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1、CHAPTER 6Building Blocks of the Flexible-Price Model1Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.QuestionsWhat is a full-employment analysis?What keeps the economy at full employment when wages and prices are flexible?What determines the level of consumption spending?What det
2、ermines the level of investment spending?2Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.QuestionsWhat determines the level of net exports?What determines the level of the exchange rate?3Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Full-Employment Analysis
3、We will now look at the economy over the short-runa period in which its productive resources are fixedWe will assume that wages and prices are flexible so that all markets clearsupply equals demand in the labor marketfull-employment analysis4Copyright 2002 by The McGraw-Hill Companies,Inc.All rights
4、 reserved.Flexible-Price ModelTwo sets of factors determine the levels of potential output and real wagesthe production functionthe balance of supply and demand in the labor market5Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Production FunctionPotential output(Y*)is deter
5、mined bythe size of the labor force(L)the economys capital stock(K)the efficiency of labor(E)a parameter indicating how quickly returns to investment diminish()6Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 6.1-The Production Function7Copyright 2002 by The McGraw-Hill Co
6、mpanies,Inc.All rights reserved.Flexible-Price ModelThe assumption that wages and prices are flexible was commonly made by“classical”economistsThus,this assumption is often called the classical assumptionguarantees that markets workguarantees full employmentguarantees that actual output is equal to
7、potential output8Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Flexible-Price ModelThe flexible-price assumption is not always a good onea market economy does not always produce full employmentThe“Keynesian”model assumes that wages and prices are stickythis will be covered in S
8、ection III of textThe Classical assumption simplifies the analysis of the economy9Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Table 6.1-Classical Flexible-Price versus Keynesian Sticky-Price Analyses10Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Lab
9、or MarketAssume there are K identical firmseach firm owns one unit of the economys capital stockeach firm hires L workers and pays them the same wage Weach firm sells Y units of output at a per-unit price of Pno firm has control over the price it receives or the wage it paysthese are determined by t
10、he market11Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Labor MarketTo determine how many workers to hire,the firm follows two ruleshire workers to boost outputstop hiring when the extra revenue from the output hired by the last worker just equals his or her wage12Copyrigh
11、t 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Labor MarketThe value of the output produced by the last worker hired is the product price(P)multiplied by the marginal product of labor(MPL)The cost of hiring the last worker is his or her wage(W)The firm will keep hiring until13Copyri
12、ght 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Labor MarketThe marginal product of labor is the difference between what the firm can produce with its current labor force(Lfirm)and what it could produce if it hired one more workerAt its current labor force,the output of the firm wi
13、ll be14Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Labor MarketTherefore,the marginal product of labor(MPL)must be equal to15Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 6.2-The Firms Output as a Function of the Firms Employment16Copyright 20
14、02 by The McGraw-Hill Companies,Inc.All rights reserved.The Labor MarketUsing the Cobb-Douglas form of the production functionSince Kfirm=117Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Labor MarketThe term in the brackets is a growth rate of a variable raised to a power18
15、Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Labor MarketThe firm hires workers up to the point where the product price multiplied by the marginal product of labor equals the wageSubstituting for MPL19Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figu
16、re 6.3-The Typical Firms Hiring Policy20Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Labor MarketThe typical firms demand for labor isBecause there are K firms in the economy,total economy-wide employment will be21Copyright 2002 by The McGraw-Hill Companies,Inc.All rights
17、reserved.The Labor MarketIf there are more workers than firms want to hire at the current wagesome of the unemployed will underbid their fellow employed workersthose who are employed will respond by accepting a lower wage to keep their jobsreal wages will fall and firms will hire more workers22Copyr
18、ight 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Labor MarketIf there are fewer workers than firms want to hire at the current wagesome firms will try to bid workers away by offering higher wagesthe real wage will rise and firms will reduce the quantity of labor demandedEquilibrium
19、 occurs in the labor market when labor demand is equal to the labor force23Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 6.4-Equilibrium in the Labor Market24Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Labor MarketEquilibrium in the labor mark
20、et means thatThis means that the equilibrium real wage is equal to25Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Labor MarketWhen the labor market is in equilibrium,the typical firm produces an output level equal toTotal output will be K multiplied by the typical firms out
21、put26Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Labor MarketSimplifying,we get the Cobb-Douglas production functionIf markets work well,the actual level of output in the economy(Y)will be equal to the economys potential output(Y*)27Copyright 2002 by The McGraw-Hill Compa
22、nies,Inc.All rights reserved.Figure 6.5-In a Full-Employment Economy,Real GDP Equals Potential Output28Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Domestic SpendingNational income can be divided into four componentsconsumption spending(C)investment spending(I)government purch
23、ases(G)net exports(NX)29Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 6.6-The Four Components of Spending Add Up to Real GDP30Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Consumption SpendingHouseholds use income(Y)in three wayspay net taxes(T)assu
24、me that T=t Y,where t is an average tax ratedisposable income is equal to income minus taxes YD=Y-T=(1-t)Ysave(SH)consume(C)31Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 6.7-From National Income to Consumption Spending32Copyright 2002 by The McGraw-Hill Companies,Inc.A
25、ll rights reserved.Consumption SpendingConsumption spending can be broken down into two componentsa baseline level of consumption(C0)the amount that households would spend on consumption goods if they had no income a fraction of disposable income(Cy YD)Cy is the marginal propensity to consume,amount
