EC:250 Intermediate Macroeconomics!

1. EC:250Intermediate Macroeconomics! Tutors: Brian Deng Course Coordinator: Steven Song

2. Today’s Schedule • Cover each chapter in detail • Question period • Exam study tips • Go over practice questions (if we have time)

3. Chapters 1 and 2

4. Chapters 1 and 2 • Shotgun blast of theory: • What’s the difference? • Macroeconomics • Study of the behaviour and performance of the economy as a whole • Microeconomics • Study of the behaviour and performance of individual parts of the economy • Gross Domestic Product (GDP) • The value of all final goods and services produced within Canadian borders over some period • Basically anything produced in Canada • It is a measure of the aggregate (whole amount of) Output or Income or Spending • Whatever is Produced creates Income which is then Spent. So all 3 show GDP!

5. shotgun cont… • Gross National Product (GNP) • The value of all final goods and services produced in Canada or elsewhere by Canadian-owned resources • Inflation Rate • A measure of how fast prices, in general are rising • Exchange rate • The rate at which one country’s currency trades for another • Macroeconomic Models • Simplification of an economy which provides a logical and consistent framework to help understand an economy • 2 types of variables: • Endogenous: Value is determined within the model (the output of the model) • Exogenous: Value is determined outside the model (the input into the model) • 2 type of models: • Classical (freshwater econ): Prices are flexible and study is of the long run effects • Keynesian (saltwater econ): Prices are fixed and study is of the short run effects

6. Rules for Calculating GDP • Don’t count inventories • Only count any level increases • Get realistic numbers • Don’t simply compare prices or quantities • Multiply them to get realistic value • Don’t count intermediate goods • Nobody cares if your country is the leading manufacturer of unfinished iPods • If there isn’t a price, use imputed value • Imputed value: Implied value based on the nature of the product • Eg. When calculating income for sailors, a dollar value is imputed for the cost of food and lodging • Don’t include any of these: • Used goods • Home production • Underground economy • Services of durable goods • Environmental effects of production

7. Real vs. Nominal GDP • Nominal GDP • ∑ P2008Q2008 • = # of apples in 2008 * cost per apple in 2008 • Real GDP • Set a base year for pricing, pricing is fixed • ∑ P2002Q2008 • = # of apples in 2008 * cost per apple in 2002 • Nominal GDP shows the change in the total value of output produced by a country while real GDP shows the change in volume by fixing the price • GDP Deflator • Price Index that measures the overall price level • Nominal GDP/Real GDP * 100

8. Example • Nominal GDP in 2010 • ∑ P2010Q2010 • = (3*600) + (2.5*450) • = $2925 • Real GDP in 2010, base year 2008 • ∑ P2008Q2010 • = (2*600) + (1.5*450) • = $1875 • GDP Deflator • =Nominal GDP/Real GDP = 2925/1875 = 156%

9. Measuring GDP • Measuring with Aggregate Expenditure (Y) • Consumption (C): Goods and services purchased by consumers • Investment(I): Goods bought for future use • Government Purchases(G) • Net Exports(NX): Total Exports – Total Imports • Add it all up! • GDP = Y = C + I + G + NX • This is known as the national accounts identity • Measuring with Aggregate Income • Basically calculate the National Income (3 steps) • Calculate GNP • = GDP – Net Income of Foreigners • Recall: This is because GNP is Canadian only • Calculate NNP (Net national product) • = GNP – Depreciation • Calculate National Income • = NNP – Indirect business taxes (GST, PST)

10. Chapter 17 Consumption

11. Keynes’s Conjectures • First, Keynes conjectured that the marginal propensity to consume – the amount consumed out of an additional dollar of income – is between zero and one. • Second, Keynes posited that the ratio of consumption to income, called average propensity to consume, falls as income rises. • Third, Keynes thought that income is the primary determinant of consumption and that the interest rate does not have an important role. (In the short run) • C=C +c*Y, C >0, 0<c<1 C = consumption, Y = disposable income, C = constant, c = marginal propensity to consume.

