Week1 & Week2(Part A)

CHAPTER 1: TOUR OF THE WORLD

The major economic crisis
• The major economic crisis in the US in 2007, also referred to as the
2008 financial crisis or the great depression.
• This is due to the declining housing prices and mortgage prices in the
US during 2007 and this went on to affect other countries associated
or relying on the US market.
• The problem took considerable time to be resolved, spanning between
2007 and 2010.

CHAPTER 2: BASIC DEFINITIONS

Macroeconomics Measures of Price
Inflation
• Refers to a situation in which the economy’s overall price level is rising.
• In other words, inflation refers to the sustained rise in general prices.
• This also represents the cost of living.
• Measures of inflation:
o GDP deflator
§ The GDP deflator represents a broader measure of
inflation than the CPI index, as it considers changes of
prices of all goods and services.
§ GDP deflator = Nominal GDP/ Real GDP * 100
§ If nominal GDP increases faster than real GDP, then the
difference comes from an increase in prices.
§ A rising GDP deflator indicates inflation while a declining
GDP deflator indicates deflation (decrease in general
price).
§
o CPI index
§ The price of a basket of goods is measured in a monthly
survey.
§ This looks at the cost of living.
§ Inflation rate = (CPI this year – CPI last year)/ CPI last year
 § Despite CPI being an accurate measure of the selected
goods that make up the typical bundle, it is not a perfect
measure of the cost of living.
§ i.e., the introduction of new goods may cause the CPI to
overstate the true cost of living and the index doesn’t
represent the actual personal consumption patterns of
consumers.

GDP
• Represents the market value of all the final goods and services
produced within the country.
• GDP can be expressed in nominal terms, which use current market
prices, or in real terms, which adjust for inflation.
• Methods to calculate GDP.
o Production approach
§ GDP = value of final goods and service produced – Value
of intermediate goods and services
o Value added approach.
§ GDP = C + I + G + (X-M)
o Income approach
§ GDP = incomes paid to foP (labor income + capital
income)
GNP
• Gross national Income GNP measures the economic output of a
country's residents, both within the country and abroad. It includes
GDP and net income from foreign investments.
• GNP = GNP = GDP + Net Income from Abroad

Macroeconomics Measures of Income

Nominal GDP
• Defines the value of final goods and services produced at current
prices.
• Increases due to:
o Production capacity
o Inflation (price level)
• Nominal GDP ($Yt) = GDP deflator (Pt) * real GDP (Yt)
o $Yt = Pt * Yt
Real GDP
• Defines the value of final goods produced at constant prices.
• Increases due to:
o Production capacity
• Used to calculate economic growth.
o GDP growth = real GDP this year – real GDP last year/ real GDP last year
* 100

Unemployment
• Strict definition
o The individual has not worked in the past 7 days.
o The individual is willing to work.
o The individual has taken active steps to find employment.
• Expanded definition.
o Includes discouraged workers.
o The individual has not worked in the past 7 days.
o The individual is willing to work.
• Working age gap (WAG)
o No. people over 16 years
o No. people not in jail/hospital
• Labor force (LF) = employed + unemployed
• Participation rate – willingness of WAP to work.
• Labor absorption - no. of WAP who has jobs.
• Unemployment rate = U/LF
• Labor absorption rate = E/WAP
• Labor force absorption rate = LF/WAP

Week2(Part B)
CHAPTER 3: GOODS MARKET
Lesson objectives
1. the goods market.
 2. The Keynesian cross model
3. Consumption function
4. The multiplier
5. The determination of the equilibrium output
a. Demand = output - production
b. Investment = savings (another way of thinking about the goods
market)

The BIG PICTURE

• The goods markets and the financial markets are well connected, as
such understanding connections between these two entities is
important.
• These markets are connected through investment spending.
• The focus is the interaction with production, income, and demand.
• Businesses use funds from the financial market to purchase capital
goods, which influence their general production level and aggregate
output in the goods market.
• The goods market will be used to derive the IS curve.
• Many factors affect demand, from consumer confidence, fiscal and
monetary policies.

General assumptions:
• We operate in a closed economy, where X-M = 0.
• There are fixed prices and unlimited supply.

The Goods market.

• demand for goods:
o Z = C + I + G, but we know that in closed economy X-M = 0
o Therefore, Z = C + I + G
• changes in demand will result in a change in supply, or vice-versa.
• changes in production lead to change in income.
• changes in income lead to changes in the demand in the goods
market.

The Consumption (C)

• Represents a function of disposable income (YD)
• The consumption function makes use of the multiplier effect.
 • The consumption function:
o C = C(YD) = Y-T
o C = C0 + C1YD = C0 + C1[Y-T]
§ C0 - Autonomous spending– describes what the
individuals would consume if their disposable income were
zero.
§ C1 – MPC (reps the slope of the function)
o

Investment (I)
• Considered exogenous because it’s determined outside the model.
o If production changes, investment will not respond.
• Ī = exogenous investment

Government (G)
• This represents government spending and taxes, which influence the
fiscal policy.
• G & T are exogenous.

Demand for goods (Z):

• Total demand for goods
o Z = C0 + C1[Y-T] + Ī + G

Equilibrium in the goods market

• Occurs when output (Y) is equal to aggregate demand (Z)
• Z=Y
• Y = Z = C0 + C1[Y-T] + Ī + G
• If (Z < Y)
o {then output will decrease}
• Else
 o {then output will increase}
• Z = Y = 1/ (1- C1) [ C0 - C1T + Ī + G]

The multiplier
• Describes how a change in autonomous spending (C o) leads to an
increased change in equilibrium level of output or income.
• The multiplier is an underlying factor in the consumption function, the
goods market and the financial market, and the Keynesian model.
• Multiplier K = 1/ (1 – MPC)
• Any increase in government spending (G) leads to increase in income
(Y), increase in consumption (C), and increase in income (Y)

The determination of equilibrium output

• Equilibrium is reached when total demand is equal to output.
o Y=Z
§ Z = AD = C + I + G
= C0 + C1 (Y-T) + G + I
• the equation for total demand (AD): C0 + C1 (Y-T) + G + I
o C0 - autonomous spending
o C1 – MPC
• The equation for the equilibrium output:
• The effect of an increase in C0
o Increase in production.
o Increase in income.
o Increase in demand.

The Investment (S = YD – C) model to find the equilibrium

• Y = C + I + G, Subtract T from LHS and RHS
o Y - T = C + I + G – T, Take C to the LHS
o Y – T – C = I + G – T.
o Therefore, S = I + G + T
I = S + (T - G)
o Investment = Private saving + Public saving // represents
IS, stay tuned….

CHAPTER 4: FINANCIAL MARKET

Lecture objectives:
• The demand for money
• The supply of money
o Traditional vs modern view
• How to determine interest rate

THE BIG PICTURE

• The financial market is referred to as the loanable funds market.
• The financial market operates on bonds and money.
• the interest rate is affected by the monetary policy.

The financial market

• Demand for money
o The demand for money (Md) is equal to nominal income
multiplied by a function of interest rate.
§ Interest rate (i) is considered to have a negative effect on
the demand for money.
§ Therefore, as interest rate increases, demand for money
will decrease.
o Demand for money depends on:
§ Level of transactions – concerns money.
§ Interest rate – concerns bonds.
o The curve for demand for money is downward sloping.
o Md depends on:
§ Level of transactions in the economy, nominal income
($Y).
§ Interest rate (i)
§ Therefore, Md = $YL(i)
§ Shift the curve – when there’s a change in nominal
income.
§ Movement along curve – when there’s a change in (i).
o So, interest rate is on the y axis and money will be on the x axis.

• Money supply
o Occurs when Ms = Md
o The Ms curve is vertical because its independent of interest rate.
o Money supply is set by the central bank.
 o Ms depends on:
§ Shifts the curve – when money supply increases, the curve
is shifted the RHS.
• The repo rate:
o The repo system involves a temporary sale of a financial asset
by the borrower (bank) in exchange for the needed cash from
the lender (SARB) with the agreement that the repurchase the
financial borrower must assets at an agreed future date.

