ECON1102 Study Notes – Macroeconomics 1
Chapter 1 – Measuring Macroeconomic Performance: Output and Prices
Key Issues
• Indicators of macroeconomic performance • Measuring output (GDP)
• Measuring prices and inflation
Criteria for Evaluating Macroeconomic Performance 1. Rising Living Standards – economic growth
• Tendency for the level of output (i.e. quantity and quality of goods and services) to increase over time.
• Material wellbeing. 2. Stable Business Cycle
• Low volatility in fluctuation of expansionary and contractionary gaps.
3. Relatively Stable Price Level (real currency value) – low (positive) rate of Inflation. • Inflation – rise in prices.
• Deflation -‐ fall in prices.
4. Sustainable Levels of Public and National Debt
• Public debt – borrowing by public sector from private sector (budget deficits/surpluses).
• National debt – borrowing by domestic residents from foreign countries (Influenced by an economy’s current account deficits/surpluses).
5. Balance between Current and Future Consumption
• Expenditure vs. need to provide resources for future (saving) 6. Full Employment
• Provision of employment for all individuals seeking work
Measuring National or Aggregate Output
• GDP: the market value of the final goods and services produced in the domestic market in a given period. It measures aggregate output or production. – flow variable as it is a function of time. Also a lag indicator.
• Final goods or services: goods or services consumed by the ultimate user – because they are the end products of the production processes they are counted as part of GDP. Intermediated goods or services: goods or services used up in the production of final goods or services and therefore not counted as part of GDP.
GDP Measurement Methods Expenditure Method
• Expenditure on Final Goods and Services by the ultimate user equals value of production
• Amount consumers spend should equal market value (economic agent) • Computed by adding total amount spent by 4 groups
o Household consumptions (durables and non-‐durables)
o Firms (Business fixed investment (Capital) and NEW residential investment, inventory.)
o Government spending (Not government transfers e.g. unemployment benefits, social security, welfare payments, interest paid of gvt. Debt) o Net purchases in foreign market
• National accounting Identity: Aggregate Expenditure = Y = C + I + G + NX Production Method
• Aggregate Market Value of final goods and services given indirectly by summing the value added of all firms in the economy.
• GDP = Amount x Market value
• Note: Intermediate goods and services: G+S used up in production are not counted in GDP e.g. flour in bread, services provided that only give value to final product (or)
• Value added: market Value of the production less the cost of inputs from other firms, of each firm (= summation of value of final goods), Allows value to be accurately distributed over periods.
• Represents portion of value to final G+S added by each firm o Value added = Revenue – Market Value
Income Method
• GDP is also given by aggregate income paid to capital and labour in production of Goods and services
• Revenue from sales is distributed to worker and owner of capital
• GDP = Labour income (wages, salaries, self-‐employed) + Capital Income (Physical capital -‐made to owner of factories, machinery, office building, Intangible
Capitals – trademarks, copyrights, patents, interest to bondholder, income to owners, rent for land, royalties)
• Despite a slight statistical discrepancy between these methods in
theory/conceptually all three should produce the same result. GDP is usually given by the average of these three outcomes
• Some items with no observed market prices are included in GDP: national defence – use costs of provisions, whilst some are excluded: unpaid housework.
• Nominal GDP: measures current dollar value of production by valuation of quantities at current market prices. Calculated by the multiplying the quantity of each good produced in the economy by current year prices and summing
• Real GDP: values quantities of goods and services produced at base year prices – measure of the actual physical volume of production. Calculated using Laspeyres index, Paasche Index or Chain weighted Index.
• Real Growth Rate calculates the growth in the physical volume of production between periods. Real Growth in GDP can be calculated using Laspeyres index, Paasche Index or Chain weighted Index.
o Lespeyres Index involves calculating the value of GDP in current year (here, 2006) and base year using a base year prices (here, 2005), by multiplying the quantities of each good produced in a each year by the corresponding price in 2005. Then commute the growth rate of real GDP. o Paasche Index involves calculating the value of GDP in current year
(2006) and pervious year (2005) using current year prices (2006). The change in GDP, which is the Real GDP in 2006 less the Real GDP is 2005, is divided by the Real GDP in 2005.
o The Chain Weighted Index averages the percentage growth of GDP given by the Laspeyres Index and the Paasche Index to accurately determine GDP.