12. Keynes cont. • C=C +c*Y, C >0, 0<c<1 C = consumption, Y = disposable income, C = constant, c = marginal propensity to consume. • c = MPC, 0<c<1which means higher income leads to higher consumption and also to higher saving. • APC = C/Y = C/Y + c, As Y rises, C/Y falls, and so the APC falls. • Notice that interest rate is not in the equation. • Keynesian consumption function was a good approximation of how consumer behave.

13. Keynes cont. • APClow income > APChigh income

14. Keynes cont. • Keynesian consumption predicted that after World War II, the low consumption would lead to an inadequate demand for goods and services, results a long depression of indefinite duration. -> Never happened LOL • Although incomes were much higher after the war than before, but it did not lead to a large increases in the rate of saving. APC would fall as income rose appeared not to hold.

15. Keynes cont. • Other economists later discovered that APC did not vary systematically with income. This relationship is called the long-run consumption function. • Notice that the short-run consumption function has a falling APC (Just like Keynes predicted), whereas the long-run consumption has a constant APC. Long- run Short- run

16. Fisher’s model • The economist Irving Fisher developed the model with which economists analyze how rational, forward-looking consumers make intertemporal choices – that is, choices involving different periods of time. • Fisher’s model illuminates the constraints consumers face, the preferences they have, and how these constraints and preferences together determine their choice about consumption and saving.

17. Fisher’s model cont. • The reason that people consume less than they desire is that their consumption is constrained by their income. • In other words, consumer face a limit on how much they can spend, called a Budget Constraint. • When people are deciding how much to consume today Vs. how much to save for the future, they face an intertemporal budget constraint, which measures the total resources available for consumption today and in the future.

18. Fisher’s model cont. • Consider how the consumer’s income in the two periods constrains consumption in the two periods. In the first period, saving equals income minus consumption. That is S = Y1-C1 S = saving. In the second period, consumption equals the accumulated saving, including the interest earned on that saving, plus second-period income. That is C2= (1+r)S+Y2 r = real interest rate, and r = int rate for borrowing = int rate for saving.

19. Fisher’s model cont. • To derive the consumer’s budget constraint, combine the two equations above. Sub the first equation for S into the second equation and we get C2=(1+r)(Y1-C1)+Y2 To make the equation easier to interpret, we have to rearrange terms, put all the consumption terms together, bring (1+r)C1to the left-hand side of the equation and divided by (1+r) both side we get C1+(C2/1+r) = Y1 + (Y2/1+r)

20. Fisher’s model cont. • C1+(C2/1+r) = Y1 + (Y2/1+r), This is the standard way of expressing the consumer’s intertemporal budget constraint. • To draw the budget constraint, we set C1 = 0, C2 = 0 and solve for C2 C1 to get the x-axis and y-axis intercepts. • When C1 = 0, C2 = (1+r)Y1+Y2 • When C2 = 0, C1 = Y1+Y2/(1+r)

21. Fisher’s model cont.

22. Fisher’s model cont. • The consumer’s preferences regarding consumption in the two periods can be represented by indifference curves. • An indifference curve shows the combinations of two periods consumption that make the consumer equally happy.

23. Fisher’s model cont.

24. Fisher’s model cont. • Having discussed the consumer’s budget constraint and preferences, we can consider the decision about how much to consume in each period of time. • The consumer would like to end up with the best possible combination of consumption in the two periods – that is, on the highest possible IS curve but also end up on or below the budget line. • This condition is called Optimization.

25. Fisher’s model cont. A Consumer Who Is a Lender A Consumer Who Is a Borrower

26. Fisher’s model cont. • An increase in either first-period income or second-period income shifts the budget constraint outward. If consumption in both period are both normal goods, this increase in income raises consumption in both periods.

27. Fisher’s model cont. A change in real interest r

28. Fisher’s model cont. • A increase in r leads to an increase in future consumption for sure, but uncertain for current consumption and current saving. • Income effect states that a increase in r would increase both current and future period consumption, but substitution effect states that a increase in r decrease current consumption and increase future consumption

29. Life – cycle hypothesis • To explain the apparently conflicting pieces of evidence that came to light when Keynes’s consumption function was confronted with data. • According to Fisher’s model, C is depends on person’s lifetime income. Franco founder of the life – cycle hypothesis emphasized that income varies systematically over people’s lives and that saving allows consumers to move income from those times in life when income is high to those times when it is low. – This interpretation of consumer behavior formed the basis for his life – cycle hypothesis.

