EC 140 Notes, Wilfrid Laurier Univeristy PDF

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EC 140 - MacroeconomicsMidterm 1 – Sat Jan 27 @ 7:00PM Use review quizzes and practice midterm Midterm 2 – Sat March 10 @ 7:00PMFinal – April 16, 7pm – focus on connections between chapters Part A – 60 questions in chapter order o 15 questions form part A o 20 questions from part B o 25 questions fr...

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EC 140 - Macroeconomics

Midterm 1 – Sat Jan 27 @ 7:00PM -

Use review quizzes and practice midterm

Midterm 2 – Sat March 10 @ 7:00PM Final – April 16, 7pm – focus on connections between chapters -

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Part A – 60 questions in chapter order o 15 questions form part A o 20 questions from part B o 25 questions from part C Part B – 20 questions from all chapters

Lecture 1 Macroeconomics -

Macro is the study of aggregated economic outcomes such as inflation, unemployment, or economic growth Trends and fluctuations over time and their analysis Less intuitive than EC120 – more practice questions

Economics: the study of how firms make decisions Scarcity -

The limited nature of society’s resources Society: people, the government, etc. If a resource is scarce or limited, the use involves an opportunity cost

Key Learning Objectives -

Core issues of macroeconomics A model that can be used to analyze macroeconomic policy Understand the effects of Canadian policy choices Apply the model to determine how the economy is affected by international events

Policy Issues and Tradeoffs -

Fiscal policy: tax rates, government spending, trade policy Monetary policy: interest rates, inflations, exchange rates Policy involves tradeoff o Importers vs exporters, lenders vs borrowers o Short-run benefits vs long-run benefits

o Unemployment rates vs economic growth Core Features of a Macro Model -

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Encompasses as much economic activity as possible o No model is perfect, need to understand the impact of gaps in the model Accommodates feedback loops – spending decisions affect income, which also affects spending o Macro analyzes general equilibrium concepts o EC120 mostly partial equilibrium (all else equal) Generates useful economic predictions of critical issues (ex: unemployment) Generates economic predictions that correspond to empirical evidence

Elements of an Economic Model -

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Exogenous variables – inputted to the model from outside sources o Variables determined outside of the model o Ex: weather, preferences, (maybe) exports Endogenous variables – calculate within the model o Variables affected by factors within the model o Obviously depends on the model o Ex: income, consumption, inflation Theories and assumptions o Abstraction is necessary to understand economic effects Value of a model is the capacity to predict

Positive and Normative Statements -

Positive: can be judged correct or incorrect Normative: cannot be judged correct or incorrect

Index Numbers -

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Macro focuses on aggregate statistics Calculating index numbers is critical to aggregation o CPI inflation is the rate of change of aggregate consumer prices o GDP deflator is the aggregate producer price Index numbers have two key features: o Comparison to a base year: choice is arbitrary, but important o Weighted average: importance of different prices determined by spending patterns (relative importance)

Economics in a Mathematical Discipline -

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Econ requires math or statistical analysis Math can demonstrate where intuition breaks down Allows for assessment of feedback effects Graphs can allow us to visualize complicated problems

Lecture 2 -

Macroeconomic issues are about either long-run trends or short-run fluctuations; government policy is relevant to both

Measuring Output and Income -

Production of goods and services generates income GDP: C+I+G+(x-m) o Consumption + investment + gov’t spending + (exports – imports) Nominal national income – calculated in current dollars o Total production of goods and services values at market prices Real national income – indexed from a base year o Measures total output, weighted by base period price Real GDP – adjusted for inflation (changes in prices from a base year) “Real” = adjusted for inflation from a base year, change in “value” “Nominal” = not accounting for inflation, measuring in current $

Potential GDP vs Actual GDP -

production possibilities frontier relationship (normally not optimally) o what we are producing vs what we normally “should” be producing Actual GDP – how much we are actually producing (real or nominal) Potential GDP – if the economy was producing “normally”, what would the GDP be? (real or nominal) Difference between Actual and Potential GDP: Output Gap