Is GDP A Good Measure of Economic Wellbeing?
• Economic welfare refers to the general economic wellbeing and interests of the population.
• GDP only accounts for the goods and services sold in the market which to some extent is a general indication of economic wellbeing – positive correlation is expected
• The following factors effect economic welfare by are not accounted for in GDP: • Leisure Time
o Having more time to enjoy worthwhile activities like family, friends, sport, hobbies is a major benefit of wealthy societies.
• Non-‐market/home Production
o No acknowledgment of unpaid house work.
o Particularly in poorer countries where citizens trade and are self sufficient – their economic activity is undervalued.
o Underground economy – legal and illegal transactions not recorded in government data e.g. baby sitting, drug dealing.
• Quality of Life
o Factors of life like traffic congestion, crime rate, open space and public organisations which are not sold in markets but still add to quality of life.
• Inequality and Poverty
o GDP does not convey the distribution of wealth. o There could be extremes of rich and poor. • Environmental degradation and Pollution
o Despite the difficulty in valuing this intangible factor, decline in air and water quality (pollution) negatively affect quality of life.
• Note: Although, GDP doesn’t capture all factors influencing economic wellbeing, higher GDP per capita is positively related to increased wellbeing. For example countries have better health care, medicine, driven by technology
Measures of the Price Level
• Consumer Price Index: For any period, measures the cost in that period of a standard basket of goods and services relative to the cost of the same based of goods and services in a fixed year (called the base year). CPI is a tool used to measure the price level and inflation in the economy
CPI = Cost of basket in current year / Cost of basket in base year
• Rate of inflation: the annual percentage change in price level measured by the CPI, mathematically represented by:
• The change in relative prices is not inflation. They are changes in response to demand and supply. Recall that inflation is a sustained change the economy’s price level – not simply a price rise. It must be a general price change, not a specific one.
• Cost of inflation: • Shoe leather costs
o Money functions as a medium of exchange, thus inflation raises cost of holding money. Inflation reduces the real purchasing power of a given amount of money -‐ longer it is hold, the larger reduction.
o Insulate this loss by holding money in bank with interest paid, but this is associated with inconvenience of frequent bank visits. Businesses employ extra staff to make trips. Bank employ extra staff for increased transaction.
• Menu costs
o Act of changing prices. Publicly lists prices need to change. E.g. change coins, menu, signs.
• Distortion of the tax system
o Taxes are not indexed to rate of inflation they are based on nominal magnitudes. For example, inflation may raise peoples nominal incomes (to compensate for rise in cost of living) moving them into higher bracket even though their real incomes may not have increased
• Unexpected redistribution of wealth
o Inflation causes redistribution/transfers wealth between parties § Employers and employees
§ Borrowers and lenders.
o If inflation is higher than expected, real wages of predetermined wages will fall à workers lose buying power. This is offset buy gain in employers buying power, since real cost of paying workers has declined. If inflation is lower than expected, real wages will increase, meaning workers with
have higher purchasing power, and employer will have to pay a higher real cost.
o High Inflation means real dollar value of loan repayment is less than expected.
o Associated with this process is fluctuation and volatility which
discourages people from working and saving, in an effort to protect them against inflation.
• Noise in the price system
o Price system functions to allocate resources efficiently à establish equilibrium. However, inflation distorts/ creates static or noise in interpretation of price system à obscuring information à creating inefficiency. Suppliers are unaware if increase in price represents true increase in prices by increase in demand, or general rise in price caused by inflation (quantity?) E.g. Asset Price Bubble.
• Interference with long-‐term planning
o Of households and firms, makes it difficult to discern how much funds need to be saved for future events, projects
§ Save too little-‐ comprise plan
§ Save too much – sacrificed pervious consumption
Note: evidence suggests inflation causes real consumption, real investment and real GDP to fall, accompanied by increase in budget deficit.
• Deflation is costly and creates unexpected redistributions of wealth. However, the main cost of deflation is is to force the real rate of inters higher than normal. This is because the nominal interest rate cannot fall below zero. This acts to discourage certain types of important expenditure in the economy, most notably firm’s investment expenditure.
• Nominal Interest rate: percentage change in the nominal value (dollar value) of a financial asset.
