Comprehensive Macroeconomics Study

Notes
Based on Macroeconomics, 6th Edition (Norton)

Chapter 1: The Science of Macroeconomics

Key Concepts

 Macroeconomics: The study of the economy as a whole, including growth, business

cycles, unemployment, and inflation
 Microeconomics vs. Macroeconomics: Micro examines individual markets and
decisions; macro focuses on aggregate economy
 Key Macroeconomic Questions:
o What determines long-run economic growth?
o What causes short-term economic fluctuations?
o What policy tools can influence economic outcomes?

Economic Models

 Model Construction: Simplification of reality to understand key relationships

 Endogenous vs. Exogenous Variables: Variables determined within vs. outside the
model
 Positive vs. Normative Economics: What is (descriptive) vs. what ought to be
(prescriptive)

Economic Data and Measurements

 GDP: Total market value of final goods and services produced in an economy
 Unemployment Rate: Percentage of labor force without jobs but actively seeking
employment
 Inflation Rate: Percentage increase in overall price level over time

Chapter 2: National Income Accounting

GDP Calculation Methods

 Expenditure Approach: GDP = C + I + G + (X-M)

o C = Consumption
o I = Investment
o G = Government Spending
o X = Exports
o M = Imports
 Income Approach: GDP = Wages + Rent + Interest + Profit

Components of GDP
  Consumption (C): Household spending on goods and services
o Durable goods, non-durable goods, services
 Investment (I): Business spending on capital goods
o Fixed investment, inventory investment
 Government Spending (G): Government purchases of goods and services
 Net Exports (X-M): Exports minus imports

GDP Limitations

 Excludes non-market transactions (household production)

 Ignores quality improvements
 Doesn't account for environmental degradation
 Doesn't measure income distribution

Real vs. Nominal GDP

 Nominal GDP: Output valued at current prices

 Real GDP: Output valued at constant prices (adjusted for inflation)
 GDP Deflator: Measures price changes across the economy
o GDP Deflator = (Nominal GDP / Real GDP) × 100

Chapter 3: Economic Growth and Productivity

Growth Measurement

 Growth Rate Formula: (Y₂ - Y₁)/Y₁ × 100%

 Rule of 70: Years to double = 70/growth rate

Production Function

 Y = AF(K,L): Output as function of technology (A), capital (K), and labor (L)
 Per Capita Production Function: y = Af(k)
o y = output per worker
o k = capital per worker

Sources of Economic Growth

 Factor Accumulation: Increasing capital or labor

 Productivity Growth: Increasing output per unit of input
o Technological advancement
o Human capital development
o Institutional improvements

Solow Growth Model

 Key Equation: Δk = sf(k) - (n+d)k

o s = savings rate
o n = population growth rate
 o d = depreciation rate
 Steady State: When investment equals depreciation
 Implications:
o Diminishing returns to capital
o Convergence hypothesis
o Growth depends on technological progress in the long run

Endogenous Growth Theory

 Knowledge as a non-rival good

 Positive externalities from R&D
 Human capital investment
 Policies can permanently affect growth rates

Chapter 4: Unemployment and Labor Market

Labor Market Definitions

 Labor Force: Employed + Unemployed

 Labor Force Participation Rate: Labor Force / Working Age Population
 Unemployment Rate: Unemployed / Labor Force

Types of Unemployment

 Frictional: Temporary unemployment during job search

 Structural: Skills mismatch or geographical mismatch
 Cyclical: Unemployment due to business cycles
 Seasonal: Unemployment due to seasonal patterns

Natural Rate of Unemployment

 Definition: Unemployment when the economy is at full employment (frictional +

structural)
 NAIRU: Non-Accelerating Inflation Rate of Unemployment
 Factors Affecting Natural Rate:
o Labor market institutions
o Demographics
o Technology
o Minimum wage laws
o Union power

Okun's Law

 Relationship between unemployment and GDP growth

 Roughly: 1% increase in unemployment associated with 2% decrease in GDP

Labor Market Policies

  Active Labor Market Policies: Training, job search assistance
 Passive Labor Market Policies: Unemployment insurance, welfare benefits
 Structural Reforms: Changes to labor market institutions

