1. For the online exam, what chapters is it based on?

Chapters 1-6 of Barro.

2. Say Hi to James that was in d New Zealand Jersey in d lodge last nite…we remember u!!

Hi James, you stud.

3. Was that a genuine or sarcastic comment about the shoes babe?

Genuine, babe. I happen to like leopard print shoes (but only because Off the Rails tells me to).

4. How many marks per question and is there negative marking?

1 mark per correct question, -0.25 per incorrect answer in the exam. No negative marking on the online tests. 

5. Is there any way we can see the qs we got right or wrong on sulis because it would really help. 

Sorry, University policy on exams won’t let me release them.

6. What’s the difference between big R and little r?

Big R is the rental rate for the entire economy, little r is the rental rate an individual household experiences.

You’ll also want to read Barro, chapter 8, before this lecture.

Economists pretend we can measure the business cycle, and make serious and deep efforts to understand it as a profession, but economists are largely powerless to do anything about business cycles. We experience them like anyone else. Even the wikipedia article defining it is continually in dispute.

What is a business cycle?

Well, we call it a ‘cycle’ because there seems to be an up and down relationship between real (or actual) GDP and trend (or potential) GDP. When an economy is below it’s trend GDP, it might be heading into a recession. When an economy is above it’s trend GDP in terms of it’s real GDP, it might be experiencing a boom period.

GDP is assumed to break down into two parts, Real trend and cyclical. The cyclical part of GDP is the real part minus the trend part, and that is what we want to explain in this section of the course.

Barro shows us the proportionate deviation from trend GDP of the US Economy. What does it look like for Ireland?

It looks like the figure below, where our ‘output gap’ to 2005 is shown. 

We’d like to explain the existence and movement of business cycles through an equilibrium framework, so we’d like to consider changes in GDP, Y, C, etc, as they are affected following a shock, say, to technology, , or to investment, , or access to credit (as we’ve seen recently).

The starting place for an equilibrium business cycle model is the production function,

.

In the short run, the capital stock , is fixed. The assumption is that if changes (say, computers fall out of the sky), that will effect only.

We derived the following two results in a previous lecture: the marginal product of labour will equal the real wage rate in equilibrium . Similarly, the interest rate will equal the marginal product of capital, which will equal the return on capital minus the depreciation rate: .

Our equilibrium business cycle model will have to explain changes in consumption, saving, and investment, over the business cycle.

So, we need an expression for a household’s budget constraint at any moment. Luckily, we have one:

.

This equation tells us the household’s consumption and saving decision is dependent on it’s real wage rate and it’s real asset income, .

If we aggregate all the household’s budget constraints in the economy, we have

,

which says that consumption and net investment is equal to real GDP minus depreciation, or real net domestic product.

If we substitute in the production function , we get

What will the income effect be on from a change in ? Because depreciation is fixed in the short run, we have technology increasing real income, and consumption will rise. The intertemporal substitution effect fights against the income effect on this, so no sharp prediction can be made.

Consumption and Investment

What does consumption and investment look like over the business cycle in Ireland?

We’ll go through more examples in the lectures.

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Firms are only  ’placeholder’ entities which consist of rental agreeements between households, who actually own all the capital, and labour, . Households rent capital to firms at a rate , and labour at a rate . The firm produces output according to , our simple production function. The total supply of labour is assumed to be used in production, so , and the total capital available is used in production, thus . Money is present in the system only as a lubricant,or medium of exchange: agents hold it temporarily while trying to get more consumption rather than for it’s own sake. Money is measured in nominal terms.

The price level, , allows us to deflate nominal values to real values. So, is the real exchange rate of goods for money, so will purchase you units of the good. The real wage rate, , in equilibrium, is equal to the marginal productivity of labour, . Similarly, the real return on capital, , is equal to the marginal product of capital, .

Now, each market is assumed to find itself in equilibrium, so the budget constraint faced by the households is going to come from it’s income in each of the four markets.

Market | Nominal Income | Real Income

Product Market | Profit, |

Labour Market | Wages, |

Capital Market | Rent, |

Bond Market | Interest, |

Now, this economy is populated by the households. The households want to maximise their total incomes for consumption given the price level, , subject to the budget constraints imposed by their holdings of their total assets (in this particular period).

The household’s total income is given by

Total Household nominal income = nominal profit + nominal wage income + nominal rent income + nominal rent income.

or:

Household nominal income = .

