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Principles

of macroeconomics

Professor: Cris+n Echeverra Valenzuela


cecheverria@udd.cl

Principles of macroeconomics Spring 2016 Cris+n Echeverra Valenzuela

Where we are:



PART 2. LONG-RUN FUNDAMENTALS: ECONOMIC GROWTH, PRODUCTIVITY
AND LIVING STANDARDS.

2.1 Economic growth, the nancial system and business cycles (HO, chapter 13)
2.2 Saving, investment, capital forma+on and growth
2.3 Interna+onal trade, capital ows and the exchange rate
2.4 Popula+on, labor force and growth
2.5 Technological progress and growth
2.6 Asset and nancial markets, money, and the Central Bank

Principles of macroeconomics Spring 2016 Cris+n Echeverra Valenzuela

2.1 Economic growth, the nancial system and business cycles


QuesUons of this secUon

What are the determinants of long run, or sustainable growth? (Why care?)
Factors of produc+on (quan+ty, quality and produc+vity of labor,
capital, land, the environment)
Technology
Why some countries grow so fast, and others so slow over extended periods?

How can we tell the economy is away from long run, or sustainable growth?

Principles of macroeconomics Spring 2016 Cris+n Echeverra Valenzuela

2.1 Economic growth, the nancial system and business cycles


Why China per capita GDP has grown 15 Umes in the last 35 years, whereas
US GDP only 80%?

Principles of macroeconomics Spring 2016 Cris+n Echeverra Valenzuela

2.1 Economic growth, the nancial system and business cycles


Long run economic growth

Economys ability to increase produc+on of goods and services (i.e. living
standards) over +me.

Aggregate produc+on func+on: a rela+onship that shows the level of
poten+al GDP (poten+al output, Q) that can be a^ained with given levels of
capital (K), labor (L), and the available technology (T):



Poten+al output = Q = F (K, L, T)

It can also show the growth rate of poten+al GDP that can be a^ained with
given growth rates of capital (i.e. investment), labor (i.e. Labor force and/(or
produc+vity growth rate), and technology.


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Principles of macroeconomics Spring 2016 Cris+n Echeverra Valenzuela

2.1 Economic growth, the nancial system and business cycles


Long run economic growth

Q = F (K, L, T)

In the short run (3 years or less), the level of K and T is pre^y much xed, and
determined by previous years investment and adop+ons of technology. Thus,
GDP uctua+ons are determined mostly by changes in L, weather, and other
transitory events.

In the long run (more than 3 years), changes in poten+al GDP are also the result
of changes in K and T.

PotenUal GDP: The level of GDP that can be a^ained when all rms are producing
at capacity, and employment is at a normal level.

Ex. 1: What are the determinants of long run economic growth for the US?
L is growing very slowly (almost zero).
K is growing rela+vely slowly (Investment/GDP = 16%; Chile = 20%;
China = 50%)
T has been growing fast.

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Principles of macroeconomics Spring 2016 Cris+n Echeverra Valenzuela

2.1 Economic growth, the nancial system and business cycles


Long run economic growth

Q = F (K, L, T)

Ex. 2: What were the determinants of long run economic growth for China
during the recent past?
L has been growing very fast (2% +; Chile = 1%; Japan = -0,2%).
K has been growing very fast (Investment/GDP reached 50%; Chile = 22%)
T has been growing very fast (largest robot importer in the world)

Ex. 3: What will be the determinants of long run economic growth for China
for the next 35 years?
L will shrink (-0,5% per year;)
K will be growing more slowly (projected investment/GDP = 30%)
T will keep growing fast
Principles of macroeconomics Spring 2015 Cris+n Echeverra Valenzuela

2.2 Saving, investment, capital formaUon and growth


Investment and output

The nancial system intermediates loanable funds between savers (lenders, supply of
funds) and investors (borrowers, demand for funds).

Saving: disposable income less consump+on.

Saving is posi+vely aected by:
An increase in wealth
An increase in the real interest rate (or the net incen+ve to save)
An increase in disposable income (a reduc+on in personal taxes).

Principles of macroeconomics Spring 2016 Cris+n Echeverra Valenzuela

2.2 Saving, investment, capital formaUon and growth


Investment and output

Investment: accumula+on of produc+ve capital. It is cri+cally important for increases
in average labor produc+vity, and living condi+ons in the long run.

Investment is posi+vely aected by:
A reduc+on in the price of new capital goods
A reduc+on in the real interest rate
Technical progress that increases the marginal produc+vity of capital
A reduc+on in corporate taxes (or capital income)
An increase in the price of nal produc+on
A reduc+on in the produc+on costs (input prices, eciency gains).

Principles of macroeconomics Spring 2016 Cris+n Echeverra Valenzuela

2.2 Saving, investment, capital formaUon and growth


Investment and output

The price of loanable funds is the opportunity cost for lenders and borrowers: the real
interest rate (or real return of deposits and loans).