• Equilibrium in the financial market

o Occurs when the supply of money is equal to the demand for
money.
o In other words, supply is equal to central bank money multiplied
by the money multiplier.
o Ms = Md
o 1/ (C + 0 [1-c]) * H = $YL(i)

o There are two main views regarding money supply in the

financial market.
o The horizontal’s view and verticalists view
§ The horizontal approach:
• This refers to the modern view.
• The central bank (government) is controlling the
financial market.
• As a result, the central bank sets the interest rate
and let’s demand for money regulate money supply.
o The verticalist view:
§ This refers to the traditional view.
§ The money supply is a vertical line at the quantity of
money (Md)

CHAPTER 5: THE IS-LM MODEL

Short run equilibrium

• Equilibrium in the goods markets:
o Y=Z
 • Equilibrium in the financial market
o Ms = Md
• IS - Y = Z = C0 + C1 (Y-T) + G + I
• LM – M = $YL(i)

Equilibrium in the goods market

o we now assume that investment (I) is endogenous in the IS-LM model
o therefore, Investment depends on:
o level of sales
o the interest rate
o the new equilibrium in the goods market - Y = C(Y -T) + I(Y ,i) + G

IS Curve
o shows the combination of interest rate and output that result in
equilibrium in the goods market.
o shifts the curve – changes in C, G, T, and I (non-interest investment)
and also consumer confidence
o Movement long the curve – changes in the interest rate.

Equilibrium in the financial market

o Equilibrium relationship between nominal income and the interest rate
o However, the relationship could also be in terms of real money by
dividing both sides by price
o Therefore, LM - M/P = YL(i)

LM Curve
o Shows the combination of interest rate and income that result in
equilibrium in the financial market
o Shifts the curve – an increase in money shifts the curve downward

Government policies
o Monetary policy:
o Monetary contraction – decrease in money supply
o Monetary expansion – increase in money supply
o Fiscal policy:
o fiscal contraction – increase in Taxes and decrease in Government
spending.
 o fiscal expansion – increase in Government spending and/or decrease
in Taxes.

South Africa’s response to the crisis

o the link between the global recession and SA’s recession is due to the
decrease in exports (X)
o in response SA was to increase activities aimed at expanding the
capacity of the economy through:
o increasing investment (I) in public infrastructure.
o increase Government spending and money supply.
o Lower taxes for low income earners.

Week3
CHAPTER 6: FINACIAL MARKET II – THE EXTENDED IS-LM MODEL

Lecture Objectives:
o The financial system and its macro-economic implication.
o Real and nominal interest rate.
o Risk premia.
o Explanation of the 2008 global economic financial crisis.

Nominal vs Real interest rate

o Nominal interest rate:
o Represents the interest rate in terms of rands.
o Inflation is not accounted for.
o (it)
o Real interest rate:
o Represents the interest rate in terms of a basket of goods.
o Adjusted to consider expected inflation.
o (1 + rt) = (1 + it) Pt/ Pe(t + 1)
o Therefore in rands, (1 + it) – represents real interest rate and rest
of the equation on the RHS represents how much you must
repay for the basket of good in year (t + 1).
Role of financial intermediaries
o Direct financing:
o Borrowing directly by the ultimate borrowers from the ultimate
lenders.
o Indirect financing:
o Financial institutions that receive funds from investors and then
lend these funds to others.
o Bank ratios:
o Capital ratio – the ratio of capital to assets.
o Leverage ratio – the ratio of assets to capital.
o Fire sale prices
o Prices below the true value.
o Bank runs
o This restricts banks from making loans, and to hold liquid and
safe government bonds.
o Wholesale funding
o The process in which banks rely on borrowing from other banks
to finance the purchase of their assets.

The financial crisis of 2008

o The financial crisis led to a decrease in consumer confidence
o Wholesale funding resulted in liquid
o The demand for goods decreased due to the high cost of borrowing
and lower confidence.
o As a result, the IS shifted to the left
o The monetary and fiscal policies led to some of shift back to the IS to
the right.
o Monetary policy led to a shift of the LM curve down.
o Despite these corrections, the policies were not sufficient to avoid a
major recession.

Week4
CHAPTER 7: THE LABOUR MARKET

Key questions
• Tour of the labour market
• Movements in unemployment
• Wage determination
• Price determination
• The natural rate of unemployment

Recap
• In the medium run, the economy returns to a level of output associated
with the natural rate of unemployment.
• In the medium run, firms respond to an increase in demand by
increasing production. Higher production leads to higher employment.
Higher employment leads to lower unemployment. Lower
unemployment leads to higher wages. Higher wages increase
production costs, leading firms to increase prices. Higher prices lead
workers to ask for higher wages. Higher wages lead to further increases
in prices, and so on
• Thus far we have focused on the short run by assuming a constant
price level in the IS-LM model.
• We now turn to the medium run and explore how prices and wages
adjust over time, and how this affects output.
• Prices are stable, or rather inflation is equal to zero when the labour
markets are in equilibrium.
• When the unemployed below equilibrium, worker’s claim to real wages
and firm’s claim to real profits are greater than productivity.
• In other words, there will be upward pressure on wages and prices and
vice versa.
 •

The tour of the labour market

• Composition of the labour market
o the whole population is made up of the working age
population(WAP) and the everyone else not eligible to work
§ WAP refers individuals aged between 15 and 64
§ Too young range from 0 to 14, and too old range 65 to
100.
o The WAP can be defines using the broad labour force definition,
which includes individuals willing and able to work, and
discouraged work-seekers
§ Discouraged workers refers to workers who have given up
looking for employment and have stopped actively seeking
jobs because of lack of opportunities or discouraging
labour conditions.
§ In other words, the employed, unemployed and
discouraged work-seekers
• The duration of unemployment can vary, depending of various factors,
such as skills of person, and the job market, but the average duration
of unemployment is usually 2 months.

Movement in unemployment
• Background information
 o Since 1948, the average yearly US unemployment rate has
fluctuated between 3% and 10%.
o This means that when the unemployment rate increases, so does
the percentage of people actively seeking jobs but unable to find
employment. This does, in turn, contribute to higher
participation rate, as more people are participating in the labour
force and actively seeking employment. However, this does lead
to a decrease in the participation rate as more people stop
seeking jobs when the unemployment rate increases.
• Official unemployment rate
o Refers to the WAP that’s actively seeking employment and are
currently without a job, but excludes discouraged workers.
o Also referred to as the narrow definition of unemployment.
o This is the widely used for official government statistic and
comparisons.
• Expanded unemployment rate
o Represents the broader definition of unemployment by including
a more comprehensive range of people who are not employed.
• Labour market statistics
o Participation rate
§ Represents an economy’s active labour workforce.
§ Participation rate = labour force/ WAP
o Unemployment rate
§ Unemployment rate = unemployed/ labour force
o Employment rate
§ Employment rate = employed/ WAP
• When unemployment is high, workers are worse off in two ways:
o Employed workers face higher probability of losing their job
o Unemployed workers face a lower probability of finding a job

Wage determination
• Collective bargaining
o Collective bargaining is a process in labour relations where
representatives of a labour union negotiate employment terms
and conditions with employers on behalf of the union members.
 o This negotiation typically covers various aspects of
employment, including wages, working hours, benefits, working
conditions, and other employment-related matters.
o Collective bargaining Acts
§ Labour Relations Act
§ Section 23 of the constitution
• Bargaining power
o Bargaining power refers to the ability of a party, whether an
individual, group, or organization, to influence the terms,
conditions, and outcomes of a negotiation or bargaining process
in their favour.
o The higher the skills needed to do the job, the more likely there
is to be bargaining between employers and individual workers.
o Workers are usually paid a wage exceeding their reservation
wage
o Furthermore, wages depends on labour market conditions, as in,
if there is a low unemployment rate, workers will demand higher
wages and vice versa.
o Firms that regards morale and commitment as essential to the
quality of workers work will be willing to pay more, compared to
those activities that are routine.
o Higher unemployment either weakens workers bargaining
power or allows firms to pay lower wages and still keep workers
willing to work.
• The aggregate nominal wage(W) is determined as follows:

Price determination
• The prices set by firms depends on their costs, which in turn depends
on the nature of the production function
o Y = AN, where (Y) is output, (N) is employment, and (A) is
labour productivity.
o The production function represents the relationship between
inputs and output produced, and the prices of these inputs.
• The marginal cost of production is equal to nominal wage(W).
 o Which implies that the cost of producing one more unit of output
is the equal to the cost of employing one more worker at W.
• Firms will set their price according to a markup(m) over the cost
o P = (1 + m)W
o Represents the price determination equation