Inflationary Gaps and Recessionary Gaps -

If the economy is producing more than if it were normal, (actual > potential), that is an inflationary gap If the economy is producing less than if it were normal (potential > actual), that is a recessionary gap More production than expected typically leads to inflation Less production than expected typically leads to recession Tend to be cyclical – inflationary gaps are followed by recessionary gaps and vice versa

Terminology of Business Cycles – always done in retrospect -

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Actual GDP vs Potential GDP: Output Gap Recession and recovery (expansion): ups and downs in Actual GDP o Recession: actual falling relative to potential GDP o Recovery: actual rising towards potential GDP Peak and trough: top and bottom of business cycle o Top of the curve of actual GDP: peak

o Bottom of the curve of actual GDP: trough

Recessions vs Recessionary Gap -

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Recessions area extended periods of weak economic activity o Sometimes define as consecutive quarters (3+3 months) with negative growth in real GDP Recessionary gaps do not imply or require a recession o If real (actual) GDP grows slower than potential GDP, this leads to a recessionary gap, but is not necessarily a recession

Measuring Unemployment -

Unemployment – not employed and actively searching for a job Labour force – number employed + number unemployed o Anyone over 15 who is working or actively looking for work Unemployment rate – number of people unemployed divided by the number of people in the labour force Employment rate – employed people / (everyone over 15 – participation) People not looking for work are not in either number – participation rate

Types of Unemployment -

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Frictional unemployment: natural period of time looking for a job o Finding work is not instant; normal period for job hunting o Can be too high or too low – taking too much time or too little time to find a new job are both bad signs for the economy Structural unemployment: workers don’t have skills needed o Normal amount that is to be expected – labour requirements change Cyclical unemployment: unemployment due to the business cycle o Firms are reducing production such that actual GDP is less than potential GDP Full employment is when cyclical = zero (actual GDP = potential GDP)

Trends in Unemployment -

Labour force: consistently growing over time Employment: less consistently, but still growing over time o More ups and downs than labour force due to cyclical unemployment When employment falls, real GDP almost always falls as well, and v.v.

Canadian Labour Productivity -

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Labour productivity: real GDP divided by employment or hours worked

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o How much more work impacts growth – how much we get out of labour = productivity Does income rise because of hours worked, or because of productivity growth? Real GDP per worker growing faster than real GDP per hour worked: o Therefore, average number of hours worked has been rising as well o Mainly from women – more women going from part to full time

Price Level and Inflation -

Price level: average level of all prices in the economy o Base year: CPI = 100 Inflation: rate of change of the price level o Derivative of price level – calculus application Anticipated vs unanticipated inflation o Anticipated: when actual inflation = expected inflation  Anticipated inflation is not a problem for the economy o Unanticipated: when actual inflation =/= expected inflation  A problem for the economy, generates people to benefit and lose from it  If you owe money it helps you and v.v.

Calculating CPI – CPI at base year = 100 1. 2. 3. -

Calculate total expenditure in the base year Calculate how much that would cost in the current year Divide (2) by (1), multiply by 100 (convert to index) How much would something cost in today’s prices?

Real and Nominal Interest Rates -

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Nominal interest rate is the rate paid or borrow money (or received when lending money) o Assume that they are the same number for this class o Measured in today’s dollars Real interest rate equals nominal interest rate minus the inflation rate o Calculated, not measured Therefore, gap between the two lines (nominal and real interest) is inflation

Exchange Rates -

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Exchange rate: amount of domestic currency needed to purchase a unit of foreign currency o Note: Canadian media report the USD-CAD exchange rate Depreciation of CAD – costs more to buy USD – CAD-USD exchange rate increases

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Think of it as a ratio – CAD-USD or USD-CAD o CAD-USD = how many CAD one USD is worth o USD-CAD = how many USD one CAD is worth

Imports and Exports – Balance of Trade -

Openness to the international economy = more of both over time o Eventually will reach diminishing returns (Law of DR) Exchange rates connected to net exports

Lecture 3 Measuring GDP -

GDP is the total production in a country If all production was sold and consumed, GDP would be easy to measure Most production process occur in stages Outputs of one company are inputs to another Measuring value of output counts some output more than once Measuring GDP is about measuring final production o Can we eliminate measuring the production of intermediate goods?

