Review Session for Exam 1Review Session for Exam 1

The

Macroeconomy

CHAPTERCHAPTER1-3 REVIEW1-3 REVIEW

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• What is Scarcity?• The Production Function• The Production Possibilities Frontier• Opportunity Cost• Dynamics of the PPF: Economic Growth• Choice: Investment or Consumption?• Public vs. Private Spending• Summary & Exercises

• What is Scarcity?• The Production Function• The Production Possibilities Frontier• Opportunity Cost• Dynamics of the PPF: Economic Growth• Choice: Investment or Consumption?• Public vs. Private Spending• Summary & Exercises

What is Scarcity?Allow me to introduce myself…I am Scarcityman the hero who will never fail to remind you that there’s no such thing as a free lunch. You can’t get get away from scarcity; it is simply an inherent condition in nature, that we all must endure. I am sure you have noticed that you can’t just have or produce everything. Opportunity costs exist and we must constantly make choices. Decisions will always be about “this or that”, not “this and that” and “now or later” not “now and later.”

No FreeNo Free Lunch!Lunch! Scarcityman won’t have to remind us to take our bitter

pill, scarcity, we will constantly run into it as we further our study of Macroeconomics. We will come to realize that scarcity exists for everyone, rich or poor.

For the richer country, scarcity forces people to work instead of play. If resources were not scarce, the people would pursue

more leisure activities like vacation.

For the richer country, scarcity forces people to work instead of play. If resources were not scarce, the people would pursue

more leisure activities like vacation.

For the poorer country, poverty and appalling living conditions make scarcity a matter of life and death.

For the poorer country, poverty and appalling living conditions make scarcity a matter of life and death.

The Production Function

The production function is a process of transforming inputs (labor (n), capital (k), institutional structure (inst) ) into outputs (final goods and services for a certain time period).

The algebraic representation is: y = F ( n, k, inst)

outputoutput isis some function ofsome function of our given inputsour given inputs

The Production The Production Possibilities FrontierPossibilities Frontier

(The PPF)(The PPF)• Our goal in working with the PPF is to see the most output Our goal in working with the PPF is to see the most output that can be produced given a certain amount of inputs.that can be produced given a certain amount of inputs.• So, first assume that as a nation, our inputs (n,k,iSo, first assume that as a nation, our inputs (n,k,instnst) are fixed ) are fixed and we produce 2 goods, xand we produce 2 goods, x11 and x and x22. In other words, right now, . In other words, right now, we only have a certain amount of workers, and capital to work we only have a certain amount of workers, and capital to work with and a certain level of institutional efficiency within our with and a certain level of institutional efficiency within our society.society.• Next, we’d like to determine what combinations of our 2 Next, we’d like to determine what combinations of our 2 goods we could produce…so here we go. goods we could produce…so here we go.

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Let’s say you decide toLet’s say you decide to produce this amount of goods xproduce this amount of goods x22 and x and x11..

Or you could cut back on xOr you could cut back on x2 2 and and increase your production of xincrease your production of x11..

Remember that Remember that pointspoints

that lie outside that lie outside the PPF, the PPF,

are unattainable.are unattainable.

RememberRememberthat points that points

that lie that lie inside theinside thePPF arePPF are

attainable, attainable, but notbut not

desirable.desirable.

Opportunity CostThe downward slope of the PPF depicts that the opportunity cost of producing more of one good is the amount of the other good that

must be sacrificed.

Suddenly you decide to produce some of good xSuddenly you decide to produce some of good x11 without withoutreducing the production of good xreducing the production of good x22..

Let’s say you are at point A, producing only good xLet’s say you are at point A, producing only good x22. .

BBUh oh…this is outside theUh oh…this is outside thePPF, so you must reduce PPF, so you must reduce

production of xproduction of x2.2.

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AA10 10 unitsunits

7 7 unitsunits

0 units0 units 8 units8 units

Notice that in order to gain 8 Notice that in order to gain 8 units of xunits of x11, you had to give up , you had to give up

3 units (10-7) of good x3 units (10-7) of good x22..

OPPORTUNITY COST

OPPORTUNITY COST

PPFPPF

Dynamics of the PPF: Economic Growth

Now, let’s suppose we can increase Now, let’s suppose we can increase ourour inputs inputs (n,k,i (n,k,instnst). This will shift out ). This will shift out

our PPF, making it possible to our PPF, making it possible to produce at a higher PPF.produce at a higher PPF.xx22

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PPFPPF

Remember that any points Remember that any points that lie beyond even the higher that lie beyond even the higher PPF...PPF...

are still unattainable!!!are still unattainable!!!

