ECO 120- Macroeconomics

1. ECO 120- Macroeconomics Weekend School #1 21st April 2007 Lecturer: Rod Duncan Previous version of notes: PK Basu

2. Topics for discussion • Module 1- macroeconomic variables • Module 2- basic macroeconomic models • Module 3- savings and investment • What will not be discussed • Answers to Assignment #1 (use the CSU forum for this)

3. Microeconomics- the study of individual decision-making “Should I go to college or find a job?” “Should I rob this bank?” “Why are there so many brands of margarine?” Macroeconomics- the study of the behaviour of large-scale economic variables “What determines output in an economy?” “What happens when the interest rate rises?” Forms of economics

4. Economics as story-telling • In a story, we have X happens, then Y happens, then Z happens. • In an economic story or model, we have X happens which causes Y to happen which causes Z to happen. • There is still a sequence and a flow of events, but the causation is stricter in the economic story-telling.

5. Kobe, the naughty dog

6. Modelling Kobe • Kobe likes to unmake the bed. • Kobe likes treats. • We assume that more treats will lead to fewer unmade beds. (Not a very good) Model: Treats↑ → Unmaking the bed↓ • We can use this model to explain the past or to predict the future.

7. Elements of a good story • All stories have three parts • Beginning- description of how things are initially- the initial equilibrium. • Middle- we have a shock to the system, and we have some process to get us to a new equilibrium. • End- description of how things are at the new final equilibrium- the story stops. • “Equilibrium”- a system at rest.

8. Timeframes in economics • In economics we also talk in terms of three timeframes: • “short run”- the period just after a shock has occurred where a temporary equilibrium holds. • “medium run”- the period during which some process is pushing the economy to a new long run equilibrium. • “long run”- the economy is now in a permanent equilibrium and stays there until a new shock occurs. • You have to have a solid understanding of the equilibrium and the dynamic process of a model.

9. What are the big questions? • What drives people to study macroeconomics? They want solutions to problems such as: • Can we avoid fluctuations in the economy? • Why do we have inflation? • Can we lower the unemployment rate? • How can we manage interest rates? • Is the foreign trade deficit a problem? • [How can we make the economy grow faster?] Not taken up in this class. This class focuses on short-run problems.

10. Economic output • Gross domestic product- The total market value of all final goods and services produced in a period (usually the year). • “Market value”- so we use the prices in markets to value things • “Final”- we only value goods in their final form (so we don’t count sales of milk to cheese-makers) • “Goods and services”- both count as output

11. Measuring GDP • Are we 40 times (655/16) better off than our grandparents? • Australian GDP in 1960- $15.6 billion • Australian GDP in 2000- $655.6 billion • What are we forgetting to adjust for?

12. Measuring GDP • Population- Australia’s population was 10 million in 1960 and 19 million in 2000. • GDP per person in 1960 = $15.6 bn / 10m = $1,560 • GDP per person in 2000 = $655.6 bn / 19m = $34,500 • Prices- $1,000 in 1960 bought a better life-style than $1,000 in 2000.

13. Nominal versus real GDP • So how to correct for rising prices over time? • Measure average prices over time (GDP deflator, Consumer Price Index, Producer Price Index, etc) • Deflate nominal GDP by the average level of prices to find real GDP Real GDP = Nominal GDP / GDP Deflator

14. Nominal versus real GDP • We use prices to value output in calculating GDP, but prices change all the time. And over time, the average level of prices generally has risen (inflation). • Nominal GDP: value of output at current prices • Real GDP: value of output at some fixed set of prices

15. Some Australian economic history

16. Business cycle • The economy goes through fluctuations over time. This movement over time is called the “business cycle”. • Recession: The time over which the economy is shrinking or growing slower than trend • Recovery: The time over which the economy is growing more quickly than trend • Peak: A temporary maximum in economic activity • Trough: A temporary minimum in economic activity.

