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Today we are trialling out a new way to answer PRS (clicker) questions. Instead of using clickers, wed like you to use your mobile devices like laptop, tablet or phone, so we can test the network capacity. You can use the ResponseWare app or vote online. 1Revision Lectures: MacroLuca Metelli2How are you voting today?

With the appOnlineClicker3What do you prefer

MicroeconomicsMacroeconomics4What are you doing in the summer?

WorkingStudyingPartyingVacationsNone of the aboveAll of the above5Summary of the Lent termGDP and National AccountingsEconomic Growth (Solow model)Economic Fluctuations (AS-AD model)Policies to address Econ. FluctuationsInflationUnemploymentFinancial systemEuro Crisis

Before startingMicro: Factor hiring rule, you can skip itLast week, for a few hours there was on Moodle a version of the Micro Revision slides with a typo in the pricing rule of monopoly. Be sure you have the most recent version!

National Accountings8GDP3 definitions:1) Production Approach: Value of final goods and services produced2) Expenditure Approach:Total expenditure on final goods and services produced domestically. Y = C + I + G + NX3) Income Approach:Total income earned by factors of production for domestic production (Return to labor, return to capital and economic profit)

QUESTION: Income approachSuppose a woman marries her butler. After the marriage, the man keeps to wait on her (but not as an employee). Does the marriage affect GDP?Yes, GDP decreases. Total labor income falls by the amount of butler salaryGDP is an imperfect measure!

QUESTION: Expenditure approach. The following transactions are to be consideredC,I,G,X or M?Boeing sells an airplane to the Air ForceGBoeing sells an airplane to American AirlinesIBoeing sells an airplane to Air France XBoeing sells an airplane to Warren Buffet CBoeing builds an airplane to be sold next year I (as inventories!)QUESTION: Production approachCalculate nominal/real GDP, GDP deflator, CPINomGDP 2000 =(100*50.000)+(500.000*10)=10.000.000NomGDP 2010 =(120*60.000)+(400.000*20)=15.200.000Real GDP 2000=Nom GDP 2000Real GDP 2010 (with base year 2000)= ($50,000 120) + ($10 400,000)=10.000.000GDP Deflator 2010= =15.200.000/10.000.000CPI 2010= =1.6

Solow Model13The Solow modelSolow model is a Long Run model to explain growthWe have seen 3 versions:Simplest (no pop change, no tech change)Population changePopulation change + Technological change

14The models features:Output given by the production function F(K,L)Output can be either consumed or investedConstant rate of saving (investment), sConstant rate of capital depreciation,

The model is easily represented in a diagram, in per worker terms (dividing all the variables by L)

15Main equation k = s f(k) k

16Prediction of the Solow modelOther things equal, poor countries (i.e countries with lower Y/L and K/L) should grow faster than rich onesthereby in the long run, poor and rich countries are expected to converge to the same steady state (conditional convergence)

17QUESTION: What determines the steady state and what doesn't?1) Simple version: no pop, no tech

Steady state (SS) is when k = 0 capital SS: k*=sf(k*)/ output SS: y*=f(k*)

Capital SS depends on sProd function fCountries with higher s and lower will have higher levels of capital and income per worker in the LR

18QUESTION: Does output grow in the Long Run?In the simple version in the LR (Steady State) there is no growth.Capital is constant in the LR so it is Output

ONLY WITH TECHNOLOGICAL CHANGE THERE IS GROWTH IN THE LONG RUN.19QUESTION: Effect of change in ( )As k*=sf(k*)/ we have that:k* Since y=f(k), y*

Lower capital p.w in LRLower output p.w in LR

Lower total capital in LRLower total output in LR

20Solow model with tech changeEverything in per-effective-worker term.. now instead of having k=K/L, we have k=K/(L E) where E=labor efficiency ---- E/E=gL E = number of effective workers

the production function in level is F(K, L E)the prod. function in per effective worker term is f(k)

21QUESTION: Find f(k)22QUESTION: what determines the steady state and what doesn't?1) Version with tech change g and pop change n

Steady state (SS) is when k = 0 k*=sf(k*)/ (+n+g)

Capital SS depends on sFunctional form fngIt doesnt depend on labor efficiency E

k = s f(k) ( +n +g)k23QUESTION: Does output grow in the LR?Output per effective worker (Y/LE) is constant (SS)

Output per worker (Y/L) grows at rate g

Total output (Y) grows at rate (g+n)

24QUESTION: Effect of an increase in gCapital p.e.w (you need less capital because tech is very productive)Capital p.w

25AS-AD Model26AS-AD modelVery different from Solow modelAS-AD is mainly a short run modelUseful to explain economic fluctuationsIn AS-AD model fluctuations stem from demand shocks (AD shifts) and supply shocks (AS shifts)Prices are sticky in the SR, Flexible in LR27QUESTION Transmission of monetary policy : Effect of a reduction in money supply Money supply causes AD to fall. Why?Look at the Money marketMoney supply=Money demand

When Money supply Interest rate . Thismean negative demandshock in AS-AD model

28

29QUESTION: Why does the aggregate demand slope downwards?Sloping downward means that for high P, AD is low , for low P AD is high

Start focusing on the money market

30In the money market, P means a reduction in real money supply (M/P)

So, higher levels of P are associated with higher interest rates

31Higher interest rates means lower Investment , thereby lower ADSumming up, higher levels of price are associated with lower AD, so the AD is downward sloping32QUESTION: Effect of increase in oil priceAs production costs increase, SRAS shifts upward, equilibrium in BIf the Fed cares about keeping output at natural level, it increases AD by increasing MThe economy immediately reaches a new equilibrium at point C. The price level is permanently higher, butno loss in outputIf the Fed cares about keeping prices stable, then there is no policy response it can implement.Hence, the Fed must simply wait, holding AD constant. Eventually, prices fall and end back in point A. Butprolonged recession.