• Real interest Rate: percentage change in real purchasing power of a financial asset, adjusted for inflation.
1 + inom = (1 + ireal)(1+ π)
Real interest rate ≅ inom – inflation rate
Fisher effect: r = i −π
• For borrowing and lending the real interest rate is most relevant. Since, if nominal interest rates increase but inflation rises by the same amount then the cost of borrowing has stayed constant. When real (not the nominal) interest rate is low, borrowers benefit from a lower real cost of borrowing. When real interest rate is high, lenders benefit from receiving an increase in purchasing power. So, lenders need to protect themselves from the decline in the real interest rate; therefore they must raise nominal interest rates in the face of inflation.
Limitation to CPI
• Quality Adjustment Bias
o Failure to adjust for Improvement in quality of goods and services, which results in an increase in prices and consequently inflation.
o For example, if the CPI basket contains monthly rent and during one period the rent increase because of kitchen renovation, the CPI will increase and incorrectly display a higher cost of living despite an increase in price based on quality
o E.g. larger data storage computer has higher price • New Goods Bias (New goods not included)
o Extreme case of quality improvement
o Where a new product is introduced, that was not available in the base year, creates distortions in comparisons (eg. computers were not common 50 years ago).
• Substitution Bias
o CPI is a fixed basket of goods meaning it does not account for the
substitution affect to relatively cheaper goods and services that are close replacements for each other. Ignores consumer’s ability to switch
between products. E.g. Coffee and Tea
Therefore, since CPI fails to account for the above factors, CPI overstates the rate of inflation and cost of living.
Chapter 2 – Saving and Wealth
Key Issues
• Definition and Measures of Saving • Saving and Wealth
• Motives for Saving
• Investment and Capital Accumulation
• Saving, Investment and the Real Interest Rate
Flow: a measure that is defined per unit of time. Stock: a measure that is defined at a point in time.
• Savings is a flow variable – measure that is defines per unit of time. If saving is positive then assets are being accumulated. If saving is negative then assets are being de-‐cumulated or liabilities (debts) accumulated Note: household saving in Australia is declining
Saving = current income – current spending Saving rate = savings/income
• Capital gains: increases in the value of existing assets. Capital loses: decreases in values of existing assets.
Wealth = assets – liabilities
Change in Wealth = Saving* + Capital gains – Capital losses W = W(-‐1) + S + Net Capital Gains
A, L, W are stock variables – measure defined at a point in time *current income – current spending; not accumulated savings.
Motives For Saving (why do people save?)
• Life-‐cycle saving -‐ Saving to meet long term objectives. Saving during working life for future consumption E.g. University fees, retirement, home or car purchase. • Precautionary Saving -‐ Resources put aside for protection/self assurance against
unexpected circumstances. E.g. loss of job, recession, medical emergency. • Bequest Saving -‐ Desire to leave family heirs or dependents an inheritance or
bequest. Often by people in higher income ladder. E.g. children or charity.
Saving and the Real Interest Rate
• Represent reward for saving – increase in r increases opportunity cost of not saving. However, small negative relationship since increase interest rate means people need to save less to reach target saving level in future years. Net effect: Other things equal (ceteris paribus) saving to increase with real interest rate • Saving is also influenced by cultural factors and neighborhood expectations
o Lack of sufficient self-‐control or will power to undertake optimal savings level. The consumptions benefits are in the future, whilst the costs are immediate.
o Availability of consumer credit – eg. Home equity loans.
o Demonstration effects – conspicuous spending by others encourages conspicuous spending by households.
o Government provision of welfare may reduce private saving for retirement.
National Saving
• Measures aggregate saving in an economy by private and public sectors (households, business, governments).
Y = C + I + G + NX S = Y – C – G
• NX is assumed to be zero and note that saving is current income – current spending, therefore I (investment) and is for future needs. Note: not all G and C are current good (durable Goods e.g. cars, furniture, appliances, roads, bridges, schools, other infrastructure). Hence, the equation above tends to overstates current spending and understates national saving.