Now, Barro defines savings as the change in assets over time. The assets in this economy are money, , bonds, , and capital, , so the nominal value of assets = . The change in the nominal value of the assets, or the savings, will look like

Assuming the change in money is zero, then we have that nominal saving is the difference between nominal income and nominal consumption.

The household budget constrain in nominal terms is given by

.

This equation tells us the household in each period has to balance their consumption and their saving against their incomes from the various sources.

The real valued version of the budget constraint is given by

Or, in words: consumption + real saving = real income.

Again, in equilibrium, the , and .

Consumption and Saving

Now, the previous section spent itself working out the details of the equilibrium macroeconomic model.

We’ll study the household’s choice of consumption profiles over time. The household has to choose how much consumption and real saving to do in each period. This amount, consumption plus saving, has to equal the amount of real income in the period.

We know from the equation above that the real budget constraint is:

Now, we want to extend it over time.

Starting at year 1, the year which follows year 0 (I know it sounds stupid, but it’ll make the equation easier to read, so bear with me), the budget constraint will be

In year 2, the budget constraint will be

.

Now, the important point to note here is to see the relationship between year 1 and year 2. Combining the two years using the relationship between bonds and price levels, we have

.

This two year budget constraint is discounted into the present by the value of the interest rate, , which divides the value of, say, consumption, in period 2 by a discount factor to obtain it’s present value. The basic idea is consumption tomorrow is less highly valued than consumption today. We would like to measure how much tomorrow’s consumption is worth in today’s terms. We use the discount factor to achieve this.

Using the discount factor approach, we can derive (see Barro pages 157-158) an expression for the present value of consumption being equal to the present value of the source of funds minus the present value of assets at the end of the second year.

.

where .

We can use this equation to examine changes in consumption and savings behaviours of households over time, using the familiar income and substitution effects.

Income and Substitution Effects.

You have studied income and substitution effects in Prof. Dineen’s class last semester.

The household wants to choose a path of consumption over the periods it is alive which maxmises consumption, given the budget constraint. The household can change the profile of it’s consumption, choosing to consume less today and more tomorrow, or vice versa. The interest rate, , allows the household to choose which course of action to take. The higher the discount factor, , the higher the reward for waiting. There is an intertemporal substitution effect brought on by a changing interest rate.

Take, for example, the SSIA scheme. This was a scheme funded by the Irish government which gave €1 for every €4 invested in a particular savings scheme, the SSIA. The savings scheme was very popular, and many people were drawn into the scheme. Because people were saving more, their consumption would go down, and they would trade off present for future consumption because of this.

This is exactly what happened, albeit in a growing economy. More details on an economic analysis of the SSIA scheme can be found here.

In our model, the household responds to a change in the interest rate (and, obviously, the discount factor), by changing it’s consumption and savings mix over time. In each period, consumption + real saving must equal real income. Because the savings rate is dependent on the interest rate, when rises, the savings rate goes up, and the level of consumption drops.

The income effect from a change in the interest rate comes when interest earned on bonds issued in the previous period comes back–when the SSIA matured, or, in period 1, . The ownership of capital, , gives us the rental income received on these assets at the end of the first year.

Putting these two effects together, assuming an increase in the interest rate, the substitution effects sees consumption in the first period drop, in favour of consumption in the next period. The income effect sees an offset in the substitution effect, because if real income rises, then consumption will rise with it and will fall. So there is a tradeoff.

Handout

EC4004_L5_NUmericalExample.pdf

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Now we’ll move onto a micro-founded macro model developed in the later chapters of the Barro book. The basic idea is to specify four markets inside the economy: the products market, the bond market, the money market, and the labour market. We’ll build our macroeconomic equilibria from behavioural assumptions about the actors in the model: households and firms. Households are assumed to want to maximise their incomes from all of these markets, subject to a budget constraint. Firms want to maximise profits. Their interactions, along with the usual macroeconomic accounting identities, such as , give us the macroeconomic equilibrium, called a general equilibrium.

Click the link below to download slides, handouts, etc.

Click the link below to download papers and interviews about growth, technical progress, and the micro-founded macro model.

