Econs UK Revision Kevin

Introduction to Economics
SIM Revision Workshop — Inflation, Output, and Unemployment
Kevin Sheedy
LSE
March–April 2018
K. Sheedy (LSE) Introduction to Economics March–April 2018 1 / 39

Inflation, output, and unemployment
The importance of price and wage adjustment in

macroeconomics
I Classical vs. Keynesian determinants of employment and output
The link between price and wage adjustment and economic
activity
I Aggregate supply curve
I Phillips curve
Monetary policy and the aggregate demand curve

Output and employment
Y
Holding capital and technology fixed in short run, production

function gives link between output Y and employment N
Prelim exam question

Question 13: AD–AS model
Consider the following model of aggregate demand and supply.

Consumption depends positively on disposable income with a
marginal propensity to consume between 0 and 1, investment
depends negatively on the real interest rate, and labour supply
depends positively on the real wage. The real interest rate is the
nominal interest rate minus the rate of inflation. Prices are flexible,
and firms hire labour up to the point where the marginal product of
labour is equal to the real wage.
Monetary policy is conducted by the central bank setting the nominal
interest rate. The nominal interest rate is adjusted in response to
changes in inflation, with the nominal interest rate rising by more
than 1% following a 1% increase in inflation.

Part (a)
Explain why aggregate demand is negatively related to the inflation

rate.

Aggregate demand
AD
Y

Monetary policy
Modern approach to studying monetary policy approach assumes
a policy rule for the nominal interest rate r set by the central
bank:
I Interest rate reacts positively to inflation
I Interest rate reacts positively to output (or output gap)
I e.g. Taylor rule
Given inflation π, implied real interest rate i obtained from
Fisher equation:
i =r −π
I Assume that central bank raises r by more than π if inflation

were to increase
I Monetary policy then implies a positive relationship between the
real interest rate and inflation (and output)

Monetary policy rule
r i
rr
ii
π π
Implies a negative relationship between inflation π and the real

interest rate i

Aggregate demand
π i
π2 i2 ii[π = π2 ]
i1 ii[π = π1 ]
π1
AD IS
Y Y
Y2 Y1 Y2 Y1
Higher inflation raises real interest rate i (monetary policy rule)

Higher real interest rate reduces demand (IS curve)

The Classical case: Flexible prices and wages

Labour market: Classical case
w
LF
w∗
LD
∗ N
N
w is real wage (w = W /P): no money illusion
LD: w = MPL LF : w = marginal rate of substitution
between leisure and consumption
Wages are flexible and so market clears: no unemployment
Goods market: Classical case
π i
AS
π∗ i∗ ii[π = π ∗ ]
AD IS
Y ∗ Y
Y∗ Y
Vertical aggregate supply (AS): output Y ∗ determined by

equilibrium employment N ∗ independently of inflation rate
Inflation π ∗ determined by intersection of AD and AS
Equilibrium inflation is such that the implied real interest rate is
consistent with equilibrium output Y ∗
Part (b)
Suppose that owing to a loss of confidence, households unexpectedly

increase the amount they would like to save (this is a reduction in the
autonomous level of consumption).
Make the classical assumption that wages are always fully flexible.
What happens to output, inflation, and the real and nominal interest
rates? Explain how the economy adjusts so that investment is equal
to saving.

Graph
π
AS
π1
π2
AD1
AD2
Y
Y1

Part (c)
Now make the Keynesian assumption that nominal wages are fixed in
the short run (but prices are flexible).
Explain why aggregate supply is positively related to the inflation
rate.

Graph
SAS

The Keynesian case: Sticky wages

Sticky nominal wages
Long-term contract specifying nominal wage W̄
I Both firms and workers can gain from a long-term contractual
relationship
I Reduces costs of bargaining if contract agreed for a particular
period, e.g. one year
I But why write contracts in terms of money? (Why not
indexation to inflation?)
I This deeper question is not addressed here: the monetary unit is
assumed to be a focal point in negotiations
Contractual nominal wage implies real wage W̄ /P
Inflation π = (P − P0 )/P0 , where P0 = last year’s price level
Using P = (1 + π)P0 , real wage is:
W̄ W̄
w= =
P P0 (1 + π)
Real wage is negatively related to inflation
Labour market: Sticky wages
w
LF
U1
W̄
P0 (1+π1 )
U2
W̄
P0 (1+π2 )
LD
N
N1 N2
Labour market cannot clear through adjustment of wages:
unemployment
More workers willing to work at prevailing wage to left of LF
Higher inflation lead firms to increase employment
Goods market: Sticky wages
π
SAS
π∗
AD
Y
Y∗
Higher inflation lowers real wage and raises supply of output

Upward sloping SAS curve

Part (d)
Consider again the increase in desired saving from part (b). With
sticky wages, what happens to output, inflation, and the real and
nominal interest rates? Explain how the economy adjusts so the
investment is equal to saving. Compare your answers to those from
part (b).