The natural rate of unemployment

• The aggregate real wage(W) based on the actual price level becomes:

o
o W/P = 1/1 +m
§ Represents the real wage
• The wage-setting relation is the relation between the real wage and
the rate of unemployment.
• The higher the unemployment rate, the lower the real wage set by
wage-setters.
• The natural rate of unemployment
o Un = 1 – W/P
o This refers to the unemployment rate such that the real wage
chosen in wage setting is equal to the real wage implied by price
setting.
o In other words, The natural rate of unemployment is the level of
unemployment that exists in the economy when it's operating at
its full potential, and it consists of both frictional and structural
unemployment.
o

o An increase in unemployment benefits leads to an increase in

the natural rate of unemployment.

o
o An increase in the markup of firms leads to an increase in the
natural rate of unemployment.
 o
• In order to derive the relationship natural rate of unemployment:
o Divide both sides of the price determination equation by the
nominal wage
§ P = (1 + m)W
§ P/W = (1 + m)
o Inverting both sides gives the implied real wage or price setting
equation.
§ W/P =1/ (1 + m)
o In order to derive the equilibrium unemployment rate(un), we
substitute the W/P with F(u, z)
§ F(u, z) = 1/ 1+m

Conclusions
• We have assumed that the price level is equal to the expected price
level.
• In the short term, the actual price level might differ from the expected
level when nominal wages are determined. As a result, unemployment
may not necessarily match the natural rate, and output may not align
with its natural level.
• However, in the medium run, because expectations are generally
accurate, output typically reverts to its natural state
Week5
CHAPTER 8: THE PHILLIPS CURVE, THE NATURAL RATE OF
UNEMPLOYMENT, AND INFLATION

The Phillips curve background

• The curve was found by A.W. Phillips, in the 1960s, and determined
that is represents the trade-offs between inflation and unemployment.
• The Phillips curve has been observed to be unstable in the long run.
Since is tends to be vertical, indicating that there’s no long term trade-
off between inflation and unemployment.
• In other words, in the long run, changes in the inflation rate do not
affect the unemployment rate, which remains at its natural rate.
• One of the reasons behind the tendency of the curve to shift over time,
is because of the role of inflation expectations.

Inflation, expected inflation, and unemployment

• The wage determination equation:
o W = P e F (u, z)
§ W – nominal wage rate
§ P e – expected inflation
§ U – unemployment rate
§ Z
• represents factors that affect wages given (P e) and
(U)
• e.g. unemployment benefits and employment
protection.
o In other words, the wage determination equation, demonstrates
that the nominal wages (W) are a function of the unemployment
rate (U) and other exogenous factors (Z), and are influenced by
the expected inflation (P e).
o Revising the equation for 𝐹(𝑢, 𝑧) = 1 − 𝛼𝑢 + 𝑧:
§ P = P e(1+𝑚)(1 – 𝛼𝑢 + z)
§ 𝜋 = 𝜋te+ (𝑚+𝑧) −𝛼𝑢
 • 𝜋 – inflation rate
• 𝜋 e – expected inflation rate
• The price determination equation:
o P = 1 + m(W)
§ P – price level
§ m – markup
§ W – wage rate
o In other words, the price determination equation, suggest that
the price level is determined by the wage rate (W) and a markup
(m).
• An increase in the expected inflation leads to an increase in inflation.
• Given the expected inflation, an increase in markup (m), or an increase
in other factors affecting unemployment (z) leads to an increase in
inflation (π).
• Given the expected inflation (πe), a decrease in unemployment (u) will
lead to an increase in inflation (π).
• An increase in the mark-up will lead to an increase in wage
determination (z) and thereby inflation
• An increase in the unemployment rate, (u), leads to a decrease in
inflation
• When looking at a specific year, the markup (m) and the other factors
that affect the unemployment rate (z) are constant.

The Phillips curve and its mutations

• The Phillips curve relation was observed in the US in the 1960s. the
steady decline in the US unemployment rate throughout the 1960s was
associated with a steady increase in the inflation rate.
• The relation vanished in the 1970s because wage setters changed the
way they formed the inflation expectations.
• The accelerationist Phillips curve:
o The accelerationist Phillips curve refines the original idea,
arguing there's no lasting trade-off between inflation and
unemployment. Only unexpected inflation affects short-term
unemployment, while long-term unemployment remains stable
at the natural rate, making the curve vertical.
• Expectations of inflation that became de-anchored during the 1970s
and 1980s became re-anchored in the mid- 1990s.
 • Under the Phillips curve conditions average inflation equals zero over
time, and therefore we assume πe = 0.
• As a result, we get:
o 𝜋t = ( 𝑚+ 𝑧) − 𝛼𝑢t [represents the original
Phillips curve]
o 𝜋t - 𝜋t -1 = ( 𝑚+ 𝑧) − 𝛼𝑢t. [represents the modified
Phillips curve]

The Phillips curve and the natural rate of unemployment

• Milton Friedman and Edmund Phelps argued that the trade-off
between inflation and unemployment in the late 1960s was an illusion.
• Accordingly, the Phillips curve is a temporary, rather than a
permanent, trade-off between inflation and unemployment that
comes not from inflation per se, but from a rising rate of inflation,
which results in unanticipated inflation.
• The natural rate of unemployment (un):
o Refers to the unemployment rate such that the actual inflation
rate is equal to the expected inflation rate.
 o In other words, the natural rate of unemployment is the level of
unemployment that exists when the labour market is in
equilibrium, excluding short-term economic fluctuations.
o It accounts for structural and frictional unemployment but not
for cyclical downturns. It's not necessarily zero, as some job
transitions and skill mismatches are inevitable.
o Furthermore, the natural rate of unemployment is the rate of
unemployment required to keep inflation at zero.
• When the unemployment rate is below the natural rate of
unemployment, the inflation rate typically increases.
• On the other hand, When the unemployment rate is above the natural
rate of unemployment, the inflation rate typically decreases.
• In the medium run:
o Actual unemployment equals to the natural rate of
unemployment.
o As a result, if unemployment returns to its natural rate in the
medium run, then output must return to its natural level too

Week 6
CHAPTER 9 – The IS-LM-PC Model

The IS-LM-PC Model

• The IS-LM describes the relationship between interest rates and output
in the goods and money markets, in the short run, with the Phillips
Curve (PC) showing relationship of inflation to unemployment in the
medium run.
• In other words, we can integrate the PC curve Into the IS-LM model,
thereby allow the model to analyse longer time periods (medium-run).
• Since the IS curve is expressed in terms of output, the PC curve should
also be expressed in terms of output.
• The output gap refers to the deviation of output from its natural level:
o If unemployment = natural rate (𝑢n), then output is equal to the
potential, and the output gap is equal to zero.
 o if unemployment > natural rate, output is less than the potential,
and the output gap is
o negative.
o if unemployment < natural rate, output is greater than the
potential and the output gap is positive.
o

o Y = N = L(1 - u) = –𝐿(𝑢 – 𝑢n)

o When u = 𝑢n
§ Natural employment is equal to, 𝑁𝑛 = 𝐿(1– 𝑢n)
§ Potential output is equal to, Yn = L(1 - 𝑢n)
• When output is above potential (positive output gap), inflation
increase, and exceeds target inflation.
• When output is below potential and therefore the output gap is
negative, and inflation is lower than target inflation.

From the Short to the Medium Run

• Over the medium run, the economy converges to the natural level of
output and stable inflation.
• Wicksellian/natural rate of interest represents the where demand for
goods is equal to potential output.
• If the central bank wants to achieve a constant level of inflation, then
the initial boom must be followed by a recession.
• Neutrality of money refers to the fact that monetary policy does not
affect real variables in the medium run.
• There are forces that pushing the economy back to potential/natural
output at the natural rate of unemployment rate, however these
depend inflation expectation are formed.
• With anchored expectations. Policymakers have more room for
adjustments than with adaptive expectations
• With adaptive expectations, the medium-run would be reached very
fast and policy would be mostly ineffective even in the short run.
•

Complications and How Things Can Go Wrong

• Reasons why it’s complicated to adjust the medium-run equilibrium
 o It is difficult for the central bank to know where potential output
is exactly and thus how far output is from potential.
o It takes time for the economy to respond.
• A deflation spiral or deflation trap results when deflation pushes real
interest rates higher, lowers output, and leads to larger and larger
deflation.

