EC108 Test 1 Flashcards
What is the measure of aggregate output called?
Gross Domestic Product
3 ways of defining GDP
GDP is the value of final goods and services produced in the economy during a given period.
GDP is the sum of value added (value of production minus the value of the intermediate goods used) in the economy during a given period.
GDP is the sum of incomes in the economy during a given period.
What is Nominal GDP?
The sum of quantities of final goods produced times their current price.
Also called dollar GDP or GDP in current dollars.
What is Real GDP?
The sum of quantities of final goods times constant prices.
Also called GDP in terms of goods, GDP in constant dollars, GDP adjusted for inflation, or GDP in 2009 dollars.
4 reasons why measuring GDP is Difficult
The quality of products is changing over time. Use hedonic pricing to solve this, valuing different parts of computers in a given year.
Many new services are given for free
Measuring illegal production is difficult
Home production is normally excluded from GDP (only housing services are included)
Employment
The number of people who have a job
Unemployment
The number of people who do not have a job but are looking for one
A person is unemployed if they don’t have a job and have been looking for one in the last 4 weeks
Labour force
The sum of employment and unemployment
Those not looking for a job are not in the labour force
Unemployment rate
The ratio of the number of people who are unemployed to the number of people in the labour force
Unemployment rate = Unemployment/Labour force
Discouraged workers
Those who give up looking for a job and so are no longer counted as unemployed
Participation rate
Ratio of the labour force to the total population of working age
Inflation
A sustained rise the general price level
Inflation rate
The rate at which the general price level increases
Deflation
Sustained decline in the general price level (negative inflation rate)
GDP deflator
Nominal GDP / Real GDP
Consumer Price Index (CPI)
A measure of the cost of living (the cost of the consumption basket of a typical consumer)
What is GDP composed of?
Consumption, Investment, Govt Spending, Net exports, Inventory investment
What is inventory investment?
Difference between production and sales
Demand for goods equation
Z = C + I + G + X - IM
Endogenous variables
Variables depend on other variables in the model
Exogenous variables
Variables not explained within the model but are instead taken as given
If a bar is drawn above a symbol or letter, what does it represent?
Investment is taken as given
Are G and T exogenous or endogenous? Why?
Exogenous
Governments do not behave with the same regularity as consumers or firms.
We typically treat G and T as variables chosen by the govt and will not try to explain them with the model.
How to calculate equilibrium output?
Assume X = IM = 0 (Closed economy)
Replace C with C0 + C1(Y-T), Replace I with bar I.
Equilibrium in the goods markets requires Y=Z. This is an equilibrium condition. Replace Z with Y.
Rearrange for Y.
You’re done.
What is autonomous spending?
Part of the demand for goods that does not depend on output.
C0 + BarI + G - C1T
Is autonomous spending positive or negative? Why?
If T=G and c1 is between 0 and 1, then (G - c1T) is positive, and so is autonomous spending
Steps to characterise the equilibrium graphically
Plot production as a function of income. Because production equals income, their relation is the 45-degree line.
Plot demand as a function of income.
Z = (c0 + barI + G - c1T) + c1Y
In equilbrium, production equals demand
Private saving equation
S ≡ Yd - C
S ≡ Y - T - C
The IS relation
S = I + G - T
or
I = S + (T - G)
Money demand equation
Md = $YL(i)
$Y is nominal income
L(i) is decreasing function of the interest rate
An increase in the interest rate ______ the demand for money? Why?
Decreases.
This is because people put more of their wealth into bonds (opportunity cost of holding money)
Equilibrium in financial markets
Ms = Md = M
so
M = $YL(i)
What are open market operations?
Central banks typically change the supply of money by buying or selling bonds in the bond market
What is an expansionary open market operation?
The central bank expands the supply of money by buying bonds
What is a contractionary open market operation
The central bank contracts the supply of money by selling bonds
Liquidity trap
People are willing to hold more money (more liquidity) at the same interest rate. Expansionary monetary is powerless.
Zero lower bound
The belief that nominal interest rates cannot go below zero
What are financial intermediaries
Institutions that receive funds from people and firms, and use these funds to buy bonds or stocks, or to make loans to other people and firms.
Assets of the banks are equal to…
The sum of bonds, loans and total reserves
Why do banks hold reserves? 3 reasons.
For everyday people who deposit/withdraw cash in their accounts.
For people at banks to write checks to people with accounts at other banks, and people at other banks write checks to people with accounts at the bank.
