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Macroeconomics

Macroeconomics. Lecture 7. Review of the Previous Lecture. Other Measures of Income Consumer Price Index CPI vs GDP Defaltor Unemployment Okun’s Law. Topics under Discussion. A Market Clearing Model Determining GDP Factor Price Determination. Key Questions to be addressed.

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Macroeconomics

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  1. Macroeconomics Lecture 7

  2. Review of the Previous Lecture • Other Measures of Income • Consumer Price Index • CPI vs GDP Defaltor • Unemployment • Okun’s Law

  3. Topics under Discussion • A Market Clearing Model • Determining GDP • Factor Price Determination

  4. Key Questions to be addressed • 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

  5. Income Factor payments Markets for Factors of Production Private Savings Financial Markets Govt. Deficit Taxes Government Households Firms Govt. Purchases Investments Consumption Firm revenues Markets for Goods and Services

  6. 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

  7. Factors of production K = capital, tools, machines, and structures used in production L = labor, the physical and mental efforts of workers

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

  9. Assumptions of the model • Technology is fixed. • The economy’s supplies of capital and labor are fixed at K K L L = = and

  10. Determining GDP Output is determined by the fixed factor supplies and the fixed state of technology: Y F ( K ,L) =

  11. The distribution of national income • determined by factor prices, the prices per unit that firms pay for the factors of production. • The wage is the price of L, the rental rate is the price of K.

  12. 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

  13. 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?

  14. 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

  15. Marginal product of labor (MPL) def: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)

  16. Production Function

  17. Marginal Product of Labor

  18. MPL 1 As more labor is added, MPL  MPL 1 Slope of the production function equals MPL 1 The MPL and the production function Y output F(K,L) MPL L labor

  19. Diminishing marginal returns • As a factor input is increased, its marginal product falls (other things equal). • Intuition:L while holding K fixed  fewer machines per worker  lower productivity

  20. Units of output Real wage MPL, Labor demand Units of labor, L Quantity of labor demanded MPL and the demand for labor Each firm hires laborup to the point where MPL =W/P

  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 • MPK curve is the firm’s demand curve for renting capital. • Firms maximize profits by choosing Ksuch that MPK = R/P.

  22. Summary • A Market Clearing Model • Determining GDP • Factor Price Determination

  23. Upcoming Topics • Marginal Product of Labor • Diminishing Marginal Rate of Return • Neo-classical Theory of Distribution • Demand for Goods and Services • Consumption • Investment • Govt. Spendings

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