Fiscal Consolidation Revisited

• Fiscal consolidation leads to a decrease in output in the short run.
• In the medium run, output returns to potential, and the interest rate is
lower.

The Effects of an Increase in the Price of Oil

• In the short run, an increase in the price of oil leads to higher inflation.
If the price increase is permanent, it leads to lower output in the
medium run
• Tends to leads to stagflation.
• An increase in the price of oil is equivalent to an increase in the
markup. It leads to lower real wages and a higher natural rate of
unemployment.

Week7
CHAPTER 17: OPENESS IN THE GOODS AND FINANCIAL MARKETS

Key Objectives
• What are the implications of openness?
• How do economies trade both goods and assets with the rest of the
word?
• What is the exchange rate and how is it determined
• How do households choose between domestic and foreign assets?
• What is the Balance of Payments and why does it have a high profile
in political arguments over economic policy?
The open economy
• Openness in the goods market means that demand is determined by
the real exchange rate
• Openness in the financial market means that the demand for domestic
goods compared to foreign goods is determined the exchange rate and
interest rate.
• In general, the open economy has three features:
o In the goods market: represents the ability of agents to choose
between domestic and foreign goods and free trade restriction
include tariffs and quotas
o In the financial market: represents the ability of financial
investors to choose between domestic and foreign assets and
capital control restrictions are placed on the ownership of foreign
assets
o In the labour market: the ability of firms to choose where to
locate their location and workers to choose where to work

Openness in the goods market

• Consumption of domestic or foreign goods is dependent on the real
exchange rate.
o This will in turn affect the domestic output and the purchasing
power of a currency.
o In other words, the real exchange rate means the price of
domestic goods relative to foreign goods.

• Exchange rates:
• Nominal exchange rates
o Nominal exchange rates (e) can be discussed as the price of one
currency in terms of another.
o This can be expressed in two ways:
§ Price of foreign currency in terms of domestic currency
• Dollars in terms of rate the Rand ($1 = R18. 92)
§ Price of domestic currency in terms of foreign currency
• Rand in terms of rate Dollars (R1 = $0.053)
o Flexible exchange rate:
§ Appreciation
 • When the domestic currency appreciates, the rand
will strengthen, and exchange rate will rise.
Inversely, the foreign currency will weaken. This will
lead to exports decreasing and the imports
increasing
§ Depreciation
• When the domestic currency depreciates, the rand
will suffer, and as a result, the exchange rate will
drop. Inversely, the foreign currency will strengthen.
This will lead to exports increasing and imports
decreasing
o Fixed exchange rate:
§ Revaluation
• Refers to an increase in the exchange rate, instead
of appreciation.
§ Devaluation:
• Refers to the decrease in the exchange rate, instead
of depreciation.
• Real exchange rates
o In words, real exchange rate (RER), represents the Nominal
exchange rate (e) multiplied by domestic price, divided by the
foreign price.
o Represents the relative price of domestic goods in terms of
foreign goods.
o This also represents the purchasing power of a currency.
o Calculation of real exchange rates.
§ If RER > 1, the domestic currency is overvalued.
§ If RER < 1, the domestic currency is undervalued.
o Causes of exchange rate changes:
§ Fluctuations in nominal exchange (e)
§ Fluctuations in P/P*
o Movements of the real exchange rate
§ Real appreciation defines the increase in the price of
domestic goods in terms of foreign goods. This will lead to
domestic goods becoming expensive
 • An increase in RER, may be due to an appreciation
of (E), increase in price of domestic goods, or
decrease in foreign prices. Vice versa.
§ Real depreciation represents the decrease in the price of
domestic goods in terms of foreign goods. Inversely, this
will lead to domestic goods becoming cheaper.

Openness in the financial market

o Trade balance
o Refers to the difference between exports and imports. As a result,
If a country exports more than it imports, it has a trade surplus.
If it imports more than it exports, it has a trade deficit.
o Trade deficit
o Occurs when a country’s value of imports exceeds the value of
its exports over a period of time
o In other words, the country is buying more goods and services
from other countries than its selling to them.
o In case of a trade deficit, the country will pay the difference using
foreign reserves or borrowing from the rest of the world.
o Trade deficits may mean that a country is borrowing from other
countries to pay for imports, leading to foreign debts.
o Trade deficit = Imports – Exports
o Trade surplus
o Occurs when a country’s value of exports exceeds the value of
its imports over a period of time.
o In other words, the country is selling more goods and services to
other countries than its buying from them.
o Trade surpluses can cause a country’s currency to appreciate.
o Conversely, a trade surplus might mean that the country is not
investing in its own economic growth, or not consuming enough
of foreign goods, this could be because they aren’t wealthy
enough or there’s not enough demand for domestic goods.
o Trade surplus = Exports – Imports
o Balance of payments
 o Refers to the systematic summary of all the transactions that
take place between one country’s residents and the rest of the
world.
o Transactions include, imports and exports, tourist expenses,
interest and dividends paid and received, and the purchase or
sale of financial assets
§ Transactions that lead to a receipt of payment from the
rest of the world, will be credited.
§ Transactions that lead to a payment to the rest of the
world, will be debited.
o The BoP is typically divided into two parts, the current account
and the capital and financial account.
§ Current account
• represents transactions related to trade of goods
and services, and secondary income.
• Current account balance - refers to the sum of net
payments to and from the rest of the world.
• Current account surplus - refers to the positive net
payments from the rest of the world.
• Current account deficit - refers to negative net
payments from the rest of the world.
§ Capital and financial account
• records transactions associated with changes in
international ownership of assets and liabilities.
Additionally, It captures the flow of capital between
a country and the rest of the world.
• Financial account balance – refers to increase in
holdings of domestic assets minus the increase in
domestic holdings of foreign assets.
• Financial account surplus – refers to the positive net
capital flows.
• Financial account deficit – refers to the negative net
capital flows.

o The interest rate parity condition

o The interest rate parity condition ensures that the foreign
exchange market and the interest rate markets of two countries
 are in equilibrium, such that no risk-free profit opportunities
exist.
o In other words, It shouldn’t matter whether you hold domestic
assets or foreign assets, because according to the interest rate
parity condition, the expected return on bonds in one currency
relative to another currency should be the same. But only
depends on whether you expect domestic or foreign currency to
appreciate or depreciate.
o Interest Rate Parity is a fundamental principle in the foreign
exchange market that equates the expected return on a
domestic bond to the expected return on a foreign bond when
the returns are measured in the same currency.
o The theory suggests that the difference in interest rates between
two countries should be equal to the difference between the
forward exchange rate and the spot exchange rate of the two
countries' currencies.
o (1+i ) = (1+ i* )( Eet/ Eet +1)
t t
§ it – domestic interest rate
§ i*t – foreign interest rate
§ Eet – forward exchange rate
§ Eet +1 – spot exchange rate

Summary

o Openness in goods markets allows people and firms to choose between

domestic goods and foreign goods. This choice depends primarily on the
real exchange rate.
o Openness in financial markets allows investors to choose between
domestic assets and foreign assets. This choice depends primarily on their
relative rates of return, and on the expected rate of appreciation of the
domestic currency.
Week8
CHAPTER 18: GOODS MARKET IN THE OPEN ECONOMY
Key objectives

o How does the IS relation change now that we open the economy?
o What is the goods market equilibrium in an open economy?
o How do we introduce imports and exports and what are their
determinants?
o How do changes in the demand (both domestic and foreign) affect
output?
o How does a depreciation affects the trade balance and output?
o Marshall – Lerner condition

Goods market in the open economy

o In the closed economy, there are no imports and exports. Therefore,

everything produced domestically will be consumed domestically.
o In other words, in the closed economy, the equilibrium is reached when
demand for production of goods is equal to domestic consumption of
goods.
o In the open economy, the demand for domestic goods comes from
foreign and domestic consumers and part of domestic demand is for
foreign goods.
o In other words, not all domestically produced goods are consumed
within the country, some will be exported. Similarly, not all goods
consumed domestically are produced within the country, some are
imported
o Additionally, in the goods market, equilibrium is reached when
domestic demand is equal to demand for domestic goods, while
aggregate demand is made up of consumption, investment,
government spending, and net exports (X - IM).