Banks are subject to reserve requirements. The actual reserve ratio - the ratio of bank reserves to bank checkable deposits - is about 10% in the US today
Demands for currency and checkable deposits equations
CUd = cMd
Dd = (1 - c)Md
Demand for reserves equation
R = θD (relationship between reserves and deposits)
R = θ(1 - c)Md (actual demand for reserves by banks)
θ is reserve ratio
The process of deriving the equation for the determination of the interest rate
Hd = CUd + Rd (Demand for central bank money)
Hd = cMd + θ(1-c)Md (Sub in demand for reserves in banks)
Hd = [c + θ(1-c)]Md
Hd = [c + θ(1 - c)]$YL(i) (Sub in money demand equation)
Determination of interest rate
H = [c + θ(1-c)]$YL(i)
Nominal interest rate
Interest rate in terms of dollars
Real interest rate
Interest rate in terms of a basket of goods
Write out the Fisher rule
Check Lecture 3, pg38
The realized real interest rate written in terms of i
i - pi^e
Openness in goods markets
The ability of consumers and firms to choose between domestic goods and foreign goods. Even countries most committed to free trade have tariffs (taxes on imported goods) and quotas (restrictions on the quantity of goods that can be imported)
Openness in financial markets
The ability of financial investors to choose between domestic assets and foreign assets. Until recently, even some rich countries had capital controls (restrictions on the foreign assets their domestic residents could hold)
Openness in factor markets
The ability of firms to choose where to locate production, and of workers to choose where to work, e.g. the North American Free Trade Agreement (NAFTA) signed in 1993 by the US, Canada and Mexico affected the relocation of US firms to Mexico.
Nominal exchange rate
The price of domestic currency in terms of foreign currency
Fixed exchange rates
A system in which two or more countries maintain a constant exchange rate between their currencies
The real exchange rate equation
ε = EP/P*
P is the price of domestic goods in domestic currency
P* is the price of foreign goods in a foreign currency
E is the nominal exchange rate
Real exchange rate
The price of domestic goods relative to foreign goods
Balance of payments
A set of accounts that summarise a country’s transactions with the rest of the world
Current account
Record of payments to and from the rest of the world
Net income balance
Difference between income received from the rest of the world and income paid to foreigners
Net transfer received
Difference in foreign aid given and received
Capital account
Records net foreign holdings of domestic assets
Net capital flows/Capital account balance
An increase in net foreign indebtness (holdings of domestic assets by foreigners minus the increase in domestic holdings of foreign assets)
Gross National Product (GNP)
Measures the value added by domestic factors of production
GNP = GDP + NI
NI is net income payments received from the rest of the world minus income paid to the rest of the world
Average propensity to consume
APC
= C/Y
= C0/Y + c1
Irving Fisher’s Intertemporal Choice
Assumes consumer is forward-looking and chooses consumption for the present and future to maximise lifetime satisfaction
Consumer’s choices are subject to an intertemporal budget constraint, a measure of the total resources available for present and future consumption
The Intertemporal Budget Constraint equation
C1 + (C2 / 1 + r) = Y1 + (Y2 / 1 + r)
Present value of lifetime consumption = Present value of lifetime income
Present value of lifetime consumption equation
C1 + C2/1+r
Present value of lifetime income equation
Y1 + Y2/1+r
Marginal rate of substitution (MRS)
The amount of C2 the consumer would be willing to substitute for one unit of C1
Graphically, where is the optimal (C1, C2) ?
Where the budget line just touches the highest indifference curve
Difference between Keynes and Fisher consumption theory
Keynes: current consumption depends only on current income
Fisher: current consumption depends only on the present value of lifetime income. The timing of income is irrelevant because the consumer can borrow or lend between periods
Income effect
If the consumer is a saver, the rise in r makes him better off, which tends to increase consumption in both periods
Substitution effect
The rise in r increases the opportunity cost of current consumption, which tends to reduce C1 and increase C2
Why would Fisher’s consumption theory end up like Keynesian theory?
If the consumer faces borrowing constraints (i.e. “liquidity constraints”), then he may not be able to increase current consumption, and his consumption may behave as in the Keynesian theory even though he is rational and forward-looking
Draw the diagram for constraints on borrowing
Check lecture 5 pg24-26
Life-Cycle Hypothesis assumptions
Zero real interest rate (for simplicity)
Consumption-smoothing is optimal
What is the Life-Cycle Hypothesis?
