Economics 100B, Fall 2020 - Sec 4

Week 3

1 Interest Rates
Interest rates measure the cost of borrowing, or the return to saving and lending. The nominal
interest rate i is the rate at which the nominal value of an asset increases over time. The real
interest rate r is the rate at which the real value of an asset increases over time.
Interest rates dier due to dierences in:
ˆ Maturity: to compensate for opportunity cost.
ˆ Credit risk: lenders need to be compensated for the risk that they won't be paid back.
ˆ Liquidity: how easy is it to get out of the investment. For example, government bonds are
very liquid because you can sell them easily if you need cash.
Loans with a high credit risk typically have a high interest rate. For example, if you have a low
credit score and try to get a loan, you will probably have to pay a higher interest rate than someone
with a higher credit score, because the bank considers you more likely to default.
Liquid investments typically have lower interest rates than illiquid investments.
Real interest rate is a vital tool of monetary policy and is taken into account when dealing with
variables like investment, ination, and unemployment. For example, when the real interest rate r
decreases (increasing money supply):
ˆ borrowing less expensive  encouraging greater spending on investment goods
ˆ cost of holding money decreases  increases the quantity of money demanded  less incentive
to save and lend.
1.1 Fisher Equation

The Fisher Equation relates nominal interest rate (i), real interest rate (r), and expected ination
(π ):
e
e
i=r+π
In real life we do not know real interest rate. Instead, we compute it from Fisher equation using
nominal interest rate and expected ination:
r = i − πe

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In economics jargon this is called ex-ante approach, as we use expected value of ination. If instead
we want to compute real interest rate for one of past periods, then we can use realized ination
instead of expected. Such approach is called ex-post.
Example: Suppose in 2012, the nominal interest rate i is 2.5% and expected ination is π = 2%.
e

Then the ex-ante real interest rate is r = 0.5%. If ination ends up being π = 1.5% instead of the
expected 2%, than the ex-post real interest rate is 1%.
2 Production
2.1 Factors of Production

For the aggregate economy, the factors of production include:

ˆ Labor (L)
 Quantitative denition: number of workers.
 Qualitative denition: human capital (the knowledge and skills workers acquire through
education, training, and experience)
 Real GDP is determined by both number of workers and human capital the average
worker has.
ˆ Capital (K): the stock of productive assets (machines, equipment, etc.).
 Productivity is higher when the average worker has more capital.
ˆ Technology (A): determines the productivity of the factors of production.
 Technological knowledge takes many forms.
 Some technology is common knowledge  after one person uses it, everyone becomes
aware of it. For example, assembly lines introduced by Henry Ford.
 Other technology is proprietary  it is known only by the company that discovers it.
For example, the secret recipe for making the famous soft drink: Coca-Cola.
 Still other technology is proprietary for a short time. For example, when a pharmaceutical
company discovers a new drug, the patent system gives that company a temporary right
to be its exclusive manufacturer. When the patent expires, however, other companies
are allowed to make this drug.
ˆ Natural resources (Z): the inputs into production that nature provides, e.g., land, mineral
deposits
 Although natural resources can be important, they are not necessary for an economy to
be highly productive in producing goods and services. Japan, for instance, is one of the
richest countries in the world, despite having few natural resources.
 To make our analysis simpler we will often omit this variable and assume that natural
resources are the part of the capital

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2.2 Production Function

The production function shows how labor, capital, and technology (exogenous variables) are
translated into output (endogenous variable).
Y = AF (K, L).

The Cobb-Douglas production function is

Y = AK α Lβ

α and β are the output elasticities of capital and labor. It measures the responsiveness of output to
a change in levels of either labor or capital used in production, holding other things constant. For
example if α = 0.45, a 1% increase in capital usage would lead to approximately a 0.45% increase
in output.
Returns to Scale: A production function exhibits constant return to scale (CRS) if
AF (cK, cL) = cAF (K, L) f or any c > 0

A production function exhibits increasing returns to scale (IRS) if AF (cK, cL) > cAF (K, L) f or any c >
1. A production function exhibits decreasing returns to scale (DRS) if AF (cK, cL) < cAF (K, L) f or any c >
1.
Example: Does the function Y = A(5K + 10L) exhibit CRS?

