A Review of the Basics

1. A Review of the Basics

2. Learning Objectives • Understand the concept of the National Income Identities • Understand the definition of Unemployment • Understand the definition of a price index • Understand the concept of Economic equilibrium and how it is influenced by expectations

3. 1. NIE Identities • Review GDP defn in Mankiw 2.1 • Before we get into models of economic behaviour we need to look some definitions and some issues in measurement • Measurement economic quantities may seem boring… • But it can give crucial insight even without a model of behaviour • Example: the current crisis

4. NIE Identity • We measure macroeconomic activity primarily by looking at annual (or quarterly) flows of Output (O), Income (Y) and Expenditure (E). • These are different ways of measuring the same thing, so they sum to identical totals • Basic Identity: Y  O  E • Think of why this is the case • Income and Product are identical: Product is Value-Added in Production, i.e sales minus purchases from other firms, which = payment of incomes to Factors (Wages, Interest…) • Expenditure equals Income, because any production not sold is counted as Inventory Investment, and is thus part of Expenditure (the firm purchases its own output from itself) • Note this is an identity not an equilibrium condition • An identity holds for all values • An eqm condition holds only for some values i.e. in eqm • Distinction important later

5. NIE: GDP vs GNP • Open economy: GNP v GDP • GNP  GDP + NFIA • (NFIA is net factor incfrom R.O.W., i.e. inflows minus outflows) • GNY  GNP + EUtrasfers – EUtaxes • GNDY  GNP + NTA (NTA is all net Transfers from R.O.W. incl EU) • GDP + NFIA + NTA  GNDY • Note: Irish GNP was approx 85% of GDP (2007) • For many other countries the distinction is not relevant • Can lead to lots of debate of which is best measure in Ireland

6. NIE: SAVINGS & INVESTMENT IDENTITY • The Income Identity • Y  C + S + T • Accounting rule: Income is either spent, saved or taxed • The Expenditure Identity • E= C + I + G + NX • Accounting rule: add up the components of expenditure • Combine the two • C + I + G + NX  C + S + T • Thus: (G – T)  (S – I) – NX • or: (G – T) + NX  (S – I) etc. • clearly, adding in net foreign factor and transfer income, including them in the totals for T and S etc as appropriate, and changing signs we get: • (T - G) + (S - I)  NX  BOP Current A/C • Note: the 2 left hand expressions are National Savings

7. NIE: SAVINGS & INVESTMENT IDENTITY • This is often known as the twin deficits identity • Even though it doesn’t involve any model or description of economic behaviour it can be informative • Implication: a current account surplus can only occur if there is an excess of national savings • Application 1: The US • The US has trade deficit (esp with China) • This is inescapable given it has insufficient savings • China surplus equates to surplus Chinese savings • Application 2: Ireland’s Bubble • We had a bubble (high investment) • Insufficient savings • So high current account deficit

9. 2. Unemployment • See Mankiw 2.3 • The labour force (L) = employed (E) + unemployed (U) • The unemployment rate u% = U/L or U/(E + U) • Letting the population of Labour-force Age = P, we also have: • The Labour force participation rate: LFPR% = L/P • Measuring Employment and Unemployment • Surveys: household QNHS in Ireland, quarterly household survey (CPS in USA); business surveys for employment. • Administrative: “Live Register” (Ireland); related to benefit claimants

10. Unemployment • The precise details of how surveys and other measures are constructed will differ from country to country. Survey methods are generally more comparable. • Key Issue: have to “want” to work to be unemployed as distinct from not working • Surveys try to capture this: “active search” • Issue of how active • Discouraged worker effects • There is a difference between what economists’ defn of U and rest of society • Claimant counts do not – may include people NILF

11. 3. Prices • Mankiw 2.2 • Some components of GDP have well-known measures of inflation: the CPI for household consumption • For a more comprehensive measure the implicit price deflator for GDP is used: this relates to all items in the GDP • A price index is a weighted average measure of price changes • Two questions arise: (i) what is included (ii) what kind of weighting system to use • For Consumption the Irish CPI includes a measure of housing costs, the Eurozone HIPC does not (why?) • Generally if an index uses base-year weights (Laspeyre), the resulting inflation is higher than if current year weights are used (Paasche) • CPI is Laspeyre

