COnsumption Investment and intoduction to macro Flashcards
What is the difference between macro and Micro economics?
Microeconomics analyses individual entities, such as markets, firms and consumers •
Macroeconomics analyses broad aggregates at the level of the entire economy, such as total output, the rate of economic growth, the balance of payments and so on…
WHat is the difference between real and nominal GDP?
GDP is the value of all final goods and services produced. •
Nominal GDP measures these values using current prices. •
Real GDP measures these values using the prices of a base year. •
Changes in nominal GDP can be due to: – changes in prices – changes in quantities of output produced
• Changes in real GDP can only be due to changes in quantities, because real GDP is constructed using constant base-year prices.
Explain Sticky and felxible prices
Market clearing: An assumption that prices are flexible, adjust to equate supply and demand.
• In the short run, many prices are sticky – adjust sluggishly in response to changes in supply or demand. For example: – many labor contracts fix the nominal wage for a year or longer – many magazine publishers change prices only once every 3 to 4 years.
The economy’s behavior depends partly on whether prices are sticky or flexible: – If prices sticky (short run), demand may not equal supply, which may explain:
• unemployment (excess supply of labor) •
why firms cannot always sell all the goods they produce –
If prices flexible (long run), markets ‘clear’ and the economy behaves very differently
Differnce between stocks and flows
A stock is a quantity measured at a point in time
A flow is a quantity measured per unit of time.
What are the components of national income in an closed and open economy?
In a closed economy, at market prices:
Y ≡ C + I + G •
Income/Output (Y) • Consumption (C) • Investment (I) • Government Expenditure (G)
At basic prices: Y ≡ (C + I + G) – Te •
Indirect taxes (Te)
With households’ PERSONAL DISPOSABLE INCOME at basic prices ≡ Y + B – Td
• Income/Output (Y) • Transfer payments (B) • Direct taxes (Td)
And savings (S) as the part of disposable income not spent on consumption S ≡ (Y + B – Td) – C
In an open economy we have to consider:
• Imports (Z) goods produced abroad but purchased domestically • Exports (X): goods domestically produced but sold abroad. •
with Net Exports NX = (X – Z)
Therefore at basic prices:
Y ≡ C + I + G + X – Z – Te ≡ C + I + G + NX – Te
WHat are the two deffinitions of GDP
– Total expenditure on domestically-produced final goods and services. –
Total income earned by domestically-located factors of production.
Expenditure equals income because every dollar a buyer spends becomes income to the seller.
Exaplin Aggregate demand and suply and the equilbirium
Exaplin DEmand for funds : Investment
The demand for loanable funds…
– comes from investment: Firms borrow to finance spending on plant & equipment, new office buildings, etc. Consumers borrow to buy new houses.
– depends negatively on r, the “price” of loanable funds (cost of borrowing).
Explain Supply of Funds : Saving
The supply of loanable funds comes from saving:
– Households use their saving to make bank deposits, purchase bonds and other assets. These funds become available to firms to borrow to finance investment spending.
– The government may also contribute to saving if it does not spend all the tax revenue it receives
private saving = (Y – T) – C
public saving = T – G
national saving, S = private saving + public saving = (Y –T ) – C + T – G = Y – C – G
Explain the role of intrest rate
r adjusts to equilibrate the goods market and the loanable funds market simultaneously:
If L.F. market in equilibrium, then Y – C – G = I
Add (C +G ) to both sides to get Y = C + I + G (goods market equilibrium)
Thus, Eq’m in L.F. market = Eq’m in goods market
Why does saving depend on the intrest rate?
Explain GDP deflator
• Inflation rate: the percentage increase in the overall level of prices •
One measure of the price level:
GDP deflator Definition:
GDP deflator = 100 * Real GDP/Nominal GDP
What is the Consumer Price Index (CPI)?
A measure of the overall level of prices
• What is it used for? It
– tracks changes in the typical household’s cost of living
– adjusts many contracts for inflation
– allows comparisons of monetary amounts over time
Define Consumption?
Definition: The value of all goods and services bought by households, inc
Durable Goods
Non durable goods
Services
What are the 6 perspectives of Consumption?
– John Maynard Keynes: consumption and current income (a reminder)
– Irving Fisher: intertemporal choice
– Franco Modigliani: the life-cycle hypothesis
– Milton Friedman: the permanent income hypothesis
– Robert Hall: the random-walk hypothesis
– David Laibson: the pull of instant gratification
What is disposable income
Disposable income is total income minus total taxes:
Y – T.
WHat is MPC?
Marginal propensity to consume (MPC) is the change in C when disposable income increases by one pound.
Explain the Keynes’ Consumption function
- 0 < MPC < 1 2.
Average propensity to consume (APC ) falls as income rises. (APC = C/Y )
- Income is the main determinant of consumption.
What problems existed for Keynesian Consumption function and what is the Consumption Puzzle
- Based on the Keynesian consumption function, economists predicted that C would grow more slowly than Y over time.
- This prediction did not come true:
- – As incomes grew, APC did not fall, and C grew at the same rate as income.
- – Simon Kuznets showed that C/Y was very stable from decade to decade.
Exaplin basic life cycle hypothesis model
The basic model:
W = initial wealth
Y = annual income until retirement (assumed constant)
R = number of years until retirement
T = lifetime in years
• Assumptions:
– zero real interest rate (for simplicity)
– consumption smoothing is optimal
Life time resources = W +RY
To achieve smooth consumption, consumer divides her resources equally over time:
What are the implications of the Life-Cycle Hypothesis?
The LCH can solve the consumption puzzle: –
The life-cycle consumption function implies APC = C/Y =a(W/Y) + ß
– Across households, income varies more than wealth, so high-income households should have a lower APC than low-income households.
– Over time, aggregate wealth and income grow together, causing APC to remain stable
Explain the investment function and the real intrest rate
The investment function is I = I(r)
where r denotes the real interest rate, the nominal interest rate corrected for inflation.
• The real interest rate is
– the cost of borrowing
– the opportunity cost of using one’s own funds to finance investment spending
What is the marginal product of an Input?
What is the nominal cost of capital?
Components of the cost of capital:
interest cost: i * PK, where PK = nominal price of capital
depreciation cost: ς* PK, where ς = rate of depreciation
capital loss: -deltaPK
(a capital gain, deltaPK > 0, reduces cost of K)
What is the real cost of capital compared to nominal cost?
The (rental) firm’s profit rate?
What is net and gross investment?
How is Investment function affected by r?
How is investment function affected by MPK or Pk/P?