S = Y – C – G
S = Y – C – G + T – T S = (Y – T – C) + (T – G)
S = Private saving + public saving
o Where: T = T – Q = net taxes = taxes paid by private sector to government – transfer payments from government to private sector – interest
payments from government to private sector bond holders.
o Transfer payments: (Q) payments the government makes to the public for which it receives no current goods or services in return
• Government budget deficit: T < G [Receipts < Expenditures] • Government budget surplus: T > G
• Government balanced budget: T = G
• National savings, not household savings, determines the capacity of an economy to invest in new capital goods and to achieve continued improvement in living standards. Australia’s national saving has showed slightly upward trends in recent years, despite a lower household savings rate.
• Investment and Capital Formation -‐ National saving provides the resources for investment. Investment is the purchase of new capital goods. New capital goods increase productivity. Influences on the level of Investment:
o Cost of capital:
§ Nominal interest rate (i)
§ The dollar price/cost of the new plane (Pk)
§ Over time the price of the plane may rise or fall (capital gain or capital loss) – (change in Pk)
§ Cost of capital = price of capital (begin year) + interest cost -‐ price of (depreciated) capital (end year)
o Most important influences on investment decision are price of capital good and real interest rate.
o Rise in the real interest rate will make investment less attractive. o Rise in the price of capital goods will make investment less attractive. o Cost vs. Benefit Investment decision: Value of marginal product of
capital (benefit net of expenses and taxes) ≥ Cost of capital
Saving, Investment and Financial Markets
• Economy with no access to international capital markets: National Saving = Investment.
• S = Y – C – T = I
• Saving is increasing function of real interest rate – supply of saving, therefore it is upward sloping.
• Investment is a decreasing function of the real interest rate – demand for saving. Downward sloping because rates link to WACC.
• New Technology à increased productivity à increase marginal product
(investment more profitable) à increase investment à shift right à increase in r à higher real interest rate makes saving attractive à move along the S curve. • Increase in Budget Deficit/ Increase in Budget Deficit à decrease in national
savings à decrease saving à shift leftà increase r à higher real interest rate makes investment less attractive and causes a move along the I curve.
• An increase in the government budget deficit will reduce private investment spending. A larger deficit reduces the supply of saving (savings curve shifts inwards) and drives up the real interest rate. The higher real interest rate makes investment less attractive and causes a move along the I curve. The tendency of a government budget deficit to reduce investment is called the crowding out effect.
• Note: change in real interest rate is a movement ALONG curve. • In a closed economy NS = I.
Chapter 3 – Unemployment and the Labour Market
Key Issues
• Demand for labour
• Supply and demand model of the labour market • Types of unemployment
• Impediments to full employment
Demand for Labour
• Diminishing returns to labour: if the amount of capital and other inputs in use is held constant, then the greater the quantity of labour already employed, the less each additional worker adds to production.
• Marginal Product of Labour (MPL): additional output associate with additional labour unit.
• Firm combines workers with a given amount of capital (machines and buildings) to produce output.
• Based on Low-‐hanging fruit principle and increasing opportunity cost – firm will assign worker to most productive jobs.
Error! Not a valid embedded object. [P is general price level] • Firm will compare benefit (Value MPL) of an additional worker with cost of
worker (Wage = W) [cost-‐benefit principle]. Note: Model assumes that firm operates in a competitive market therefore cannot set the wage it pays workers or price it receives for its product.
• Firms will continue to employ labour until (value of MPL = money wage)
• Since MPL decreases as firm employs more workers, real wage also has to fall (as more workers are employed). This implies that a firm’s demand for labour is a decreasing function of the real wage.
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Shifts in Demand for Labour
• Higher relative price for firm’s output (e.g. due to increased demand). Workers production is more valuable, and therefore value of marginal product increases (shifts right).
• Higher marginal productivity of labour (e.g. large increase of capital stock or new technology) as this leads to an increase in the value of marginal product.
Supply of Labour
• At any given wage people decide if they are willing to work – by reservation price (minimum payment that leaves you indifferent between working and not working) à cost-‐benefit principle application. Supply of labour is the total number of people willing to work at each real wage, Wi/P.
Shifts in Supply of labour
• Size of working-‐age population (influenced by birth rate, retirement ages, immigration rates).
• Participation rate/Social changes – percentage of working age population who seek employment e.g. women working more.