Papers on Technical Progress

A.J. Julius, Steady-state growth and distribution with an endogenous direction of technical change, Metroeconomica, 56: 1, 2005 [note]

L. Zamparelli, ‘The Relevance of Industrial Policy in a Quality-Ladder Growth Model’ (with P. Giordani), accepted for pubblication to The Berkley Economic Journals in Macroeconomics (download).

Papers on Barro’s Microfounded Macromodel:

JAMES W. DEAN (1990) ON COMPLETING THE MICRO-FOUNDATIONS OF NEW CLASSICAL MACROECONOMIC MODELS*

Australian Economic Papers 29 (54) , 53–67 doi:10.1111/j.1467-8454.1990.tb00471.x.

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Phillip Lane thinks Iceland’s financial problems can be sorted out with the help of the EU. Click below to read why. This reading is especially good for Economics for Business students, so check it out.

Iceland: The EU is the future | vox - Research-based policy analysis and commentary from leading economists

As U.S. gasoline prices go down, driving goes up

As U.S. gasoline prices go down, driving goes up - International Herald Tribune

From calculated risk via Delong. 

Beginning from the growth accounting equation 

and simplifying the notation to look at accumulation in per worker  (, etc) terms with no technological change, we should see that the growth rate of real GDP per worker will be the difference between the growth rate of real GDP and the growth rate of labour, because of diminishing marginal productivity of labour. In our notation, 

And using the same idea, we can show

.

The equation above just says the growth rate of capital per worker is equal to the growth rate of capital minus the growth rate of labour. 

Rearranging our first equation above using the new identities, we get

But we know that in per worker terms, we can reduce this equation to 

The growth of real GDP per worker depends only on the growth rate of capital per worker. 

So, Solow says we should spend time thinking about policies to increase the growth rate of capital per worker in an economy in order to develop. 

Solow Lesson 1: Focus on growth rate of capital per worker, .

How does the growth rate of capital change? 

The growth rate of the capital stock depends on how much the economy saves. This is because, in the medium term, everything saved gets invested. Real income in the macroeconomy must equal the Net Domestic Product, which is GDP taking depreciation () of the capital stock, , into account. We can define real saving as the saving rate times the level of real income, or

Real Saving =  

We know that household income equals the sum of what gets consumed and what gets saved, so the following equation must be true:

And, because in macroeconomic equilibrium savings will always equal net investment, we can say 

.

The change in capital stock will equal gross investment (that in the equation above), so we can write

, and then because the change in the capital stock will equal gross investment minus depreciation of the capital stock, we have something like

.

Which in per worker terms, after some rearranging, which we’ll do in class, is

.

Combine this result with the requirement that the growth rate of labour should be constant, or 

to get the result that the growth rate of capital per worker is dependent on the amount saved out of output per worker minus the cost of replacing depreciated capital per year minus the labour force growth rate, and we have

.

Reversing this equation and plugging in the value for the growth rate of capital per worker, we have

.

Phew! That was a bit of a struggle, but don’t worry, we’ll go through some numerical examples tomorrow. You can also download the slides and a podcast after the lecture. 

You really should read Barro, chapters 3 and 4, to understand this material deeply. 

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There are 6.7 billion people on planet earth right now. 300 people are born every minute, 1/10 of them born to teenagers. 16 of those 300 babies will die by age 5. One of their mothers will die in childbirth, which if you work it out is 40,000 people dead a month. 1,100 people will die every ten minutes, on average, on Earth. Human life generated 2.3 billion tons of carbon dioxide per month in 2007, and we use more than 1/2 of the total fresh water on the planet while producing more than 3 tonnes of waste per person, and cleverly shoving that waste in our water supplies.

We produced $65.61 trillion worth of stuff on earth last year, 2% of which was spent on defence. Globally the average output per person is worth about 10 grand. 30% of the people on Earth who want to work can’t, because they are unemployed. Some might call this a reserve army of labour, but more of that later. Only 4% of the Earth’s population is directly engaged in agriculture, with everyone else either making stuff or selling that stuff. Only 10% of the Earth’s surface is arable land.
We trade a lot with each other, and spend a huge amount of our time digging stuff out of the ground to start productive processes.

