Macro Unit 3 Flashcards
How is output measured?
Output is measured by GDP (a measure of total output of goods and services in an economy in a given period)
GDP can be constructed from 3 different points in the circular flow: output, income and expenditure
- the sum of outputs: production is measured by the value added by each industry, so the cost of goods used as inputs is subtracted from the value of output. These inputs are measured in the value added of other industries which prevents double counting
- the sum of incomes paid to the various factors of production, ie wages, profits, interest, dividends
- the sum of expenditures on total production in the home economy by its final users such as households, firms, government and foreign consumers
Explain the circulars flow between households and firms
Firms produce goods and services which are consumed by households.
Households provide factors of production, ie labour, capital and land to firms.
Households spend money on firms’ goods and services (expenditure)
Households receive income (wages, profits, interest) from the production of goods ans services from firms (total value added by firms = income)
How are exports, imports and the government factored into GDP?
Because GDP is ‘domestic’ product, it includes exports of a country because the country receives income for goods produced domestically but not imports because this is money spent on foreign-produced goods.
The government can be seen as a 3rd actor in the circular flow. The government receives taxes from firms and households (expenditure for them) and uses taxes to provide public services. It is assumed tax revenue = value of public services provided
Explain the components of GDP when viewed as expenditure
Expenditure in the economy can be broken down into:
- consumption (C) (expenditure by households on consumer goods and services)
- fixed investment (I) (expenditure by firms and government on fixed investment in machinery and buildings)
- investment (II) (expenditure by firms on changes in inventories)
- government spending (G) (expenditure by the government on goods and services, mainly health and education)
- exports (X) (expenditure by consumers in other countries)
- we also subtract imports (M) which is expenditure by consumers, firms and government on goods produced abroad
- this gives (X-M) which is net exports or the trade balance, if X>M this is a trade surplus, if X<M this is a trade deficit
GDP = C+I+II+G+(X-M)
What is nominal and real GDP?
Nominal gdp is calculated by computing the price of a good, multiplied by the quantity of the good consumed and adding this up for all goods and services.
Nominal gdp uses current prices, ie the prices at which goods and services are sold in the market
Real gdp helps gauge whether an economy is growing or shrinking by measuring the total quantity of goods and services sold.
Real GDP uses a base year and defines real gdp using the prices from the base year as equal to the nominal gdp that year. To calculate the real gdp for the following year, nominal gdp for the following year is calculated, and using the quantities from the following year by the base year’s prices, real gdp for the following year ca be estimated.
What is purchasing power parity (PPP)?
Price indices that measure how much it costs to purchase a basket of goods and services in one country compared to how much it costs to purchase the same basket in a reference country in a particular year.
This allows for comparison of GDP per capita across countries by choosing a common set of prices (PPP prices) and applying it to both countries.
What is the multiplier process?
A mechanism through which the direct effect of an increase (or decrease) in aggregate spending is amplified through indirect effects that further increase (decrease) aggregate output.
Ie suppose a positive demand shock occurs aggregate spending increases. The increased spending from households means more income for firms, and so higher wages for workers and profits for owners who will then spend their higher income on goods and services, causing the incomes of these firms to rise, meanwhile firms increase employment to produce more goods and services.
What is the multiplier model?
A demand-side model of aggregate demand that shows how spending decisions generate demand for goods and services, and as a result determine the levels of employment and output.
We assume firms respond to changes in demand by adjusting output rather than prices.
We assume firms are willing to supply any amount of the goods demanded by those making purchases in the economy. Ie if there is an increase in demand, firms increase their production to meet this demand.
Thus we assume firms do not operate at full capacity utilisation.
Explain the simplified multiplier model
GDP = C+I+II+G+(X-M)
We begin with a restricted case that excludes the government and foreign trade, reducing GDP to:
Y = C+I+II (Y=output or income)
Aggregate demand (AD) is the total demand for domestically produced goods and services from households, firms, government and other countries.
In the restricted model, it is the total demand from households and firms only (their planned expenditure)
Changes in inventories are assumed to be unplanned so II is not part of AD
Thus we have that AD = C+I in the restricted demand-side model
Explain the consumption function
Consumption (expenditure on goods and services by households) has 2 parts;
- autonomous consumption (c0): a fixed amount (how much households spend regardless of their income)
- income-dependent consumption (c1): a variable amount which depends on household income
The aggregate consumption function shows consumption spending as a function of income:
Aggregate consumption = autonomous consumption + income-dependent consumption
C = c0 + c1Y (Y is income)
This is a linear function whereby c0 is the y intercept and c1is the gradient, thus C is a straight line with aggregate consumption on the y axis and income on the x axis
The gradient, c1, gives the effect of one additional unit of income on consumption, called the MPC
This is a number between 0 and 1, eg if MPC=0.6, for every £1 of extra income, 60p is spent and 40p is saved
Explain the aggregate demand function
This shows how aggregate demand relates to the levels of output, Y. Combining the consumption function and fixed, exogenous investment (independent of output) gives:
Aggregate demand = consumption + investment
AD = C+I = c0 + c1Y + I
Graphically, this function is similar to the consumption function, but incorporating investment, which is independent of output, shifts the AD function vertically upwards
Therefore, the y intercept, c0 + I, is autonomous demand (demand that does not depend on output)
The slope is equal to c1
Remember that the y axis is aggregate demand and x axis is output, Y
Explain the goods market equilibrium
This is a 45 degree line on the AD diagram starting from the origin, with AD on the y axis and output on the x axis.