Chapter 5: Inflation and Price Level

Inflation Measurement

 Consumer Price Index (CPI): Measures cost of fixed basket of goods

 Producer Price Index (PPI): Measures prices received by producers
 GDP Deflator: Broadest measure, includes all goods and services

Inflation Calculation

 Inflation Rate: (Price Level₂ - Price Level₁)/Price Level₁ × 100%

Types of Inflation

 Demand-Pull Inflation: Excess aggregate demand

 Cost-Push Inflation: Supply shocks, input cost increases
 Built-In Inflation: Expectations and wage-price spiral

Costs of Inflation

 Menu Costs: Costs of changing prices

 Shoe Leather Costs: Costs of reducing money holdings
 Tax Distortions: Inflation's impact on nominal tax brackets
 Redistribution Effects: Between debtors and creditors
 Uncertainty: Hampering long-term planning

Hyperinflation

 Very high inflation rates (>50% per month)

 Usually caused by monetary financing of government deficits
 Historical examples: Germany (1920s), Zimbabwe (2000s), Venezuela (recent)

Deflation

 Persistent decline in price level

 Problems: Increased real debt burden, delayed spending, wage rigidity

Chapter 6: Aggregate Demand and Supply

Aggregate Demand (AD)

 Definition: Total planned expenditure at different price levels

 Components: C + I + G + (X-M)
 Slope: Downward sloping due to:
 o Wealth effect
o Interest rate effect
o Exchange rate effect

Aggregate Supply (AS)

 Short-Run AS: Upward sloping due to sticky prices/wages

 Long-Run AS: Vertical at potential output
 Factors Shifting AS:
o Input prices
o Productivity
o Supply shocks
o Expected price level

Equilibrium

 Short-Run Equilibrium: Where AD intersects SRAS

 Long-Run Equilibrium: Where AD intersects LRAS
 Output Gap: Difference between actual and potential output

AD-AS Dynamics

 Demand Shocks: Shift AD curve

o Examples: Changes in consumer confidence, investment, government
spending
 Supply Shocks: Shift AS curve
o Examples: Oil price changes, natural disasters, technological changes
 Adjustment Process: Economy moves from SR to LR equilibrium

Policy Applications

 Demand-Side Policies: Fiscal and monetary policy to shift AD

 Supply-Side Policies: Deregulation, tax reform, education to shift AS

Chapter 7: Classical Theory and Long-Run

Macroeconomics
Classical Model Assumptions

 Flexible prices and wages

 Say's Law: Supply creates its own demand
 Rational expectations
 Market clearing

Money Neutrality

 Definition: Changes in money supply affect nominal variables but not real variables
in the long run
  Quantity Theory of Money: MV = PY
o M = Money supply
o V = Velocity of money
o P = Price level
o Y = Real output

Labor Market in Classical Model

 Wages adjust to clear market

 Unemployment is voluntary
 Real wage equals marginal product of labor

Loanable Funds Market

 Supply: Savings (S)

 Demand: Investment (I)
 Equilibrium: Interest rate balances S and I

Classical Dichotomy

 Separation of real and nominal variables

 Real variables determined by real factors (technology, preferences)
 Nominal variables determined by monetary factors

Policy Implications

 Limited role for stabilization policy

 Focus on long-run growth and productivity
 Importance of price stability

Chapter 8: Business Cycles and Short-Run

Macroeconomics
Business Cycle Characteristics

 Phases: Expansion, peak, contraction, trough

 Key Measurements:
o Duration
o Amplitude
o Co-movement across sectors

Business Cycle Indicators

 Leading: Predict future economic activity (e.g., stock market)

 Coincident: Move with the cycle (e.g., industrial production)
 Lagging: Follow the cycle (e.g., unemployment rate)

Keynesian Model
  Key Features:
o Sticky prices and wages
o Effective demand determines output
o Multiplier effect
o Involuntary unemployment possible

Consumption and Investment

 Consumption Function: C = C₀ + MPC × Y

o C₀ = Autonomous consumption
o MPC = Marginal propensity to consume
 Investment Determinants:
o Interest rates
o Expected future demand
o Business confidence
o Capacity utilization

Multiplier Effect

 Formula: ΔY = ΔA × [1/(1-MPC)]
o ΔA = Change in autonomous spending
o MPC = Marginal propensity to consume

