Principles of macroeconomics
Summary Chapter13-18
Chapter 13
Introduced in previous chapter, the economy's potential output is based on the average worker's productivity, so this chapter will further discuss the factors that affect productivity. The primary factors are the labor and capital stock. The optimal combination of these two factors will aid the firm to achieve the maximum productivity. In addition, those factors determine the rate of transferring labor and capital into output are the secondary factors. For instance, the technology, managerial expertise and skills are all secondary factors. According to the law of diminishing return on capital, the marginal revenue product of capital(MRPk) needs to be calculated. It defines the extra revenue received by a firm from selling the product obtained from an extra unit of capital. Similar to the marginal product of labor. The firm will have the incentive to increase the capital stock if the MRPk is at least great as the real interest rate, which is the opportunity cost for the firm to invest in capital. Therefore, the optimal capital stock level is when the costs of adding another unit of capital can exactly offset by the marginal revenue product. Furthermore, for another primary factor labor, the optimal labor number should hire by the firm is when the MRPl is equal to the wage. This can be rewritten to when the marginal product of labor is equal to the real wage. Bringing up the capital and labor factor together, a production function can be represented: which is , at which the A is the total factor of productivity(secondary). Therefore, we can predict if we hold either capital or labor constant, increase in capital/labor will raise the output at a diminishing rate. For more practical use, the Cobb-Douglas production function which utilize the specific parameter α. It represents the share of total income in the economy that is paid to the owners of capital. Given by the formula:, so we can also calculate the marginal product of capital with and the MPl with. Applying the Cobb-Douglas function, we can determine the economic growth rate in real GDP in terms of primary and secondary factors. Because of the constant scale of return, the proportion changed in output should be resulted from the exactly proportion changed on input.So, ; and . The total growth framework will be .
Chapter 14
Both the national savings and investment spending represent the holding of resources from current income so it can be used to generate future benefits. As a consequence, in a closed economy, the saving is expected to be equal to the investment. The Solow-Swan model(Neo-classical) of economic growth focus on the capital formation in a country and to evaluate the relationship between the nation’s GDP per capita and savings(investments). Hence, the Solow-Swan model assumes the labor forces are held constant in an economy, then the production function will be rewritten into y=Af(k). Where y is the GDP per capita, and k is the capital-labor ratio which represents the average capital available for each worker. As studied before, the law of diminishing return of capital defines the increase in capital stock at the start will have a larger impact on output. Eventually the y will enter the steady state which the per capita capital stock is neither growing nor shrinking. Thus the per capita income is unchanging. To access further analysis, the investment on capital stock is divided into two categories: the replacement investment that is either to replace wor0out, depreciated capital or to provide capital to new workers. It does not change the size of the per capita capital stock. Another type is the net investment that adds to the size of the per capita capital stock. With rearranging the mathematical function, we can observe that the that is the saving rate on total income, d is the depreciation rate on capital stock, and n is the population growth rate The steady rate is when the capital-labor ratio is not changing, therefore it will occur when the saving of the economy is equal to the replacement investment. As a consequence, the economy growth only occurs when the savings have excess the replacement investment. The Solow-Swan function also predicts that poor countries will grow at a fast rate than rich countries as long as both groups of countries have the same long-run steady state. This hypothesis is called the convergence hypothesis, the reason behind it is the diminishing return of capital. Although the Solow-Swan model provides the insight of the savings and capital that affect economic growth, it ignores the impact on Solow-residuals(secondary factors). So than the extension model like endogenous growth model can be used.
Chapter 15
When an economy opens to free-trade, there are associated problems and benefits. In order to understand the future benefit in a concise layout, the present value of the return in the future has to be calculated. There are two types of commodities are trading on the international market, the merchandises and the services, defined by the WTO. The gap between the import and export for a country indicates it economy is experiencing a trade deficit or trade surplus. Obviously, if the price on a specific good in an economy is greater than the world price, the economy will tend to be come a net importer of that product. In contrast, the economy will become the net exporter of that good or services. As discussed in previous chapter, the consumers of imported goods and the producers of exported goods are the winner form global trade. On the other hand, the consumers of exported goods and producers of imported goods are the losers. In order to compensate the losers in world trade and reduce the trade deficit, the government adopts tariff and quota on the imported goods. The tariff acts as an increase in the world price, so the excess demand corresponding to that price is reduced. The quota restricts the volume of imports that can enter the country, so it acts together with the supply. which shift the supply curve to the right as to reach a new equilibrium level. Neither the tariff nor a quota creates economic efficiency, since there is always a dead-weight loss in the total economic surplus. Many nationals establish free-trade agreement to against the inefficiency generated by the trade barriers. The factor price equalization theory claims that countries which trade freely with each other will have the same ratio of payments to capital and labor as each other. Therefore it will reduce the inequality. However, the trade will also bring the countries having the least stringent environment regulations to become a pollution heaven for the industrial countries.
