Econ 102 Spring 2004 Midterm 2 Review Sheet: Classical Economic Model - Prof. Elizabeth S., Study notes of Introduction to Macroeconomics

Download Econ 102 Spring 2004 Midterm 2 Review Sheet: Classical Economic Model - Prof. Elizabeth S. and more Study notes Introduction to Macroeconomics in PDF only on Docsity! ECON 102 SPRING 2004 REVIEW SHEET FOR MIDTERM 2 This is not meant to be a complete list, but is instead a guideline of many of the topics covered for this midterm. Professor Kelly reserves the right to ask questions about material that is not listed here, or that is found in your text but was not covered in the large lecture. Please review your notes carefully, work the practice questions, and take care of yourself physically and mentally in preparation for the exam. If you need additional questions remember to check the website for help: www.ssc.wisc.edu/~ekelly/econ102 THE CLASSICAL MODEL Assumptions: - markets clear by price adjustment; - there is a market for labor, loanable funds and each good and service; - all capital, labor and land are being used. Labor Market: Full Employment is achieved by the economy on its own; there is no need for government intervention. In particular, the real wage will adjust instantaneously such that the quantity of labor demanded is equal to the quantity of labor supplied. There is no cyclical unemployment in this model. Remark: In the labor market, households supply labor, while businesses demand labor. The quantity of labor households supply increases as the real hourly wage increases; the quantity of labor businesses demand decreases as the real hourly wage increases. At any quantity of labor, the supply of labor curve shows the opportunity cost of the last worker hired, while the demand for labor curve shows the benefit for businesses from the last worker hired (if this concept is not clear to you, draw the picture depicting the labor market and consider a fixed quantity of labor. What is the real wage at which individuals are willing to work? What is the wage that businesses are willing to pay to hire new workers? What does this imply?) Aggregate Production Function: It shows the total output an economy can produce with different quantities of labor, holding constant land, capital and technology. The principle of the diminishing returns to labor tells us that as the number of workers employed increases, output will initially increase at an increasing rate and then eventually increase at a decreasing rate (we can see this from the shape of the aggregate production function). As the employment of labor increases the amount of capital available per laborer decreases leading to lower productivity for subsequently hired workers. Therefore, as the number of workers increases, the output produced increases but by smaller amounts. Say’s law: Total spending = Total value of production (or: supply will create its own demand). Remember: in a model in which households consume, save and pay taxes and government and business have a role in spending, Say’s law does not generally hold; it does only if: Leakages (income earned but not spent) = Injections (spending from sources other then Households) Leakages = Savings + Taxes + Imports = S + T + M Injections = Investments + Government spending + Exports = I + G + Exports This condition, in the Classical model, is guaranteed by the equilibrium in the loanable funds market. Loanable funds market: In general, the Supply of loanable funds = Savings = S The supply of loanable fund increases as the real interest rate increases. Demand for loanable funds = Government’s demand for loanable funds + Businesses’ demand of loanable funds Government’s demand forf loanable funds = Budget Deficit = (G-T) This demand is not affected by the real interest rate. Businesses’ demand for loanable funds = Investments = I It decreases as the real interest rate increases. Remark: make sure you know how to deal with a Budget Surplus instead of a Budget Deficit. In this case, the Government does not demand funds: it supplies them. Quantity Theory of Money Supply of Money: controlled by the Government or Central bank MM S  Demand for Money: demand for transactions MD = kPY where Y = Real GDP (and hence PY is the nominal GDP) k = percentage of income that people desire to hold as money. In equilibrium, money supply = money demand, or MS = MD Remember: in the Classical model, a change in the supply of money does not affect the real GDP; it affect the price level and the Nominal GDP (PY). Demand Management Policies: Fiscal Policy: a change in G (or T) designed to change total spending (and then total output) in the economy. In the Classical model, these policies have a crowding out effect: ICG  ; the increase in G completely crowds out private sector spending (consumption + investment). The total spending is therefore unchanged. Monetary Policy: a change in the supply of money to achieve macroeconomic goals. In the Classical model, any change in M will be reflected in a change in the price level P. Policies that enhance growth: 1. Policies that promote an increase in the Supply of Labor: this will increase the equilibrium quantity of labor and consequently real GDP. The equilibrium real wage will decrease. (To check this, draw the picture of the labor market and the aggregate production function and consider the effects of a shift in the supply of labor). 2. Policies that promote an increase in the Demand of Labor: the equilibrium quantity of labor will increase, and consequently real GDP. The equilibrium wage, in this case, will increase. (Again, you should be able to check that these statements are true). 3. Policies that promote an increase in the Capital Stock: the aggregate production function shifts up at any quantity of labor; real GDP increases. The capital stock increases if investment is greater than capital depreciation. In order to increase investment, the government needs to pursue policies that will increase the demand or the supply of Loanable funds.