• Real Unit Labour Costs = Real average labour cost / Average labour productivity
Increasing Wage inequality: Globalisation and Technological change. Globalisation
• Globalisation is the process of breaking down national barriers: o Free trade agreements
o Deregulation
o Reduced tariffs/taxes
• Open up economies to international market and encourages specialization. • Demand for workers in industries with comparatives disadvantage experience
lower real wages and employment (shift demand left). This is due to suffering from increased foreign competition, consumer’s purchase overseas (cheaper or higher quality), which leads to a decrease in the value of marginal product and therefore a decrease in demand for workers.
• Demand for workers in industries with comparatives advantage experience higher real wages and employment (shift demand right). This is because there is a greater demand for exports and therefore there is an increase in the value of marginal product and an increase in the demand for workers.
• Note: countries employing higher skilled worker do better in international trade à heightening the inequality
Technological Change
• Technological change increases worker productivity and is the basic source of rising living standards. However, technological change affects different workers in different ways. Note worker mobility counteracts trends of wage inequality. A policy of providing transition aid in training workers with obsolete skills is useful response to problem.
• Skill-‐biased technical change (replaces or assists):
o Raises marginal product of high-‐skill workers à increase in productivity à increase in demand à rise in real wages and employment.
o Reduces marginal product of low-‐skill workers (no longer required) à decrease in productivity à decrease demand à fall in real wages and employment. Unemployment
• Labour Force: total number of people available for work. • Labour Force = Employed + Unemployed
o Employed: Person worked full-‐time or part-‐time during the past week (or was on leave from a regular job)
o Unemployed: Person did not work during the preceding week and made some effort to find work.
o Not in Labour Force: Person did not work in the past week and was not actively seeking work (e.g. retirees, unpaid homemakers, full-‐time student).
• Unemployment Rate = (Unemployed/Labour Force)*100
• Participation Rate = (Labour Force/Working-‐age (15+) Population)*100 • Working-‐age (15+) Population = Labour force + Not in Labour force
Costs of Unemployment
• Economic costs: output that is foregone since workforce is not fully utilised. • Psychological costs: long periods of unemployment can lead to loss of self-‐
esteem, unhappiness and depression.
• Social costs: high unemployment can lead to increased crime and associated social problems e.g. crime, violence, alcoholism, drug abuse
• Discouraged Workers: People who have given up looking for work (and so a not counted as unemployed)
Types of Unemployment
• Natural rate of employment: the part of the total unemployment rate that is attributable to frictional and structural unemployment; equivalently, the
employment rate when cyclical is zero; i.e. the economy is not in an expansionary or contracitonary gap.
• Frictional unemployment: the short-‐term unemployment associated with the process of workers searching for the right job.
• Labor market is dynamic à driven by changes in technology, globalization and changing consumer tastes. This means new products and companies (and thus jobs) are always being created.
• Cyclical unemployment can improve efficiency of market à bring together those seeking and offering employment (e.g. left school or change careers).
• Cost are low (short-‐term – physiological and direct economic affects low) • Can be economically beneficial/essential – negative costs (better fit of workers
into job positions à higher productivity à higher output in long run).
• Structural unemployment: the long-‐term and chronic unemployment that exists when the skills or aspirations of workers are not matched to jobs available in the economy.
• Refers to availability and distribution of jobs and can be caused by: lack of skills, language barriers or discrimination. Also unions and minimum wage laws can cause structural unemployment.
• Cyclical unemployment: the extra unemployment that occurs during periods of economic contractions and especially recessions. Cyclical unemployment is costly in terms of foregone output and underutilization of labour resources.
Factors that affect the rate of unemployment
• Minimum wage: legal minimum hourly rate firms can pay employees (Award wages).
o Despite minimum wages raising the unemployment rate it benefits those workers who are lucky enough to receive a job in this market (0 – ND) as
they will receive higher than normal wages. Of course, those who are shut out of the market lose and are left jobless.
o Taxpayers are worse off – pay for unemployment insurance and support and higher prices.
o Consumers are worse off, lower output
o When minimum wage laws are below equilibrium the market is not affected, and will continue to operate in equilibrium.
• Labour union – workers may negotiate on an individual basis with a firm over wages and conditions. Alternatively may form labour unions to bargain
collectively. Unions tend to produce higher than normal wage outcomes (above equilibrium clearing). Outcome wmin=wunion.