The IS relation in an open economy and its determinants

o Z = C + I + G – IM/E + X
o Determinants of the demand for domestic goods
o Domestic demand:
§ C + I + G + IM/ e = C(Y - T) + I(Y, r) + G.
 § Consumption is positively related to disposable income(Y
- T).
§ Investment is positively related to income and negatively
related to real interest rate.
§ government spending is given.
§ The real exchange rate affects the composition of
consumption and investment, but not the overall level of
these aggregates.
§ this simply means that it’s not a matter of how much to
individuals consume or invest, but rather where and when
they decide to consume and invest in domestic or foreign
goods.
o Determinants of imports
o IM = IM (Y, e )
o An increase in domestic income (Y), leads to an increase in
imports.
o An appreciation in the real exchange rate (e) can lead to an
increase in imports, all else being equal. This is because, in
relative terms, domestic goods become more expensive
compared to foreign goods. As a result, foreign goods may
become more attractive and cheaper for domestic consumers,
potentially leading to an increase in imports.
o Determinants of exports
o X = X (Y*, e )
o An increase in foreign income (Y*), will lead to an increase in
exports.
o An appreciation in the real exchange rate ( e) leads to a decrease
in exports, ceteris paribus. This is because domestic goods
become more expensive relative to foreign goods, making them
less attractive for foreign consumers.

the effects of changes in the demand (demand and foreign)

Þ How increase in the domestic demand affect output in an open
economy.
o The effects of an increase in Government spending
§ In an open economy, government spending on output is
smaller than it would be in a closed economy.
 § Increase in domestic demand leads to more imports, while
exports remain the same. As a result, this will dampen the
multiplier effect.
§ As output increase, so will imports, thus resulting in a
trade deficit. This is because part of domestic demand falls
on foreign goods, but exports remain unchanged.
§ the more open the economy, the smaller the effect of an
expansionary fiscal policy and the larger the adverse effect
on the trade balance.
o The effects of an decrease in Government spending
§ In an open economy, a decrease in government spending
can lead to a reduction in domestic demand. This might
push producers to seek foreign markets, potentially
increasing exports.
§ If imports remain unchanged, the net export component
of aggregate demand might increase, leading to a trade
surplus.
§ However, the overall decrease in domestic demand would
likely dampen the multiplier effect.
Þ How does an increase in the foreign demand affect output in an open
economy.
o For a given level of output, an increase in exports leads to an
increase in demand for domestic goods and overall output (Y).
o The demand curve ZZ will shit upwards to a new demand curve
ZZ I
o As a result of the increase in foreign demand for goods, net
exports will increase by the change in exports.
o Due to the increase in net exports, there will be a trade surplus.

The marshal-Lerner condition (MLC)

• The Marshall-Lerner Condition relates to the effect of exchange rate

changes on a country’s trade balance.
• Specifically, represents a condition that under which a depreciation of
a country’s currency will lead to an improvement in the trade balance.
• The effects of depreciation on the trade balance and output
 o In the short run, given that the domestic price level and foreign
price level are the same, nominal depreciation will be equal to
real depreciation.
o Real depreciation will affect the trade balance through three
channels:
§ Due to a depreciation of a currency, exports in the
economy will increase, because domestic goods become
relatively cheaper than foreign goods.
§ On the other hand, making imports more expensive for
domestic consumers.
§ The relative price of foreign goods in terms of domestic
goods increase.
• Marshall-Lerner condition is the condition under which a real
depreciation leads to an increase in net exports (NX)
• To reduce the trade deficit without changing output
o The government must reduce their spending.
o The central bank must depreciates the currency.

The J-curve
• The J-curve represents the relationship of net exports (NX) over time.
• According to the J-curve, a depreciation of the exchange rate will lead
to a decrease in the trade balance, but not immediately.
• But eventually the depreciation in the exchange rate will lead to an
improvement in the trade balance
• An increase in investment is reflected in increased savings. In other
words, the deterioration in the trade balance NX. Increase in the
budget deficit (T-G) is reflected as a decrease in investment or increase
in private spending.

Week9
CHAPTER 19

Key questions
 § What determines the exchange rate.
§ Where is the exchange rate determined.
§ How policymakers affect the exchange rate.
§ Implications on the equilibrium in the goods and financial market.
§ Mundell-Fleming model.

The equilibrium in the goods market in the Mundell-Fleming model

§ Know equation derived from previous chapters:

o
§ Main implication: both the real interest rate(r) and the real exchange
rate(e) affect demand, as a result, affecting also the equilibrium.
o For instance, an increase in the real interest rate leads to a
decrease in investment spending, and to a decrease in the
demand for domestic goods, as a result, decreasing output
through the multiplier.
o An increase in the real exchange rate leads to a shift in demand
towards foreign goods, and to a decrease in net export, then
leading to a decrease in output through the multiplier.
§ The two simplifications:
o The nominal and real exchange rate move together, because
both domestic and foreign price levels are given

§
o Actual and expected inflation is zero, meaning there is no
inflation.

The equilibrium in the financial market and foreign exchange market

§ In the closed economy:
 o Investors are concerned with choosing between money and
bonds
§ In the open economy:
o On the other hand, investors are concerned between choosing
money and bods.
o As well as, choosing between domestic and foreign bonds.
§ In general sense, investors will be willing to choose bonds
that have higher expected rate of returns.
§ However, in equilibrium, both bonds must have the same
expected rate of return, otherwise, the interest rate parity
condition would not hold.

§
§ Rearranging the IRP condition equation we can determine
the current E as a function of interest rate(i), foreign
interest rate(i*), and expected E.

•
• This implies that the current exchange rate depends
on the domestic interest rate(i), foreign interest
rate(i*), and on the expected future exchange
rate(E).
 o An increase in the domestic interest rate leads
to an increase in the exchange rate.
o An increase in the foreign interest rate leads
to a decrease in the exchange rate.
o An increase in the expected future exchange
rate leads to an increase in the current
exchange rate.

The equilibrium in both financial and goods market determining output,

interest rate and the exchange rate
§ the goods market equilibrium implies that output depends, among
other factors, on the interest rate( i) and the exchange rate(E).
o where the central bank sets interest rate(policy rate).

o
§ The IRP condition implies a positive relation between the domestic
interest rate and the exchange rate.
§ The IS and LM equations in the open economy:
 o
o The effects of an increase in interest rate:
§ (1), in the closed economy, this is has direct effect on
investment. In other words, increase in interest rate leads
to lower investment and lower demand, as a result a
decrease in output.
§ (2), present in the open economy, the effect is felt through
the exchange rate, meaning higher interest rate( i) leads
to an appreciation, given P and P*.

§ The IS-LM-IP model in the open economy

The effects of policies in the open economy.

§ Technique of answering these questions:
o What happened to the level of output(Y).
o What happens to the composition of output(Y)(i.e.
Consumption, Investment, NX and Government spending).
o What happens to the interest rate.
o What happens to the exchange rate.
§ The effects of the monetary policy:
o
o Remember the monetary policy focuses on the money supply
and interest rate to affect the economy.
o assume initial position A: in the case of a monetary contraction
§ A monetary contraction represents set of actions by a
central bank to reduce money supply within an economy.
§ The primary objective of this measure is to reduce
inflation, stabilize economic growth, and maintain the
stability of the currency.
§ This is typically implemented through measures of selling
government securities and increasing interest rate, to
name a few.
§ These actions lead to a decrease in the availability money
of money in the economy.
§ The intended effect is to make borrowing more expensive,
subsequently leading to higher interest rates on loans and
increased yields on savings and investments.
§ Consumption - As a result, consumption will decrease
because it becomes more attractive for consumers to save
money and take advantage of the high interest rates.
§ Investment – typically investments will decrease due to the
high interest rates, because borrowing for investments
becomes expensive.
§ Government spending – government spending does not
change.
 § NX - increase in interest rates lead to domestic assets
becoming attractive to foreign investors, potentially
leading to an appreciation of the domestic currency. When
the domestic currency appreciates, it can make exports
more expensive for foreign buyers, which may result in a
decrease in net exports.
§ Concluding remarks:
• An increase in the interest rate leads to a decrease
in output and an appreciation of the exchange rate.
• A decrease in the interest rate leads to a increase in
output and a depreciation of the exchange rate.
• In turn, output decreases because of the reduced
borrowing and investment.
•
§ The effects of fiscal policy:

o
o Remember that fiscal policy focuses on using government
spending and taxes to affect the economy.
o Assume initial position: in the case of fiscal expansion(without
any change in taxes)
§ An increase in government spending leads to an increase
in output.
§ If the central bank keeps the interest rate unchanged, then
the exchange rate also remains unchanged.
 § Consumption – due to increase in government spending,
this will lead to an increase in consumer confidence,
potentially boosting consumption.
§ Investment - Businesses may invest more to meet the
rising demand, especially if they expect increased future
sales.
§ Government spending – this increases as part of the fiscal
policy.
§ NX - An increase in government spending can lead to
higher imports, potentially reducing net exports.
§ Interest rate - No change in the interest rate.
§ Exchange rate – if the interest rate remains unchanged,
then the is no change in the exchanged.