Output Gap and Economic Stabilization

 Recessionary Gap: Actual output below potential

 Inflationary Gap: Actual output above potential
 Policy Responses:
o Expansionary policy for recessionary gaps
o Contractionary policy for inflationary gaps

Modern Business Cycle Theories

 Real Business Cycle Theory: Technology shocks

 New Keynesian Models: Price rigidities and imperfect competition
 Financial Accelerator: Role of credit markets in amplifying shocks
The Solow Growth Model: Comprehensive
Notes
Introduction and Context
The Solow Growth Model (also called the Solow-Swan model) was developed by Robert
Solow and Trevor Swan in the 1950s. It represents a foundational neoclassical approach to
understanding long-run economic growth and is a cornerstone of modern macroeconomics.
The model aims to explain how economic output is determined by capital accumulation, labor
growth, and technological progress over time.

Core Assumptions
1. Single Homogeneous Output: The economy produces a single good that can be
consumed or invested
2. Closed Economy: No international trade or capital flows
3. Perfect Competition: Firms are price-takers in all markets
4. Constant Returns to Scale: Doubling all inputs doubles output
5. Diminishing Marginal Returns: Each additional unit of capital or labor yields less
additional output
6. Exogenous Savings Rate: A fixed proportion of output is saved
7. Exogenous Population Growth: Labor force grows at a constant rate
8. Exogenous Technological Progress: Technology improves at a constant rate
9. No Government: Initially excludes government taxation or spending
10. Full Employment: Resources are fully utilized

The Production Function

Basic Form

The aggregate production function is:

$$Y = F(K, L, A)$$

Where:

 $Y$ = Total output (GDP)

 $K$ = Capital stock
 $L$ = Labor input
 $A$ = Technology or productivity factor

Cobb-Douglas Specification

The model typically uses a Cobb-Douglas production function:

$$Y = AK^{\alpha}L^{1-\alpha}$$

Where:

 $\alpha$ = Capital share of output (typically between 0.3-0.4)

 $1-\alpha$ = Labor share of output

Per-Worker Form

To analyze growth on a per-person basis, we convert to per-worker terms:

$$y = \frac{Y}{L} = A\left(\frac{K}{L}\right)^{\alpha} = Ak^{\alpha}$$

Where:

 $y$ = Output per worker (labor productivity)

 $k$ = Capital per worker (capital intensity)

Capital Accumulation Dynamics

Investment and Depreciation

Capital accumulation follows the equation:

$$\Delta K = I - dK$$

Where:

 $\Delta K$ = Change in capital stock

 $I$ = Gross investment
 $d$ = Depreciation rate
 $dK$ = Total depreciation

Savings and Investment

In a closed economy:

 Savings equals investment: $S = I$

 Savings is a fraction of output: $S = sY$

Therefore: $I = sY$

Fundamental Equation of the Solow Model

The change in capital per worker over time is:

$$\Delta k = sy - (n + d)k$$

Where:
  $\Delta k$ = Change in capital per worker
 $s$ = Savings rate
 $y$ = Output per worker
 $n$ = Population growth rate
 $d$ = Depreciation rate
 $(n + d)k$ = Break-even investment (investment needed to maintain k)

Substituting the production function:

$$\Delta k = sAk^{\alpha} - (n + d)k$$

Steady State
Definition

The steady state occurs when capital per worker remains constant over time: $\Delta k = 0$.

Setting the fundamental equation to zero:

$$sAk^{\alpha} = (n + d)k$$

Solving for steady-state capital per worker ($k^*$):

$$k^* = \left(\frac{sA}{n+d}\right)^{\frac{1}{1-\alpha}}$$

Steady-state output per worker ($y^*$):

$$y^* = A(k^*)^{\alpha} = A\left(\frac{sA}{n+d}\right)^{\frac{\alpha}{1-\alpha}}$$

Key Properties of Steady State

1. Convergence: Economies converge toward their steady state regardless of starting

position
2. Balanced Growth: All per-worker variables are constant
3. Level Effects vs. Growth Effects: Changes in parameters affect the level of steady-
state output but not its growth rate

Golden Rule Level of Capital

The golden rule is the steady state that maximizes consumption per worker.

