ECO 120- Macroeconomics

1. ECO 120- Macroeconomics Weekend School #1 16th April 2005 Morning Session Lecturer: Rod Duncan Previous version of notes: PK Basu

2. Topics for discussion • Module 1- basic macroeconomic concepts • Income determination, basic macroeconomic theory, investment decision • Module 2- the money market • The Australian financial system, the role of money, the market for money • What will not be discussed • Answers to Assignment #1 (use the CSU forum for this)

3. Microeconomics- the study of individual decision-making “Should I go to college or find a job?” “Should I rob this bank?” “Why are there so many brands of margarine?” Macroeconomics- the study of the behaviour of large-scale economic variables “What determines output in an economy?” “What happens when the interest rate rises?” Forms of economics

4. Economics as story-telling • In a story, we have X happens, then Y happens, then Z happens. • In an economic story or model, we have X happens which causes Y to happen which causes Z to happen. • There is still a sequence and a flow of events, but the causation is stricter in the economic story-telling.

5. Kobe, the naughty dog

6. Modelling Kobe • Kobe likes to unmake the bed. • Kobe likes treats. • We assume that more treats will lead to fewer unmade beds. (Not a very good) Model: Treats↑ → Unmaking the bed↓ • We can use this model to explain the past or to predict the future.

7. Elements of a good story • All stories have three parts • Beginning- description of how things are initially- the initial equilibrium. • Middle- we have a shock to the system, and we have some process to get us to a new equilibrium. • End- description of how things are at the new final equilibrium- the story stops. • “Equilibrium”- a system at rest.

8. Timeframes in economics • In economics we also talk in terms of three timeframes: • “short run”- the period just after a shock has occurred where a temporary equilibrium holds. • “medium run”- the period during which some process is pushing the economy to a new long run equilibrium. • “long run”- the economy is now in a permanent equilibrium and stays there until a new shock occurs. • You have to have a solid understanding of the equilibrium and the dynamic process of a model.

9. What are the big questions? • What drives people to study macroeconomics? They want solutions to problems such as: • Can we avoid fluctuations in the economy? • Why do we have inflation? • Can we lower the unemployment rate? • How can we manage interest rates? • Is the foreign trade deficit a problem? • [How can we make the economy grow faster?] Not taken up in this class. This class focuses on short-run problems.

10. Economic output • Gross domestic product- The total market value of all final goods and services produced in a period (usually the year). • “Market value”- so we use the prices in markets to value things • “Final”- we only value goods in their final form (so we don’t count sales of milk to cheese-makers) • “Goods and services”- both count as output

11. Nominal versus real GDP • We use prices to value output in calculating GDP, but prices change all the time. And over time, the average level of prices generally has risen (inflation). • Nominal GDP: value of output at current prices • Real GDP: value of output at some fixed set of prices

12. Nominal versus real GDP • So how to correct for rising prices over time? • Measure average prices over time (GDP deflator, Consumer Price Index, Producer Price Index, etc) • Deflate nominal GDP by the average level of prices to find real GDP Real GDP = Nominal GDP / GDP Deflator

13. Some Australian economic history

14. Business cycle • The economy goes through fluctuations over time. This movement over time is called the “business cycle”. • Recession: The time over which the economy is shrinking or growing slower than trend • Recovery: The time over which the economy is growing more quickly than trend • Peak: A temporary maximum in economic activity • Trough: A temporary minimum in economic activity.

15. Australian business cycle

16. Unemployment • To be officially counted as “unemployed”, you must: • Not currently have a job; and • Be actively looking for a job • “Labour force”- the number of people employed plus those unemployed • “Unemployment rate” • (Number of unemployed)/(Labour force)

17. Unemployment • Working age population = Labour force + Not in labour force • Labour force = Employed + Unemployed

18. Unemployment

19. Inflation • Inflation is the rate of growth of the average price level over time. • But how do we arrive at an “average price level”? • The Consumer Price Index surveys consumers and derives an average level of prices based on the importance of goods for consumers, ie. a change in the price of housing matters a lot, but a change in the price of Tim Tams does not.