17. Australian business cycle

18. Unemployment • To be officially counted as “unemployed”, you must: • Not currently have a job; and • Be actively looking for a job • “Labour force”- the number of people employed plus those unemployed • “Unemployment rate” • (Number of unemployed)/(Labour force)

19. Unemployment • Working age population = Labour force + Not in labour force • Labour force = Employed + Unemployed

20. Unemployment

21. Inflation • Inflation is the rate of growth of the average price level over time. • But how do we arrive at an “average price level”? • The Consumer Price Index surveys consumers and derives an average level of prices based on the importance of goods for consumers, ie. a change in the price of housing matters a lot, but a change in the price of Tim Tams does not.

22. Consumer Price Index • Then the CPI expresses average prices each year relative to a reference year, which is a CPI of 100. CPIt = (Average prices in year t)/(Average prices in reference year) x 100 • Inflation can then be measured as the growth in CPI from the year before: • Inflationt = (CPIt – CPIt-1) / CPIt-1

23. Inflation

24. Calculating GDP • Gross domestic product- The total market value of all final goods and services produced in a period (usually the year). • Alternates methods of calculating GDP • Income approach: add up the incomes of all members of the economy • Value-added approach: add up the value added to goods at each stage of production • Expenditure approach: add up the total spent by all members of the economy • The expenditure approach forms the basis of the AD-AS model.

25. Expenditure approach • GDP is calculated as the sum of: • Consumption expenditure by households (C) • Investment expenditures by businesses (I) • Government purchases of goods and services (G) • Net spending on exports (Exports – Imports) (NX) Aggregate Expenditure: AE = C + I + G + NX

26. Consumption and savings • We assume consumption (C) depends on household’s disposable income: • Disposable income YD = (Income – Taxes) • The consumption function shows how C changes as YD changes. • Household savings (S) is the remainder of disposable income after consumption. • The savings function shows how S changes as YD changes.

27. Properties of a consumption function • What assumptions are we going to make about aggregate consumption of goods and services in an economy? • An aggregate consumption function is simply adding up all consumption functions of all individuals in society. • If personal income is 0, people consume a positive amount, through using up savings, borrowing from others, etc, so C(0) should be greater than 0. • As personal income rises, people spend more, so the slope of C(Y) should be positive.

28. Consumption function • Consumption is a function of YD or C = C(YD). We assume that this relationship takes a linear (straight-line) form C = a + b YD where a is C when YD is zero and b is the proportion of each new dollar of YD that is consumed. • We assume that C is increasing in YD, so 0 < b < 1.

29. A linear consumption function • C(Y) = a + b Y, a > 0 and b > 0 C(Y) C(0) = a, so even if Y=0, C > 0. Slope is b > 0, so C is increasing in Y. a Y

30. Graphing a function in Excel • This subject use a lot of “quantitative data” (which means lists of numbers measuring things). • Students will need to develop their quantitative skills- • Graphing data • Using data to support an argument • Modelling in Excel • We will be using Excel during this subject. You must become familiar with Excel.

31. Savings function • Household savings is a function of YD or S = S(YD). We assume S = c + d YD where c is S when YD is zero and d is the proportion of each new dollar of YD that is saved. • We assume that S is increasing in YD, so 0 < d < 1. • But also households must either consume or save their income, so C + S = YD. This can only be true if c = -a and b +d = 1.

32. More terms • Average Propensity to Consume (APC) is consumption as a fraction of YD: APC = C / YD • Average Propensity to Save (APS) is savings as a fraction of YD: APS = S / YD • Since all disposable income is either consumed or saved, we have: APC + APS = 1

33. More terms • Marginal Propensity to Consume (MPC) is the change in consumption as YD changes: MPC = (Change in C) / (Change in YD) • Marginal Propensity to Save (APS) is the change in savings as YD changes: MPS = (Change in S) / (Change in YD) • For our linear consumption and savings functions, MPC = b and MPS = d. If YD changes, then consumption and savings must change to use up all the change in YD , so MPC + MPS = 1.