• Unemployment Benefits – Government transfer payment paid to the unemployed. This is a basic income to workers who are unemployed and
searching for work. Can have a disincentive effect on a worker’s search effort à prolong period before individual accepts employment.
• Other government regulations – OH&S or Anti-‐discrimination.
Chapter 4 -‐ Short-‐run Economic Fluctuations
Key Issues
• What is a recession? • Business cycle fluctuations
• Natural rate of unemployment • Okun’s law
Business Cycle
• The business cycle refers to the fluctuations in economic activity/GDP associated with periods of expansion (strong economic performance) and contraction (weaker economic performance).
• Contraction: period where GDP falls, moves from a peak to a trough • Expansion: period when GDP rises, moves from a trough to a peak
• Peak is the beginning of a contraction, end of expansion à high point prior to a downturn
• Trough is the end of a contraction, beginning of expansion à low point prior to a recovery
Note: “Rule of Thumb” for a recession is at least two quarters of negative economic growth à i.e. level of GDP has to fall for at least two quarters.
Potential Output (y*)
• Amount of output (real GDP) an economy can produce when using its resources (labour and capital) at normal rates.
• Not the maximum output.
• Grows over time with growth in labour, capital inputs and growth in technology. Actual output (y)
• Actual level of GDP produced in the economy • Vary (expand or contract) due to:
o Changes in potential output ( y*) e.g. extreme weather conditions à decrease actual output à contractionary gap à recession
o Changes in utilization rate of labour and capital e.g. immigration, new technologies à increase actual output à expansionary gap / boom.
• Output gap = y – y* at a point in time.
• Occurs when utilization of labor and capital is above or below normal rate. Thus, y <> y*
• Expansionary gap: y* < y (Positive output gap) -‐ opportunity cost • Contractionary gap: y* > y (Negative output gap) -‐ inflation
• Natural Rate of Unemployment (u*): the part of the total unemployment rate that is attributable to frictional and structural unemployment; equivalently, the unemployment rate that prevails when there is no cyclical unemployment. Unemployment rate (u) tends to co-‐move with the output gap in economy. • Contractionary gaps link to high unemployment rate
• Expansionary gaps low unemployment rate • Unemployment = (frictional + structural) + cyclical • Cyclical unemployment = u – u*
• Okun’s law is systematic, quantitative relationship between output gap and cyclical unemployment. Implies, an extra percentage point of cyclical
unemployment is associated with an specific percentage point increase in the output gap.
For Australia, the β percentage point in approximately 1.5. • Okun’s law implies negatively proportionality, meaning:
o Positive output gap (expansionary) causes a reduction in cyclical unemployment.
o Negative output gap (contractionary) cause an increase in cyclical unemployment
o When output gap = 0, there is no cyclical unemployment.
• Policymakers generally view both, a persistent contractionary or expansionary as problems.
• Contractionary gaps are associated with capital and labour not being fully utilised (cost in terms of forgone output).
o Reduced total economic value à higher unemployment à reduced livings standards.
o In order to reduce cyclical unemployment levels, policy makers must attempt to create an expansionary output gap. This can be achieved by using resources at greater than normal rates. For example, creating new infrastructure projects is new capital investment, while using resources such as labour at higher rates than normal.
o Implies that it is possible for an economy to suffer from ‘jobless
recoveries’, that is, output growth resumes however employment does not grow. An increase in labour productivity can mean that real net output grows leading to an expansionary gap without net unemployment rates falling, as there is no strict relationship between the two as a variable β is involved. It is this variable that changes in such situations. • Expansionary gaps are associated with firms operating above normal capacity to
meet demand. This can lead them price increase (inflationary), leading to inefficient market.
Chapter 5 – Spending and Output in the Short-‐Run
Key Issues
• A model of output determination – Keynesian Model • Planned verses actual expenditure
• A consumption function
• Equilibrium output in the short-‐run
Keynesian Model
• Key Assumption: Prices of goods are fixed/sticky in the short-‐run. Firms do not change prices in response to a change in demand for their products. Fix their price and meet demand at this preset price by varying their level of production (labour and output). The implication: changes in spending yield a change in output above or below potential. Thus spending determines aggregate output. • If prices where fully flexible, in theory prices would be changing instantaneously
with changes in demand – menu costs. Also, there will never be excess production because firms will cut prices to sell it and never be persistent unemployment because workers will cut their wages to keep and get jobs. Fluctuations in demand will be accommodated by flexible prices and wages without changes in output and employment.