Measuring Value Added -

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To avoid double counting – measure value added by all firms Value added is sales revenue – cost of intermediate goods Value added is equal to wages paid to workers plus profits aid to owners Total value added in the economy is a measure of total output Ex: o bakery buys intermediate goods, pays workers, and has profits o value added = total sales – intermediate goods  profit = total sales – wages – intermediate goods  therefore, value added ends up being functionally equal to wages paid + profits taken eliminates double counting by not counting intermediate sales: o a loaf of bread purchased from a grocery store counts as value added for that grocery store, but an intermediate product for the restaurant that bought it o therefore, to eliminate double counting, only the final sale is counted

GDP (cont’d) -

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a measure of total output

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GDP is the total value of final goods and services produced Wide range of approaches to measuring GDP o Value of final goods and services produced  Avoids double counting with minimal effort o Value added by all firms in the economy  Best way, but also the most difficult o Value of expenditure on output  Fastest method of calculating GDP o Income generated by producing that output Production, expenditure, and income are all equal by definition – accounting connection? – GDP by expenditure = GDP by income

Circular Flow Model of Economics

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Result: total spending = total income; critical to macroeconomics

Measuring Expenditures – C+I+G+(x-m) -

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Consumption expenditure – largest portion of economy o Goods and services sold to final users Investment expenditure – buying a hammer is investment, nails are not o Goods not for current consumption

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o Inventory, plant/equipment, housing Government spending – any money the government spends o Current expenditure, government investment Net exports – very small in Canada, potentially negative o Total exports minus total imports o Count both goods and services  Services – harder over time with the Internet

Measuring Income – all the money that comes in -

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Factor payments o Wages and salaries o Interest o Business profits Non-factor payments o Depreciation  Depreciation is subtracted off of profits, but is not “paid”  Therefore, must be added back in to balance equation o Indirect taxes and subsidies (ex: sales tax)  Also taken from profits, therefore added back in to balance

Real and Nominal GDP -

Nominal GDP: output values at current prices o Quantity of Output * Prices Real GDP: output valued in base-year prices o Quantity of Output * Base-Year Prices GDP deflator: ratio number to convert nominal GDP to real GDP Consumer price index: change in price of consumer goods over time

Calculating Real and Nominal GDP -

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Find the quantity produced of each good in the economy Multiply quantities by current prices for nominal GDP Multiply those quantities by prices from the base period for real GDP o Base year is arbitrary, but must be somewhat current for the values to make sense against one another Divide nominal GDP by real GDP and index to calculate the GDP deflator o GDP deflator = (nominal GDP / real GDP in base year) * 100

GDP Deflator vs CPI -

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GDP deflator: rising prices of products that are produced in Canada

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CPI: rising prices of products that are consumed in Canada – inflation o CPI = (current P * base Q) / (base P * base Q) Difference between the two – ex: rising prices of coffee o GDP deflator – coffee is not produced in Canada, not impacted o CPI – coffee is consumed in Canada, impacted

Omissions from GDP -

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Illegal activities – ex: drug dealing Underground (informal) economy – ex: cash payment for window washing Home production – ex: making food at home vs eating out at a restaurant Economic “bad” – externalities o We don’t deduct the effects of negative externalities o We also don’t include the value of positive externalities Partial production – ex: R&D costs before a product is done

GDP and Living Standards -

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Living standards might relate to purchasing power or average/median income Few people would argue that income is a complete measure of living standards GDP per capita is a measure of average income It does not fully reflect a variety of factors that people might value: o Life expectancy o Economic equality o Environmental quality o Education/literacy levels However, correlation between income and these external factors is very strong