Graph
SAS
π1
π2
AD1
AD2
Y
Y2 Y1

Part (e)
What action should the central bank take to stabilize output

following the increase in desired saving? What will be the resulting
nominal and real interest rates if the central bank takes this action?
Explain whether or not your answers would be different if the central
bank was aiming to stabilize inflation.

Graph
SAS
π1
AD1
AD2
Y
Y1

Wage setting

Wage setting
w
LF
W̄
Pe
= w∗
LD
∗ N
N
When setting W̄ , firms and workers care about real wage
Not known until price P determined. Expected real wage
= W̄ /P e
Set W̄ /P e = w ∗ , where LD = LF at w ∗
Inflation expectations
By definition, P = (1 + π)P0 , where π = inflation and P0 = last

year’s price level
Price expectations P e and inflation expectations π e are therefore
related: P e = (1 + π e )P0
If the nominal wage is set so that W̄ = w ∗ P e , the implied real
wage is:
W̄ w ∗P e w ∗ (1 + π e )P0 1 + πe
w= = = = w∗
P0 (1 + π) (1 + π)P0 (1 + π)P0 1+π

Employment, inflation, and inflation expectations
w
LF
U
e
w ∗ 1+π
1+π
w∗
LD
∗ N
N N
Using LD: N depends negatively on w ∗ (1 + π e )/(1 + π)
Using LF : U depends positively on w ∗ (1 + π e )/(1 + π)
Negative relationship between unemployment rate
u = (LF − LD)/LF and (1 + π)/(1 + π e )
Expectations-augmented Phillips curve
π
π2e
π1e
u
0

Wage setting and unemployment
w
AJ LF
W̄
= w∗ U∗
Pe
LD
L
N∗
Wages W̄ may not be set to clear labour market

Unemployed may not accept first job they find (search process)
Collective bargaining: push up wages, accept low employment
Employment, inflation, and inflation expectations
w
AJ LF
U
e
w ∗ 1+π
1+π
w∗ U∗
LD
∗ N
N N
Positive unemployment even when expectations correct
Negative relationship between (1 + π)/(1 + π e ) and
unemployment
Fluctuations in unemployment around natural rate
Natural-rate Phillips curve
π
πe
u
0 u∗

Empirical evidence on the Phillips curve

Singapore: Unemployment rate

Singapore: Inflation rate (CPI)

Singapore: Inflation rate (GDP deflator)

Singapore: Phillips curve (using CPI inflation)

Singapore: Phillips curve (using GDP deflator)

Introduction to Economics
SIM Revision Workshop — Economic Growth
Kevin Sheedy
LSE
March–April 2018

Why study economic growth?
Explain average (real) income in economies

Major (but not only) determinant of living standards
Focus on incomes per capita, i.e. real GDP per person

Singapore: Real GDP

Singapore: Population

Singapore: Real GDP per person

Singapore: Real GDP per person (logarithm)

Singapore: Growth rates of real GDP per person

Singapore: Capital share of income

Analysis of economic growth

Economic growth
Economic growth in the long run

Focus on the economy’s supply side
I Ignore demand-side issues (treat economy as operating at full
capacity)
Output (GDP) produced by combining factors of production
Production function gives link between factor inputs and output

Factors of production
Labour
I and also human capital (skills and knowledge possessed by
workers)
Land
Capital

Production function
The production function provides the link between the factor

inputs and the economy’s output (GDP):
GDP = A × f (Labour, Land, Capital, . . .)
The term A represents total factor productivity (TFP)

I TFP is introduced to capture changes in output that cannot be
explained by adding more factor inputs
The economy’s production processes, techniques, and
technologies are represented by the production function f (·) and
the level of TFP A

Properties of the production function
Distinguish between returns to increasing individual factors and

returns to increasing all factors proportionately (returns to scale)
Usual assumptions:
I Positive but diminishing marginal returns to each individual
factor
I Constant returns to scale

The historical stagnation of living standards

Economic progress is a recent phenomenon

Malthus and economic stagnation
Consider an economy where output is produced using only

labour and land:
Y = A × f (T , L)
I Y = output
I T = land
I L = labour
Land is in fixed supply

Population and living standards
With fixed land T and no improvements in TFP, GDP can only

increase with population L
But diminishing marginal product of labour implies output Y
rises more slowly than population L
Output per person y = Y /L (average product of labour)
diminishes
Eventually incomes per person fall to the minimum required for
subsistence
The result is stagnation

