ECO 317 Intermediate Macroeconomics

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ECO 317
Intermediate Macroeconomics
Instructor
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Jing Li (sounds like Lee)
7-year experience of teaching at US colleges
Second year at MU
Married with two kids
Teaching eco 311 as well
Expectation
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Hard-working is expected
Cramming for exam does not work
Memorizing does not work
Understanding is the key
If you need A or B, earn it!
Required Textbook
Webpage
• http://www.fsb.muohio.edu/lij14/
• I use Nihhka only when I need to send group
email and post grade
• Google “jing li miami university”
Grades
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Six homeworks, 10 points
Term paper, 10 points
Three midterm exams, 60 points
Final exam, 20 points
(bonus) Attendance, worth 3 points
None of the exam is accumulative
Hot Issues
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National Debt
Income gap: 1% vs. 99%
Globalization
2007-2009 Recession
Review
• Labor (input) L is used to produce output Y
• Production is captured by production function ( )
 = ()
• Marginal product of labor (MPL) is the extra output
that can be produced by using one more unit of labor

 =
≈   + 1,  − (, )

• Q: What is the sign of MPL?
• Q: What happens to MPL as L rises?
Two Properties of MPL
• >0, so total product rises when input rises
•

<0

(decreasing or diminishing marginal
product). The extra labor becomes less and less
productive.
• Graphically, the production function (total
product curve) is upward sloping, and becomes
flatter and flatter.
• Q: how does the marginal product curve looks
like?
Profit Maximizing
• Profit = revenue – cost =  −  =   −
− . We assume competitive market.
• Profit rises when marginal revenue is greater
than marginal cost, and decreases otherwise
• Profit is maximized when
marginal revenue = marginal cost
• Mathematically, the first order condition is
 ∗  = 
Summary
• Output does not grow if input and technology
remain constant
• Wage is determined by the marginal product.
Discuss
• What is the long run prospect of Japanese
economy, where both population and
technology stagnate?
• Why does a doctor earn much more than a
plumber?
Cobb-Douglas Production Function
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 =  ,  =   1− , (0 <  < 1)
Constant return to scale
Constant factor share in income
Marginal product is proportional to average
product
Calculus
•   ′ =  −1
• Multivariate function  = (, )
• Partial derivatives
 
,
 
Example:  =     ,

=  −1  


=  −1  

Why Cobb-Douglas Function?
• It can explain the following two facts
• The shares of capital and labor incomes are
constant
• Real wage grows at the same rate as average
product
The Demand Side
• The supply side is captured by production
function
• We need to specify the demand side in order
to find equilibrium
• Demand = consumption + government
expenditure + investment
Aggregate Demand
• Consumption:  =   −  , which is fixed

,

• Investment:  =  
< 0, which varies as
the real interest rate  changes
• Government expenditure:  = , which is
fixed
Equilibrium
• Equilibrium: supply = demand
• Mathematically
 = − +  +
• We can solve this equation for , and obtain
the equilibrium real interest rate
• In short, real interest rate adjusts to
equilibrate the market
Another Perspective
• Alternatively, we can study the equilibrium for
loanable funds market
• At equilibrium, the supply and demand of
funds are equal:
− − − = 
Note the supply of fund is fixed
Application
1. Why was interest rate high in early 1980?
2. Why was interest rate high in early 1990?
Crowding Out
• Chapter 3 implies that expanding government
expenditure will completely crowd out
investment
• Fiscal policy is ineffective
• How about monetary policy?
MVPY
Monetarism
• In long run, price is mainly affected by money
supply
• Inflation rate equals growth rate of money
supply if assuming fixed income and constant
velocity
• What if those two assumptions fails?
Hyper-Inflation (to get Seigniorage)
Quantitative Easing (as a Policy Tool)
• http://www.youtube.com/watch?v=PTUY16Ck
S-k
• http://en.wikipedia.org/wiki/Quantitative_eas
ing
Classical Dichotomy
• According to the long run classical theory,
money is neutral (monetary neutrality): the
money supply does not affect real variables
• The theoretical separation of real and nominal
variables is called classical dichotomy
• Real variables are studied in Chapter 3
• Price is determined in Chapter 4
• They jointly determine nominal variables
Fisher Equation
Application of Classical Dichotomy
=+ 
So nominal interest rate  is the sum of real
interest rate  and inflation rate .
 is determined in chapter 3, (Figure 3-8)
 is determined in chapter 4, (MV=PY)
Proof
• You have two options: saving a good and
earns real interest; or saving money and earn
nominal interest.
• There is no arbitrage at equilibrium:
1+
1+ =
1+
Fisher equation follows assuming  = 0
How to Forecast
Nominal Interest Rate in Long Run?
• First determine the real interest rate  =  
• Then determine the inflation rate  = % +
% − %
• Finally use Fisher Equation:  =  + 
• Nominal interest rate matters because it is a
key variable in Financial and Housing markets
A Short Run Theory
• Consider the equilibrium in money market
• Money supply =

,

a vertical line
• Money (liquidity) demand = (, ), a
downward sloping line
• At equilibrium

= (, )

Discuss
Dear Professor Li,
I am in your 317 class and had a question regarding interest rates. Prior
to class today I was reading an article that stated that a main reason
why our economy has not felt the same effects of having a 70% debt to
GDP ratio is that we have lower interest rates compared to European
countries who have similar debt-GDP ratios(but these countries have
higher interest rates). If our economies are similar in terms of this
ratio, how come we have such a lower interest rate in comparison to a
country such as Spain?
Also, thanks for an enjoyable class today.
Stephen H.
Answer
• US real interest rate is low because high
(foreign) supply of loanable fund. Spain is
opposite
• US nominal interest rate is low because of
quantitative easing
Review
• Nominal vs Real
Y: Real GDP
PY: Nominal GDP
W/P: Real Wage
W: Nominal Wage
r: Real Interest Rate
i: Nominal Interest Rate
Classical Dichotomy
• Money does not affect real variables
• Real variables are determined in Chapter 3
• Price is determined in Chapter 4
Review
• Long Run vs Short Run
Long Run:  = 
Short Run:


= (, )

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