an increase in r might also reduce saving through the income effect: a higher interest rate makes net savers better off, so they purchase more of all “normal” goods. If current consumption is a normal good, then it will rise and saving will fall. It is usually assumed that the substitution effect is at least as great as the income effect, so that an increase in the interest rate will either increase saving or leave saving unchanged. Suggestion: Display these questions and give your students 3-4 minutes, working in pairs, to try to find the answers. Then display the analysis on the next slide. Reasons why saving might depend on r: An increase in r makes saving more attractive , increases the reward for postponing consumption Many consumers finance their spending on big-ticket items like cars and furniture, and an increase in r makes such borrowing more expensive. However, an increase in r might also reduce saving through the income effect: a higher interest rate makes net savers better off, so they purchase more of all “normal” goods. If current consumption is a normal good, then it will rise and saving will fall. It is usually assumed that the substitution effect is at least as great as the income effect, so that an increase in the interest rate will either increase saving or leave saving unchanged.

    57. 57 An increase in investment demand when saving depends on r

    58. 58 FYI: Markets, Intermediaries, the 2008 Crisis In the real world, firms have several options for raising funds they need for investment, including: borrow from banks sell bonds to savers sell shares of stock (ownership) to savers The financial system includes: bond and stock markets, where savers directly provide funds to firms for investment financial intermediaries, e.g. banks, insurance companies, mutual funds, where savers indirectly provide funds to firms for investment These slides correspond to a new FYI box on p.69. This material gives more detail about the financial system. While it ends with some information on the financial crisis, which will be explored in later chapters, the point here is that our loanable funds model, while abstracting from most of this detail, is fine for our present purposes. These slides correspond to a new FYI box on p.69. This material gives more detail about the financial system. While it ends with some information on the financial crisis, which will be explored in later chapters, the point here is that our loanable funds model, while abstracting from most of this detail, is fine for our present purposes.

    59. 59 FYI: Markets, Intermediaries, the 2008 Crisis Intermediaries can help move funds to their most productive uses. But when intermediaries are involved, savers usually do not know what investments their funds are financing. Intermediaries were at the heart of the financial crisis of 2008…. These slides correspond to a new FYI box on p.69. This material gives more detail about the financial system. While it ends with some information on the financial crisis, which will be explored in later chapters, the point here is that our loanable funds model, while abstracting from most of this detail, is fine for our present purposes. These slides correspond to a new FYI box on p.69. This material gives more detail about the financial system. While it ends with some information on the financial crisis, which will be explored in later chapters, the point here is that our loanable funds model, while abstracting from most of this detail, is fine for our present purposes.

    60. 60 FYI: Markets, Intermediaries, the 2008 Crisis A few details on the financial crisis: July ’06 to Dec ’08: house prices fell 27% Jan ’08 to Dec ’08: 2.3 million foreclosures Many banks, financial institutions holding mortgages or mortgage-backed securities driven to near bankruptcy Congress authorized $700 billion to help shore up financial institutions Sources: House price data is the Case-Shiller U.S. national home price index and Case-Shiller 20-city composite index, obtained from: http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_csmahp/0,0,0,0,0,0,0,0,0,1,1,0,0,0,0,0.html Foreclosure data is from realtytrac.com, http://www.realtytrac.com/ContentManagement/pressrelease.aspx?ChannelID=9&ItemID=5681&accnt=64847Sources: House price data is the Case-Shiller U.S. national home price index and Case-Shiller 20-city composite index, obtained from: http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_csmahp/0,0,0,0,0,0,0,0,0,1,1,0,0,0,0,0.html Foreclosure data is from realtytrac.com, http://www.realtytrac.com/ContentManagement/pressrelease.aspx?ChannelID=9&ItemID=5681&accnt=64847

    61. Chapter Summary Total output is determined by: the economy’s quantities of capital and labor the level of technology Competitive firms hire each factor until its marginal product equals its price. If the production function has constant returns to scale, then labor income plus capital income equals total income (output).

    62. Chapter Summary A closed economy’s output is used for: consumption investment government spending The real interest rate adjusts to equate the demand for and supply of: goods and services loanable funds

    63. Chapter Summary A decrease in national saving causes the interest rate to rise and investment to fall. An increase in investment demand causes the interest rate to rise, but does not affect the equilibrium level of investment if the supply of loanable funds is fixed.

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