30. Life – cycle hypothesis cont. • Consider a consumer who expects to live another T years, has wealth of W, and expects to earn income Y until she retires R years from now. What level of consumption will the consumer choose if she wishes to maintain a smooth level of consumption over her life? • W = initial wealth, R*Y = life time earnings (we assume interest rate is zero). • The consumer can divide up her lifetime resources among her T remaining years of life. We assume that she wishes to achieve the smoothest possible path of consumption over her life time. Therefore, she divides W+R*Y equally among the T years and for each year consumes: C = (W + R*Y)/T

31. Life – cycle hypothesis cont. • C = (W + R*Y)/T, we can write this person’s consumption function as C = 1/T*W + R/T*Y. • For example, if the consumer expects to live for 50 more years and work for 30 of them, then T=50, R=30, so her consumption function is C=0.02W+0.6Y This equation says that consumption depends on both income and wealth. An extra $1 of income per year raises consumption by $0.60 per year, and an extra $1 of wealth raises consumption by $0.02 per year.

32. Life – cycle hypothesis cont. • In general we can write this function as C = a*W + b*Y, where a = marginal propensity to consumer out of wealth, and b = marginal propensity to consume out of income. • According to the life – cycle consumption function, the APC is C/Y = a*(W/Y)+b • Because wealth does not vary proportionately with income from person to person or from year to year, we should find that high income corresponds to a low APC when looking at data across individuals or over short periods of time. • At long run, wealth and income grow together, resulting in a constant ratio W/Y and thus a constant APC.

33. Life – cycle hypothesis cont. aW Income Y

34. Life – cycle hypothesis cont. If consumption depends on wealth, then an increase in wealth shifts the consumption function upward aW2 aW Income Y

35. Permanent income Hypothesis • Milton Friedman proposed the permanent income hypothesis to explain consumer behavior. • He argues that consumption should not depend on current income alone. But unlike the life – cycle hypothesis, which emphasizes that income follows a regular pattern over a person’s lifetime, the permanent income hypothesis emphasizes that people experience random and temporary changes in their incomes from year to year.

36. Permanent income Hypothesis cont. • Friedman suggested that we view current income Y as the sum of two components, permanent income Yp and transitory income Yt ,that is Y = Yp+Yt Permanent income is the part of income that people expects to persist into future. Transitory income is the part of income that people do not expect to persist.

37. Permanent income Hypothesis cont. • Friedman found that consumers spend their permanent income, but they save rather than spend most of their transitory income. • Friedman concluded that we should view the consumption function as approximately C = a*Yp Where a is a constant that measures the fraction of permanent income consumed. The permanent – income hypothesis, as expressed by this equation, states that consumption is proportional to permanent income.

38. Permanent income Hypothesis cont. • Friedman’s hypothesis suggesting that the standard Keynesian consumption function uses the wrong variable. According to permanent income hypothesis, consumption depends on permanent income Yp • APC = C/Y = aYp/Y • PIH states the APC depends on the ratio of permanent income to current income. When current income temporarily rises above permanent income, the APC temporarily falls; when current income temporarily falls below permanent income, the APC temporarily rises.

39. Ch.18 Investment

40. Ch.18 Investment • There are Three types of investment spending: • Business fixed investment • Residential investment • Inventory investment BFI: includes the machinery, equipment, and structures that business buy to use in production. RI: includes the new housing that people buy to live in and that landlords buy to rent out. Ii: includes those goods that business put aside in storage, including materials and supplies, work in process, and finished goods.

