EC413 - Macroeconomics Lecutres 7-10 PDF

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The purpose of macroeconomic models is to describe the functioning of the economy.
Since it is impossible to represent the functioning of an economy as a whole, taking into account the specificities of each individual and each good, macroeconomics uses a reference framework that allows for the...

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MACROECONOMY (lectures 7-10)

BOOK COURSE Md = (PY).L(i) with PY the nominal R, L(i) is a function of the interest rate. "The demand for money is equal to nominal income multiplied by a function of the interest rate L(i). » -

If i increases, the demand for money decreases (we place, investments and/or investments) For a given level of nominal R, a lower i increases the demand for money ; For a given level of i, an increase in PY (R nom) increases the demand for money.

ABOUT THE GDP GDP, three definitions : -

Sum of the value added created in the economy during a given period The sum of the income distributed in the economy during a given period Value (in euros, dollars, etc.) of final goods & services produced in the economy during a given period.

Nominal GDP = ratio at current price, sum of the quantities of final goods & services produced, multiplied by their current price. Real GDP = ratio at a constant price, sum of the quantities of final goods & services produced multiplied by a constant price. In National Accounting, about the : -

REAL GDP is said to be in constant euros, or GDP in terms of goods, GDP adjusted for inflation, GDP at the price of year N. Nominal GDP is said to be in current euros.

Recession èat least two (consecutive) quarters of negative growth. GDP growth rate, year t : (Yt - Yt-1) / Yt-1

Inflation rate: the rate of increase in the price level, i.e. the proportion by which prices rise over time, using the GDP deflator and the consumer price index. GDP deflator (year t), Pt : Pt = nominal GDP (in t) / real GDP (in t) Inflation rate (è Pt - Pt-1) / Pt . We have the equation: Nominal GDP = Real GDP x Pt : Nominal GDP is equal to Real GDP x GDP deflator. The CPI or Consumer Price Index, gives the price of a basket of goods determined over time (average consumer basket of an urban consumer).

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These two indices rarely vary by more than 1% per year; moreover, they often vary together. GDP deflator refers to goods produced in the economy, CPI to goods consumed in the economy. Consumption C: the most important component of GDP (57.1% of GDP in 2008 in UK) Investment I: by businesses + individuals (21.9% in 2008) Government expenditure G : purchase of goods & services by the government. does NOT include transfer expenditure from the government (social insurance) nor interest on the debt (therefore only 23.2% of GDP, against more than 50% if they were included). Exports - imports, X-M: trade balance surplus or deficit, net exports. Inventory change, IS: accumulation of stocks not yet sold. GDP: Y = C + I + G + (X - M) i.e. GDP is the sum of final purchases, consumption, investment, government expenditure and trade balance. PRODUCTION FUNCTION: Y = F(K, N) K the Capital, N the Labor; depends on the state of the technology. Returns to scale are decreasing (of K, N). Growth increases over time, is a product of capital accumulation and technical progress. General theory of employment, interest and money: 1936 (Keynes) then 1937 (Hicks) IS/LM model that studies the correlation between financial and goods markets.

CHAPTER 1: A FRAME OF REFERENCE The purpose of macroeconomic models is to describe the functioning of the economy. Since it is impossible to represent the functioning of an economy as a whole, taking into account the specificities of each individual and each good, macroeconomics uses a reference framework that allows for the classification of agents and goods into broad categories: this is national accounting. Theoretical macroeconomic models generally adopt a simplified accounting framework, inspired by national accounting, their objective being to provide a description of the economy that is conducive to macroeconomic analysis, i.e. the study of the effects of shocks that may affect the equilibrium of the economy.

1/ Description of the economy We distinguish four types of agents: - household company State rest of the world.

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We distinguish 5 types of markets: - the market for goods and services the market for labor the market for securities (supply of loanable funds) - the market for national currency - the market for foreign exchange

We place ourselves in a closed economy, so we do not (yet) study the interactions between the country and the rest of the world, and therefore not the foreign exchange market. Prices are expressed in national currency, so the model uses three prices: - P the price of goods and services- W the nominal wage- R the nominal interest rate All goods are treated as a single good (investment, consumption or public good); similarly, there is only one type of work (homogeneous), and only one type of security. All households will be assumed to behave as a single (representative) household. The set of firms will be assumed to behave as a single (representative) firm.