For Cobb-Douglas production function:

ˆ If α + β = 1, the production function has constant returns to scale, meaning that doubling
the usage of capital K and labor N will also double output Y. Most of the time we will work
with this case.
ˆ If α + β < 1, the returns to scale are decreasing.
ˆ If α + β > 1, the returns to scale are increasing.
2.3 Marginal Products and Comparative Statics

The marginal product of capital (MPK), also the real cost of capital (r ) and demand for capital
(K ), is
c
D
∂Y
MPK =
∂K
The marginal product of labor (MPL), also the real wage and the demand for labor, L , is D

∂Y
MPK =
∂L

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We use production functions that exhibit increasing returns to labor and increasing returns
to capital, meaning that more labor generates more output, and more capital generates more
output. However, the increasing returns slow down as you add more and more labor or capital. In
other words, there is diminishing marginal product of capital and of labor. The MPL is positive
for all values of L, but it decreases with L. Similarly, the MPK is positive for all values of K, but it
decreases with K.
Practice drawing the MPL curve. Make sure to label all axes. Then suppose the labor supply is
xed (vertical line). Draw it. Show on the graph where the wage is.
Figure 1: Marginal Product of Labor

Now suppose that the labor force participation rate falls. Which curve shifts and in which direction?
Then what happens to the wage?
What are some other things that can shift the labor supply curve to the left?
ˆ Increase in wealth
ˆ Increases in expected future real wage
ˆ Decrease in working-age population or labor force participation rate
Example 1: Suppose Y = 8K L . What is the MPK? What is the value of the MPK when
0.25 .75

L = 10 and K = 50? Suppose K doubles to 100. Does the MPK increase or decrease?

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Example 2: Vineyard has 10 workers and 3 wine presses. At harvest they produce 1800 barrels of
wine. Let α = 0.3, K = 3, L = 10, Y = 1800. Assume CRS Cobb Douglas production function.
1. Solve for A.

2. Solve for MPK.

3. Solve for MPL.

4. Suppose it costs $1000 to hire an additional worker and $2000 to buy an additional press. The
vineyard can invest $2000. What should the owner do to maximize productivity?

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From examples 1 and 2 see that in Cobb-Douglas case M P K positively depends on the amount
of labor: if L exogenously decreases, then M P K curve would shift down. This happens because a
decrease in labor force would always decrease total output (recall increasing returns to labor), hence
for every level of capital marginal productivity would go down. Graphically:
Figure 2: Marginal Product of Capital and Decrease in Labor

To sum up Figures 1 and 2, an exogenous decrease in L (for example due to a fall in labor force
participation rate) would result in:
ˆ On MPL diagram: Labor Supply curve shifts to the left. MPL curve remains the same.
Equilibrium wage goes up.
ˆ On MPK diagram: MPK curve shifts down. Capital Supply curve remains the same. Equi-
librium interest rate goes down.
At home draw the MPL and MPK diagrams for the exogenous change in capital. Assume that
devastating storm destroyed a signicant portion of productive capital, but luckily none of the
workers died.
Supply shocks, or changes in A, occur if there is a change in the amount of output that can be
produced with a given amount of capital and labor. Technology shocks (e.g. faster computers),
natural environment shocks (e.g. earthquakes), energy price shocks (e.g. oil price), and signicant
nancial shocks are all examples.

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Exercise: Draw a production function with capital on the horizontal axis. Also draw a xed capital
stock. Let's suppose the year is 1781 and James Watt has just invented an improved steam engine.
What happens to the MPK and the real rental cost of capital? What happens to the MPL and the
real wage?

3 Exercises
1. Suppose you take out a loan at your local bank and the nominal interest rate is 12%. The bank
expects the ination rate to be 4% during the life of your loan.
a) What is the bank's ex ante real interest rate?

b) What is the bank's ex post real interest rate if the ination rate happens to be larger than 4%
during the life of this loan?

c) As a borrower, would you benet from a higher or lower actual ination rate?

2. Consider the following production function: Y = AF (K, L) = AK 0.4 L1.0

a) Calculate the marginal product of labor.

b) Does this production function exhibit diminishing marginal product of labor?

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3. A manufacturer of toys is employing fty workers and using fteen pieces of equipment to
assemble toys. Currently, the marginal product of labor is $5 and the marginal product of capital
is $25. Assuming the market prices for labor and capital are $12 and $20 respectively, answer the
following:
a) Is this rm maximizing its prot?

b) What should this rm do with respect to its employees and its use of equipment?

4. Assume that the marginal product of labor is given by the following expression: M P L = 52
(L
is measured in millions). L0.3

a) What is the marginal product of labor when L = 80 million?

b) Determine the equilibrium real wage if the labor supply equals 100 million workers.