Lecture 5 Using the Long-Run Model Lecture Notes PDF

***SUPPLY AND DEMAND-SIDE ASPECTS:*** **[Division of National Income:]** The share of income which goes to labour and capital depends on how the marginal product changes as K and N vary. We can examine the issue of division of income between capital and labour by using the *Cobb-Douglas* producti...

***SUPPLY AND DEMAND-SIDE ASPECTS:*** **[Division of National Income:]** The share of income which goes to labour and capital depends on how the marginal product changes as K and N vary. We can examine the issue of division of income between capital and labour by using the *Cobb-Douglas* production function. - Y = output, A = total factor productivity (a constant) - v and (1-v) sum to one, which represents constant returns to scale. - We have MPN = real wage = vY/N, and MPK = real rental price of capital = (1-v)Y/K. - Share of income going to labour = (MPN X N)/Y = ((vY/N) x N)/Y = v - Share of income going to capital = (MPK x K)/Y = (((1-v)Y/K) x K)/Y = (1-v) - Check week 1 appendix to see where MPN and MPK were derived from. - Hence, as long as v is constant over time, so is the share of income going to capital and labour. - In the UK, v is estimated around 0.75 while in the US, it is found to be around 0.7 - the government uses some of it to spend (check).  +-----------------------------------------------------------------------+ | The graph shows a relatively flat but downward trending share of | | labour income over time. | | | | Other factors influencing income share include: | | | | - Technological change | | | | - Firms / trade unions bargaining power | | | | - Tax system | | | | Short term changes: (the small variations) | | | | - Short-run movements of the economy, e.g. recession - less output | | / less productivity | +-----------------------------------------------------------------------+ +-----------------------------------------------------------------------+ | Beyond the share of income to capital and labour, the appendix to | | Mankiw chapter 3 discusses the path of the Gini coefficient (a | | measure of inequality across the population) in the US since the | | second world war. | | | | As shown by the graph, inequality has increased. The Mankiw Ch. 3 | | appendix provides various explanations based around a rising Capital | | Share, Human Capital / Technology (other reading by Dening), | | Globalisation, Marriage. | | | | - The story for the UK is similar to the US. | | | | Other reading: Jones (2015) - general perspective, Kolavich (2020) - | | role of gender equality. | +-----------------------------------------------------------------------+ **[The Role of Government in National Savings and Real Interest Rate:]**  +-----------------------------------------------------------------------+ | The long run trend of National Saving is driven mainly by household | | decisions. Short-run variation is mainly dependent on Government | | expenditure / tax decisions. | | | | We can use the closed / global economy model to illustrate historical | | episodes (when financial markets weren't integrated) and to consider | | the impact of Government budget decision making. | | | | Suppose Governments spend more. National saving will fall. Interest | | rates will rise (supply of loanable funds decreases, demand stays the | | same, competition increases r). Historically, this has been an | | important driver of interest rates. | +-----------------------------------------------------------------------+ +-----------------------------------------------------------------------+ | The graph displays the impact of various historical episodes that are | | associated with high Government Spending due to wars. | | | | Other reading: Reinhart et al and Yared - how Government budgets | | impact on the macroeconomy. | | | | As military spending increases, interest rates increase. | +-----------------------------------------------------------------------+ **[What do Trade Restrictions do in the Long-run in the Small Open Economy?:]** +-----------------------------------------------------------------------+ | - S - I = loanable funds market | | | | - Check recording for equilibrium explanation | | | | - S - I won't change with protectionist policies | | | | - Assumption: other countries don't retaliate - export position | | won't change | | | | - Demand for imports will decrease = increase net exports | | | | - Real exchange rate increases as foreign goods more expensive | | | | | | | | - Epsilon = EP/P\* -\> increase in domestic price = increase in | | real exchange rate | +-----------------------------------------------------------------------+ **[What do Trade Restrictions do in the long-run in the Large Open Economy?]** **[The US Trade Deficit:]** The LONG RUN analysis tells us that the US is running a large trade deficit because (S\^N) - I (=CF=NX) \< 0. - The US has to borrow from other countries to fund its domestic spending - fill the gap between S\^N - I. - The focus of policy on trade restrictions (blanket ones) and switching consumption to US goods will not correct the deficit *in the long run*. - More government spending and more investment will make the imbalance worse unless national savings grows. - Recent policy to enhance the US industrial base may generate supply-side effects.  **How long can a country run a trade deficit?** - How long are creditors willing to lend? - What interest rates will they charge? - What happens if the country cannot pay? - What about the US? - Globally dominant in financial markets - US\$ is the world's currency - Countries willingly hold US assets **What determines capital flows to developing countries?** (see case study in Mankiw p138) - Capital should flow to countries where K/N is low since MPK is high. - But many developing countries (where K/N is small) don't experience this: - Production conditions are different. - Human capital is lower. - Poor legal systems that don't protect producers. - Corruption and expropriation. ***SUMMARY:*** - We have considered the share of income going to capital and labour in the long run and used the Cobb Douglas production function, which seems to explain what is observed. - The long-run importance of the Government in changing National Savings is highlighted, particularly at times when wars are financed and national emergencies such as the pandemic. - The impact of trade restrictions are considered in the long run and we have shown that they only cause the real exchange rate to appreciate with no effects on output. - We have examined the US trade deficit from a long-run perspective and have identified that it will continue for as long as foreign investors are willing to buy US Government debt or until US National Saving increases. - We have also looked at factors that influence capital flows to developing countries. - Finally, we have briefly reviewed (see appendix) the implications of the long-run model in terms of policy. ***APPENDIX: POLICY IN THE LONG-RUN: ENHANCING SUPPLY:*** There are a range of policy options to increase long run output, by improving the operation of markets and the productivity of the economy. - Legislation and regulation to focus on reducing costs to business. - Institutional and market structures to enhance competitiveness. - Increase in skills and human capital through education and training. - Tax system to encourage entrepreneurship and innovation (R&D). - Migration to support economic development. - Fiscal / monetary policy stability to increase risk-taking. - Enhance efficiency of corporate and household financial behaviour. - See a growth perspective in later lectures. But these policy choices are made on the assumption that households are only interested in output and don't care about such issues as, for example, inequality and the environment. - Other reading: Jones & Klenow on this topic, and the later discussion about the Golden Rule in the Solow model.