• In long-‐run, sustained changes in demand will eventually lead firms to change their prices and cause production to return to normal capacity.
Aggregate Expenditure
• The actual expenditure in the economy is equivalent to production/GDP since aggregate output is determined by spending. Thus: AE = C + I + G + NX. (Note, I = real investment not financial).
• PAE is the total level of planned spending on goods and services and may differ from the actual level of production. PAE = C + IP + G + NX.
• Since firms are meeting demand at preset prices they cannot control how much they sell. Consequently, differences arise when firms sell more or less than expected. When firms sell less output than planned, it adds more than planned to its inventory stocks (investment) and hence actual investment will exceed planned (I>Ip). When firms sell more output than planned, it adds less than planned to its inventory stocks (investment) and hence actual investment will be below planned (I<Ip).
• When output differs from desired spending (i.e. demand) there is a change in the inventory investment accounting for the difference in AE and PAE:
o I – IP = ∆ Inventories o ∆ Inventories + AE = PAE
A Model of Consumption Expenditure
• Current disposable income is an important influencer of household consumption – aggregate income less net taxes (Y – T).
• Consumption Function: Error! Not a valid embedded object.
o C-‐bar is exogenous (or autonomous) consumption. Factors (other than disposable income) that could affect consumption, e.g. wealth, real interest rates (external factors).
o Wealth Effect: changes in asset prices that affect spending.
o c(Y-‐T) Captures the effect of disposable income on consumption (induced consumption). c is the marginal propensity to consume (parameter), or the change in consumption when disposable income changes by a dollar. [0<c<1]
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o 1st term is independent of output and is called exogenous expenditure. o 2nd term is called induced expenditure and is dependent on output.
Short-‐Run Equilibrium Output
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Injections and withdrawals – short-‐run equilibrium Error! Not a valid embedded object.
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• Injection: all sources of exogenous expenditure in the economy (All exogenous spending).
• Withdrawals: That part of income not used for consumption purposes. • Circular flow of income: the economy’s national income, which can be
• Disequilibrium
o PAE > Y and INJP>WD; PAE < Y and INJP<WD.
o In Keynes’ model, short-‐run equilibrium output is defined as the level of output at which Actual output (Y) = Planned Aggregate Expenditure (PAE), and clearly, Y= PAE for all points on the 45 degree line, and thus equilibrium occurs when the PAE curve crosses the 45 degree diagram, at actual output Ye. Further, when Y=PAE, this means that Y= C + Ip.
Subtracting C from both sides, Y-‐C=Ip, that is, the economy is in
equilibrium when withdrawals (income that is not consumed) is equal to total planned injections (total exogenous spending in the economy). o Suppose that at a point in time, the economy’s actual output than Ye.
Hence, planned expenditure falls short of the actual level of production (Y>PAE and WD>INJ) in the economy, and thus, firms find an increase in their inventory (unsold stock), such that their actual investment, which includes inventories, is greater than their planned investment. This situation is also known as excess supply. As there are costs involved with carrying unsold stock, less income is consumed so that withdrawals exceed injections. Firms attempt to remove this excess inventory, however, in the short term, prices do not change, such that the firm cannot dump their inventory and instead revise their production levels downward in order to avoid these costs. Subsequently, GDP will fall until it reaches equilibrium level. The reverse is also true – firms cannot raise prices to satisfy excess demand, and therefore the only option is to increase production, resulting in GDP rising to its equilibrium level. [REVIESE GRAPHS]
The Paradox of Thrift
• Consider a savings function given by and investment function IP where equilibrium is initially at Y0e, that is where savings equals investment
• Suppose there is an exogenous increase in an agents’ desire to save (). That is, at every level of income there is an increase in savings by a constant amount. Resulting in a parallel shift in savings function to S1.
• Since the actions of saving reduce economic activity, the aggregate amount of savings actually remains unchanged, but the level of GDP will fall. Hence, an attempt to increase savings results in the economy being worse off.
• This decline in exogenous consumption can be explained using the Y=PAE diagram. Essentially, the decrease in PAE means there is less actual expenditure (Y) and lower levels of income to ensure that savings again match planned investments.
