1 1 The classical model of economics

2 Economics 122a Fall 2012 Agenda for next two classes: 1. The classical macro model 2. How economists measure output/income

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 be an optional section on logs and math review next Friday. 3

The great chasm of macroeconomics 4 Classical macro: - perfect markets -rational individuals - flexible wages and prices - full employment Keynesian macro: - imperfect competition -bounded rationality - sticky wages and prices - unemployment This is our topic for today: classical approach

5 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 popovers 6 Courtesy of Florence Kling Harding, Twentieth Century Cookbook, 1921

Potential Output 7 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. 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

Real GDP over the cycle 8 Large GDP “gap”

9 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)

10 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

11 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.

Incomes in the National Income Accounts 12 Source: U.S. Bureau of Economic Analysis (

13 Near-constancy of labor’s share of national income ?

14 Other sources of national income

15 Applications of static neoclassical model Impact of immigration: problem set 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 What are the macroeconomic effects of immigration? Alfred Stieglitz

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

18 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.

19 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…”

What we missed at the end of last lecture… 20

International macro In a world of rapid globalization, international macro becomes increasingly important. Role of exchange rates, international trade, currencies. The biggest issues today are: 8. What are “global imbalances?” Why does the US have such a huge current trade deficit while China has such a large surplus? How will these resolve? 9. What is the reason for the Euro crisis? Will the Eurozone fall apart, or evolve closer to a standard fiscal union? Is disaster waiting around the corner? 21

So this leads to the biggest question of them all… 22 Why study macroeconomics?

23 Because you may be the next Ben Bernanke – in charge of rescuing the world economy from the wreckage of some future depression!

A puzzler for the next class Assume there are two goods (computers and shoes) Period 1 P Shoes = P computers = $1 Q shoes = Q computers = 1 Nominal GDP = $2 Period 2 P shoes = 1; P computers = $0.01 Q shoes = 1; Q computers = 100 Nominal GDP = $2 What is the growth of real GDP from period 1 to period 2? 24