The loanable funds market equilibrium implies that total saving in the economy is
equal to total investment:

Y = C + I + G + NX
I = Y C G NX But: Sp = private saving = (Y + TR T C)


SG = government saving = (T G TR)


= > S = na+onal saving = Y C - G

= > I = S NX


Investment is funded by na+onal saving and external saving from the rest of world (i.e.
the current account decit). This is the rela+onship between capital ows, saving and
investment.
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2.2 Saving, investment, capital formaUon and growth


Investment and output

Demand for loanable funds (demand for investment):
Depends nega+vely on the real
interest rate (r), or opportunity
cost of funds). Why?

An increase in the real interest


rate reduces the NPDV of
investment projects.

r1
r0

-
I ( r, u, x)

I1

I0

Less investment projects will be


protable, and implemented.
I

Less loanable funds will be demanded


for investment.
It also depends on perceived
uncertainty (u) , and expecta+ons
about the future (x).

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2.2 Saving, investment, capital formaUon and growth


Investment and output

Supply of loanable funds (supply of saving):
r
+
S ( r, Yd, u, x, SG, NX)

r1
r0

S0

S1

Depends posi+vely on the real


interest rate (r), or opportunity
cost of funds). Why?
An increase in the real interest
rate induces households (and
some rms)to save more.
It also depends on disposable income
(Yd), perceived uncertainty (u),
expecta+ons about the future (x),
government saving (SG), and net
exports (NX).

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2.2 Saving, investment, capital formaUon and growth


Investment and output

Investment in the long run:
What would be the eect of a
corporate tax increase on
investment and poten+al output?

r
S

Reduces the demand of loanable


funds for investment.

r0
r1

Reduces the long run equilibrium


level of investment (and saving).

I0
I1

I1

I0

S, I

Reduces the equilibrium real interest


rate.
Reduces poten+al output, since it
reduces the growth rate of the stock
of capital K.

Principles of macroeconomics Spring 2016 Cris+n Echeverra Valenzuela

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2.2 Saving, investment, capital formaUon and growth


Investment and output

Investment in the long run:
r

What would be the eect of an


increase in the budget decit on
investment and poten+al output?

S1
S0

r1

Reduces the supply of saving


(loanable funds for investment).

r0

Reduces the long run equilibrium


level of saving (and investment).

I1

I0

S, I

Increases the equilibrium real interest


rate.
Reduces poten+al output, since it
reduces the growth rate of the stock
of capital K.

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2.2 Saving, investment, capital formaUon and growth


Investment and output

Investment in the long run:

What would be the eect of an


increase in foreign direct
investment (FDI) on investment
and poten+al output?

r
S1

S0

r1

Increases the supply of saving


(loanable funds for investment)
and the demand for investment.

r0
I0

I0

I1

Increases the long run equilibrium


level of saving and investment.

I1

S, I

Uncertain eect on the equilibrium


real interest rate.
Increases poten+al output, since it
increases the growth rate of the stock
of capital K.

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2.3 InternaUonal trade, capital ows and the exchange rate


The equilibrium in the foreign exchange market implies:

X + AX = M + AM
X = exports of goods and services


AX = exports of assets


M = imports of goods and services


AM = imports of assets


NX = X M = net exports

KI = AX AM = capital inows

X M = AM AX => NX = - KI
E

O = X + AX

690

D = M + AM

Quan+ty of US$
Principles of macroeconomics Spring 2016 Cris+n Echeverra Valenzuela

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2.3 InternaUonal trade, capital ows and the exchange rate


The loanable funds market equilibrium implies that total saving in the economy is
equal to total investment:

Y = C + I + G + NX

NX = X - M
I = Y C G NX But: Sp = private saving = (Y + TR T C)


SG = government saving = (T G TR)


= > S = na+onal saving = Y C - G

= > I = S NX
=> S I = NX

But NX =

The excess of saving over investment is equal to net exports.
If S I > 0 => NX > 0 => there is a capital ouxlow.

Why?

Principles of macroeconomics Spring 2016 Cris+n Echeverra Valenzuela

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2.3 InternaUonal trade, capital ows and the exchange rate


Ex: Sustained increase in exports

In the long run implies sustained capital ouxlows. The external component of total
saving would decrease. Total investment would decrease, reducing long run growth.

O = Xo + AX
O1 = X1 + AX

690

D = M + AM

Quan+ty of US$

Principles of macroeconomics Spring 2016 Cris+n Echeverra Valenzuela

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2.3 InternaUonal trade, capital ows and the exchange rate


Ex: Decrease in domes+c interest rates (or increase in interna+onal interest rates)

Depreciates the domes+c currency. Reduces the external component of total saving.
Reduces investment. Can reduce poten+al output if it is the result of a long term
change (permanent reduc+on in the supply of total saving, or reduc+on in the demand
for investment).

O = X + AX1
O = X + AX0

480

D = M + AM1
D = M + AMo
Quan+ty of US$

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2.4 PopulaUon, labor force and growth


In the long run, the labor input in the produc+on func+on depends on:

Demographics: popula+on and labor force growth.

Economics: labor force par+cipa+on rate (males, females, young workers); migra+on;
educa+onal level; skills composi+on of the labor force.