12. LaspeyrevsPasche • A Laspeyre index of prices uses the quantities prevailing in some base (e.g. survey) year to weight prices. The index takes the form: • (p1q0/ p0q0)x100 • Note: base-year quantities (q0) are used to compare prices in the two years (p1 and p0 ) • A Paasche index of prices uses the quantities prevailing in the terminal year to weight prices. The index takes the form: • (p1q1/ p0q1)x100 • Note: current-year quantities (q1) are used to compare prices in the two years (p1 and p0) • As relatively cheaper are substituted for dearer goods, the Laspeyre index of prices has an upward substitution bias. • So CPI inflation is biased upwards

13. 4. Equilibrium • Key concept in economics • illustrate with the simplest possible macro model • Mankiw 11 • Equilibrium is a point of balance or stability • Specifically in economics it is a point where economic agents’ plans are mutually consistent and therefore are realised • Disequilibrium • plans are inconsistent • then someone’s plans are not realised • Somebody is disappointed • Behaviour will change • The economy will change • so not stable or balanced

14. MACROECONOMIC EQUILIBRIUM • First, Output (which equals Income) is a function of inputs: for simplicity, Capital (K) and Labour (L) Y = f(K, L) • This is the amount firms planto spend • There will also be Aggregate Demand or Planned Expenditure (PE) • the amount of Expenditure which agents plan to make • Agents: Households, firms, the Government and foreigners • In equilibrium plans are consistent Y = PE • Later we will see that sometimes Output or Income do not equal planned expenditure: this corresponds to a disequilibrium • The general idea is that in equilibrium the forces acting on some variable (Y) are balanced and hence Y will not change.

15. Planned Expenditure • Conventionally we look at separate components of aggregate (planned) expenditure: C, I, G, NX. This is because they behave differently. • Crucially C (Consumption) depends partly on Income: so part of Expenditure depends on Income: hence the term Induced (Consumption) Expenditure • Other components of Expenditure are Autonomous: this should be understood as depending on something other than Income. • We have • an Autonomous component of Consumption (Ca) • Investment (I) • Government purchases (G) • Foreign demand (NX)

16. Consumption Function • An equation that describes consumption plans • Very Generally, Consumption depends on Disposable Income (Y minus net taxes, T). • More specifically: C = Ca + c(Y – T) • the “Autonomous” and “Induced” elements are on the right-hand side. • For simplicity Mankiw leaves out Ca • The coefficient c (The Marginal Propensity to Consume) is > 0 and < 1, implying that for any given increase or decrease in disposable income C will change in the same direction, but by a lesser amount. • i.e. 0 < dC/d(Y – T) = c < 1 • This is a model of consumption insofar as it is a simplified representation of how people make their consumption plans • It doesn’t say that plans will be successful • It is very simple (even simplistic): no interest rates, future income, life cycle

17. THE CONSUMPTION FUNCTION (2) • Note: Ca is “Autonomous” consumption; C/Y (APC) falls as Y increases; c (MPC) is < APC. C 45 (C = Y) Ca + c(Y – T) Slope = c Ca 0 (Y-T )

18. Equilibrium • As always equilibrium is where plans are consistent • Specifically in this case planned production is equal to planed demand Y = PE, • Sub in equation for planned expenditure (“Aggregate Demand”) PE = C + I + G + NX • To get Y = C + I + G + NX • Sub in consumption function • To get: Y= Ca + cY – cT + Ip + G + NX • Note • cYis the one part of Expenditure which depends on Income • The other components (Ca –cT + I + G + NX) may be termed autonomous planned spending, in that they do not depend in Income (at least for now…) • Alternatively we might term them the Endogenous and Exogenous components of planned spending.

19. Eqm. VsIdenitity • We have an accounting identity: Y = C + I + G + NX • This different from the equilibrium condition • The equilibrium condition describes planned magnitudes • These plans may or may not be realised • The identity describes what actually happens • This may or may not have been what was planned • Thus the equilibrium condition is true only for certain values of the variables • The identity is true always • Best thought of as an account rule

20. DISEQUILIBRIUM • To illustrate the concept of equilibrium consider a numerical example • Suppose we have Ca = 50, c = 0.8, T = 150, I = 40, G = 150, NX = 60 • Suppose we have Y = 600 • Is Income at equilibrium? • Calculate Planned expenditure (Aggregate Demand) • PE = Ca + c(Y – T) + I + G + NX • = 50 + 0.8(450) + 40 + 150 + 60 • 300 + 360 = 660 • So Planned Production (Y) < Planned Expenditure (PE) • Somebody’s plans will not be realised • Production is not sufficient to meet demand

