1 Economics 122a Fall 2009 Agenda for this week: 1. The Classical macro model 2. Measuring output

Some announcements First problem set will be posted the week of Sept 21 and due the next week. Course is limited to those on course list on web page. I will post readings on logarithms on the course web page. There will probably be an optional section on logs and math review in the next couple of weeks. We may have occasional optional extra sessions on Fridays, 11:35- 12:50 for technical review. Sections will begin next week. You should sign up on the Registrar’s section list. Wednesday 4:50-4:50 and 5:00-5:50 Wednesday 7:00-7:50 and 8:00-8:50 Thursday 4:50-4:50 and 5:00-5:50 2

Repeat: The two themes of macro There are two major recurrent themes running through macro: i)Business cycles ii)Economic growth Virtually every macroeconomic issue revolves around these issues, or a confusion concerning them. 3

The Other Central Concern of Macroeconomics: Economic growth Economic growth concerns the trend in output over the long run. Questions: 1.What determines “potential output” (Mankiw: “natural output”)? 2.What determines to growth of output over time? 3.What determines the differences in productivity among nations? In macroeconomics, we use the neoclassical growth model to understand economic growth.

GDP trends in 3 big regions 5

Per capita growth trends in 3 big regions 6

7 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 DR: ∂ 2 Y/∂K 2 <0; ∂ 2 Y/∂L 2 <0

Production function for omelette 8 Courtesy of Elizabeth David, An Omelette and a Glass of Wine

9 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: ∂ 2 Y/∂K 2 <0; ∂ 2 Y/∂L 2 <0

Potential Output 10 Potential output. With exogenous labor force (LF), inherited capital (K), unemployment at the NAIRU (u*), this gives potential output (Y p ): (2) Y p = F[K, (1-u*)LF] Potential output critical for unemployment theory and growth theory and for medium and long-run forecasts. NAIRU (Mankiw “natural rate of unemployment”) = non-accelerating inflation rate of unemployment = unemployment rate at which inflation neither rises or falls = lowest sustainable rate of unemployment.

Actual and Potential GDP 11

Output gap (potential minus actual GDP) 12

13 Example: Cobb-Douglas production function Very important production function: Cobb-Douglas (log linear) F( K, L) = AK α L 1-α Properties: MPL = ∂[AK α L 1-α ]/∂L=(1-α)AK α L 1-α /L = (1-α)Y/L = (1-α) x APL (and similarly for MPK)

14 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 Exhaustion of product theorem: With CRTS and competitive pricing, paying factors their marginal product leads income = output.

15 Example: 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 slide.

16 Near-constancy of labor’s share of national income

17 What are the macroeconomic effects of immigration? Alfred Stieglitz

18 L W/P MPL Real wages and MPL: graphics L* (W/P)*

19 L W/P MPL Output = sum of the slices of MPL from 0 to L* L*

Calculus of marginal and total product Total product = sum of marginal products up to input level. 20

21 L W/P MPL Neoclassical distribution of output/income L* (W/P)* Total wages Capital income* *More generally, all non-labor income Can reverse axes and get analogous results for capital.

22 L W/P MPL Effect of immigration L* (W/P) 1 (W/P) 2 E1E1 E2E2 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.

23 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 Other applications of static neoclassical model 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 outsourcing: What is effect of hiring foreign workers for call centers, radiology, computer programming? Very similar to immigration: like having workers here. Impact of government debt: 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.

25 Let’s go back and ask: “Just what is this ‘Y’?” “Just how do we measure GDP and real GDP?”

26 Survey of Current Business, August 2009

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Inflation as measured by the price of gross domestic purchases* 28 Note: This is a new concept not in the textbooks. It reflects the prices of domestic purchases rather than domestic product.

29 Major concepts in national economic accounts 1.GDP measures final output of goods and services. 2.Two ways of measuring GDP lead to identical results: Production = income 3.Savings = investment is an accounting identity. We will also see that it is an equilibrium condition. Note the advanced version of this includes government and foreign sector. 4.GDP v. GNP: differs by ownership of factors 5.Constant v. current prices: correct for changing prices 6.Value added: Total sales less purchases of intermediate goods - Note that income-side GDP adds up value addeds 7.Net exports = exports – imports 8.Net v. gross investment: Net investment = gross investment minus deprecation

30 How to measure output growth? Now take the following numerical example. Suppose good 1 is computers and good 2 is shoes. How would we measure total output and prices?