This action is calledThis action is called

ConsumptionConsumptionmeasured in millions of dollarsmeasured in millions of dollars

Invest

men

tIn

vest

men

tm

easu

red

in

mill

ion

s of

dolla

rsm

easu

red

in

mill

ion

s of

dolla

rsChoice:

Consumption or Investment?

AA

A nation at point A is choosing “zero-growth”, that is, they would rather

consume right now, than invest and consume more later.

A nation at point A is choosing “zero-growth”, that is, they would rather

consume right now, than invest and consume more later.

00 1010

BB

A nation choosing point B shows more willingness to invest.

By investing more, the nation can increase its capital stock

and therefore experience an increase in their PPF in the future.

A nation choosing point B shows more willingness to invest.

By investing more, the nation can increase its capital stock

and therefore experience an increase in their PPF in the future.

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66

A nation choosing point C is investing even more and will see an even larger increase in their PPF.

A nation choosing point C is investing even more and will see an even larger increase in their PPF.

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55

CC

ConsumptionConsumptionmeasured in millions of dollarsmeasured in millions of dollars

Invest

men

tIn

vest

men

tm

easu

red

in

mill

ion

s of

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rsm

easu

red

in

mill

ion

s of

dolla

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BB

88

66

99

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CC A nation choosing point C, is said to have aLow Rate of Time Preference.

A nation choosing point C, is said to have aLow Rate of Time Preference.

A nation choosing point B, is said to have a High Rate of Time Preference.

A nation choosing point B, is said to have a High Rate of Time Preference.

Consumption or investment? Consumption or investment? There is no “better” choice, it just depends on whether one places a higher value on current consumption, than on growth. Keep in mind that investment implies future consumption, so the decision is really

about when to consume.

Public vs. Private Spending

The issue of Public and Private spending must also run into the boundaries set by scarcity. There is an opportunity cost whereby

more government output means less private output.

Pu

blic

Ou

tpu

tPu

blic

Ou

tpu

t

Private OutputPrivate Output

++gg

--(c+i)(c+i)

AA

(c+i)(c+i)AA

ggAA

(c+i)(c+i)BB

BBggBB

Starting at point A, if the government decidesStarting at point A, if the government decidesto increase public spending...to increase public spending...

It It mustmust diminish private spending diminish private spendingand land at point B.and land at point B.

This is known asThis is known as

Copyright 1997 Dead Economists Society

• Historical Background• A Glimpse of Adam Smith• A Visit to The Classical Factory:

AS* and AD• Market Clearing• Quantity Theory of Money• Conclusions on the Classical

Model

Historical BackgroundHistorical BackgroundThe Classical model of economics relates the standard supply-demand analysis to the macroeconomy. It holds that wages and prices will be “flexible” as opposed to “sticky.” Adam Smith’s Wealth of Nations (1776) suggested that the economy was controlled by the “invisible hand” whereby the market system, instead of government would be the best mechanism for a healthy economy.

A Glimpse of A Glimpse of Adam SmithAdam Smith

The central thesis of The Wealth of Nations is that capital is best employed for the production and distribution of wealth under conditions of governmental noninterference, or laissez-faire, and free trade. In Smith's view, the production and exchange of goods can be stimulated, and a consequent rise in the general standard of living attained, only through the efficient operations of private industrial and commercial entrepreneurs acting with a minimum of regulation and control by governments. To explain this concept of government maintaining a laissez-faire attitude toward commercial endeavors, Smith proclaimed the principle of the “invisible hand”: Every individual in pursuing his or her own good is led, as if by an invisible hand, to achieve the best good for all. Therefore any interference with free competition by government is almost certain to be injurious.

"Smith, Adam," Microsoft® Encarta® 96 Encyclopedia. © 1993-1995 Microsoft Corporation. All rights reserved. © Funk & Wagnalls Corporation. All rights reserved.

PP

QQ

P*P*

Q*Q*

SS

DD

The place where Classical Model

mechanics are made easy!

The place where Classical Model

mechanics are made easy!

Welcome to...Welcome to...Welcome to...Welcome to...

Market ClearingMarket clearing is an alignment process whereby decisions between suppliers

and demanders reach an equilibrium.

Here’s how it works...Here’s how it works...Here’s how it works...Here’s how it works...

