Closed Economy In The Long Run - SUPPLY SIDE

Question 1

Long run key issues/characteristics (6)

Answer 1

Flexible prices
Households supply FoP to firms, firms produce G&S.
Households buy G&S using income from FOP
Government also buy G&S from tax rev.
All FOP employed so supply determines output
Financial markets sets interest/exchange rate ensuring AD=AS

Question 2

Circular flow (WHATS NEW)

Answer 2

Added 2 agents - gov and financial markets

Households pay tax to gov, and private saving to financial markets.

Government demand G&S and also public saving to financial markets.

Financial markets invest in firms G&S

Question 3

Aggregate production function
And its assumption…

Answer 3

Y= F(N,K)
N is labour, k is capital

Assume DMR

Question 4

Competitive firms decision - to maximise profit

What is the profit formula?

Answer 4

Profit = PY - WN - RK

P=price
Y= output
W=wage
R=rental price of capital

Remember N and K from production function (labour and capital)

Question 5

So what can this be simplified to

Answer 5

Profit = PF(N,K) - WN - RK

So firms need to choose n and k to maximise profit.

Question 6

From this , what is the MPL and MPK

Answer 6

MPL= W/P
MPK= R/P

The RHS terms indicate real wage and real rental cost of capital (since /p)

Question 7

Now consider labour demand…

1. What does the MPL schedule indicate?
2. Learn labour market equilibrium graph, why is labour demand downward sloping.

Answer 7

1. Indicates anything that increases labour productivity increases real wages. (As LP increase, living standards increase)
2. y axis - real wage
   x axis - labour

Labour demand is downward sloping as MPL falls as labour increase.

Supply of labour is constant (vertical)

Question 8

Learn the capital market equilibrium graph

Answer 8

Y axis - real rental price (R/P)
X axis - Capital (K)

Demand for capital downward sloping as when MPK falls as output increases (too much capital per worker to utilise)

Supply is constant.

Question 9

Why is supply of capital constant?

How is this concept expressed

Answer 9

Because we consider depreciation counteracting the investment of capital.

As long as I=δk then supply of k (k*) constant.

Question 10

Cobb douglas function: Need to know different types of returns to scale, and when.

Answer 10

Constant returns when v+λ=1
Diminishing returns when v+λ<1
Increasing returns when v+λ=1

Question 11

Learn MPL and MPK in CD function

Answer 11

MPL = v/N Y
MPK = 1-v/K Y

Question 12

So when does a profit maximising firm hire up to

Answer 12

When MPL is equal to the real wage

Hence why MPL schedule is also the labour demand curve

Question 13

What is the total real wages paid to labour , and total real return paid to capital owners.

Answer 13

MPL x L

MPK x K

Question 14

What is economic profit

Answer 14

Income remaining after the factors of production costs have been paid

Economic profit = Y - (MPL x L) - (MPK x K)

But since we want to look at the distribution of income (Y) rearrange to put Y first.

Question 15

If the government reduces taxes and expenditure by an equal amount what happens to the long-run equilibrium of the closed economy. Is your answer dependent on the marginal propensity to consume and how?

(seminar q4)

Answer 15

Given national saving is S=Y-C-G, a reduction in taxes causes consumption to increase by bΔT. Following the fall in expenditure, G falls by ΔT.

This means national saving rises by (1-b)ΔT since G falls by ΔT (a bigger amount than the increase in consumption bΔT. Hence real interest rate will fall (since Sn shifts right) and so investment more attractive so increases.

So larger B is, the smaller the impact of tax fall on national saving, and consequently interest rate and investment.

Question 16

What does a fall in taxes increase consumption by?

Answer 16

Consumption goes up by bΔt (MPC x change in tax)

Question 17

Effect of a fall in taxes

Answer 17

Consumption increases by bΔT

However this is balanced by a fall in investment.
There will be a fall in national savings equal to increase in consumption. (Y=C+S+G)

Fall in national savings increases r, and so this is how investment falls.

Question 18

Effect of an increase in G (government purchases)

Answer 18

G would increase. However, we have said that output is fixed at Y* (since we said NK is fixed in LR).

This means the increase must be met by an equal fall It can’t be C(Y-T unchanged). So it will be met by a fall in investment. How?

G spending causes crowding out, (national saving falls) pushing interest rate up and reduces investment!!

Question 19

long run economy - what are the factor markets in…

Answer 19

equilibrium: so full employment (hire up to MPL=W/P MPK=R/P in capital market and labour market graphs

(Remember first assumption was all factors employed, so supply determines output)