ECO 317
Intermediate Macroeconomics
Instructor
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Jing Li (sounds like Lee)
7-year experience of teaching at US colleges
Second year at MU
Married with two kids
Teaching eco 311 as well
Expectation
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Hard-working is expected
Cramming for exam does not work
Memorizing does not work
Understanding is the key
If you need A or B, earn it!
Required Textbook
Webpage
• http://www.fsb.muohio.edu/lij14/
• I use Nihhka only when I need to send group
email and post grade
• Google “jing li miami university”
Grades
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Six homeworks, 10 points
Term paper, 10 points
Three midterm exams, 60 points
Final exam, 20 points
(bonus) Attendance, worth 3 points
None of the exam is accumulative
Hot Issues
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National Debt
Income gap: 1% vs. 99%
Globalization
2007-2009 Recession
Review
• Labor (input) L is used to produce output Y
• Production is captured by production function 𝐹( )
𝑌 = 𝐹(𝐿)
• Marginal product of labor (MPL) is the extra output
that can be produced by using one more unit of labor
𝜕𝑌
𝑀𝑃𝐿 =
≈ 𝐹 𝐿 + 1, 𝐾 − 𝐹(𝐿, 𝐾)
𝜕𝐿
• Q: What is the sign of MPL?
• Q: What happens to MPL as L rises?
Two Properties of MPL
• 𝑀𝑃𝐿>0, so total product rises when input rises
•
𝑑𝑀𝑃𝐿
<0
𝑑𝐿
(decreasing or diminishing marginal
product). The extra labor becomes less and less
productive.
• Graphically, the production function (total
product curve) is upward sloping, and becomes
flatter and flatter.
• Q: how does the marginal product curve looks
like?
Profit Maximizing
• Profit = revenue – cost = 𝑃𝑌 − 𝑊𝐿 = 𝑃𝐹 𝐿 −
− 𝑊𝐿. We assume competitive market.
• Profit rises when marginal revenue is greater
than marginal cost, and decreases otherwise
• Profit is maximized when
marginal revenue = marginal cost
• Mathematically, the first order condition is
𝑃 ∗ 𝑀𝑃𝐿 = 𝑊
Summary
• Output does not grow if input and technology
remain constant
• Wage is determined by the marginal product.
Discuss
• What is the long run prospect of Japanese
economy, where both population and
technology stagnate?
• Why does a doctor earn much more than a
plumber?
Cobb-Douglas Production Function
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𝑌 = 𝐹 𝐾, 𝐿 = 𝐴𝐾 𝛼 𝐿1−𝛼 , (0 < 𝛼 < 1)
Constant return to scale
Constant factor share in income
Marginal product is proportional to average
product
Calculus
• 𝑥 𝑎 ′ = 𝑎𝑥 𝑎−1
• Multivariate function 𝑦 = 𝑓(𝑥, 𝑧)
• Partial derivatives
𝜕𝑦 𝜕𝑦
,
𝜕𝑥 𝜕𝑧
Example: 𝑦 = 𝑥 𝑎 𝑧 𝑏 ,
𝜕𝑦
= 𝑎𝑥 𝑎−1 𝑧 𝑏
𝜕𝑥
𝜕𝑦
= 𝑏𝑧 𝑏−1 𝑥 𝑎
𝜕𝑧
Why Cobb-Douglas Function?
• It can explain the following two facts
• The shares of capital and labor incomes are
constant
• Real wage grows at the same rate as average
product
The Demand Side
• The supply side is captured by production
function
• We need to specify the demand side in order
to find equilibrium
• Demand = consumption + government
expenditure + investment
Aggregate Demand
• Consumption: 𝐶 = 𝐶 𝑌 − 𝑇 , which is fixed
𝑑𝐼
,
𝑑𝑟
• Investment: 𝐼 = 𝐼 𝑟
< 0, which varies as
the real interest rate 𝑟 changes
• Government expenditure: 𝐺 = 𝐺, which is
fixed
Equilibrium
• Equilibrium: supply = demand
• Mathematically
𝑌 =𝐶 𝑌−𝑇 +𝐼 𝑟 +𝐺
• We can solve this equation for 𝑟, and obtain
the equilibrium real interest rate
• In short, real interest rate adjusts to
equilibrate the market
Another Perspective
• Alternatively, we can study the equilibrium for
loanable funds market
• At equilibrium, the supply and demand of
funds are equal:
