Analysis of Macroeconomic Models and their Implications on the Economy

Macroeconomics Content Summary

Hi, Below are the content summaries of each topic I study in my economic paper.

Please help me come up with some interesting questions for each topic and justify why they are interesting with some examples related to the topics using the different models mention in each topic. Please keep each answer within 150 words.

The Supply Side with Homogeneous Labour. Here we study the classical model of the macroeconomy. It focuses on the production side of the economy to describe the GDP as the output of a single production function for the whole economy. It is critical to note that it does not arise by aggregating the production function of individual firms.

Nevertheless, the model assumes that the employment levels of all factors of production are consistent with the choices of the profit maximising firms. Consequently, measuring a macroeconomy's productivity requires us to estimate the parameters of the economy's production function empirically. Furthermore, the empirical properties of the national income imply that the production function must satisfy constant  returns to scale, product exhaustion and a stable factor share of national income. The Cobb-Douglas function satisfies these properties.

So the classical model describes GDP and factor shares of income with the Cobb-Douglas production technology, which yields four measures of macroeconomic productivity: marginal, average, factor share (or elasticity = marginal/average), and total factor productivity (TFP). Each measure highlights a distinctive aspect of the macroeconomic performance measure.

Heterogenous Labour and Income Inequality. This section modifies the classical production function and the labour market by considering heterogeneous labour: skilled versus unskilled. Access to education gives a section of the population the privilege to acquire skill-premium from the relative scarcity of educated workers in an economy. This scarcity arises from the race between education and technology. A faster technology growth increases demand for skilled labour, i.e., workers with the necessary expertise to operate high-tech machines.

A slower pace of growth of educated adults in the macroeconomy contributes to excess demand in the market for skilled labour. Technology growth typically creates tools to replace physical work and, hence, decreases the demand for unskilled labour. However, the growth of skilled labour in the economy sometimes increases the demand for unskilled labour in manual work if that is complementary to occupations that require skilled labour. Income inequality explained by this skill-premium increases if technology runs faster than education. Moreover, recent research indicates that a rise in inequality could be detrimental to technology growth.

Topic 1a: The Supply Side with Homogeneous Labour

This Section establishes the notion of balance in the macroeconomy by suggesting that flexible movements of relative prices ensure a balance between demand and supply in each factor market and simultaneously in the goods and financial market. We define such an outcome of the classical model as the long-run outcome (equilibrium) for the macroeconomy.

In the long-run equilibrium, flexible real wage eliminates unemployment in the labour market. In addition, the flexible real interest rate adjusts to ensure the balance between saving and investment in the financial market and, thereby, a balance between the full-employment GDP and the aggregate demand for GDP in the goods market. In particular, excess demand in the goods market shows up as excess demand for loanable funds in the financial market. In response, the real interest rate increases to eliminate that excess demand.

If there is an excess supply, the process reverses until the macroeconomy restores its long-run balance.

Establishes the origin and sustainability of economic growth based on Solow’s (1956) growth model. In essence, it highlights that investment is not only a critical component of aggregate demand. It also carries the seeds of growth in the supply of output in the macroeconomy. Economic growth appears and continues if investment exceeds depreciation of capital stock.

However, Solow’s (1956) model also establishes a salient fact: the law of diminishing returns to capital implies that investment in physical capital alone cannot sustain the long-run growth of GDP. Eventually, GDP converges to a steady state. Moreover, an optimal saving and investment rate (as a fraction of GDP) maximises the steady-state consumption, representing the golden rule for achieving a sustainable long-run outcome. The above conclusions remain robust in the model extended to include exogenous population and technology growth.

provides alternative explanations based on alternative macroeconomic stories (i.e., models) for apparently perpetual economic growth that we observe in many countries today. Each of those models offers an economic rationale to justify how individual activities in a macroeconomy can cause perpetual economic growth.

There are two alternative storylines. One follows Romer (1986) to develop a constant return to capital production function by incorporating physical and human capital as complementary inputs for the production of GDP and interpreting capital broadly to include both types of capital. The alternative storyline follows Lucas (1988) or Romer (1990) to model the growth of TFP as an outcome of the activities in the macroeconomy. In Lucas (1988), private accumulation of human capital and the knowledge spillover at the workplace feed each other to produce endogenous TFP growth.

Topic 1b: Heterogenous Labour and Income Inequality

In Romer (1990), the division of the workforce between the Research and Development sector and the sector for producing goods and services determine the growth rate of TFP. Many other models follow these seminal endogenous growth models but incorporate additional interesting features that you can study at a higher level.

Introduces money to the classical model via the fractional reserve banking system with a variable reserve ratio. By definition, money is a private asset that serves as the medium of exchange.

There are two types of money:

(a) Hard currency that only the central bank can create, and

(b) Demand deposits (DD) which the commercial banks create under a fractional reserve system through multiple deposit creation. Hard currency determines the money base (B), which consists of the currency in circulation (C), i.e., hard currency owned by the private sector, and currency held by the commercial banks as reserves (R). The money supply M = C + D. The central bank can estimate the money supply using a formula: M=mB, where m=money multiplier varies inversely with the reserve ratio (rr), a fraction of demand deposits banks keep as reserves (rr = R/D). In many countries like New Zealand, the central bank has a policy of unlimited lending at a lending rate that depends on the official cash rate (OCR).

Commercial banks optimally choose rr to avoid having to borrow from the central bank and consider the OCR as its opportunity cost of having inadequate reserves. Consequently, the reserve ratio moves up and down in the same direction as the OCR. Therefore, it implies that the money multiplier varies inversely with the OCR. In other words, a higher OCR means a lower quantity of money and vice versa.

In the classical model (i.e., in the long run), money as the medium of exchange enters the model through the equation of exchange: MV=PY, where V = velocity of money, defined by the average number of times one unit of money changes hands in a year. The model assumes V is constant and the quantity of money, M, determines the nominal GDP = PY. This particular formulation by Friedman is called the quantity theory of money. According to that theory, the inflation rate equals the difference between the money and output growth rates. However, according to this theory, money is neutral. Thus, we have a classical dichotomy such that money does not affect output or any other real variables in the long run. Therefore, the inflation rate moves one for one with the growth rate of money.

Further, given the real interest rate (r) determined in the financial market from savinginvestment equality, the nominal interest rate (i) moves one for one with the expected inflation rate (Ep): i=r+ Eπ (the Fisher Effect.). Topic 3 ends with the description of the money market and how the adjustment of the flexible price level (P) ensures a balance between the real money balance (M/P), or the real money supply, and the real money demand, L(i, Y). In the long run, the money market equilibrium requires M/P = L(r+ Eπ, Y), where Y=F(K, L). It implies that in the LR, the real balance, M/P, cannot change. Consequently, the price level moves proportionately with the money supply.

Interestingly, the above equation also illustrates how the price level may increase, even if the money supply does not change, in response to higher inflationary expectations. This result gains relevance in Topic 8b.