34. Graphing the functions • When YD = 0, C + S = 0, so at point A, the intercept terms are both just below 2 and of opposite sign. • The 45 degree line in the top graph shows the level of YD. At point D, C is equal to YD, so S = 0. • MPC = 0.75 is the slope of the C function. • MPS = 0.25 is the slope of the S function.

35. What else determines C? • Household consumption will also depend on: • Household wealth • Average price level of goods and services • Expectations about the future • Changes in these factors will produce a shift of the whole C and S functions.

36. Shifts of C and S functions • A rise in household wealth will increase C for every level of YD, so C shifts up. • A rise in average prices will lower the real wealth of households and so lower C for every level of YD, so C shifts down.

37. Example: Alice and Sam • Question: Alice and Sam are a typical two-income couple who live for ballroom dancing. Their combined salaries come to $1,400 per week after tax. They spend: • $300 per week on rent, • $300 per week on car payments, • $200 per week on ballroom dancing functions and • $200 per week on everything else. • (a) Calculate their APC, APS, MPC and MPS.

38. Example: Alice and Sam • Sam injures his back and is forced to take a lighter work-load, so their combined incomes drop to $1,000 per week. Due to the back injury, Alice and Sam are forced to stop their ballroom dancing, however their spending in the ‘everything else’ category rises to $300. • (b) Calculate their APC, APS, MPC and MPS. Create graphs to show this information.

39. Consumption function • The consumption function relates the level of private household consumption of goods and services (C) to the level of aggregate income (Y). • We can represent the consumption function in three different and equivalent ways. • An mathematical equation • A graph • A table • For example the consumption function could be: • C = $100bn + 0.5Y

40. Consumption function • We can represent this same function with a graph. C C(Y) = $100bn + 0.5Y $150bn Slope is 0.5 $100bn The MPC is 0.5 Y $100bn

41. Consumption function • Or we can represent the same function with a table. • Three ways of represent-ing the same function.

42. Exogenous variables • Exogenous variables are variables in a model that are determined “outside” the model itself, so they appear as constants. • For the aggregate expenditure model, we treat as exogenous: • Investment (I) • Government consumption (G) • Taxes (T) • Net Exports (NX)

43. Aggregate expenditure • In a closed (no foreign trade) economy: AE = C(Y) + I + G • In an open economy: AE = C(Y) + I + G + NX • Changes in a or the exogenous variables (I, G, T or NX) will shift the AE curve. A change in b will tilt the AE curve. • Equilibrium occurs when goods supply, Y, is equal to goods demand, AE.

44. Two sector model • Aggregate expenditure (AE) in the two sector model is composed of consumption (C) and investment (I). AE = C + I • In this model, we treat I as exogenous, so it is a constant. • Let’s use the same simple linear consumption function: C = 100 + 0.5Y I = 100 AE = C + I = 100 + 0.5Y + 100 = 200 + 0.5Y

45. Aggregate expenditure function • This equation is a relationship between income (Y) and aggregate expenditure (AE). AE = 200 + 0.5Y $250bn Slope is 0.5 $200bn Y $100bn

46. Aggregate expenditure function • But we could also use the table form.

47. Equilibrium in two sector model • Equilibrium in a model is a situation of “balance”. In our AE model, equilibrium requires that demand for goods (AE) is equal to supply of goods (Y). Y = AE = C + I • For the equilibrium we are looking for the value of GDP, Y*, such that goods demand and goods supply are equal. • In our two sector AE model that means that we can look up our AE table and find where AE = Y. • The equilibrium value of Y will be our prediction of GDP for our AE model.

48. Equilibrium • The equilibrium value of GDP is $400bn.

49. Equilibrium • We could accomplish the same by using our graph of the AE function. • The AE line shows us the level of goods demand for each value of Y. • The 45 degree line represents the value of Y or supply of goods. • Equilibrium will occur when the 45 degree line and the AE line cross. At the crossing, goods demand is equal to goods supply for that level of Y.

50. Equilibrium • The equilibrium value of Y is where the 45 degree line and the AE line cross. Y* is at $400bn. Y AE = 200 + 0.5Y 400 Y 400