Capital accumulation — The Solow model

Capital accumulation — The Solow model
Now consider the possibility of using capital to produce output

Differently from land, additional capital can be accumulated
Production function:
Y = A × f (K , L)
I K = capital
I L = labour

The labour force
The Solow model treats the labour force as the same as the
population
Both are assumed to grow at a constant rate n
Mathematically:
L̇
=n
L
Also, labour input is proportional to the number of workers
(assumes constant hours per worker)

Singapore: Growth rate of total employed workers

Singapore: Average annual hours per worker

Saving and investment
The Solow model assumes a closed economy, so investment

(capital accumulation) must come from output that is not
consumed, i.e. saving
Total saving is assumed to be a fraction s of income
Investment = Saving = s × Y

Singapore: Saving rate

Investment and capital accumulation
Without maintenance, some capital will wear out through use

(depreciation)
Assume depreciation is a fraction δ of the total capital stock K
The change in the capital stock is the difference between
investment and depreciation
Change in capital stock = K̇ = I − δ × K
K̇ I
Growth rate of capital stock = = −δ
K K

Output and capital per worker
The predictions of the Solow model are easiest to understand by
thinking in terms of capital per worker and output per worker
(here: per worker = per person)
I Capital per worker: k = K /L
I Output per worker: y = Y /L
Under constant returns to scale, total output is equal to L times
A × f (k, 1), i.e. what each worker could produce using the
average amount of capital per worker k:
Y = A × f (k, 1) × L
Output per worker y thus depends only on capital per worker k,

TFP A, and the per-worker production function F (k) = f (k, 1):
y = A × F (k)

Prelim exam question

Question 14: Solow growth model
In the Solow growth model, output Y is produced using capital K

and labour L. There are constant returns to scale, and diminishing
returns to capital and labour individually. The production function is
Y = f (K , L), capital depreciates at rate δ, the population grows at
rate n, and the saving rate is s.

Part (a)
Sketch graphs of saving per worker, and the amount of investment

per worker needed to maintain a constant level of capital per worker,
both plotted against capital per worker on the horizontal axis.
Explain the shapes of these graphs.

Saving per worker
Output per worker is y = AF (k)

A fraction s of output is saved, so saving per worker is sy

Investment needed to maintain capital per worker
Capital per worker k = K /L will be stable over time if total

capital K grows at the same rate as labour L
This is true when:
I
−δ =n
K
Adding δ to both sides and multiplying by K :
I = (δ + n)K
Dividing both sides by L to obtain investment per worker

i = I /L:
i = (δ + n)k

Graph
(δ + n)k
i = sy

Part (b)
Explain why there exists a steady state for capital per worker and
output per worker.

Steady state?
Capital per worker is increasing if sy > (δ + n)k

Capital per worker is decreasing if sy < (δ + n)k
Capital per worker is stable if sy = (δ + n)k
Since y = AF (k), output per worker is stable if capital per
worker is stable

Graph
y
y∗
(δ + n)k
i = sy
k
k∗

Part (c)
Suppose the countries of the world were to share the same

parameters (saving rate, population growth rate, etc.). Explain why
the Solow model predicts convergence over time in living standards
across countries.

Graph
y∗ y
y4
y3
y2
(δ + n)k
y1
y0 i = sy
k
k0 k1 k2 k3 k4 k∗

Singapore: Capital stock

Singapore: Capital per worker

Part (d)
Consider a country that is relatively poor compared to the richest

countries of the world. How will its growth rate compare to richer
countries according to the Solow model? What will happen to its
growth rate over time? Explain.

Graph
Growth rate
Poor
n Rich
Time

Predictions of the basic Solow model
It is possible to have a rise in living standards through capital

accumulation
However, given a saving rate, there exists a steady state for
capital per worker and output per worker
No further growth in income per worker occurs once the steady
state is reached (GDP grows only because of population growth)
During the transition to the steady state, growth in income per
worker is positive
Growth is faster the further the economy is from its steady state

Part (e)
Is it possible to change the long-run predictions in parts (c) and (d) if

a country increases its saving rate? Explain your answer.

Graph
y2∗ y
y1∗
(δ + n)k
i = s2 y
i = s1 y
k
k1∗ k2∗

Graph
Growth rate
Raised saving rate
Time

Technological progress

Technological progress
To understand why growth in income per worker does not

appear to fall to zero in the long run, the basic Solow model can
be extended to account for technological progress
Technological progress leads to continual improvements in TFP
This can be a source of long-run growth in the Solow model

Singapore: Growth rate of total factor productivity

Endogenous growth

Exogenous and endogenous growth
The extended Solow model explains long-run growth in income

per worker by introducing technological progress
The source of this technological progress is left unexplained — it
is exogenous
This means that the long-run growth predicted by the extended
Solow model is also exogenous
Are there alternative models of growth that are able to explain
growth endogenously?