41. Business Fixed Investment • The standard model of business fixed investment is called Neoclassical model of investment. • The neoclassical model examines the benefits and costs to firms of owning capital goods. The model shows how the level of investment – the addition to the stock of capital – is related to the marginal product of capital, the interest rate, and the tax rules affecting firms. • In the model we imagine that there are two kinds of firms; production firms produces goods using capital they rent. Rental firms make all the investments in the economy; they buy capital and rent it out. (*draw graph)

42. The rental price of capital • To see what variables influence the equilibrium rental price, we use a particular production function – Cobb – Douglas (ch.3) production function to see how the actual economy turns capital and labour into goods and services. Y=A*K^(a) * L^(1-a) Where Y is output, K is capital, L is labour, A is a parameter measuring the level of technology, and a is a parameter between zero and one that measures capital’s share of output

43. The rental price of capital • The marginal product of capital for the Cobb – Douglas production function is MPK = a*A(L/K)^1-a • Because the real rental price equals the marginal product of capital in equilibrium we can write R/P = a*A(L/K)^1-a, where R = rental rate, P = selling price, R/P = the real cost of a unit of capital to the production firm. (* Show in the graph) • The lower the stock of capital, the higher the real rental price of capital • The greater the amount of labour employed, the higher the real rental price of capital • The better he technology (A), the higher the real rental price of capital

44. The cost of capital • Rental firm borrows to buy a unit of capital, it must pay interest on the loan, Pk is the purchase price, and i is the nominal interest rate, then i*Pk is the interest cost. • While the rental firm is renting out the capital, the price of the capital might change. If the price of capital falls, the firms loses. -∆Pk represents the loss or gains in capital (minus sign is here bec we are measuring costs not benefits, and in this case we assume the company has a gain) • Depreciation also exists, if ∂ is the rate of depreciation, then the dollar cost of depreciation is ∂Pk

45. The cost of capital • The total cost of renting out a unit of capital for one period is therefore Cost of Capital = iPk - ∆Pk + ∂Pk = Pk(i- ∆Pk /Pk+∂) To make it simple, we assume that the price of capital goods rises with the price of other goods, in this case ∆Pk/ Pkequals the overall rate of inflation ∏. i - ∏ equals the real interest r, we can write the cost of capital as Cost of Capital = Pk (r+∂)

46. The cost of capital • Cost of Capital = Pk (r+∂), this equation states that the cost of capital depends on the price of capital, the real interest rate, and the depreciation rate. • Finally, we want to express the cost of capital relative to other goods in the economy. The real cost of capital – the cost of buying and renting out a unit of capital measured in units of the economy’s output – is Real cost of capital = (Pk/P)*(r+∂), P = price of other goods

47. The determinants of investment • Now consider a rental firm’s decision about whether to increase or decrease its capital stock. For each unit of capital, the firm earns real revenue R/P and bears the real cost (Pk/P)*(r+∂). The real profit per unit of capital is Profit rate = revenue – cost = R/P – (Pk/P)*(r+∂) Because the real rental price in equilibrium equals the marginal product of capital, we can write the profit rate as Profit rate = MPK – (Pk/P)*(r+∂) *show in graph We can see now that the firm’s decision regarding its capital stock – that is whether to add to it or let it depreciate – depends on whether owning and renting out capital is profitable.

48. The determinants of investment • The change in the capital stock, called net investment, depends on the difference between the marginal product of capital and the cost of capital. • If the MPK exceeds the cost of capital, firms find it profitable to add to their capital stock. • If the MPK falls shorts of the cost of capital, they let their capital stock shrink. • For a firm that both uses and owns capital, the benefit of an extra unit of capital is the marginal product of capital, and the cost is the cost of capital. Like a firm that owns and rents out capital, this firm adds to its capital stock if the MPK exceeds the cost of capital. Thus we can write ∆K = In (MPK-(Pk/P)(r+∂)) where In ( ) is the function showing how much net investment responds to the incentive to invest

49. The determinants of investment • We can now derive he investment function. Total spending on business fixed investment is the sum of net investment and the replacement of depreciated capital. The investment function is I = In (MPK-(Pk/P)(r+∂))+∂K Business fixed investment depends on the MPK, the cost of capital, and the amount of depreciation. (show graph figure 18 – 3)

50. Taxes and investment • Three most important provisions of corporate taxation: The corporate profit tax rate itself, depreciation allowance, and the investment tax credit. • The effect of a corporate profit tax on investment depends on how the law defines “profit” for the purpose of taxation. • The depreciation allowance is based on the price of the capital when it was originally purchased. • The Investment tax credit is a tax provision that encourages the accumulation of capital.