2/ Budget constraints Each category of agent can carry out certain buying and selling operations, and each agent is confronted with a budget constraint that indicates that for a given period the sum of an agent's expenditures must be equal to the sum of his or her resources (which may consist of loan(s)). 2.1 / The company's account NB: company will sometimes be abbreviated by ets Firms produce "the" good in quantity Y, whose price is P; they can issue securities to finance their expenditures. They pay interest and dividends to the holders of these securities (households), and wages to the workers. In addition, they invest: we note PI the amount of their investment. CF : F2 manuscript course -> A Firms distribute their production in wages, interests, dividends, and keep part of it for self-financing. Here, we assume that self-financing is zero. Cf : course manuscript F2 -> A'. The investment is fully financed by borrowing, i.e. by the issuance of new shares by the company. 2.2/ The household account

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Households consume a quantity C of goods. They receive the full value of production, in the form of interest and dividends, assuming that self-financing is zero. They have this income at their disposal to pay their taxes, to pay their consumption expenditure, and to save. Cf : course manuscript F2 -> A''

2.3/ The government account The state buys a quantity G of public goods, financed by taxes, the issuance of public securities, and the issuance of money. Cf : course manuscript F2 -> B The budget deficit (G-T) can be financed by issuing government securities, or by issuing money.

3/ Agents' behaviors The accounting framework has made it possible to present the transactions carried out by the various economic agents; since the aim of macroeconomics is to explain or even predict the amounts of the various transactions just described, it is therefore necessary to explain the agents' behavior. 3.1/ The consumption function It is assumed to depend on disposable income Y-T: C = C(Y-T) The marginal propensity to consume is assumed to be between 0 and 1: 0 < C'(Y-T) = dC/d(Y-T) < 1It indicates how much consumption varies when disposable income varies. Keynes: marginal propensity to consume between 0 and 1. Cf : course manuscript F2 -> B'. Form: C = Co + C1 (Y-T) This (Keynesian) form was the subject of much criticism that it could affect consumption. In fact, the initial real wealth plays a role (the greater it is, the more likely one is to consume), àwhich refers to Modigliani's "life cycle". This refers to the theory of permanent income (Friedman). The expected real interest rate also influences consumption: if this rate increases, agents will be encouraged to postpone consumption from today to tomorrow. A consumption function more adapted to reality would be: C = C (Y-T, (M0+B0) / P, Ya ) 3.2/ The investment function It is assumed to depend on the expected inflation rate: I = I (R-PI)

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I' < 0 Cf : course manuscript F2 -> B'' I' is negative because: -first explanation: (R-PI) represents the cost associated with the investment, i.e. the cost of borrowing. second explanation: when the firm decides to invest X euros in an investment project, it commits financial capital that it could place on the securities market, thus earning X x (R-PI), which is the opportunity cost. I = I0 + b (R-PI) with b < 0 There are other economic variables that can affect investment. Wa/Pa is the expected real wage: if we think it will increase, then the producer is encouraged to reduce his investment, which determines production capacity àand thus reduces investment. The second element is the anticipated demand Ya . If I anticipate that it will decrease, then I would have an incentive to produce less (otherwise I would not be able to sell everything). Since production capacity depends on investment, this leads to a reduction in investment. The investment function would then be of the form : I = I (R-PI, Ya, Wa/Pa) 3.3/ The money demand function Md/P = L(Y,R) L'Y > 0 and L'R < 0 The household can save by holding two types of assets: money and financial securities (public or private, bonds or shares). They must therefore choose between holding money and securities, knowing that investing in money is not remunerated, unlike investing in securities. Keynes distinguishes three reasons justifying a preference for liquidity: 1/ for reasons of transactions (means of payment),à hence L'Y > 02/ to cope with falls in income or unforeseen expenditure. 3/ for speculative reasons (money is then considered as a particular security, whose nominal value is stable). It is then "cash awaiting investment on the financial market". The higher the nominal interest rate, the greater the incentive for the household to hold securities. For the same amount of savings, this is only possible if he holds less money for speculation. Hence the relationship L'R < 0. Notes: 1/ the demand for money is a demand in real terms, because households are not interested in the nominal value of their cash but in its purchasing power: no monetary illusion. 2/ the nominal interest rate, R, is the variable that arbitrates the choice between holding money or securities, because it reflects both the difference in nominal return between securities and money (R-0) = R and the difference in expected real return (R-PI - (-PI)) = R 3.4/ The demand for work