Structural policies: labor market development and liberaliza+on;

Ins+tu+onal framework: labor and tax legisla+on; social security and welfare state;
educa+on system.

Culture: work habits and aytudes; mo+va+on; crea+vity and produc+vity.

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2.4 PopulaUon, labor force and growth


Employment and output


Q

Q ( K, L, T )

The slope is the


marginal product
of labor MPL (or
labor produc+vity).

Is decreasing on L.

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2.4 PopulaUon, labor force and growth


Employment and output

Demand for labor
The MPL is the
demand for labor:
relates real wage
and employment.

MPL, w/P

wH

- + +-
MPL = Ld ( w, K, T )

Is decreasing on w.

wL

LdwH

LdwL

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2.4 PopulaUon, labor force and growth


Employment and output

Supply of labor

Households choose between


leisure and work.

MPL, W/P

+ +
Ls (w, N)

The individual supply of labor


depends on real wages (+ -).
The subs+tu+on eect is always +

wH

The income eect can be + or -

wL

The total eect can be + or -

LswL

LswH

The agregate supply of labor is


posi+vely sloped, even if for some
individuals it could be nega+vely
sloped for very high wages.
The aggregate supply of labor also
depends on demographics (N).

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2.4 PopulaUon, labor force and growth


Employment and output

Employment in the long run:
MPL, w/P

What would happen if there is a


reduc+on in the stock of capital?

Ls (w, N)

Reduced demand for labor.


w0
Ld ( w, K0, T )

w1

Ld ( w, K1, T )

L1 L0

If wages are exible, lower wages and


less employment.
If wages are not exible, increase in
unemployment.

Ls, Ld

What happens with poten+al output?

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2.4 PopulaUon, labor force and growth


For the same levels of K, T, improvements in the labor input can increase poten+al
output.


Given K, L and T,
Q

more skilled or

mo+vated workers
would allow the
Q ( K, L1, T )
economy to
Q ( K, L0, T )
produce more in
the long run.

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2.5 Technological progress and growth


Technological progress shi_s upwards the producUon funcUon


Q
Q ( K, L, T1 )
Q ( K, L, T0 )

The slope is the


marginal product
of labor MPL (or
labor produc+vity).

Is decreasing on L.

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2.5 Technological progress and growth


Technological progress increases producUvity

Demand for labor
The MPL is the
demand for labor:
relates real wage
and employment.

MPL, w/P

- + +-
MPL = Ld ( w, K, T )

Is decreasing on w.

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2.5 Technological progress and growth


Improvement in technology

MPL, w/P

Ls (w, N)

w1
w0

L0

L1

Ls, Ld

There is more
employment, and
poten+al output
increases, because
of an increase in L,
MPL and T.

Poten+al output = Q1 = F (K, L1, T1)

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2.6 Assets and nancial markets, money and the Central Bank
Financial markets

They intermediate the supply of savings (from househols and some rms) and
the demand for investment (from households and most rms).

Financial intermediaries: specialized rms on borrowing funds from savers,
and lending them to borrowers. Banks, pension funds, mutual funds and life
insurance companies, among others (brokers, hedge funds, etc.).

They also help to share risk, provide liquidity, and informa+on.

Risk: a context in which event occur with some probability. Not to be
confused with the probability itself. It is related to expected gain or loss.


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2.6 Assets and nancial markets, money and the Central Bank
Risk sharing

Ability to spread nancial risks, by saving on a variety of assets and
dierent ins+tu+ons, or borrowing from a variety of ins+tu+ons (banks, the
bond market, other rms) and instruments (loans, bonds), with poten+ally
dierent performances under the same expected economic and market
condi+ons

Liquidity

The ease with which a nancial asset can be bought or sold at a price close to
its fundamental value.

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2.6 Assets and nancial markets, money and the Central Bank
Uncertainty and informaUon

In normal +mes, the nancial system and markets provides informa+on, and
reduces uncertainty among borrowers and lenders about the fundamental
value of assets.

In +mes of crisis, markets and the nancial system become dislocated,
liquidity decreases, risks and uncertainty increase.

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2.6 Assets and nancial markets, money and the Central Bank
The Central Bank and the long run

The Central Bank (and the nancial authori+es) regulate and supervise the
appropriate func+oning of the nancial system. They try to keep at bay the
conicts of interests, informa+on assymmetries, and moral hazard.

The sustainability of the nancial system can contribute in a signicant way to
the sustainability of long term economic growth.

The Central Bank also implements monetary policy: controls short run
interest rates and/or the quan+ty of money. In the short run, it can also
inuence the yield curve.

The goal of monetary policy is to keep ina+on within its target all these are
nominal variables.

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2.6 Assets and nancial markets, money and the Central Bank
The economy in the long run

The aggregate supply in the long run is given by the level or the growth rate
of poten+al GDP. Depends on real resources: labor input, capital, technology,
environmental resources and condi+ons, the nancial system, the
ins+tu+onal framework, and culture. It does not depend on the ina+on rate
(up to a point).
Ina+on

AS LR

Yp

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