𝑌−𝐶 𝑌−𝑇 −𝐺 =𝐼 𝑟
Note the supply of fund is fixed
Application
1. Why was interest rate high in early 1980?
2. Why was interest rate high in early 1990?
Crowding Out
• Chapter 3 implies that expanding government
expenditure will completely crowd out
investment
• Fiscal policy is ineffective
• How about monetary policy?
MVPY
Monetarism
• In long run, price is mainly affected by money
supply
• Inflation rate equals growth rate of money
supply if assuming fixed income and constant
velocity
• What if those two assumptions fails?
Hyper-Inflation (to get Seigniorage)
Quantitative Easing (as a Policy Tool)
• http://www.youtube.com/watch?v=PTUY16Ck
S-k
• http://en.wikipedia.org/wiki/Quantitative_eas
ing
Classical Dichotomy
• According to the long run classical theory,
money is neutral (monetary neutrality): the
money supply does not affect real variables
• The theoretical separation of real and nominal
variables is called classical dichotomy
• Real variables are studied in Chapter 3
• Price is determined in Chapter 4
• They jointly determine nominal variables
Fisher Equation
Application of Classical Dichotomy
𝑖=𝑟+ 𝜋
So nominal interest rate 𝑖 is the sum of real
interest rate 𝑟 and inflation rate 𝜋.
𝑟 is determined in chapter 3, (Figure 3-8)
𝜋 is determined in chapter 4, (MV=PY)
Proof
• You have two options: saving a good and
earns real interest; or saving money and earn
nominal interest.
• There is no arbitrage at equilibrium:
1+𝑖
1+𝑟 =
1+𝜋
Fisher equation follows assuming 𝑟𝜋 = 0
How to Forecast
Nominal Interest Rate in Long Run?
• First determine the real interest rate 𝑆 = 𝐼 𝑟
• Then determine the inflation rate 𝜋 = 𝑀% +
𝑉% − 𝑌%
• Finally use Fisher Equation: 𝑖 = 𝑟 + 𝜋
• Nominal interest rate matters because it is a
key variable in Financial and Housing markets
A Short Run Theory
• Consider the equilibrium in money market
• Money supply =
𝑀
,
𝑃
a vertical line
• Money (liquidity) demand = 𝐿(𝑖, 𝑌), a
downward sloping line
• At equilibrium
𝑀
= 𝐿(𝑖, 𝑌)
𝑃
Discuss
Dear Professor Li,
I am in your 317 class and had a question regarding interest rates. Prior
to class today I was reading an article that stated that a main reason
why our economy has not felt the same effects of having a 70% debt to
GDP ratio is that we have lower interest rates compared to European
countries who have similar debt-GDP ratios(but these countries have
higher interest rates). If our economies are similar in terms of this
ratio, how come we have such a lower interest rate in comparison to a
country such as Spain?
Also, thanks for an enjoyable class today.
Stephen H.
Answer
• US real interest rate is low because high
(foreign) supply of loanable fund. Spain is
opposite
• US nominal interest rate is low because of
quantitative easing
Review
• Nominal vs Real
Y: Real GDP
PY: Nominal GDP
W/P: Real Wage
W: Nominal Wage
r: Real Interest Rate
i: Nominal Interest Rate
Classical Dichotomy
• Money does not affect real variables
• Real variables are determined in Chapter 3
• Price is determined in Chapter 4
Review
• Long Run vs Short Run
Long Run: 𝑴𝑽 = 𝑷𝒀
Short Run:
𝑀
𝑃
= 𝐿(𝑖, 𝑌)