• PAE = C + IP + G + NX
• Consumption Function:Error! Not a valid embedded object. • Tax Function: Error! Not a valid embedded object.
• Import Function: Error! Not a valid embedded object. • Error! Not a valid embedded object.
The Multiplier
• Multiplier is the effect of a one-‐unit increase in exogenous expenditure on short run equilibrium output. The multiplier suggests that an additional dollar of exogenous PAE results in more than a dollar’s worth of GDP.
• For example, if the multiplier is 5 and increase of 10 units in exogenous expenditure results in a 50 units increase in output.
• In general, a change in exogenous expenditure produces a larger change in short-‐run output since actions to spend by one party, results in successive rounds of changes in income and spending for others – which results in a larger change in short-‐run output.
• For example, if consumer’s increase spending this increases sales directly, but also inadvertently increases the income of workers and firm owners. This enables workers and owners to increase their own spending, which results in a recursive process.
• As the marginal propensity to consume is typically less than 1, the
income/expenditure benefit of each round decreases as less of diminishing proportion transfers between parties.
• 2-‐sector Model
Multiplier = 1 / 1 – c [M>1 since 0<c<1] Error! Not a valid embedded object. • 4-‐Sector Model
Error! Not a valid embedded object.
• To eliminate output gaps and restore full employment, the government employs stabilisation policies. The two major types are fiscal and monetary. Stabilisation policies work by changing the PAE and hence short-‐run equilibrium output.
o Contractionary Policies – decrease PAE and output.
• Recall, an increase in real output raises planned aggregate expenditure, since higher output (and, equivalently, higher income) encourages households to consume more (and firm’s too).
Chapter 6 -‐ Fiscal Policy
Key Issues
• Fiscal policy and output gaps
• Effects of different fiscal instruments • Limitations of fiscal policy
• Fiscal policy and demographics
• Public debt and government budget constraint
Fiscal Policy Introduction
• Components of Fiscal policy:
o Government expenditure (G): current goods & services, investment and infrastructure.
o Taxes (T -‐ direct, indirect) – income taxes, consumption taxes.
o Transfer payments (Q) – benefits, pensions. Note that transfer payments are not part of G because the government does not receive any goods or services in return.
• Government decisions about these variables can affect the level of output in the economy.
• G spending has a direct effect on PAE. T and Q have an indirect effect. • Government Spending and Output Gaps
o Government purchases component of PAE à exogenous G à shift PAE (parallel).
• Taxes, Transfers and PAE
o Indirect effect on PAEà affect disposable income (Y-‐T)
o Tax cuts and increases in transfer payments (decrease T) increase disposable income à PAE increases.
o Tax increases and decreases in transfer payments (increase T) decrease disposable income à PAE decreases.
o Thus, slope of PAE curve and depends on t. § Larger t -‐ flatter PAE (decrease PAE) § Smaller t – steeper PAE (increase PAE)
• Governments can change the exogenous part of T, ‘T-‐bar’ or the tax rate t. • Taxes on labour à Income rate rates and structure of government payments can
influence labour supply decisions
• Taxes on capital à Company tax rates can influence firms’ investment decisions and affect the level of private capital
Fiscal Multipliers in the 4-‐Sector Model
• Total change in GDP is given by the change in variable multiplied by multiplier value.
Error! Not a valid embedded object.
• A proportion of tax cuts may be saved and not fully spent, therefore the tax multiplier is lower.
• Balanced Budget Multiplier: the short-‐run effect of equilibrium GDP of an equal change in government expenditure and net taxes. The initial government budget surplus/deficit is T – G. Hence, the initial deficit is kept constant when there is equal change in T and G components. The balanced budget multiplier
determines the change in output that results from an equivalent change in T and G. Note – budget surplus/deficit is a flow variable.
• Hence, output will change by less than one for every unit change in G as c and m are < 1. Hence, output will change by less than one for every unit change in G. Graphically since an increase in G will shift the PAE upwards by increase in G (PAE1), simultaneously an increase in T will shift the PAE curve downwards (PAE2) by less than increase in G since (c-‐m) < 1. The net effect of these operations will be an overall increase in PAE at every level of output and consequently a net increase in equilibrium output from Y to Y2.