Image via Wikipedia

We fight about land. “Stretching over 250,000 km, the world’s 322 international land boundaries separate 194 independent states and 70 dependencies, areas of special sovereignty, and other miscellaneous entities”.  Ethnicity, culture, race, religion, and language have divided states into separate political entities as much as history, physical terrain, political fiat, or conquest, resulting in sometimes arbitrary and imposed boundaries. Boundary, borderland/resource, and territorial disputes vary in intensity from managed or dormant to violent or militarized; un-demarcated, indefinite, porous, and unmanaged boundaries tend to encourage illegal cross-border activities, uncontrolled migration, and confrontation. Ethnic and cultural clashes continue to be responsible for much of the territorial fragmentation and internal displacement of the estimated 6.6 million people and cross-border displacements of 8.6 million refugees around the world as of early 2006.

87% of us have the ability to read the directions on a medicine bottle, and on average humans can expect to live to be 66 years old or so, well up from 40 years ago, when the average age some one could expect to live to was only 40 across the globe. Most people have some form of education, but standards (and definitions of what it means to be educated) are very different depending on where you go.

On Earth, we produce more cars per hour than babies. But only just.

56 Million deaths occur per year,  Which, per day, is 153,781, or 2 per second.  Today 356,201 people were born. In the last 3 seconds, 12 people popped out. Most of those 12 people came from India, China, and Africa.

The world is a very large place, and it is sometimes a good idea to talk about issues using a large frame of reference like a country, or a trading bloc, or a planet. When we talk about the determinants of cycles of boom and bust in the economy as a whole, or talk about the inflation rate, or compare the growth of one country with another, we are using concepts best talked about in macroeconomics. We’ll begin by defining our terms, then move on to talk about economic growth on Friday.

Growth matters. You’ll see why in the lecture when I show you this.

Important concepts I’ll show you tomorrow: GDP, gross domestic product, economic growth, inflation, living standards. Read chapter 1 of Barro, the second part of the book.

In the end, the Panic of 1873 demonstrated that the center of gravity for the world’s credit had shifted west — from Central Europe toward the United States. The current panic suggests a further shift — from the United States to China and India. Beyond that I would not hazard a guess.

The Real Great Depression - ChronicleReview.com

Click below for the notes, kids.

1. Costs, Redux.

Last week we looked at the theory of costs. We defined total cost, marginal cost, and average cost.
We saw that total cost was the sum of fixed costs and variables,
, average cost was the division of total cost by the quantity of output produced, and Marginal cost is the change in cost for a one unit change in output, . We saw their relationship using a Mathematica demonstration.

We saw the difference between short run costs and long costs. The short run has the disadvantage of fixed costs, which are costs associated with inputs one can’t change in the short run. The long run allows one to be more flexible with respect to costs. When we look at per-unit short run cost curves, we see the  familiar relationship, as in the picture below. Play with these curves using the Mathematica demonstration.

1.1 What shifts cost curves in the short run?

We’ll go through these in lecture:

• Changes in input prices.
• Technological Innovation
• Economies of Scope

The relationship between long run and short run cost curves can be seen using this Mathematica demonstration, and yes folks, we’ll go there.

2. Profit Maximisation and Supply

Firms exist to capture economies of scale by reducing transactions costs. This is the Coase Theorem. The firm is assumed to want the most for itself and its shareholders or owners. The firm is assumed in simple models to try to maximize its profits, , which we defined in the last lecture as

,

where represents the total revenues the firm gets for producing some level of output , and represents the total cost the firm incurs for producing some level of output, .

The firm has to choose what level of output to produce. Remembering the definition of marginal cost: , we’ll show in lectures that the profits of the firm reach a maximum when the slope of the total cost curve is equal to the slope of the total revenue curve, or, at the optimum level of output, ,

Or:

(It’s really important to remember that one, so I’m putting it in red.)

How does the firm actually do this? By trial and error. The firm will experience for output levels below , which tell it to produce more output, , until it equals or exceeds . If the firm produces more output than , it will experience , so it is losing money on each additional sale. There are a fair few examples of this situation occurring in real life, notably in the music industry.

For example, a popular story about the New Order song, “Blue Monday” holds that the single’s die-cut sleeve, created by Factory designer Peter Saville, cost so much to produce that Factory Records actually lost money on each copy sold. . D’oh.

How does the firm decide what inputs to produce? The marginal conditions give us simple rules for this decision. Mathematically the firm wants the biggest difference between its Revenues, , and its costs . The

One important idea we’ll have a look at in the lecture is the concept of the firm as Price Taker.

