Chapter 5 A Closed- Economy One-Period Macro- economic Model Copyright © 2014 Pearson Education, Inc.

1-2 © 2014 Pearson Education, Inc. Chapter 5 Topics Introduce the government. Construct closed-economy one-period macroeconomic model, which has: (i) representative consumer; (ii) representative firm; (iii) government. Economic efficiency and Pareto optimality. Experiments: Increases in government spending and total factor productivity. Consider a distorting tax on wage income and study the Laffer curve. Public goods: How large should the government be?

1-3 © 2014 Pearson Education, Inc. Closed-Economy One-Period Macro Model Representative Consumer Representative Firm Competitive Equilibrium Experiments: What does the model tell us are the effects of changes in government spending and in total factor productivity?

1-4 © 2014 Pearson Education, Inc. Figure 5.1 A Model Takes Exogenous Variables and Determines Endogenous Variables

1-5 © 2014 Pearson Education, Inc. Competitive Equilibrium Representative consumer optimizes given market prices. Representative firm optimizes given market prices. The labor market clears. The government budget constraint is satisfied, or G = T.

1-6 © 2014 Pearson Education, Inc.v Income-Expenditure Identity In a competitive equilibrium, the income-expenditure identity is satisfied, so

1-7 © 2014 Pearson Education, Inc. The Production Function

1-8 © 2014 Pearson Education, Inc. Figure 5.2 The Production Function and the Production Possibilities Frontier

1-9 © 2014 Pearson Education, Inc. Figure 5.3 Competitive Equilibrium

1-10 © 2014 Pearson Education, Inc. Key Properties of a Competitive Equilibrium

1-11 © 2014 Pearson Education, Inc. Figure 5.4 Pareto Optimality

1-12 © 2014 Pearson Education, Inc. Key Properties of a Pareto Optimum In this model, the competitive equilibrium and the Pareto optimum are identical. We know this as, at the Pareto optimum,

1-13 © 2014 Pearson Education, Inc. First and Second Welfare Theorems These theorems apply to any macroeconomic model. First Welfare Theorem: Under certain conditions, a competitive equilibrium is Pareto optimal. Second Welfare Theorem: Under certain conditions, a Pareto optimum is a competitive equilibrium.

1-14 © 2014 Pearson Education, Inc. Figure 5.5 Using the Second Welfare Theorem to Determine a Competitive Equilibrium

1-15 © 2014 Pearson Education, Inc. Effects of an Increase in G Essentially a pure income effect C decreases, l decreases, Y increases, w falls

1-16 © 2014 Pearson Education, Inc. Figure 5.6 Equilibrium Effects of an Increase in Government Spending

1-17 © 2014 Pearson Education, Inc. World War II Increase in G Very large increase in G. Y increases, C decreases by a small amount.

1-18 © 2014 Pearson Education, Inc. Figure 5.7 GDP, Consumption, and Government Expenditures

1-19 © 2014 Pearson Education, Inc. Effects of an Increase in z (or an increase in K) PPF shifts out, and becomes steeper – income and substitution effects are involved. C increases, l may increase or decrease, Y increases, w increases.

1-20 © 2014 Pearson Education, Inc. Figure 5.8 Increase in Total Factor Productivity

1-21 © 2014 Pearson Education, Inc. Figure 5.9 Competitive Equilibrium Effects of an Increase in Total Factor Productivity

1-22 © 2014 Pearson Education, Inc. Figure 5.10 Income and Substitution Effects of an Increase in Total Factor Productivity

1-23 © 2014 Pearson Education, Inc. Figure 5.11 Deviations from Trend in GDP and the Solow Residual