This line shows all the points where aggregate output, Y, equals aggregate demand, AD (Y=AD).
When aggregate demand for output is equal to the quantity of output being produced, the economy is in equilibrium.
So at all points on this line, the economy is in equilibrium
When combining this 45 degree line with the AD function, we find the level of output at which the two cross, ie where the economy is in equilibrium.
At points where Y>AD, ie points above equilibrium, firms will be increasing their stocks of unsold inventories, sending a message to firms to decrease production.
At points where AD>Y, ie points below equilibrium, firms are running down their unsold inventories of unsold goods, sending a message to firms to increase production
Note that only at equilibrium, Y=AD, implying II (inventory investment) is 0
Explain how the simplified AD model responds to a demand shock
A demand shock is an exogenous change in demand, ie a change in c0 or I. Suppose investment decreases by £15bn
- the economy starts in goods market equilibrium, Y=AD
- the fall in investment cuts AD by £15bn and the economy moves vertically down
- this new point is not an equilibrium as it lies below the 45 degree line. Here AD is below output and there is an increase in unsold goods, so change in inventories is positive
- with lower demand and unsold goods piling up, firms cut back on production and reduce employment, causing incomes to fall by £15bn, moving the economy leftwards
- less output is being produced and sold and fewer people are employed so households’ incomes fall and consumption falls. Because MPC=0.6, aggregate consumption falls be 0.6 times the fall in income (0.6x15=9) so the economy moves vertically downward by £9bn
- firms cut production due to inventories piling up, so output falls and the economy moves leftwards by £9bn
- this process continues and adjustments become smaller until the economy reaches a new point, where the new AD curve intersects the 45 degree line, forming a new equilibrium
- the new AD line is £15bn vertically below the original one
- the total fall in output exceeds the initial £15bn cut in investment (2.5 times the initial change I )
Explain the general multiplier process in response to a negative demand shock
- a demand shock causes a fall in demand
- this leads to a fall in production and equivalent fall in income, causing a further, smaller fall in demand
- this leads to a further fall in production and so on
- the multipler is the sum of all these successive decreases in production
- eventually, output has fallen by a larger amount than the initial change in demand so output change is a multiple of the initial change
- firms supply the amount of goods demanded at the prevailing price - the model assumes they do not adjust their prices
How is the multiplier and change in total output calculated?
Combining Y=AD and AD=c0+c1Y+I gives Y= c0+c1Y+I
Which can be written as: Y(1-c1)=c0+I
Dividing thru by (1-c1): Y=1/(1-c1) x (c0+I)
Y=k(c0+I ) where k = 1/1-c1
Thus output is equal to autonomous demand multiplied by a factor k. If autonomous demand changes, Y changes by k times as much.
Multiplier, k = 1/1-c1 (1/1-MPC)
Explain the model of AD with the government and foreign trade included
Now, AD = C+I+G+(X-M)
- C: now we must include tax. Gov charges a tax, t, which is assumed proportional to income. Income after tax, (1-t)Y, is disposable income. MPC, c1, is now the fraction of disposable income consumed. So C=c0+c1(1-t)Y
- I: now we include the interest rate. Aggregate investment is I=a0-a1r, where a0 is autonomous investment and a1 reflects how sensitive investment is to the interest rate, r
- G: government spending is exogenous in the model, an increase in G shifts AD upwards
- (X-M): the amount of foreign goods demanded by the home economy depends on incomes. We assume exports are exogenous and imports depend only on domestic incomes, Y. The fraction of each additional unit of income spent on imports is m (marginal propensity to import), so net exports = X-M = X-mY
- AD function = c0+c1(1-t)Y + a0-a1r + G + X-mY
What affects the size of the multiplier?
With the inclusion of the government and net exports, the slope of the AD function is no longer just c1, but now depends on the tax rate, t, and the marginal propensity to import, m.
Taxes and imports reduce the size of the multiplier because some household income goes straight to the government as taxation and some is used to buy goods produced abroad, but in the model, we assume the government does not increase its spending when axes go up and foreign buyers do not import more when we buy more of their exports.
So some of the initial increase in income does not lead to further indirect income increases
So a higher m reduces k and a higher t also reduces k
What shifts and changes the slope of the AD function?