21. Disequilibrium • Plans must be updated • How? • We will assume that production will be increased to meet demand • Note we assume prices don’t change • Will provide empirical evidence later • Note this is a key assumption • We will spend much of the course looking at how plans are updated • This will depend on expectations and timeframe (LO 3) • In this simple model we assumes that plans cannot be updated by changing prices • This turns out to be valid in the short term but not in the long term

22. EQUILIBRIUM • What is Equilibrium Y in this case? • We could try by trial and error • Or we could solve the equations • By definition equilibrium is where planned production equals planned expenditure: Y = PE Y = Ca + c(Y – T) + I + G + NX Y – cY = Ca – cT + I + G + NX Y(1-c) = Ca – cT + I + G + NX Y(1 – c) = PA • Where PA = Autonomous planned spending = Ca – cT + I + G + NX • Plug in numbers • Y = PA/(1 –c) = (50-120+40+150+60)/(0.2) = 180/0.2 = 900 • One can re-check by plugging in all the components of PE when Y = 900 and getting PE = 900, i.e. equilibrium

23. EQUILIBRIUM • This can all be illustrated graphically • When PE > Y, Y < Ye hence Y rises: similarly when PE < Y….. Ep 45 (PE = Y) PE = PA + c(Y – T) Ap 0 Y Ye

24. Comment • The process is self sustaining • If we are not at equilibrium there is an automatic adjustment process that will bring us into equilibrium • If this were not the case no point in studying eqm • If not at eqm we are heading there • We assume for the moment that the adjustment process works by producers changing out put to meet demand • We also assume that prices don't change • Seems counter intuitive • This model effectively assumes that prices are fixed • We will • provide empirical evidence alter that this is approximately true in the short run • and spend much of the rest of the course discussing when and how it isnt true

25. A CHANGE IN AGGREGATE SPENDING (1) • Suppose Ip and therefore PA fall by 40, Ye1 falls to Ye2 by a multiple of 40 (Ye > PA) Ep 45 (PE = Y) PE1= PA1+ c(Y – T) PE2= PA2+ c(Y – T) PA1 PA2 0 Y Ye2 Ye1

26. A CHANGE IN AGGREGATE SPENDING (2) • Initial Equilibrium is: Y1 = PA1+ c(Y1 – T) • Following Shock to PA: Y2 = PA2+ c(Y2 – T) • Subtracting: Y2 – Y1 = PA2 – PA1+ c(Y2 – Y1) • i.e. Y =PA + c Y • so Y(1 – c) = PA • And thus: Y/PA = 1/(1 – c) or 1/s • So if c = 0.8, s = 0.2, multiplier = 5: etc…. • Intuitively: an increase in PA (say G) is spent: it becomes income to someone who re-spends c times the increase, etc… • Y = G(1 + c + c2 + c3 + ….. + cn) •  cY = G(c  c2  c3 + ….. + cn+1) then adding • And Y(1  c) =G(1) (the other terms cancel) • So Y/G = 1/(1-c) • You should have seen this before . If note review it in your fits year book or in Mankiw

27. CHANGES IN SAVINGS, TAXES • In the previous example, an increase in G of 100 produced an increase of 500 in Y. • As T is given this means that (Y – T) increased by 500, and C increased by c.Y so savings increased by s.Y = 100 • Financing the increased G by selling Bonds to Savers?? • Now what happens if T were reduced by 100 instead of increasing G? • Initial Equilibrium is: Y1 = PA + c(Y1 – T1) • Following cut in T: Y2 = PA + c(Y2 – T2) • i.e. Y =c.Y– c.T • So Y(1 – c) = – c.T •  Y/ T = – c/(1 – c) • Thus if c = 0.2, –c/(1 – c) = – 0.8/0.2 = – 4. • Note sign, magnitude (intuition of this)

28. Conclusions • Understand the concept of the National Income Identities • Accounting rule so true by definition for all values • Understand the definition of Unemployment • NILF vs U • Understand the definition of a price index • CPI inflation biased upwards • Understand the concept of Economic equilibrium and how it is influenced by expectations • Plans are consistent • What adjusts when plans are not consistent?

29. What’s Next? • We will spend the rest of the course expanding on L.O. 4 • We will add more detailed accounts of how plans are formed • Progressively more complicated models • We will also carefully consider what adjusts when plans are inconsistent • Next topic provides more detail on how consumption and investment plans are made specifically we take into account interest rates.