Lecture 4 Circular flow model – starting point of the macroeconomic model

Desired Aggregate Expenditure -

GDP measured in expenditure is: C+I+G+(x-m) Autonomous expenditure: does not change when income changes Induced expenditure: changes when income changes o Autonomous vs induced: as income changes, induced changes while autonomous does not

Consumption and Savings

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Households earn income and decided to spend some and save some Consumption and savings are functions of disposable income The consumption function: o People buy consumption goods from disposable income, Y(d) o In a model with no government or tax, Y = Y(d) o What households do not spend on consumption is savings o Consumption: C = a + b * Y(d)  A = autonomous consumption  B * Y(d) = induced consumption  B = marginal propensity to consume (MPC)  Y(d) = disposable income The savings function: o What households do not spend on consumption is savings o Savings may be positive or negative o Savings: S = -a + (1-b) * Y(d)  Same variables as above o Average propensity to save  APS = S / Y(d) o Marginal propensity to save  MPS = delta S / delta Y(d)  MPS is constant is our model

APC vs MPC -

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Average vs marginal propensity to consume o APC = C / Y(d) o MPC = delta C / delta Y(d) APC (normally) decreases as income increases MPC is constant in our model o Equals B in our desired consumption equation (“slope”)

Consumption Function: C = 30 + 0.8Y(d) -

30 = y-intercept = consumption where income is zero (autonomous) 0.8 = slope = MPC (how much of your disposable income are you spending) Y(d) = x = disposable income C = y = consumption 45-degree line: C = Y(d) – slope of one means that all money made is spent

Shifting the Consumption Function -

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Changes in household wealth o Increases in wealth shift the consumption function up  More wealth = more spending, less saving (lottery winners) o Increases in income shift along the consumption function

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Changes in interest rates o A fall in interest rates shifts the consumption function up  If my savings are going to earn $, why save as much Expectations about the future o Optimism about the future shifts the consumption function up  If I will earn more money next year, I can spend more now Shifts vs rotations o Changes often assumed as shifts (no changes in MPC) o If something changes MPC, it rotates the function If consumption shifts up, then savings must fall (inverse functions) o The sum of consumption and savings is disposable income

Investment -

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Investment fluctuates over the business cycle Firms borrow money to purchase equipment, produce output, and sell that output to households for income o Investment: anything firms do that makes it easier to produce in the future Inventory accumulation o Firms may change how much inventory they want to hold  Expectations: If the economy is expected to improve, they might want to hold more inventory Residential construction o Interest rates affect residential construction  Interest up = residential construction down New plant and equipment o Real interest rates determine opportunity cost of investment  Interest up = investment down o Business optimism would affect desired investment

Desired Investment -

For the simplest model, assume desired investment is autonomous expenditure Autonomous does not mean constant Justification of this assumption: o Choice of investment related to long-run factors o Not driven by current income (other factors) o I = I(zero)

The Aggregate Expenditure Function (no savings included, spending only)

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In our simple model: o AE = C + I Given our models of C and I o AE = a + b*Y(d) + I(zero) Or simplifying into autonomous and induced expenditures o AE = (a + I(zero)) + b*Y(d)

Marginal Propensity to Spend -

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Fraction of new income that people spend on domestic output is the marginal propensity to spend, denoted by z o How much of your income you will spend in Canada? In this simple model, marginal propensity to consume equals the marginal propensity to spend o AE = (a + I) + b*Y(d) o AE = A + z*Y Once we add trade/government spending to the model, that won’t be the case

Equilibrium National Income -

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Equilibrium national income occurs where desired aggregate expenditure equals actual national income If AE > Y, then inventories will be falling, putting pressure on firms to increase output and therefore income o If people buy more than produced, firms will produce more If AE < Y, then inventories will be rising, putting pressure on firms to reduce output and therefore income o If people buy less than produced, firms will produce less Defines the model as a demand-determined model – demand changes output
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