Long Run Macroeconomic Equilibrium Lecture 1 PDF

***THE REAL ECONOMY IN THE LONG RUN:*** - The supply side determines economic activity. **[Long-run Model: The Basics: (circular flow of income)]** +-----------------------------------------------------------------------+ | - Households supply factors of production to firms. |...

***THE REAL ECONOMY IN THE LONG RUN:*** - The supply side determines economic activity. **[Long-run Model: The Basics: (circular flow of income)]** +-----------------------------------------------------------------------+ | - Households supply factors of production to firms. | | | | - Firms use factors of production to produce goods and services. | | | | - Households purchase goods and services using income generated | | from selling factors of production. | | | | - The Government is a demander of goods and services funded by | | taxes on households. | | | | - Prices are flexible and hence all markets in equilibrium. | | | | - **In equilibrium, all factors of production are employed: supply | | determines output.** | | | | - **In equilibrium, all goods and services are sold (demand equals | | supply).** | +-----------------------------------------------------------------------+ **[Representing supply with the aggregate production function:]** There are two factors of production, labour and capital - these are owned by households. *Aggregate Production Function:* Y (Output) = F(N,K), where F(.,.) is the production function. - N = labour - K = capital We assume positive and diminishing marginal product  - Partial derivative - useful because e.g. differentiating with respect to N whilst holding K constant. - Differentiate to show marginal product of labour - how much does Y go up when N increases by 1 unit. - Double differentiation - diminishing marginal product. Those assumptions are necessary to ensure an economic equilibrium. CHECK What about other factors of production, such as Land, Exhaustible Resources, Human Capital, Environment? (Note that Mankiw uses L to represent labour while these slides use N.)  **[The competitive firm's decision:]** Suppose all firms operate according to the same production function and that they operate in competitive markets. We can write the profits of the firm as: **Profit = PY - WN - RK** - Where Y= output, - P = price of output - W = wage - R = rental price of capital (the rate of return) Firms maximise their current profits. They will choose the amount of labour and capital for a given W, R, P, and production function. Thus, the optimisation problem to solve is: - Choose N and K to maximise PF(N,K) - WN - RK. The solution is: - The terms on the left-hand side are the *Marginal Product of Labour* and *Marginal Product of Capital* respectively. - The terms on the right-hand side are the real wage and real return on (or rental cost of) capital. The real prices of factors are flexible and will ensure that all resources in the economy are employed (factor markets clear). Total output will be given by: **Y\* = F(N\*,K\*)**, where \* indicates full employment of factors.   ***SUMMARY:*** - We have outlined the model of long-run equilibrium where prices are flexible and markets clear (The market clearing price is the price at which the demand for a good by consumers is equal to the number of goods that can be produced at that price. At this price, the supply and demand are exactly equal: there are no unused goods waiting to be sold, and no buyers who are unable to buy). - Output is determined by technology and the quantity of factors of production available. - Firms are assumed to profit maximise and hence use resources as efficiently as possible. - Factors markets are in equilibrium and hence there is full employment (N\* and K\*). - The level of output is determined by the N\* and K\*. ***APPENDIX:***