Inflation and Hyperinflation34Inflation, 2 measures:GDP deflatorCPI indexHigh inflation has many social costs: Revise!Costs of expected inflationCosts of unexpected inflation35QUESTION: In WWII, Germany and England had plans for a paper weapon: they each printed the others currency with the intention of dropping large quantities by airplane. Why?The intention was to create inflation (and hyperinflation) in the other countryThis would have created troubles because of:Shoeleather costsMenu costsRelative price more variableCreates uncertainty and redistribution of wealth

36QUESTION:An article reports low inflation has a downside: 45 million recipients of Social Security will see their checks go up by just 2.8% next year. Why does inflation affect the increase in Social Security?Is this effect a cost of inflation? Why?SS checks are indexed contracts If inflation turns out to be lower than the expected one, SS checks will NOT go up by muchRecipients are unaffected by this. What matters is the real value of SS checks. Thereby this effect is not a cost of inflation37QUESTION:38QUESTION:Q: Is expected inflation a possible problem for an indexed lending/borrowing contract? What about unexpected inflation?Sketch:Explain what is indexed contractInflation does not affect this contract. Why?

39QUESTION: What is the inflation tax? Who pays for that?The holders of money pay the inflation tax. That is, a given amount of money buys fewer goods and services since prices are higherAlso holder of nominal bonds pay for the inflation tax

40QUESTION: Inflation is repudiation, a finance ministry said. What does it mean? Think that a government is a net debtor in nominal terms to the private sector. Let B denote the governments outstanding debt. The debt in real terms equals B/P, where P is the price level. By increasing inflation, the government raises the price level and reduces in real terms the value of its outstanding debt. In this sense we can say that the government repudiates the debt. Only when inflation is unexpected. If inflation is expected, people demand a higher nominal interest rate. Hyperinflation and policies to end itHyper-inflation is when inflation is higher than 50% per monthHyperinflation is caused by excessive money supply growthUsually when a government cannot raise taxes or sell bonds, it start finance spending by printing money (seignioraige), causing hyperinflation

42To end hyperinflationFiscal reform (spending less/taxing more)Stop printing moneyFixed rate of M growth (choose and keep a constant and lower money supply growth)Inflation target (adjust money supply growth to achieve the desired inflation rate)Fixed exchange rate (central bank needs to maintain a money supply growth compatible with a fixed exchange rate. If M grows too much exch rate depreciation!

43Unemployment44A first model of the natural rate: L = # of workers in labor force E = # of employed workersU = # of unemployed

L is exogenously fixed. 2.During any given month, s = rate of job separations, fraction of employed workers that become separated from their jobsf = rate of job finding, fraction of unemployed workers that find jobss and f are exogenous

45The steady stateThe labor market is in steady state if the unemployment rate is constant. The steady-state condition isFinding the equilibrium U rate (substituting E=L-U) s E = f U

46QUESTION: What determines the natural rate of unemployment?As nat.rate=s/(s+f), it depends only s and fImportant to know how different factor/policies affect s and fUIGovt employment agenciesJob protectionTaxesWage setting

47QUESTION: Do Americans work more or fewer than Europeans? List 3 hypothesesEuropeans work fewer hours than Americans. Higher income tax rates in Europe reduce the incentive to work.Larger underground economy in Europe as a result of more people attempting to evade the high tax rates.Greater importance of unions in Europe

48QUESTION:Can the real wage remain above the level that equilibrates labor demand and supply? Give 3 explanationsMinimum wage lawsThe monopoly power of unionsEfficiency wages.

Structural unemployment49QUESTION: Difference frictional and structural unemploymentFrictional unemployment is the unemployment caused by the time it takes to match workers and jobs. Because different jobs require different skills and pay different wages, unemployed workers may not accept the first job offer they receiveStructural unemployment is the unemployment resulting from wage rigidity and job rationingThese workers are unemployed because at the prevailing real wage the supply of labor exceeds the demand.The Financial system51The story of the financial crisisHousing Excessive optimism and too much lax lending standards made house prices to boomOver time, housing boom unsustainable, many homebuyers fell behind their debt paymentsPrices fell by over 30%From housing to banksAs House is usually a collateral, value of collateral fallsBank not able to recover its moneyFear of bank insolvencies

52From banks to the economyConfidence in financial institution droppedInvestor started to withdraw their funds from banksBanks, to be able to fullfill the withdrawing requests, started to firesale and to cut lendingCredit crunchRecessionVicious circle53What does it mean for a Central bank to act as Lender of Last Resort?When a central bank acts as a lender of last resort, it helps to alleviate a liquidity crisis.A liquidity crisis occurs when the financial institution has insufficient funds (but still is solvent) to satisfy the claims of its creditors.If the central bank lends funds to the financial institution, the creditors claims can be met. These actions help to restore and maintain the publics confidence in the banking system.QUESTION: What is a shadow bank? Shadow banks include investment banks, hedge funds, private equity firms, and insurance companies. (Everything but commercial banks)Their deposits are not federally insured, so they are not heavily regulated like traditional banks and can take on much more risk. After the crisis policymakers suggest limiting the risk they can take

QUESTION: How does the leverage ratio influence the stability of a financial institution in response to a crisis?The leverage ratio is the ratio of a banks assets to its bank capital.

The higher its leverage ratio, the less stable the financial institution during a time of bad economic news. If a bad economic news reduces the value of the bank assets by 5%, this is equivalent to the $50 of bank capital. Beyond this point, the financial institution has no funds with which to pay off future creditors.

Here Leverage ratio = 20