A price taker is a firm or individual whose decisions regarding buying or selling have no effect on the prevailing market price of a good or service. For a price taking firm it must hold that

If the firm experiences a downward-sloping demand curve, then we can say with confidence that , because when you’re selling one more unit, and that sale causes the price to decline, then you can be sure the firm’s will be less than . We’ll show a Mathematica demonstration of this property in class, if the program actually works for me this time

We’ll also see how the marginal revenue of the price taking firm is dependent on the price elasticity of demand for that product. Recall that elasticity, , defined at a certain price and quantity , is defined as the percentage change in quantity demanded divided by the percentage change in price.

(elasticity of demand)

When the price change occurs across an area of the demand curve which is elastic, so , the marginal revenue will be greater than 0. When , so demand is inelastic, marginal revenue will be negative. The relationship can be summarised as

We’ll also look at the supply decision of the firm. The firm, if it is a price taker, will find itself in the short run trying to maximise profits by picking to get revenues above short run variable cost. The firm, as we’ll see, will shut down when , and continue to operate anywhere above that price.

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In a society which experiences scarcity, trade offs allow a sharp definition of opportunity cost. In a perfectly competitive market, which we assume, the cost of labour is the wage, , and the cost of capital is the interest or rental rate, . We also experience sunk costs, which are costs that can’t be recovered once made.

Economic profits are the difference between the amount of revenue and the total economic cost of producing a good.

The main idea of this lecture is to show you the economic ideas behind cost minimisation and the theory of economic profits.

Economic profits are defined as the difference between total costs and total revenues. Our expression for total costs will be the amount of labour we hire times their wage rate, and the amount of capital we rent times its rental rate, so total cost, , will be

. (Total Cost)

If the firm produces only one good as its output, then the price they get for selling units of the good will be . The expression for economic profit, , will then be:

. (Economic Profit)

But we know from the last lecture that the quantity produced is equal to the production function for a given level of output, or . So we can replace in the equation above with to get another expression for economic profits in terms of the production function for these goods.

What does this minimisation look at? If it doesn’t break, we’ll use a Mathematica demonstration to make the firms expansion path and the minmising choice of costs as clear as possible.

Image via Wikipedia

We’ll alsodemonstrate the difference between average, marginal, and total costs in class.

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In this lecture we’ll finish off talking about game theory by spending time talking about dominant and mixed strategies, subgame perfect equilibria, best response functions, and bac

kward induction.

Dominant Strategies

A dominant strategy refers to the best response to any strategy chosen by the other player. When a player has a dominant strategy in a game, there is good reason to predict that this is how the player will play the game.

A mixed strategy, in contrast, refers to situations when the player randomly selects from several possible actions.

The strategies in which a player chooses one action or another with certainty are called pure strategies.

We’ll illustrate these concepts using two famous games: Matching Pennies, which we have seen before, and the battle of the sexes.

Best Response Function

The function which gives the payoff-maximizing

choice for one player in each of a continuum of actions of the other player is referred to as the best-response function.

Image via Wikipedia

Subgame Perfect Equilibria

Game theory offers a formal way of selecting the reasonable Nash equilibria in sequential games using the concept of subgame-perfect equilibrium.

A proper subgame consists of the part of the game tree including an initial decision not connected to another in an oval and everything branching out below it.

Backward Induction

A shortcut to finding the subgame-perfect equlibrium directly is to use backward induction. Backward induction solves for the equilibrium by working backwards from the end of the game to the beginning. We’ll see this working in the battle of the sexes.

Click the link below to download the slides for the lecture. I’ll have them up at slideshare.net as well, and you can get a podcast of the lecture after the fact.

Right click to download Slides

In the next lecture, we’ll move on to talk about Production. The first half of the course is nearly over!

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Image via Wikipedia

Last time we looked at the history of game theory and the components of any game: players, strategies, and payoffs. We also discussed the first equilibrium concept we are going to see: the Nash equilibrium.

The prisoners in the game are two suspects, and , who have been caught in the act doing something illegal. The two suspects are put in different cells, where they can’t communicate, and they are given the following set of choices by the police officer, who withdraws and lets them choose.

We summarise their payoffs to each choice using the Normal form of a game, where player ’s strategies are summarised on the rows, and player ’s strategies are summarised in the columns. The matrix allows us to glance and see the payoffs from each strategy by each player in one simple box. Think of the matrix as the user interface for the game, kind of like the desktop on a computer. The payoffs look like this: