Week 8 Introduction to macroeconomics

1. Week 8Introduction to macroeconomics

2. Macroeconomics is ... • the study of the economy as a whole • it deals with broad aggregates • but uses the same style of thinking about economic issues as in microeconomics.

3. Some key issues in macroeconomics • Inflation • the rate of increase of the general price level • Unemployment • a measure of the number of people looking for work, but who are without jobs • Output • real gross national product (GNP) measures total income of an economy • it is closely related to the economy's total output

4. More key issues in macroeconomics • Economic growth • increases in real GNP, an indication of the expansion of the economy’s total output • Macroeconomic policy • a variety of policy measures used by the government to affect the overall performance of the economy

6. Inflation in UK, USA and Germany1960 - 2001

7. Unemploymentin UK, USA and Germany

8. Economic growthin UK, USA and Germany

9. I C + I C S Households Firms Y The circular flow of income, expenditure and output

10. I C + I + G C + I + G - Te C S G Te Households Government Firms B - Td Y + B - Td Y Government in the circular flow

11. Adding the foreign sector • To incorporate the foreign sector into the circular flow • we must recognize that residents of a country will buy imports from abroad • and that domestic firms will sell (export) goods and services abroad.

12. GDP and GNP • Gross domestic product (GDP) • measures the output produced by factors of production located in the domestic economy • Gross national product (GNP) • measures the total income earned by domestic citizens • GNP = GDP + net income from abroad

13. Three measures of national output • Expenditure • the sum of expenditures in the economy • Y = C + I + G + X - Z • Income • the sum of incomes paid for factor services • wages, profits, etc. • Output • the sum of output (value added) produced in the economy

14. What GNP does and does not measure • Some care is needed: • to distinguish between real and nominal measurements • to take account of population changes • to remember that GNP is not a comprehensive measure of everything that contributes to economic welfare

15. Output and aggregate demand

16. Aggregate output in the short run • Potential output • the output the economy would produce if all factors of production were fully employed • Actual output • what is actually produced in a period • which may diverge from the potential level

17. Some simplifying assumptions • Prices and wages are fixed • The actual quantity of total output is demand-determined • this will be a “Keynesian” model • For now, also assume: • no government • no foreign trade • Later chapters relax these assumptions

18. Aggregate demand • Given no government and no international trade, aggregate demand has two components: • Investment • firms’ desired or planned additions to physical capital & inventories • for now, assume this is autonomous • Consumption • households’ demand for goods and services • so, AD = C + I

19. Consumption demand • Households allocate their income between CONSUMPTION and SAVING • Personal Disposable Income • income that households have for spending or saving • income from their supply of factor services (plus transfers less taxes)

20. With zero income, desired consumption is 8 (“autonomous consumption”). The marginal propensity to consume (the slope of the function) is 0.7 – i.e. for each additional £1 of income, 70p is consumed. 8 The consumption function The consumption function shows desired aggregate consumption at each level of aggregate income C = 8 + 0.7 Y Consumption 0 Income

21. The saving function The saving function shows desired saving at each income level. Saving S = -8 + 0.3 Y Since all income is either saved or spent on consumption, the saving function can be derived from the consumption function or vice versa. 0 Income

22. AD = C + I I The AD function is the vertical addition of C and I. (For now I is assumed autonomous.) The aggregate demand schedule Aggregate demand is what households plan to spend on consumption and what firms plan to spend on investment. Aggregate demand C Income

23. E AD Given the AD schedule, equilibriumis thus at E. Equilibrium output 45o line The 45o line shows the points at which desired spending equals output or income. Desired spending This the point at which planned spending equals actual output and income. Output, Income

24. AD1 a fall in aggregate demand to AD1 Leads the economy to a new equilibrium at Y1. Y1 Effects of a fall in aggregate demand 45o line Suppose the economy starts in equilibrium at Y0. AD0 Desired spending Y0 Output, Income Notice that the change in equilibrium output is larger than the original change in AD.

25. The multiplier • The multiplier is the ratio of the change in equilibrium output to the change in autonomous spending that causes the change in output. • The larger the marginal propensity to consume, the larger is the multiplier. • The higher is the marginal propensity to save, the more of each extra unit of income “leaks” out of the circular flow.

26. Fiscal policy and foreign trade

27. Some key terms • Fiscal policy • the government’s decisions about spending and taxes • Stabilization policy • government actions to try to keep output close to its potential level • Budget deficit • the excess of government outlays over government receipts • National debt • the stock of outstanding government debt

28. Government in the income-expenditure model • Y=C+I+G (assumption: no foreign trade) • Direct taxes • affect the slope of the consumption function • and hence the slope of the AD schedule. • Government expenditure affects the position of the AD schedule

29. This seems to suggest that the government could influence aggregate output in the economy by raising AD from AD0 to AD1, AD1 thus raising equilibrium output from Y0 to Y1. Y1 Fiscal policy? 45o line Aggregate demand AD0 But this ignores some important issues – prices, interest rates, and the need to fund the government spending. Y0 Income, output

30. If government spending is independent of income NT Balanced budget but net taxes depend on income, then the budget will be in deficit at low levels of income G but in surplus at high levels Y0 The balanced budget multiplier states that an increase in government spending plus an equal increase in taxes leads to higher equilibrium output. The government budget The budget deficit equals total government spending minus total tax revenue. G, NT Income, output

31. Foreign tradeand income determination • Introducing exports (X) & imports (Z) • TRADE BALANCE • the value of net exports (X - Z) • TRADE DEFICIT • when imports exceed exports • TRADE SURPLUS • when exports exceed imports • Equilibrium is now where • Y = C + I + G + X - Z

32. Imports Assume that exports are independent of income, but that imports increase with income Exports At relatively low income, exports exceed imports – there is a trade surplus. Y* At higher income levels, there is a trade deficit. There is trade balance at income Y*, but there is no guarantee that this corresponds to full employment. Exports, imports and the trade balance X, Z Income

33. Foreign trade and the multiplier • The marginal propensity to import • is the fraction of additional income that domestic residents wish to spend on additional imports. • The effect of foreign trade is to reduce the size of the multiplier • the higher the value of the marginal propensity to import, the lower the value of the multiplier.