Chapter 16
The exchange rate for a country’s currency can be determined with different policies: the flexible exchange rate, which the rate varies according to the supply and demand for the currency in the foreign exchange market. Alternatively, the government can use the fixed exchange rate police, that set an official rate and maintain it with government force. When trading in the international market, the real exchange rate is essential for the firm to compare the relative price of product. It can be calculated with divide the price of domestic good by the price of foreign goods values in domestic currency. A high real interest will reduce the net export value, therefore, the total output in an economy. The exchange rate between two countries can be determined by the purchasing power parity, which assumes the currencies of countries that experience significant inflation will tend to depreciate. This is an implication of the law of one price, so in the long-term when the transportation costs are relatively low, compare the price of a basket of domestic commodities with the price of an exact basket in another country, will represent the relationship of the two countries nominal exchange rate. Inflation implies that a nation’s currency is losing purchasing power in domestic market, whereas depreciation indicates losing purchasing power in the international market. In the foreign exchange market, the nominal exchange rate is determined by the supply and demand of the currency. The market equilibrium is called the fundamental value of the exchange rate. The suppliers in the foreign market supply the domestic currency in order to settle foreign transaction or purchasing foreign assets. Hence the supply will increase if there is an increase on preference of foreign goods, the domestic real GDP or the foreign real interest rate. The demander in the market, on the contrary, is pursuing domestic goods and assets. Therefore, when the reserve bank applies a tighter monetary policy that leads to a high real interest rate, the demand of domestic currency will increase and pull up the nominal interest rate. Consequently, the high real interest rate will not only reduce the aggregate demand of consumption and the investment spending, but also the export due to the high nominal exchange rate. A country may want to maintain a fixed rate of its currency, and if this fixed rate is higher than the fundamental value, it faces a devaluation pressure. So the government needs to use its international reserves to provide balance-of-payments by purchasing the excess supply of the currency. However, the international reserve is not unlimited, plus the fear of devaluation may cause a speculative attack by foreign investors, which creates more excess supply in the market. Thus the government may choose to set up import barriers to reduce the supply of domestic currencies. It is extremely costly to the economy so the more common way is to raise real interest rate by a tighter monetary policy. That will bring the demand of currency to a higher level, so the fixed exchange rate can be maintained. But the reserve bank will lose control over the stabilization force of inflation.
Chapter 17
The balance of payments is a record kept by a country for all transactions made between the country and other nations. This record is divided into two sectors: the current account and the capital account. The current account records transactions leading to a change of ownership of commodities or a direct flow of income or other similar payment. To illustrate, the accounts in this sector include: the balance on merchandise trade, net services, net income, current transfers. The merchandise trade are the net balance of a country’s total exports and imports, it will be a positive amount if the country is experiencing trade surplus. These amounts are measured free on board, which the freight and insurance charges are assumed to be paid by the purchasing country, recorded as the net services. The net income is the direct income such as interest, dividend and royalty payments from overseas. People live overseas receive income in domestic will be recorded as a debit item. Current transfers are those one-off transactions that are not recorded elsewhere in the current account, such as a fund from new migrants, or the foreign aid to developing countries. If the currency needs to be exchange to foreign currency to make the transaction, it is a debit item. If the transaction leads to an outflow of foreign exchange, it is recorded as a credit. On the other hand, the capital account records all transactions that are related to acquisition of either an asset or a liability. There are three accounts to be reported: the net capital transfers, the nest acquisition/disposal of non-produced, non-financial assets, and the balance on financial account. The capital inflow is when domestic resident selling domestic assets or borrowing from foreign lenders. In contrast, the capital outflow is domestic citizens purchasing foreign assets or invests in foreign financial products. The capital inflow/outflow is determined by the return and risks in the both domestic and international market. In any given period, the sum of the balance in current account and capital account equals to zero. That is because the domestic currency held by a foreigner must be used to purchase goods, services or asset from domestic residents. As stated before, the investment expenditure is supplied by the national savings in and closed economy. But in an open economy, the firm may borrow from foreign agents, so the investment is equaled to the national savings plus the net capital inflow. However, if the domestic real interest rate is high, the excess supply of funds will create a capital outflow, vice versa. By rewriting the equation Y=C+I+G+NX, we can find out the net export is the national savings less the investment, so the low national saving level can have a enormous impact over net export.
Chapter 18
The Keynesian economists look to the aggregate demand side of the economy to explain business cycle fluctuations. They believe that government management of the macroeconomics is required to maintain a high level of aggregate demand so that economy can avoid recessions. Monetarists disagree with the view that the economy has a tendency to move into recession. They view inflation is the major threat to the ability of the market to efficiency allocate resources. The new classical macroeconomics assumes that the agents within the economy have rational expectations, so people will adjust their behavior in ways that ensure that output is unaffected. Macroeconomics is constantly evolving, so there will be more endeavors required in the future
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