Fixed exchange rates

§ Under the fixed exchange rates, the central bank gives up monetary
policy as a policy instrument.
§ However, central banks act under implicit and explicit exchange-rate
targets and use monetary policy to achieve those targets.
§ Pegging
o Refers to a situation where countries maintain a fixed exchange
rate in terms of some foreign currency, such as the US dollar.
o In other words, a country fixes its exchange rate to another
currency, such as the U.S dollar.
o The central bank intervenes in the foreign exchange market to
maintain the fixed exchange rate by buying or selling its own
currency.
§ Crawling pegging
o In the crawling pegging system, the exchange rate is fixed, but
periodically adjusted within a predetermined range.
o These adjustments are typically pre-announced and occur at
regular intervals, like daily, monthly, or annually.
o The purpose is to allow for gradual changes in the exchange rate
over time in response to economic conditions.
o For instance, some countries craw peg their currency to the U.S
dollar.
 § In the European Monetary System (EMS) and similar arrangements,
member countries agree to keep their exchange rates within certain
limits or bands around a central rate.
§ This central rate serves as a reference point, and currencies should not
fluctuate too much above or below this rate.

§
o Under the fixed exchange rate and perfect mobility, the domestic
interest rate must be equal to the foreign interest rate.
§ The effects of an increase in government spending are identical to the
flexible exchange with unchanged monetary policy.
§ If the increase in G leads to inflationary pressures, the option to
increase interest rate by the central bank is no longer available under
fixed exchange rates.
§ Under fixed exchange rates, the central bank gives up monetary policy
as a policy instrument.
§

Week 10
CHAPTERR 20

Exchange rate regimes

• the exchange rate regime refers to the system or set of rules that a
country’s central bank or government follows in managing its currency
exchange rate.
• During the period of 1944 and 1972, a number of countries adopted a
system of fixed exchange rates, fixing the price of their currency in
terms of the US dollar.
• There are two types of regimes:
o Fixed exchange rate regime
 § The central bank or the government losses the ability to
use monetary instruments(i.e. affect interest rate and
exchange rate)
§ The domestic interest rate has to remain constant to the
foreign interest rate, according to the IRP.
§ In other words, the central bank or government commits
to keeping the exchange rate of its currency fixed to
another currency, typically a large currency like the US
dollar or Euro.
§ the nominal exchange rate is fixed and thus cannot be
adjusted.
§ Uses techniques such as devaluation(decrease in the
nominal exchange rate) and revaluation(increase in the
nominal exchange rate).
o flexible exchange rate regime
§ In order to reduce trade deficit and get out of recession, a
country will need to achieve real depreciation.
§ Relies on the monetary policy to adjust the interest rate
and exchange rate
§ Exchange rates fluctuate based on economic factors, trade
balances, and market sentiment.
§ this regime may be considered more attractive.
§ This regime provides flexibility but can lead to exchange
rate volatility.
§ Uses techniques such as appreciation and depreciation.

Openness in the medium-run

• In the medium-run, the difference between the fixed and flexible
exchange rate regimes fades away.
• In other words, in the medium-run, the economy reaches the same
real exchange rate and the same level of output, whether it operates
under the fixed or flexible exchange rate.
• the ways in which the real exchange rate can change:
o through a change in the nominal exchange rate(E)
o through a change in the domestic price level(P), relative to the
foreign price level(P*).
 • The IS relation for aggregate demand in an open economy with fixed
exchange rates

o
o
o Demand or output depends:
§ Negatively on the real exchange rate.
§ Positively on government spending and negatively on
taxes.
§ negatively on the domestic real interest rate
§ positively on foreign output through the effect on exports
• the Phillips curve relation in the medium-run

o
§ p, represents the actual inflation
e
§ p , represents the expected inflation.
o This implies that, if two economies operating at potential,
inflation rates would be the same, relative prices would remain
constant, and real exchange rate would also remain constant.
o If domestic and foreign inflation are equal, the real exchange
rate is constant.
• In the medium-run, the real exchange rate can even adjust even if the
nominal exchange rate is fixed.
• This adjustment are achieved through movements in the relative price
level over time.

Devaluation
• In favour of devaluation
o Under the fixed exchange rate, the economy always returns to
the natural level output in the medium-run, however, this
process may result in low output high unemployment for a long
time.
 o One way to combat this would be, the government can opt for
a one-time devaluation within a fixed exchange rate regime, as
a result, lowering the nominal exchange rate, causing a real
depreciation, which shifts the aggregate demand curve to the
right and boosts output.
o More specifically, a devaluation of the right size can return an
economy in recession back to a natural level of output.
o However, the effects of the devaluation on output do not happen
right away, this is demonstrated through the J-curve.
o There’s likely to be a direct effect of devaluation on the price
level.
o In a fixed exchange rate system, trade deficits or high
unemployment often lead to political pressure for either
abandoning fixed rates or implementing a one-time
devaluation.
• Against devaluation
o Too much willingness to devaluate defeats the purpose of
adopting a fixed E in the first place and leads to an increase in
the likelihood of nominal exchange rate crisis.
o In conclusion, in a fixed exchange rate regime, for a given price
level:
§ Devaluation will lead to a real depreciation of the
currency.
§ Devaluation will lead to an increase in net exports.
§ Devaluation will lead to an increase in output.
o The real exchange rate may be too high, the domestic currency
may be overvalued, and this may lead to a low level of
competitiveness and trade balance deficit.
o Internal conditions may call for a decrease in the domestic
interest rate BUT a decrease in the domestic interest rate cannot
be achieved under fixed exchange rates.
§ This will require the abandonment of the fixed exchange
rate and then decrease interest rate.
§ But once the exchange rate is flexible, the decrease in
interest rate will in turn to decrease the real exchange rate
 o Under the fixed exchange rates, if the markets are expecting that
interest rate parity(IRP) will be maintained, then the domestic
and foreign interest rate will be equal

o
o In the expectation of a devaluation, the following can be
implemented:
§ The central bank or government can try to convince
markets that they have no intention of devaluating.
§ The central bank can increase the interest rate slightly and
compensate for part of the expected devaluation.
§ Either increase the interest rate or validate the market’s
expectations and devalue.
o
o Disadvantages of increasing interest rate
§ Firms will decrease investments.
§ Consumers will increase borrowing.
§ There will be a decrease in demand, and in turn,
increasing the expectations of a future devaluation.

Choosing between fixed and flexible exchange rate regimes.