Remember that the demand curve slopes downward meaning that as you increase the Remember that the demand curve slopes downward meaning that as you increase the price (by moving along the demand curve), the quantity demanded decreases. price (by moving along the demand curve), the quantity demanded decreases.

Conversely, the supply curve slopes upward implying that as the price increases (by Conversely, the supply curve slopes upward implying that as the price increases (by moving along the supply curve), the amount supplied will increase.moving along the supply curve), the amount supplied will increase.

Let’s say you begin with an initial Let’s say you begin with an initial demanddemand and and supplysupply curve for CDs. curve for CDs.

PP

QQ

DD SS

Now, suppose that there is a sudden Now, suppose that there is a sudden increase in the demand for CDs.increase in the demand for CDs.

Demand will shift from Demand will shift from DD to to D´D´..

The center point A is the place where The center point A is the place where market decisions reach an market decisions reach an equilibriumequilibrium..

Q*Q*

P*P* AA

D´D´

Q´Q´

P´P´BB

The increase in demand places The increase in demand places upward pressure upward pressure

on the price to point Bon the price to point Bsince the original price, since the original price,

P* no longer clears the market.P* no longer clears the market.

Shortage

Aggregating the Model:Aggregating the Model:AS*AS*

The first step in building the classical model involves constructing an Aggregate Supply curve (AS*). It is based on the market-clearing process, (with flexible wages) which occurs in the labor market.

W/PW/P

nndd

Real W

age

Hours Worked

Let’s begin at full employment, n*, with a wage of w/p0.

nn*

W/PW/P

W/W/22PP

Now let’s see how workers will respond when there is a sudden increase in the price level.

nnss

(Employees)

(Employers)

nn

At this new lower real wage, workers will cut back on hours worked.

But, at the same time, employers

increase their demand for workers.

nn What will happen next?What will happen next?

W/PW/P

nndd

Hours Workednn*

W/W/22PP

(Employees)

(Employers)

nn nn

So, right now the labor market is in “disequilibrium”

where the quantity demanded exceeds the quantity supplied.

nnss

We’re now going to see how “flexible wages” willallow the labor market to come back to equilibrium,

at full employment,n*.In order to hire more workers,

the employer must raise the real wage to 2W.

22W/W/22PP

As a result of 2W, more workers are

hired, and the labor market can move...

The mechanism we just went through will enable usto build our vertical A S curve.

PP

yyy *y *

The vertical line suggests that changes in the

price level will have no lasting

impact onfull employment.

The vertical line suggests that changes in the

price level will have no lasting

impact onfull employment.

y*=f (n,k,inst)

If...1) Y= c + i + x +

g

2) c= co + ci (y-t)

3) t= to + ti y

4) i= io - i2 r

5) x = xo - xiy -x2 r

6) g = go

-Equilibrium Condition

-Behavioral Relationship

-Policy Instrument

-Behavioral Relationship

-Behavioral Relationship

-Policy Instrument

Then...What if + r?

+r -i + -x

-y

-c -y

-t +c

+y

+x

+y

IS equation: the solution equation which sums all 6 AD

equations.

Example: y=(z0 + g0 - c1t0)

IS stands forInvestment Saving

7) L/P=M/P 8) L/P=j0+j1y-j2r 9) M=M010SR) P=P010LR) y*=F(n*,K0,I0nst)

If...1) Y= c + i + x + g2) c= co + ci (y-t)3) t= to + ti y4) i= io - i2 r5) x = xo - xiy -x2 r 6) g = go

7) L/P=M/P 8) L/P=j0+j1y-j2r 9) M=M010SR) P=P010LR) y*=F(n*,K0,I0nst)

IS

LM

Aggregate

Demand(Equ. 1-

9)

AggregateSupply

What happens if there

is a

+ x0?

What happens if there

is a

+ x0?

What is the impact on y,p,r,c,i,x,b?

LMp0rr

yypp

yy

IS1) +x causes IScurve to shift rightto IS’.

AD

ASSR

IS

’

2) This leads to arightward shift in AD to AD’.

p0

AD’

Short Run: Move from A to B.

Long Run:Market clears at p0 to p2

from B to C.

p2 C

3) +p causes LMp0

to shift leftward to LMp2.

ASLR

LMp2

C

ASSR

Short Run:

y +p 0r +c +I -x ?b -

Long Run:

0+

++0--+0

IS

’ LMp0rr

yypp

yy

IS

AD

p0

AD’

p2 C

ASLR

LMp2

C