Steady-state consumption per worker: $$c^* = y^* - i^* = f(k^) - (n+d)k^$$

The golden rule capital stock satisfies: $$MPK = f'(k_{gold}) = n + d$$

For Cobb-Douglas: $$k_{gold} = \left(\frac{\alpha A}{n+d}\right)^{\frac{1}{1-\alpha}}$$

The golden rule savings rate: $$s_{gold} = \alpha$$

Technological Progress
Incorporating Technological Growth

With technological progress at rate $g$, the effective depreciation rate becomes $(n + g + d)
$.

The fundamental equation becomes: $$\Delta k = sAk^{\alpha} - (n + g + d)k$$

Steady-state growth rates:

 Capital per effective worker: 0%

 Output per effective worker: 0%
 Capital per worker: $g$
 Output per worker: $g$
 Total output: $n + g$

Steady State with Technology

Output per effective worker: $$y^* = A\left(\frac{s}{n+g+d}\right)^{\frac{\alpha}{1-\

alpha}}$$

Implications and Extensions

Sources of Economic Growth

1. Factor Accumulation (Movement toward steady state):

o Higher savings rate $(s)$
o Lower population growth $(n)$
o Lower depreciation rate $(d)$
2. Long-Run Growth (Beyond steady state):
o Technological progress $(g)$

Convergence Hypothesis

1. Absolute Convergence: All economies converge to the same steady state (not
empirically supported)
2. Conditional Convergence: Economies with similar structural characteristics
converge to the same steady state
3. Club Convergence: Economies with similar initial conditions converge to the same
steady state

Growth Accounting

$$\frac{\Delta Y}{Y} = \frac{\Delta A}{A} + \alpha\frac{\Delta K}{K} + (1-\alpha)\frac{\

Delta L}{L}$$

This decomposes growth into:

  Total Factor Productivity growth $\left(\frac{\Delta A}{A}\right)$
 Contribution from capital accumulation $\left(\alpha\frac{\Delta K}{K}\right)$
 Contribution from labor growth $\left((1-\alpha)\frac{\Delta L}{L}\right)$

Policy Implications

1. Savings Policy: Increasing savings rate raises steady-state output level

2. Population Policy: Reducing population growth raises steady-state output per worker
3. Education Policy: Improving human capital enhances productivity
4. R&D Policy: Accelerating technological progress increases long-run growth rate

Limitations of the Solow Model

1. Exogenous Technology: Doesn't explain how technological progress occurs
2. Savings Rate: Treats savings decisions as exogenous rather than based on household
optimization
3. Convergence Puzzle: Doesn't fully explain persistent income differences between
countries
4. Returns to Capital: Assumes diminishing returns to all factors
5. Human Capital: Basic model doesn't explicitly account for education and skills
6. Institutional Factors: Doesn't address the role of institutions, property rights, etc.

Extensions to the Basic Model

Human Capital

Augmented production function: $$Y = AK^{\alpha}H^{\beta}L^{1-\alpha-\beta}$$

Where $H$ = Human capital

Endogenous Growth Theory

Addresses limitations by making technological progress endogenous:

 AK Model: $Y = AK$ (constant returns to capital)

 R&D Models: Innovation drives productivity growth
 Learning-by-doing: Productivity increases with production experience

Mathematical Dynamics
Phase Diagram Analysis

The phase diagram plots:

 Savings curve: $sAk^{\alpha}$

 Break-even investment line: $(n+d+g)k$

The steady state occurs at their intersection.

Stability Analysis

For any initial capital stock:

 If $k < k^*$: $\Delta k > 0$, capital per worker increases

 If $k > k^*$: $\Delta k < 0$, capital per worker decreases

Therefore, the steady state is globally stable.

Speed of Convergence

Near the steady state, the speed of convergence is approximately: $$\lambda = (1-\alpha)
(n+g+d)$$

The half-life to the steady state is: $$t_{1/2} = \frac{\ln(2)}{\lambda}$$

Historical Empirical Evidence

Growth Accounting Results

For developed countries (1950-2000):

 TFP growth: 40-60% of output growth

 Capital deepening: 30-40% of output growth
 Labor growth: 10-20% of output growth

Convergence Evidence

 Strong evidence of conditional convergence at about 2% per year

 Income differences persist due to differences in:
o Savings rates
o Population growth
o Education levels
o Institutions and policies
o Technology adoption