20. Consumer Price Index • Then the CPI expresses average prices each year relative to a reference year, which is a CPI of 100. CPIt = (Average prices in year t)/(Average prices in reference year) x 100 • Inflation can then be measured as the growth in CPI from the year before: • Inflationt = (CPIt – CPIt-1) / CPIt-1

21. Inflation

22. Calculating GDP • Gross domestic product- The total market value of all final goods and services produced in a period (usually the year). • Alternates methods of calculating GDP • Income approach: add up the incomes of all members of the economy • Value-added approach: add up the value added to goods at each stage of production • Expenditure approach: add up the total spent by all members of the economy • The expenditure approach forms the basis of the AD-AS model.

23. Expenditure approach • GDP is calculated as the sum of: • Consumption expenditure by households (C) • Investment expenditures by businesses (I) • Government purchases of goods and services (G) • Net spending on exports (Exports – Imports) (NX) Aggregate Expenditure: AE = C + I + G + NX

24. Consumption and savings • We assume consumption (C) depends on household’s disposable income: • Disposable income YD = (Income – Taxes) • The consumption function shows how C changes as YD changes. • Household savings (S) is the remainder of disposable income after consumption. • The savings function shows how S changes as YD changes.

25. Consumption function • Consumption is a function of YD or C = C(YD). We assume that this relationship takes a linear (straight-line) form C = a + b YD where a is C when YD is zero and b is the proportion of each new dollar of YD that is consumed. • We assume that C is increasing in YD, so 0 < b < 1.

26. Savings function • Household savings is a function of YD or S = S(YD). We assume S = c + d YD where c is S when YD is zero and d is the proportion of each new dollar of YD that is saved. • We assume that S is increasing in YD, so 0 < d < 1. • But also households must either consume or save their income, so C + S = YD. This can only be true if c = -a and b + d = 1.

27. More terms • Average Propensity to Consume (APC) is consumption as a fraction of YD: APC = C / YD • Average Propensity to Save (APS) is savings as a fraction of YD: APS = S / YD • Since all disposable income is either consumed or saved, we have: APC + APS = 1

28. More terms • Marginal Propensity to Consume (MPC) is the change in consumption as YD changes: MPC = (Change in C) / (Change in YD) • Marginal Propensity to Save (APS) is the change in savings as YD changes: MPS = (Change in S) / (Change in YD) • For our linear consumption and savings functions, MPC = b and MPS = d. If YD changes, then consumption and savings must change to use up all the change in YD , so MPC + MPS = 1.

29. Graphing the functions • When YD = 0, C + S = 0, so at point A, the intercept terms are both just below 2 and of opposite sign. • The 45 degree line in the top graph shows the level of YD. At point D, C is equal to YD, so S = 0. • MPC = 0.75 is the slope of the C function. • MPS = 0.25 is the slope of the S function.

30. What else determines C? • Household consumption will also depend on: • Household wealth • Average price level of goods and services • Expectations about the future • Changes in these factors will produce a shift of the whole C and S functions.

31. Shifts of C and S functions • A rise in household wealth will increase C for every level of YD, so C shifts up. • A rise in average prices will lower the real wealth of households and so lower C for every level of YD, so C shifts down.

32. Exogenous variables • Exogenous variables are variables in a model that are determined “outside” the model itself, so they appear as constants. • For the aggregate expenditure model, we treat as exogenous: • Investment (I) • Government consumption (G) • Taxes (T) • Net Exports (NX)

33. Aggregate expenditure • In a closed (no foreign trade) economy: AE = C(Y) + I + G • In an open economy: AE = C(Y) + I + G + NX • Changes in a or the exogenous variables (I, G, T or NX) will shift the AE curve. A change in b will tilt the AE curve. • Equilibrium occurs when goods supply, Y, is equal to goods demand, AE.

34. Equilibrium in the AE model • Supply of goods equals demands of goods (in the closed economy): Y = C + I + G Y = a + b(Y – T) + I + G (1 – b)Y = a – bT + I + G • Finally we get:

35. Expenditure multiplier • Imagine the government wishes to affect the economy. One tool available is government consumption, G, or government taxes, T. This is called “fiscal policy”. • Any change in G (∆G) in our AE model will produce:

36. Multiplier • If b=0.75, then the multiplier is (1/0.25) or 4, so $1 of new G will produce $4 of new Y. • Our multiplier is equal to 1/(1-MPC). • Since 0<MPC<1, our multiplier will be greater than 1. • The larger is the MPC, the larger is our multiplier.

