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1 Economics 122a Fall 2013 Agenda for next two classes: 1. The classical macro model 2. How economists measure output/income 2 Some announcements • Course is limited to those on course list on web page plus juniors (appeals are under consideration and should be decided early next week). • There will probably be an optional section on logs and math review next Friday (Sept 8). 3 The great chasm of macroeconomics Classical macro: - perfect markets -rational individuals - flexible wages and prices - full employment This is our topic for today: classical approach 4 Keynesian macro: - imperfect competition -bounded rationality - sticky wages and prices - unemployment Basics of Static Classical Model: Production Theory Classical production model. The basic model is simplest representation of the classical approach. When dynamized, it becomes the neoclassical growth model. Factor markets: capital and labor inputs (K and L) One sector for output (Y). Aggregate production function (for real GDP, Y) What is a production function? Recipe for combining inputs into outputs for given technology. (1) Y = F( K, L) Standard assumptions: positive marginal product (PMP), diminishing returns (DR), constant returns to scale (CRTS): CRTS: mY = F( mK, mL) PMP: ∂Y/∂K>0; ∂Y/∂L>0 5 DR: ∂2Y/∂K2<0; ∂2Y/∂L2<0 Basics of Static Classical Model: Production Theory Classical production model. The basic model is simplest representation of the classical approach. When dynamized, it becomes the neoclassical growth model. Factor markets: capital and labor inputs (K and L) One sector for output (Y). Aggregate production function (for real GDP, Y) (1) Y = F( K, L) Standard assumptions: positive marginal product (PMP), diminishing returns (DR), constant returns to scale (CRTS): CRTS: mY = F( mK, mL) PMP: ∂Y/∂K>0; ∂Y/∂L>0 DR: ∂2Y/∂K2<0; ∂2Y/∂L2<0 6 Production function for popovers Courtesy of Florence Kling Harding , Twentieth Century Cookbook, 1921 7 Potential Output Potential output. With exogenous labor force (LF), inherited capital (K) , unemployment at the NAIRU (u*), this gives potential output (Yp): (2) Yp = F[K, (1-u*)LF] Potential output critical for unemployment theory and growth theory and for medium and long-run forecasts. u* = Jones “long-run or natural rate of unemployment” = non-accelerating inflation rate of unemployment (NAIRU) = unemployment rate at which inflation neither rises or falls = lowest sustainable rate of unemployment = around 5-6 percent today 8 Real GDP over the cycle 15,000 Real GDP (billions of 2005 $) 14,500 Real GDP (Actual) Real Potential GDP 14,000 13,500 Large GDP “gap” 13,000 12,500 12,000 2004 9 2005 2006 2007 2008 2009 2010 2011 2012 Anyone heard of the Cobb-Douglas production function? 10 Example: Cobb-Douglas production function Very important production function: Cobb-Douglas (log linear) F( K, L) = AKαL1-α Properties: MPL = ∂[AKαL1-α]/∂L=(1-α)AKαL1-α /L = (1-α)Y/L = (1-α) x APL (and similarly for MPK) L MPL (discrete) Y 0.00 0.00 MPL (continuous/ derivative) na 1.00 1.00 1.00 0.50 0.41 2.00 1.41 0.35 0.32 3.00 1.73 0.29 0.27 4.00 11 2.00 0.25 Y, MPL F( K, L) = 1.5L1-.5 2.0 1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 Y MPL 0 0.5 1 Labor inputs (L) 1.5 Factor Markets Factor markets: capital and labor inputs (K and L): - Capital inherited from past investments - Labor inputs exogenous (from biology, health, customs, pharma) Real wage rate: = W/P = MPL = ∂Y/∂L = ∂[F( K, L)]/∂L (see Fig. 1) Real rental rate on capital (like apartment rental as $ per month): = R/P = MPK = ∂Y/∂K = ∂[F( K, L)]/∂K National income = labor income + capital income = WL + RK 12 Distribution with the Cobb-Douglas production function National income Y = MPL x L + MPK x K = L[(1-α)Y/L] +K[αY/K ] = Y (exhaustion of product theorem) Shares of capital and labor: share of K = RK/Y = (αY/K ) x (K/Y) = constant = α Why do economists like Cobb-Douglas? See next slides on historical data on factor shares. 13 Incomes in the National Income Accounts 1929 1948 1965 1992 2012 54.6% 59.0% 61.5% 66.8% 61.6% 53.6% 55.3% 55.1% 53.9% 49.6% 14.9% 16.0% 9.6% 7.3% 8.8% Rental income of persons with CCA 6.5% 3.1% 2.9% 1.2% 3.9% Corporate profits with IVA and CCA 11.5% 12.8% 13.5% 8.6% 14.4% Net interest and misc 4.9% 1.1% 3.0% 7.0% 3.1% Taxes on production and imports 7.2% 8.0% 9.2% 8.8% 8.0% 99.5% 100.0% 99.8% 99.6% 99.8% Compensation of employees Wages and salaries Proprietors' income with IVA/CCA TOTAL Source: U.S. Bureau of Economic Analysis (www.bea.gov) 14 Near-constancy of labor’s share of national income 80% 80% 70% 70% 60% 60% ? 50% 50% 40% 40% 30% 30% Compensation of employees Share of compensation Wages and salaries Share of wages 20% 20% 10% 10% 0% 0% 1929 1929 15 1939 1939 1949 1949 1959 1969 1979 1959 1969 1979 1989 1989 1999 1999 2009 2009 Applications of static neoclassical model Impact of immigration (today) Impact of foreign investment : • Assume that foreign firms build a factory in US. What is effect in simple neoclassical model? • Answer: Same as immigration, but reverse the factors. Impact of government debt (later in course): • What is the effect of a growing government debt? • Slightly more complicated, but might crowd out capital stock. This then reduces output. Note effects on wages and rentals. 16 So this is the simplest classical model K = given L = given Y = F(K,L) Factors paid their marginal products 17 What are the macroeconomic effects of immigration? Alfred Stieglitz 18 W/P Real wages and MPL: graphics (W/P)* MPL L* 19 L W/P L* Output = sum of the slices of MPL from 0 to L* MPL L 20 L* Calculus of marginal and total product Total product = sum of marginal products up to input level. L* Y F ( K , L *) 0 21 L* M P L ( L )d L [ F ( K , L ) / L ]d L 0 Neoclassical distribution of output/income W/P *More generally, all non-labor income Capital income* Can reverse axes and get analogous results for capital. (W/P)* Total wages MPL L* 22 L W/P (W/P)1 Effect of immigration E1 E2 (W/P)2 Assume immigrants are perfect substitutes for L Results: 1. Wage rate falls. 2. Output and national income rise. 3. Capital income rises. 4. More generally, income of substitutes fall and complements rise. 5. Empirical studies suggest that low-skilled and Hispanic workers are hurt by Mexican immigration. MPL L* 23 L National Academy of Sciences study (The New Americans) “Immigration over the 1980s increased the labor supply of all workers by about 4 percent. On the basis of evidence from the literature on labor demand, this increase could have reduced the wages of all competing native-born workers by about 1 or 2 percent. Meanwhile, noncompeting native-born workers would have seen their wages increase…” “Based on previous estimates of responses of wages to changes in supply, the supply increase due to immigration lowered the wages of high school dropouts by about 5 percent…” 24 Immigration and increasing wage inequality? 25 “Just what is this ‘Y’?” “Just how do we measure GDP and real GDP?” 26