26、 by which consumption spending rises in response to a$1 increase in disposable income33Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Consumption SpendingConsumption is assumed to be a linear function of real GDP(Y)There are other factors that affect consumption besides disposab
27、le incomeassumed to affect baseline consumption(C0)only34Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 6.8-Other Determinants of Consumption Spending35Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Consumption SpendingCy is the marginal propensity to
28、 consume0Cy1if incomes rise,households will use some of their extra income to increase their consumption spendingas incomes rise,households will also increase their saving36Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 6.9-The Consumption Function37Copyright 2002 by The
29、McGraw-Hill Companies,Inc.All rights reserved.Consumption SpendingExamplethe tax rate(t)=25%,national income(Y)=$10 trillion,the baseline level of consumption(C0)=$2 trillion,and the marginal propensity to consume(Cy)=0.6 38Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Investme
30、nt SpendingFluctuations in investment spending have two sourcesthe interest ratea higher real interest rate makes investment projects more expensive and lowers investmentbusiness managers and investors confidencethe higher their confidence,the higher is investment spending39Copyright 2002 by The McG
31、raw-Hill Companies,Inc.All rights reserved.Investment SpendingFirms invest because their managers believe that the investment projects will be profitablethis means that the discounted returns on the investments must be greater than the investments coststhe most relevant interest rate for determining
32、 the profitability of an investment is the long-term,real,risky interest rate 40Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Investment SpendingInvestment spending has two componentsthe baseline level of investment(I0)the responsiveness of investment to changes in the interest
33、 rate(Ir)41Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 6.10-The Investment Function42Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Investment SpendingExamplethe baseline level of investment(I0)=$2 trillion,the interest-sensitivity of investment(Ir
34、)=$10 trillion,and the real interest rate=5%43Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Investment SpendingAn alternative way of looking at investment is to see the level of investment as a function of the level of the stock marketThe same things that determine the value of
35、 the stock market also determine the level of investmentexpected future profits(confidence)the real interest rate44Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Government PurchasesGovernment purchases(G)include purchases of labor and other goods and services by federal,state,a
36、nd local governmentsGovernment purchases do not include transfer paymentstransfer payments are negative taxesEconomists do not inquire into what determines G(or the tax rate t)45Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 6.11-Government Purchases,Transfer Payments,and
37、 Taxes46Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.International TradeNet exports(NX)is the difference between gross exports(GX)and imports(IM)47Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 6.12-Gross Exports,Imports,andNet Exports48Copyright 20
38、02 by The McGraw-Hill Companies,Inc.All rights reserved.Gross ExportsThe volume of gross exports(GX)depends on two variablesthe real GDP of the countrys trading partners(Yf)the real exchange rate()Xyf is the increase in exports generated by an increase in foreign GDPX is the increase in exports from
39、 an increase in the real exchange rate49Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 6.13-Gross U.S.Exports and the Real Exchange Rate,1980-199050Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Gross ExportsIn the real world,there are substantial lag
40、s that occur between changes in the real exchange rate and changes in the level of gross exportsa change in the real exchange rate this year will have little or no effect on gross exports this year,but will have effects on gross exports one,two,and three years into the future51Copyright 2002 by The
41、McGraw-Hill Companies,Inc.All rights reserved.Figure 6.14-The J-Curve in the 1980s52Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Gross ImportsThe value of demand for imports depends on domestic real GDP(Y)The quantity of imports demanded depends also on the real exchange rate(
42、)however,the value of imports is largely independent of the real exchange rategross imports will be a constant share of real GDP53Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Net ExportsNet exports(NX)are the difference between gross exports(GX)and imports(IM)Net exports depen
43、d on three thingsthe real exchange rate()the level of real GDP abroad(Yf)the level of real GDP at home(Y)54Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Exchange RateThe lives of foreign exchange speculators are ruled by fear and greeda higher U.S.interest rate means that a
44、n individual can profit from buying U.S.bondsthe greater this interest differential,the higher the greed factorif the U.S.real exchange rate rises,profits from holding U.S.bonds will be lowerthe higher the greed factor,the lower must be the exchange rate in order for fear to offset the greed55Copyri
45、ght 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 6.15-Greed and Fear in Foreign Exchange Markets56Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Exchange RateThe real exchange rate is determined by two componentsthe average foreign exchange traders opinio
46、n of what the exchange rate should be if there was no interest differential(0)the sensitivity of the exchange rate(r)to the interest rate differential between domestic real interest rates(r)and foreign real interest rates(rf)57Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Net E
47、xportsSubstituting in for the real exchange rate,we getHaving the definition of net exports in this form tells us directly how domestic and foreign interest rates affect net exports58Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Chapter SummaryWhen the economy is at full employ
48、ment,the level of real GDP is equal to potential output-the level of output generated by the aggregate production function,given the current stocks of labor and capital and the current level of the efficiency of labor59Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Chapter Summa
49、ryWhen wages and prices are flexible,the working of the labor market keeps the economy at full employmentif labor demand is less than the labor force,falling wages raise employmentif labor demand is greater than the labor force,rising wages soon curb labor demand60Copyright 2002 by The McGraw-Hill C
50、ompanies,Inc.All rights reserved.Chapter SummaryThe level of consumption spending is determined by many things,but the most important of them is the level of disposable incomeThe level of investment spending is primarily determined by business managers degree of optimism and by the real interest rat