- Higher G (government expenditure) shifts AD upwards
- Higher r (interest rate) shifts AD downwards as it reduces investment spending. The extent to which AD shifts down depends on a1 which reflects how sensitive investment is to a change in r
- Higher t (tax rate) reduces the size of the multiplier, k, so AD becomes flatter, ie the indirect effects of exogenous changes are now smaller
- Higher m (marginal propensity to import) reduces the size of the multiplier, k, so AD becomes flatter, ie the indirect effects of exogenous changes are now smaller
- basically, AD is shifted by changes in exogenous factors such as autonomous consumption, autonomous investment, government expenditure, exports and the interest rate
- the slope of AD is affected by non exogenous factors, ie changes in MPC (c1), the tax rate and the marginal propensity to import
What is consumption smoothing?
The acts taken by households to spread out consumption relatively evenly between time periods.
These acts include saving for the future in periods of high current income and borrowing if income is currently low but expected to rise in the future.
One reason for wanting to save or borrow is to be able to purchase necessity goods. Another reason is that the additional benefit gained from increased consumption falls as consumption level rises.
What is the life cycle model of consumption?
A model of consumption spending in which an individual’s consumption depends not only on their current income but also future expected income.
On a diagram with income and consumption on the y axis and time on the x axis, we can model an individual’s path of income and path of consumption
Before starting work, we assume the individual’s income and consumption are the same. Their income comes from support from parents.
On starting work they initially earn a similar income for themselves, and after getting promoted their income rises and then falls at retirement.
On starting work, the individual’s consumption rises to a level that is sustained through to retirement
While income is low, a smooth path of consumption means the individual wants to consume more than their income so they borrow.
When earnings a high, consumption is below income so some income is used to repay debt and accumulate savings.
Whilst income changes over the life cycle, consumption remains smooth and with most consumers doing this, it dampens shocks to the economy
What are idiosyncratic shocks and how do households respond to them?
When good or bad fortune hits an individual household, ie someone receives a large bonus or loses their job.
- Self insurance: households who encounter an unusually high income in some period will save so that they can spend their savings in periods of low income in the future. In periods of low income they can borrow to maintain smooth consumption.
- Coinsurance: households that have been fortunate in a particular period can help households who haven’t. This can be done between members of extended family, friends, neighbours etc. this also takes place through households paying taxes which are used to support individuals whom suffer during economy wide shocks.
What are limits to consumption smoothing?
- Credit constraints: restrictions on the amounts households can borrow. People who need credit most to smooth consumption are often unable to borrow as this tends to be less wealthy households. This means they must wait until their income actually rises before increasing consumption.
- Limited co-insurance: many households lack a network of family/friends who can help out in substantial ways during a negative income shock. In some countries, policies to redistribute income are poor, and so a negative income shock results in an equal fall in consumption.
- Present bias: when a households places more importance on spending in the present rather than in the future. Even if they expect income to fall in the future, they may still prefer to consume all of their income now.
Why is investment volatile?
Firms increase their stock of machinery and equipment and build new premises whenever they identify an opportunity to make profits. There is no incentive to smooth investment.
One reason investment may soar is due to new technology. Firms identify an opportunity to improve their production processes to keep up with other firms as if they don’t, they may be forced out of business or lose market share.
Credit constraints affect firms too and are another reason for the clustering of investment projects.
Coordination also plays a role in investment. Firms will only invest if they expect increased demand. If all firms in the economy are in low capacity utilisation, they are making low profits. Incomes remains low and so does demand. This crates a vicious cycle of low expected demand, low capacity utilisation and profits, no incentive to invest or hire, low spending by firms and workers and back to low expected demand
If firms coordinate and invest in new capacity and hire at the same time, they would employed more workers who spend more, increasing demand and increasing profits for firms
What is fiscal, monetary policy and the government budget?
Fiscal policy: policies setting the levels of taxes, transfers and government spending, it may be used to stabilise the economy by changing AD
Monetary policy: central bank or government actions influencing economy activity by changing interest rates
The government’s budget:
(Spending on goods and services + gov fixed investment + transfers + interest payments) - taxation
If this equation is positive, the budget is in surplus, if it is negative the budget is in deficit.
What are the tools of fiscal and monetary policy?
We assume there are two policymakers; the gov control fiscal policy and central bank control monetary policy
The government’s budget uses changes in spending and government revenues (taxation) to affect AD in 3 ways:
- gov spending on goods and services (ie education), G
- gov investment (ie public infrastructure) is a component of aggregate investment, I
- taxes and transfer payments (benefits, pensions) affect AD indirectly by impacting household disposable income and hence aggregate consumption, C
The central bank change the policy interest rate to steer inflation towards the gov’s inflation target.
What is the difference between the nominal and real interest rate?
Nominal: interest rate that is not corrected for inflation. This includes the policy rate and market rates.
Real: interest rate corrected for expected inflation