• In general terms, flexible exchange rates are preferable.
• Case 1: countries to constitute an optimal currency area, three
conditions must be satisfied.
o If the countries experience similar shocks, and thus can choose
roughly the same monetary policy.
o If the countries experience different shocks, prices and wages
must be very flexible.
• Case 2: there’s a common currency, such as the Euro, allowing
countries to lower the transaction costs of trade
o A hard peg is the symbolic or technical mechanism by which a
country plans to maintain exchange rate parity.
• Case 2: dollarization is an extreme form of a hard peg
Week 11
CHAPTER 10

Key Questions
• What is economic growth
• Framework for understanding growth
• Sources of economic growth
• What is required for sustained economic growth

The Solow Growth Model

Economic growth
• Economic growth represents the steady increase in aggregate output
over time.
• In other words, economic growth refers to the sustained increase in
production and consumption of goods and service in an economy over
a period of time.
• Economic growth and technological advancements increased
agricultural productivity and leading to higher wages and improved
living standards, but real wages started to increase as they moved
away from the Malthusian trap, primarily the industrial revolution.
• The Malthusian trap:
o The Malthusian trap refers to how low real wages resulted from
resource limitations and high population growth, but economic
growth and technological progress eventually led to higher real
wages.
o Thomas Malthus argued that, population growth kept living
standards, including real wages, low. Only during the Industrial
Revolution in the late 18th and 19th centuries, with technological
advancements and increased agricultural productivity, did real
wages begin to rise, allowing societies to escape the Malthusian
trap.
 o Furthermore, Malthus argued that the proportional increase in
population and output is not a coincidence.
• The importance of economic growth:
o Economic growth is of paramount importance as impacts the
standard of living of individuals, overall happiness, and the level
of welfare in the society.
o Instead of using GDP as a measure for economic growth, GDP
per capita presents an accurate measure of assessing the growth
in an economy.
• Measure of standard of living:
o GDP per capita: total output (GDP)/ total population
o Exchange rates have a significant impact on individuals'

purchasing power and consumption. Since the differences in the

prices of goods and services, influenced by exchange rates, can

affect the level of welfare and standard of living.

o As a result, the lower the GDP per capita, the lower the price of

goods and services in the country.

o This can be solved through the use of the purchasing power

parity, which measures the purchasing power across countries.

Framework for understanding growth

• Production function
o In order to understand growth, it’s imperative we understand the
relationship between aggregate output (Y) and the inputs to
production (K) and (N).
§ Y = F(K, N)
o State of technology
§ This refers to the plan defining the range of products and
methods used to and available to produce them.
 § This also includes internal organisation of firms, quality of
government, legal institutions, system of laws etc.
§ In other words, the state of technology determines how
much output (Y) can be produced, given the level of K and
N.
§ In general, the higher the state of technology, the higher
the (Y), given the level of K and N.
• Properties of the production function
o Returns to scale
§
§ There are three types of returns to scale:
• Increasing returns to scale
o Refers to when an increase in all inputs results
in a more than proportional increase in
output.
o This typically occurs when an organization
expands its operations, and efficiency and
productivity improve as a result of increased
scale
o Y = F(K, N) = A(Ka, Nb)= 2(K0.4, N0.6)
• Constant returns to scale
o When a proportional increase in all inputs
results in an equal proportional increase in
output.
o In this case, the organization's efficiency and
productivity remain consistent as it scales up
its operations.
o F(cK, cN) = cY
o E.g. F(2K, 2N) = 2Y
§ The production function has constant returns to scale
o Returns to factors
• Returns to factors, refers to the relationship between
the factors used in a production process and the
resulting output. It describes how changes in the
quantities of these input factors affect the level of
production.
 • The following represent situations where increasing
the amount of one input (either capital or labour)
while holding other inputs constant leads to
diminishing or decreasing returns in terms of
output.
• Decreasing returns to capital
o For a given quantity of labour, increases in
capital lead to smaller and smaller increases
in output per worker.
• Decreasing returns to labour
o For a given quantity of capital, increases in
labour lead to smaller and smaller increases
in output per worker.
o Output per worker and capital per worker
§ Y/N = F(K/N, N/N) = F(K/N, 1)
§ The amount of output per worker, Y/N depends on the
amount of capital per worker, K/N.
§ In other words, output per worker is an increasing function
of capital per worker but at a decreasing rate – decreasing
returns to capital.
§ As capital per worker increases, so does output per worker,
but at a smaller and smaller rate.
§ This equation represents constant returns scale
§ The following production function shows decreasing
returns to capital per worker.
• For a given quantity of labour, increases in capital
per worker lead to smaller and smaller increases in
output per worker.
 §

Sources of economic growth

• There are two sources of economic growth:
o Capital accumulation
§ When an economy invest in and accumulates physical
capita(machinery, infrastructure), it can increase its
productive capacity.
§ This can lead to higher output, job creation and economic
expansion.
§ This causes a shift along the production function, because
increases in capital per worker (K/N) leads to smaller and
smaller increases in output per worker.
o Technology advancement
§ Technological progress and innovation drive efficiency,
competitiveness, and productivity.
§ In other words, new technology can lead to development
of new products, processes, and improved overall output.
§ Improvements in the state of technology
§ This causes the production function to shift up, leading to
an increase in output per worker
 §

Sustained economic growth

• Economic growth cannot be sustained solely through the capital
accumulation of capital, but it requires technological progress.
• In simpler terms, the economy's rate of growth of output per worker
is determined by the economy's rate of technological progress.

Convergence
• Convergence occurs when countries have similar institutions.
• For instance, institutions such as property rights, political stability,
honest government, dependable legal system, competitive and open
market, etc.
• Conditional convergence represents institutions that enable the
incentives accumulate and to use the foP in a socially optimal way.
• Solow model assumes absolute convergence.

CHAPTER 12
Key questions
• The interactions between output and capital accumulation.
• Dynamics of capital and output over time.
• The steady state of capital and output.
• How the saving rate affects the growth rate of output per worker.
• The golden rule of level of capital.
 • Difference between physical capital and human capital.

Interactions between output and capital

• Output in the long run, is determined by the relation between output
and capital:
o The amount of capital determines the amount of output
produced – f1.
o The amount of output determines the amount of saving, and in
turn, determines the amount of capital accumulation over time
– f2. .

o Under constant returns to scale:

§ Y/N = y = F(K/N, 1) = f(K/N) = f(K)

• the effects of capital on output:

o assumptions:
§ the size of the population, the participation rate, the
unemployment rate are all constant.
§ There’s no technological progress.
o

o
o This represents the first equation of the model, where capital
determines output.
 o Higher capital per worker leads to higher output per worker.

• the effects of output on capital accumulation.

o assumptions:
§ economy is closed(I = S + [T -G]).
§ Public saving is zero(I = S).
§ Private saving is equal to income(S = Y).
o in order to derive the second equation, we follow 2 steps:
§ derive the relation between output and investment.

•
• Investment is proportional to output.
• higher output, leads to higher (lower) saving and
higher (lower) investment.
§ derive the relation between investment and capital
accumulation.

•
• This represents the capital stock equation.
• 𝛿 denotes the rate of depreciation

•
• This equation is the output per worker and capital
per worker.

•
• We get the second equation, where output
determines capital accumulation.
• the change in capital accumulation per
worker(LHS) and the saving per worker less
depreciation(RHS).

Dynamics of capital and output over time.

• the relationship between output and capital over time is represented
by combined equation:
o the equation basically combines two basic equation, the
production function and capital accumulation.

o
• the change in capital per worker from this year to next year depends:
o if investment per worker exceeds depreciation per worker, the
change in capital per worker is positive, and capital per worker
increases.
o Alternatively, if investment per worker is less than the
depreciation per worker, the change in capital is negative, and
capital per worker is negative.
o The figure below shows the capital and output dynamics.

o
§ According to the figure, when capital and output are low,
investment is greater than depreciation, and capital is
increasing.
§ In turn, when capital and output are high, investment is
less than depreciation, and capital is decreasing.
 § As a result, the output per person curve will converge to
point SS(Y*/N, K*/N).
§ Therefore, the equilibrium level is at point Y*/N, where
capital per worker and output per worker remains the
same.

Steady state capital and output

• The steady state of the economy refers to a state in which output per
worker and capital per worker are no longer changing.

•
• In simpler terms, the change in capital from year t to next year will be
equal to zero.
• Therefore, investment per worker is equal to the depreciation per
worker.

•
• In other words, the steady-state value of capital per worker is such
that the amount of saving per worker is sufficient to cover
depreciation of the capital per worker.

How the saving rate affects the growth rate of output per worker.
• The saving rate does not have an effect on the long run growth rate
of output per worker, which is equal to zero.
• Countries with higher saving rates will achieve higher output per
worker in the long run, ceteris paribus.
• Moreover, increases in saving rates lead to higher growth of output
per worker for some time, but not forever.
• A country with a higher saving rate achieves a higher steady-state
level of output per worker.
• An increase in the saving rate leads to a period of higher growth until
output reaches its new higher steady-state level.

