LR macro equilibrium
Circular flow of income
- Households supply capital and labour to firms- consume goods and save to
fund firms capital investment
- Firms demand labour and capital from households- produce output and make
capital investment decision
- Identifies the interaction between the financial sector and the real economy-
savings to investment for firms
- Introduces the government as a demander of goods and services
- Implies that all goods produced are demanded
LR model macro equilibrium
- Model assumes that market always clear since all prices are flexible- assume
markets are perfectly competitive
- Supply determines output- resources fully employed- Say’s law- producing
full according to the economy’s production function
- Real interest rate determines the structure of demand for the closed/global
economy
- Real exchange rate determines the structure of demand for the small open
economy- UK
- Both the real interest rate and real exchange rate determine the structure of
demand in the large open economy- USA
- Output determined from the supply side
Output and factors of production
- 2 factors of production- L and Capital- owned by households
- Production of output is represented by an economy wide production function
- Y(output)=F(N,K)- F is production function N labour and K capital
- Assume one good is produced- used for both consumption and investment
, - All other factors are combined in fixed proportions with capital and labour
e.g land, enterprise- changing N and K- change the fix proportions of these
factors
Cobb Douglas production function
- CD production function is a particular specification which has properties:
- Simple specification
- Positive marginal product at all levels of input- as you add one extra unit of
labour or capital-
will get extra
product/output
>0
- Diminishing
marginal product
as you increase
inputs
- CD is a particular
version of the general functional form
- When V + lamda =1- CD function as production function= zY
- If its less than one- diminishing returns to scale greater than one increasing
returns to scale as you add more factors
Competitive firm decision
- Suppose all firms operate according to the same production function- work in
competitive markets
- Profit for firm= PY - WN - RK
, - Y is output- P is price of output (revenue), W is wage and R is price of
capital- the rate of return
- Wage x no. workers and rate of return X number of capital
- Assume- firms maximise current profits rather than the value of the firm-
present value of current and all future profits
- They will choose the amount of labour and capital for a given W, R P
production function
- Thus the the optimisation problem to solve is
- Choose N and K to
maximise PF(N,K)-
WN - RK
- Set real wage= MPL- (marginal product of labour)
Demand side in the long run- closed economy
Demand for goods and services
- Consumption investment and government expenditure
- Decisions are forward looking- future and present taken into account
- Basic life cycle model assumes that individuals try and smooth their
consumption over time- save when working to fund retirement
, - Firms capital investment is based upon the value maximising model where
firms determine capital investments to max the present value of current and
future profits
- Governments make decisions on policy variables- taxes and spending- take
them as exogenous
Consumption
- Major component of AD- 50-60%- advanced economies
- c=b(Y-T)- C consumption and b is the MPC- 0-1
- C=bY(1-t)- t is the average rate of tax on income
- Assume that all income changes in the long run are permanent so that any
change in income today represents a change in income in the future
Nominal and real interest rates
- Nominal interest rate I expresses the return on investment in money terms
- Real interest rate r represents the return we get expressed in terms of what
goods we buy today
- We buy one unit of a good today as an addition to the capital stock- give up
an amount Pt (price of good)
- We earn an amount of money (1+i)Pt at the end of the period from the
investment Pt
Investment
- I is the activity of firms adding to and replacing their fixed capital stock- plant
and machinery
- Most of Europe 15-20% and china 40-50% of GDP
- Range of projects firms can undertake- deliver different returns- they have to
compare investing in those projects with the opportunity cost of doing so-
represented by the real interest rate on financial assets- as they need to
borrow
Circular flow of income
- Households supply capital and labour to firms- consume goods and save to
fund firms capital investment
- Firms demand labour and capital from households- produce output and make
capital investment decision
- Identifies the interaction between the financial sector and the real economy-
savings to investment for firms
- Introduces the government as a demander of goods and services
- Implies that all goods produced are demanded
LR model macro equilibrium
- Model assumes that market always clear since all prices are flexible- assume
markets are perfectly competitive
- Supply determines output- resources fully employed- Say’s law- producing
full according to the economy’s production function
- Real interest rate determines the structure of demand for the closed/global
economy
- Real exchange rate determines the structure of demand for the small open
economy- UK
- Both the real interest rate and real exchange rate determine the structure of
demand in the large open economy- USA
- Output determined from the supply side
Output and factors of production
- 2 factors of production- L and Capital- owned by households
- Production of output is represented by an economy wide production function
- Y(output)=F(N,K)- F is production function N labour and K capital
- Assume one good is produced- used for both consumption and investment
, - All other factors are combined in fixed proportions with capital and labour
e.g land, enterprise- changing N and K- change the fix proportions of these
factors
Cobb Douglas production function
- CD production function is a particular specification which has properties:
- Simple specification
- Positive marginal product at all levels of input- as you add one extra unit of
labour or capital-
will get extra
product/output
>0
- Diminishing
marginal product
as you increase
inputs
- CD is a particular
version of the general functional form
- When V + lamda =1- CD function as production function= zY
- If its less than one- diminishing returns to scale greater than one increasing
returns to scale as you add more factors
Competitive firm decision
- Suppose all firms operate according to the same production function- work in
competitive markets
- Profit for firm= PY - WN - RK
, - Y is output- P is price of output (revenue), W is wage and R is price of
capital- the rate of return
- Wage x no. workers and rate of return X number of capital
- Assume- firms maximise current profits rather than the value of the firm-
present value of current and all future profits
- They will choose the amount of labour and capital for a given W, R P
production function
- Thus the the optimisation problem to solve is
- Choose N and K to
maximise PF(N,K)-
WN - RK
- Set real wage= MPL- (marginal product of labour)
Demand side in the long run- closed economy
Demand for goods and services
- Consumption investment and government expenditure
- Decisions are forward looking- future and present taken into account
- Basic life cycle model assumes that individuals try and smooth their
consumption over time- save when working to fund retirement
, - Firms capital investment is based upon the value maximising model where
firms determine capital investments to max the present value of current and
future profits
- Governments make decisions on policy variables- taxes and spending- take
them as exogenous
Consumption
- Major component of AD- 50-60%- advanced economies
- c=b(Y-T)- C consumption and b is the MPC- 0-1
- C=bY(1-t)- t is the average rate of tax on income
- Assume that all income changes in the long run are permanent so that any
change in income today represents a change in income in the future
Nominal and real interest rates
- Nominal interest rate I expresses the return on investment in money terms
- Real interest rate r represents the return we get expressed in terms of what
goods we buy today
- We buy one unit of a good today as an addition to the capital stock- give up
an amount Pt (price of good)
- We earn an amount of money (1+i)Pt at the end of the period from the
investment Pt
Investment
- I is the activity of firms adding to and replacing their fixed capital stock- plant
and machinery
- Most of Europe 15-20% and china 40-50% of GDP
- Range of projects firms can undertake- deliver different returns- they have to
compare investing in those projects with the opportunity cost of doing so-
represented by the real interest rate on financial assets- as they need to
borrow
