Professor Christina Romer. LECTURE 20 SAVING AND INVESTMENT IN THE LONG RUN April 5, 2016

Transcription

1 Economics 2 Spring 2016 Professor Christina Romer Professor David Romer LECTURE 20 SAVING AND INVESTMENT IN THE LONG RUN April 5, 2016 I. OVERVIEW II. APPLICATION OF OUR LONG-RUN LABOR MARKET FRAMEWORK: EUROPEAN UNEMPLOYMENT A. Facts B. Candidate Explanations III. SAVING AND INVESTMENT A. Introduction: The role of capital in potential output B. Definitions: capital and investment C. The uses of Y* D. Equilibrium E. The real interest rate (r) IV. NATIONAL SAVING AND THE REAL INTEREST RATE A. Utility maximization B. The supply of saving curve C. Example: A tax cut D. Decomposing national saving into private and public saving V. INVESTMENT DEMAND AND THE REAL INTEREST RATE A. Profit maximization and why it is the real interest rate that is relevant to investment decisions B. The demand for investment curve C. Example: An investment tax credit VI. THE DETERMINANTS OF INVESTMENT AND THE REAL INTEREST RATE IN THE LONG RUN A. Equilibrium r* and I* B. Example: A tax cut revisited C. Example: A new technology that raises future MRPK s

2 Economics 2 Spring 2016 Christina Romer David Romer LECTURE 20 Saving and Investment in the Long Run April 5, 2016

3 Midterm 2 Reminders Thursday, April 7, 3:30 5:00. Sections 109, 110, 111, 112 (GSIs Dounia Saeme and Jeanette Ling) go to 245 Li Ka Shing Center (corner of Oxford and Berkeley Way). Everyone else come to the usual room (2050 VLSB). You do not need a blue book; just a pen.

4 Midterm 2 Reminders (continued) Format: Like Midterm 1 and the sample midterms. Coverage: All of the material since the first midterm (starting with monopoly) and up through today s lecture (saving and investment). Review Session: Today, 5:15 6:30, here.

5 I. OVERVIEW

6 The Aggregate Production Function

7 II. APPLICATION OF OUR LONG-RUN LABOR MARKET FRAMEWORK: EUROPEAN UNEMPLOYMENT

8 Unemployment in the Euro Area, Germany, and Italy Source: FRED; data from the OECD.

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10 Some Candidate Sources of High Natural Rates of Unemployment in Europe High minimum wages and strong unions High payroll taxes High firing costs

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12 Real Wage, w* w A Wage Floor S D N D N S N* Unemployment

13 Payroll Taxes, Selected Countries Source: Wall Street Journal.

14 High Payroll Taxes in the Presence of Job Rationing Real Wage, w* w S D 2 D 1 N D2 N D1 N S N* Unemployment 1 Unemployment 2

15 Firing Costs: The Example of Italy The laws are so unclear that many dismissals of workers end up in the country s dysfunctional court system, where if a judge decides a worker was let go unfairly, he will likely rule that the employer has to reinstate him with back pay for the time he was gone. When an investor asks about severance costs, all the other countries can provide an answer, says Pietro Ichino, an Italian senator and professor of labor law at the University of Milan. Italy can t. Duccio Astaldi, president of Condotte, one of Italy s largest construction companies, says the difficulty of firing often prevents him from hiring when times are good. Source: Italy s Labor Pains, BusinessWeek, 11/16/2011.

16 Firing Costs (in the Presence of Job Rationing) Real Wage, w* S 1 w D 1 D 2 N D2 N D1 N S N* Unemployment 1 Unemployment 2

17 III. SAVING AND INVESTMENT

18 Can Increases in K*/N* Explain Growth? An increase in K*/N* will raise Y*/POP. But there are diminishing returns to capital. Observed increases in K*/N* are not enough to account for much of the observed rise in Y*/POP. However, increases in K* could be important if there are spillovers from capital to technology.

19 Capital and Investment Capital: The accumulated stock of man-made aids to the production process. Investment: Changes in the capital stock. That is, the construction or purchases of new machines and structures.

20 The Uses of Potential Output Consumption (C*) Investment (I*) Government purchases (G) Net Exports (NX*) Stars denote normal, long-run values. For now, we will assume that NX* = 0.

21 Equilibrium Condition Y* = C* + I* + G* We can rearrange this as: Y* C* G* = I* Y* C* G* is normal national saving (S*). I* is normal investment.

22 where: The Real Interest Rate (r) r i π, i = nominal interest rate π = inflation rate We can rearrange this as: i = r + π (Aside: If we want to be precise, the relevant inflation variable is in fact the expected rate of inflation, not the actual rate of inflation.)

23 Nominal and Real Interest Rates (1-year nominal interest rate, and 1-year nominal rate minus 1-year inflation rate) Nominal Real Source: FRED.

24 IV. NATIONAL SAVING AND THE REAL INTEREST RATE

25 The Supply of Saving Recall: Normal national saving (S*) = Y* C* G*. Y* is determined by K*/N*, T, and N*/POP. We take G* as given. So: To understand what determines S*, we need to understand what determines C*.

26 Utility Maximization between the Present and the Future MU current P current = MU future P future The opportunity cost of 1 unit of current consumption is 1 + r units of future consumption. So, a higher r means that the price of current consumption relative to future consumption is higher. Thus, if r rises, to maximize utility the consumer needs to consume less today. That is, they need to save more.

27 The Supply of Saving r* S Saving (S*) Recall: S* = Y* C* G*

28 A Tax Cut r* S 2 S 1 Saving (S*) Recall: S* = Y* C* G*

29 Private and Public Saving S* = Y* C* G* = Y* C* G* + (T* T*) (where T*is normal tax revenue) = (Y* T* C*) + (T* G*) Private Saving Public Saving

30 V. INVESTMENT DEMAND AND THE REAL INTEREST RATE

31 Investment Demand Firms want to purchase new capital up to the point where: PV(Stream of Future MRP K s) = Purchase Price Recall that i = r + π. If i rises only because π rises, PV won t change because the MRP K s will also rise. Only if i changes because r changes will PV change. Thus: Investment demand depends on the real interest rate.

32 Firms Investment Demand r* I Investment (I*)

33 An Investment Tax Credit r* I 1 I 2 Investment (I*)

34 VI. THE DETERMINANTS OF INVESTMENT AND THE REAL INTEREST RATE IN THE LONG RUN

35 The Saving and Investment Diagram r* S r 1 I I 1 S*, I*

36 A Tax Cut and Crowding Out r* S 2 S 1 r 2 r 1 I 1 I 2 I 1 S*, I*

37 A New Technology That Raises Future MRP K s r* S 1 r 2 r 1 I 2 I 1 I 2 I 1 S*, I*