37. Deriving aggregate demand • How do average prices affect demand for goods and services? • Wealth effect: higher prices means our assets have less value so people are poorer and consume less. • Interest rates: higher prices drive up the demand for money and so drive up interest rates, at higher interest rates, investment falls (see later) • Net exports: at higher Australian prices, foreign goods are cheaper, so net exports falls (see later) • As the average price level rises, demand for goods and services should fall, with all else held constant.

38. Aggregate demand • We would like to have a relationship between the demand for goods and services and the price level. We call this the “aggregate demand” (AD). • The AD curve is downward-sloping in prices.

39. Shifts of the AD curve • Factors that affect the AE curve will affect the AD curve. For example, if household wealth rose, then C would increase for all levels of disposable income. Demand would be higher for all levels of prices, so the AD curve shifts to the right. • C: household wealth, household expectations about the future • I: interest rates, business expectation about the future, technology • G and T: changes in fiscal policy • NX: the currency exchange rate, change in output in foreign countries

40. AD and the multiplier • A change in I will shift the AE curve up. This will produce a shift to the right of the AD curve. • The shift in the AD curve will be the change in I times the multiplier.

41. Aggregate supply • Likewise, there must be a relationship between goods supply and the average level of prices- the aggregate supply (AS) curve. • How do prices affect goods supply? • Short-term: Since wages are determined by contracts, wages do not change in the short-term. A rise in prices holding wages fixed means that firms are making higher profits on production, so firms will expand supply of goods. • Long-term: Wage contracts will be renegotiated if prices rise. In the long-term, we would expect that there is no relationship between goods supply and prices.

42. Aggregate supply • There will be a short-run AS curve which is upward-sloping in prices. • The long-run AS curve is vertical at the level of potential output, since wages will change proportionately to price changes. • What factors will shift the AS curves? • Changes in prices of inputs, like land, capital energy or entrepreneurial skill • Changes in technology that affect productivity • Changes in taxes, subsidies or laws affecting business productivity

43. Shift in AD

44. Shift in AD in the SR • The price level rises, which pushes the AE curve back down to where the AD-AS curves intersect. • But output is above the potential rate of output at point C. This means that there is a shortage of labour and will push up wages.

45. Shift in AD in the LR • In the long-run, workers renegotiate wages based on the higher prices. This raises the cost of production to firm and shifts the short-run AS curve to the left. • It is only when we get back to potential output that wages stop rising, at point A’.

46. Investment • Investment refers to the purchase of new goods that are used for future production. Investment can come in the form of machines, buildings, roads or bridges. • What determines investment? • Businesses make an investment if they expect the investment to be profitable.

47. Investment decision-making • How to determine profitability of investment? • Example: An investment involves the current cost of investment (I). The investment will pay off with some flow of expected future profits. The future stream of profits is R1 in one year’s time, R2 in two year’s time, … up to Rn at the nth year when the investment ends. • Net Present Value (NPV) = Present Value of Future Profits (PV) – Investment (I)

48. Interest rates • Interest rates are a general term for the percentage return on a dollar for a year: • that you earn from banks for saving • that you pay banks for borrowing or investing • For example, the interest rate might be 10%, so if you put $1 in the bank this year, it will become $(1+i) in one year’s time. • Or if you borrow $100 today, you will have to repay $(1+i)100 next year.

49. Interest Rates

50. Discounting future values • How do we place a value today on $1 in t years’ time? • This is called “discounting” the future value. One way to think about this question is to ask: • “How much would we have to put in the bank now to have $1 in t years’ time?” • Money in the bank earns interest at the rate at the rate i, i>0. If I put $1 in the bank today, it will grow to be $(1+ i)1 in one year’s time, will grow to be $(1+i)(1+i)1 = $(1+i)2 in two years’ time and will grow to $(1+i)n in n years’ time.