Unlike the Fisher model, the LCH says that income varies systematically over the phases of the consumer’s “life cycle”
And because of that, saving allows the consumer to achieve smooth consumption
Smooth consumption equation
C = (W + RY) / T
W = Initial wealth
Y = annual income until retirement (assumed constant)
R = number of years until retirement
T = lifetime in years
W + RY = Lifetime resources
Life-cycle consumption function for APC
APC = C/Y = α(W/Y ) + β
α - marginal propensity to consume out of wealth - 1/T
β - marginal propensity to consume out of income - R/T
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
Permenant Income Hypothesis equation
Y = Yp + Yt
so
C = αY^P
Y = current income
Yp = permenant income (average income, which people expect to persist into the future)
Yt = transitory income (temporary deviations from average income)
α is a fraction of permenant income that people consume per year
Permenant Income Hypothesis solving the consumption puzzle APC
APC = C/Y = C = αY^P/Y
If high-income households have higher transitory income than low-income households, APC is lower in high-income households
Over the long run, income variation is due mainly (if not solely) to variation in permenant income, which implies a stable APC
Difference between Permenant Income Hypothesis and Life-Cycle Hypothesis
Both: people try to smooth their consumption in the face of changing current income
LCH: current income changes systematically as people move through their life cycle
PIH: current income is subject to random, transitory fluctuations
Both can explain the consumption puzzle
Business fixed investment
Business’ spending on equipment and structures for use in production
Residential investment
Purchases of new housing units (either by occupants or landlords)
Inventory investment
The value of the change in inventories of finished goods, materials and supplies, and work in progress
Marginal productivity of capital (MPK)
Amount of extra output that can be obtained when an additional unit of capital is installed (return from an additional unit of capital)
Slope of the production function
Assume labour input is constant
Opportunity cost of investment
1 + r
With the resources that could instead be invested in financial assets - opportunity cost of the investment
By borrowing - marginal cost of investment
Firm’s profits after making investment equation
Profit = F(K,L) - (1+r)K
It is captured by the vertical distance between the production function Y = F(K,L) and the total cost (1+r)K
Marginal productivity of capital
MPK = r + 𝛿
𝛿 is the depreciation as an additional cost of capital and r + 𝛿 is the user cost of capital
What is the purpose of investment?
To bring the capital stock to its desired level
To make up for capital lost through depreciation
Present value of income/profit received in the future equation
This is related to income expectations for investment.
Check lecture 6, pg20
Tobin’s q Theory of Investment
Forward looking - firms choose the amount to invest with a view to maximising expected discounted profits over the lifetime of the project
Investment demand equation
Kt+1 = It + (1-𝛿)Kt
What does the value of q indicate
q > 1 = managers can raise the market value of their firm’s stock by buying more capital
q < 1 = managers will not replace capital as it wears out
2 factors that investment relies on
Production/sales and interest rates
IS relation equation
Y = C(Y-T) + I(Y,i) + G
What does pi and i equal in the short run analysis of the IS relation?
pi = 0
i = r
Why is ZZ (demand for goods) upward-sloping?
For a given value of the interest rate, an increase in output leads to an increase in the demand for goods through its effects on consumption
Why is ZZ (demand for goods) a curve rather than a line?
We have not assumed that the consumption and investment relations are linear
Why is ZZ (demand for goods) flatter than the 45-degree line?
Because we have assumed that an increase in output leads to a less than one-for-one increase in demand
Why is the IS curve downward sloping?
An increase in the interest rate decreases the demand for goods at any level of output, leading to a decrease in the equilibrium level of output
Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output
An increase in taxes have what effect on the IS curve?
Inwards, left shift
What is the LM relation?
M/P = YL(i)
If there is an increase in income, at a given interest rate, what happens to the demand for money?
There is an increase in the demand for money
Why is the LM curve upwards sloping?
Equilibrium in the financial markets implies that an increase in real income leads to an increase in the interest rate.
A decrease in G-T means what?
Fiscal contraction -> fiscal consolidation
An increase in G-T means what?
Fiscal expansion
Fiscal policy affects the IS or the LM curve?
IS
Monetary policy affects the IS or LM curve?
LM
Domestic domand in an open economy
C + I + G = C(Y-T) + I(Y,r) + G
Demand for domestic goods in an open economy
Z = C + I + G + X - IM/ε
What is DD, AA and ZZ?
DD = C + I + G (Domestic demand)
AA = C + I + G - M/ε (Domestic demand for domestic goods)
ZZ = C + I + G + X - M/ε (Demand for domestic goods)
The distance between ZZ and AA is constant because exports do not depend on domestic income but they depend on foreign income
The equilibrium condition for output can be expressed as….
Y = C(Y-T) + I(Y,r) + G + X(Y*,ε) - IM/ε (Y,ε)
An increase in government spending affecting the trade balance?
It can lead to an increase in output, and to a trade deficit
Net exports relationship with exchange rate equation
NX = X(Y*,ε) - IM/ε (Y,ε)
Marshall-Lerner condition
A real depreciation leads to an increase in net exports
Marshall-Lerner condition equation
(ΔNX)/X = (Δε)/ε + (ΔX)/X - ΔIM/IM
The proportional change in the real exchange rate
The proportional change in exports
The proportional change in imports
If the Marshall-Lerner condition holds, the sum of the three terms is positive (in which case a real depreciation improves the trade balance)
2 ways for the govt to eliminate trade deficit without changing output?
Achieve a depreciation sufficient to eliminate the trade deficit
Reduce govt spending so as to shift ZZ back
Import compression
A decrease in imports (improved current account balance) triggered by a decrease in output
The J curve
A depreciation initially increases the trade deficit, and over time, exports increase and imports decrease, reducing the trade defict
Current account balance equation
CA = S - I + (T-G)
What is Tobin’s equation for q?
q = market value of the firm / cost of capital
= value of the firm’s capital as determined by the stock market / price of that capital if it were purchased today