Endogenous growth
Possible sources of endogenous growth:

1 Human capital accumulation
2 Externalities to capital accumulation

Singapore: Human capital per person

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Introduction to Economics

SIM Revision Workshop — Inflation, Output, and Unemployment

K. Sheedy (LSE) Introduction to Economics March–April 2018 1 / 39

The importance of price and wage adjustment in

K. Sheedy (LSE) Introduction to Economics March–April 2018 2 / 39

Holding capital and technology fixed in short run, production

K. Sheedy (LSE) Introduction to Economics March–April 2018 4 / 39

Consider the following model of aggregate demand and supply.

K. Sheedy (LSE) Introduction to Economics March–April 2018 5 / 39

Explain why aggregate demand is negatively related to the inflation

K. Sheedy (LSE) Introduction to Economics March–April 2018 6 / 39

K. Sheedy (LSE) Introduction to Economics March–April 2018 7 / 39

I Assume that central bank raises r by more than π if inflation

K. Sheedy (LSE) Introduction to Economics March–April 2018 8 / 39

Implies a negative relationship between inflation π and the real

K. Sheedy (LSE) Introduction to Economics March–April 2018 9 / 39

Higher inflation raises real interest rate i (monetary policy rule)

K. Sheedy (LSE) Introduction to Economics March–April 2018 10 / 39

K. Sheedy (LSE) Introduction to Economics March–April 2018 11 / 39

Vertical aggregate supply (AS): output Y ∗ determined by

Suppose that owing to a loss of confidence, households unexpectedly

K. Sheedy (LSE) Introduction to Economics March–April 2018 14 / 39

K. Sheedy (LSE) Introduction to Economics March–April 2018 15 / 39

K. Sheedy (LSE) Introduction to Economics March–April 2018 16 / 39

K. Sheedy (LSE) Introduction to Economics March–April 2018 17 / 39

K. Sheedy (LSE) Introduction to Economics March–April 2018 18 / 39

Higher inflation lowers real wage and raises supply of output

K. Sheedy (LSE) Introduction to Economics March–April 2018 21 / 39

K. Sheedy (LSE) Introduction to Economics March–April 2018 22 / 39

K. Sheedy (LSE) Introduction to Economics March–April 2018 23 / 39

What action should the central bank take to stabilize output

K. Sheedy (LSE) Introduction to Economics March–April 2018 24 / 39

K. Sheedy (LSE) Introduction to Economics March–April 2018 25 / 39

K. Sheedy (LSE) Introduction to Economics March–April 2018 26 / 39

By definition, P = (1 + π)P0 , where π = inflation and P0 = last

K. Sheedy (LSE) Introduction to Economics March–April 2018 28 / 39

K. Sheedy (LSE) Introduction to Economics March–April 2018 30 / 39

Wages W̄ may not be set to clear labour market

K. Sheedy (LSE) Introduction to Economics March–April 2018 33 / 39

K. Sheedy (LSE) Introduction to Economics March–April 2018 34 / 39

K. Sheedy (LSE) Introduction to Economics March–April 2018 35 / 39

K. Sheedy (LSE) Introduction to Economics March–April 2018 36 / 39

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K. Sheedy (LSE) Introduction to Economics March–April 2018 38 / 39

K. Sheedy (LSE) Introduction to Economics March–April 2018 39 / 39

K. Sheedy (LSE) Introduction to Economics March–April 2018 1 / 52

Explain average (real) income in economies

K. Sheedy (LSE) Introduction to Economics March–April 2018 2 / 52

K. Sheedy (LSE) Introduction to Economics March–April 2018 3 / 52

K. Sheedy (LSE) Introduction to Economics March–April 2018 4 / 52

K. Sheedy (LSE) Introduction to Economics March–April 2018 5 / 52

K. Sheedy (LSE) Introduction to Economics March–April 2018 6 / 52

K. Sheedy (LSE) Introduction to Economics March–April 2018 7 / 52

K. Sheedy (LSE) Introduction to Economics March–April 2018 8 / 52

K. Sheedy (LSE) Introduction to Economics March–April 2018 9 / 52

Economic growth in the long run

K. Sheedy (LSE) Introduction to Economics March–April 2018 10 / 52

K. Sheedy (LSE) Introduction to Economics March–April 2018 11 / 52

The production function provides the link between the factor

GDP = A × f (Labour, Land, Capital, . . .)

The term A represents total factor productivity (TFP)

K. Sheedy (LSE) Introduction to Economics March–April 2018 12 / 52

Distinguish between returns to increasing individual factors and