The golden rule level of output

• The saving rate and consumption:
o Saving rate is affected by the government
§ Changing public saving, through the budget surplus.
§ Using taxes to affect private saving, through tax breaks.
o If the saving rate is zero, output is also equal to zero and
consumption will also be zero.
o If saving rate is one people save all their income and the level
of capital and output will be very high, but consumption will be
zero.
o Consumption per worker is equal to output per worker minus
depreciation per worker.

o
o Governments are unlikely to ask current generations to make
large sacrifices meaning that capital is likely to stay far below
its golden-rule level.
• The golden rule level of output
o The level of capital associated with the saving rate that yields
the highest level of consumption in the steady-state.
o For a saving rate between zero and the golden-rule level (𝑆 ), a
higher saving rate leads to higher capital per worker, higher
output per worker and higher consumption per worker.
o For a saving rate between zero and the golden-rule level, a
higher saving rate leads to higher capital per worker, higher
output per worker, but a lower consumption per worker.

o
Difference between physical capital and human capital.
• Physical capital refers to the tangible assets used in production, such
as machinery, equipment, infrastructure, and buildings.
• Human capital refers to the set of skills of workers in the economy.
• These skills are built though education and on-job training.

•
• output per workers depends on both the level of physical capital per
worker, K/N, and the level of human capital per worker, H/N.
• In the long run, output per worker depends not only on how much
society saves and invest in physical capital but also how much it
spends on education.

Endogenous growth model.

• Output per worker depends roughly equally on the amount of
physical capital and the amount of human capital in the economy.
• Models that generate steady growth even without technological
progress are called models of endogenous growth, where growth
depends on variables such as the saving rate and the rate of
spending on education.

Week 12
CHAPTER 13

Key questions
• the role of technological progress in growth.
• what is the growth rate of output in an economy where there is both
capital accumulation and technological progress
• the determinants of technological progress
• growth accounting
the technological progress and production function
• Technological progress:
• technological progress simply refers to the process of innovation and
product innovation that enables productivity and efficiency.
• In other words, technological progress is a result of firm’s research
and development activities.
• This can be represented in various ways:
o Better products
o New products
o Larger variety of products
o Larger quantities of output produced in less time
• Moreover, technology progress leads to increases in output for given
amounts of capital and labour.
• There are two thought process behind its efficiency:
o Technological process reduces the number of workers needed
to achieve a given amount of output.
o Technological process increases the output that can be
produced with a given number of workers.
• The production function:
o Everything with the production function will be the same as the
production function for capital and labour, but this time we
include the state of technology.
o The properties remain the same as the earlier production
function, in terms of returns to scale and returns to factors.

§
o Where, (K) – capital, (N) – labour, and (A) – state of
technology.
o This can be denotated to assume technology to be labour
augmenting.

§
o Output depends on both capital (K) and effective labour (AN).

§
 o Output per effective worker is a positive function of capital per
effective worker, but at a decreasing rate.

technological progress and the growth rate of output.

• Assumptions under chapter 12:
o We assume technological progress and population growth.
o We consider dynamics of output and capital per effective
worker.
• Interaction between capital and output
o We introduce the investment curve
§ I = S = s(Y), then derived to the following:

§
§ Represents the investment per effective worker curve,
and in other words, this is the production function
multiplied by the saving rate.
§ The accumulation or investment per effective worker
curve lies below the production function
o The required investment line:
§ Based on the last chapter 11, capital (K), was considered
to be constant when investment was equal to the
depreciation of existing capital stock (i.e. no technological
progress and population growth)
§ However, since there is technological progress and
population growth, as the state of technology (A)
increases, the effective labour (AN) increases.
§ We introduce new terms, gA – rate of technological
progress, and gN – rate of population growth.
o AN = gA + gN
§ Represents the growth rate of effective labour
§ E.g. when rate of technological progress (gA ) is 2% and
rate population growth(gN) is 1%, the effective
labour(AN) is 3%.

o
§ Represents the level of investment of required to
maintain a given level of capital per effective worker.
 o
§ Represents the amount of investment per effective worker
needed to maintain a constant level of capital per
effective labour.
• The dynamics of capital per efficient worker and output per efficient
worker
o From the previous production function, we notice that capital
per effective worker and output per worker converge to
constant values in the long run.
o Now that we allow technological progress and population
growth, the state of technology increases over time and the
effective worker also increases over time.

§
o Explaining the above graph:
§ According to the graph, at level (K/AN)0 , actual
investment exceeds the investment level required to
maintain the existing level of capital per effective worker
§ Resulting in the level of capital per effective worker
increasing over time, moving to the point (K/AN)*
§ However, in the long run, capital per effective worker
reaches a constant level, and so does the output per
effective worker.
 § In other words, the capital per effective worker and
output per effective worker will converge to the steady
state, (Y/AN)* and (K/AN)*
o This implies that output(Y) and capital(K) are growing at the
same rates as effective labour(AN), and they are growing at a
rate of (gA + gN)
o In the Steady state, growth rates of both output, population,
and technological progress are independent of saving rate
o Balanced growth is the steady state of the economy, where
capital, output, and effective labour all grow at the same rate.
(gA + gN).
o Characteristics of balanced growth:
§ Capital per effective worker is constant, meaning growth
rate is equal to zero.
§ Output per effective worker is constant, meaning growth
rate is equal to zero.
§ Capital per worker is growing at the rate of technological
progress(gA).
§ Output per worker is growing at a the rate of
technological progress(gA).
§ Labour is growing at a rate of population growth(gA).
§ capital is growing at a rate equal to the sum of rate of
technological progress and population growth, (𝑔𝐴 +
𝑔𝑁).
§ output is growing at a rate equal to the sum of rate of
technological progress and population growth, (𝑔𝐴 +
𝑔𝑁)
• effects of alternative saving rates.
o An increase in the saving rate leads to an increase in the
steady state levels of output per effective worker and capital
per effective worker.
 §
o Furthermore, an increase in the saving rate leads to a higher
growth until the economy reaches its new, higher, balanced
growth path.

The determinants of technological progress

• Technological progress is a result of firm’s research and
development(R&D) activities.
• Expenditure on R&D depends on:
o The productiveness/fertility of the research process, whether
this will translate into new ideas and new products.
o The appropriability of research results, or the extent to which
firms benefit from the result of their own R&D.
• Determinants of productiveness/fertility include:
o Basic research, the search for general principles and results.
o Applied research, simply refers to the application of results to
specific uses.
 o In a nutshell, the determinants of fertility is based on the
interaction between basic research and applied research.
o Some countries are more successful at basic research, while
others are more successful at applied research and
development.
o It takes many years for the full potential of major discoveries to
be realised.
• Determinants of appropriability of research:
o Is there a payoff in being first at developing a new product
o Legal protection, this can be achieve in the form of patents,
that give firms the ability to exclude anyone else from the
production or use of the new product for a specific period of
time.
o How should a government design patent laws:
§ To sustain growth, advanced countries that are at the
technology frontier must innovate.
§ The difference between innovation and imitation explains
why countries that are less technologically advanced
often have poor patent protection.

Growth accounting
• Production function represents the relation between output and the
inputs(K, N, A)
• Growth accounting refers to the relation between the growth rate in
output(Y), and the growth rate in capital(K), labour(N), and state of
technology(A).
• Different ways of introducing the state of technology(A):
o As an additional input
§ Y = F(K, N, A)
o As increasing the level of output(Y) for given K, and N (also
called the Hicks Neutral)
§ Y = AF(K, N)
o As labour augmenting, (also called Harrod-neutral)
§ Y = F(K, AN)
• Growth rate in output(Y), in words, means that the change in
output(DY) in proportion to the actual output(Y),
 o E.g. if Y = 100 and during period t, Y increased by 1(DY = 1).
Then the growth rate ( DY/Y) = 1/100 = 0.01.
• Another example:
o Given the production function, Y = AF(K, N)
o Assuming Cobb-Douglas production function, Y = AKa NB
o With capital and labour share, under CRS: a + B = 1.

o
§ The growth rate of output equals the rate of
technological progress plus the contribution from the
growth in capital and labour.
§ Shows how much of the growth in output is coming from
capital accumulation, labour growth and technology.

o
§ Since the state of technology is not directly observable,
we use the Solow residual derived from the growth
accounting equation.
§ DA/A – represents the total factor productivity or Solow
residual