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Formulated by the firm. The determinant of labor demand will be the real wage W/P. Nd = N(W/P) The demand for labor is traditionally derived from the solution of the profit maximization program. To solve this program, we need to define the firm's production function. Y = F (K0, N) = F(N) because K0 does not vary in the time horizon considered. F'(N) > 0 with F'(N) the marginal productivity of labor. F''(N) < 0 which means that the marginal productivity of labor is decreasing. We place ourselves in perfect competition: no firm can influence the price at which it sells, this price is a given. The program is therefore : Max PY - WN - Cf (with Cf a fixed cost) s/c Y = F(N) i.e. Max P x F(N) - WN - Cf Cf: poycopied course for the conditions of optimality and max of profit Under pure and perfect competition, the firm employs a quantity of workers Nd such that the marginal productivity of labor associated with this quantity is equal to the real wage W/P, to maximize its profit. Labor demand is a decreasing function of the real wage: Nd ' < 0 Cf : course manuscript F2 -> C From Nd , we can determine the profit-maximizing supply of goods, which we denote by Ys. Thus, Ys is deduced from the production function Ysà= F (F'-1 (W/P) ) When W/P increases, then Nd must decrease since Nd is a decreasing function, and this implies that Ys output decreases. 3.5/ Work supply It comes from households (this corresponds to the demand for employment), just as the demand for labor comes from firms. It is an increasing function of the real wage W/P. NB: We will not consider non-wage income, taxation or the interest rate as variables that could potentially affect the supply of labor. This labor supply noted Ns is exogenous in the exercises.

4/ The markets

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With the demands for consumption, investment, and money defined, as well as the demand for labor, we can then study the way in which these behaviors intervene in each of the markets that make up the economy. 4.1/ The property market We seek to define its equilibrium; to do this, we must define the demand for goods. In a closed economy, the demand for goods is the sum of the demand for consumer goods, investment goods and public goods. Mathematically: YD = C + I + G Or more precisely: YD = C(Y-T) + I (R-PI) + G With PI, G and T given, there is an infinite number of (Y, R) solution pairs, thus ensuring equilibrium on the market for the good. The set of (Y, R) pairs ensuring the equilibrium on the market of the good forms the IS curve. Cf: handwritten course F2 -> C' + page 3 of the teacher's course supplement To show that the IS curve is decreasing, there are two ways: - mathematically: we calculate the derivative, the slope of the curve (which must be negative) We must differentiate the equilibrium of the goods market Cf : course manuscript F3 -> C'' - economically: when income increases, consumption increases but less than income. There is therefore a drop in the demand for goods, and the market is in excess supply (of goods). To regain equilibrium, production must decrease. This describes a shift along the curve. Any change in G, PI or T will cause a parallel shift in the IS curve: - when G or PI increases, IS moves up when T increases, IS moves down. NB: the IS curve can also be interpreted in terms of loanable funds. This is why it is called IS, where I Investment and S saving. It is interpreted as giving the interest rate that equilibrates the market for loanable funds. 4.2/ The money market It is a market that characterizes the equality between the stock of money existing in the economy and the stock of money desired by the agents. The supply of money corresponds to the means of payment, i.e., the sum of the means of payment (coins, banknotes) and the demand deposits available in the second-tier banks. We assume that the money supply concerns the Central Bank (CB). By adjusting the money supply, the CB influences all monetary devices.

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Assumptions: the money supply is perfectly controlled by the CB, and beyond by the government. The nominal money supply, noted MS, is exogenous. MS/P is the real money supply. At the equilibrium of the money market:MS/P = MD/P henceM(bar)/P =L (Y,R) For a given M(bar) and P, there are an infinite number of pairs (Y,R) that ensure equilibrium in the money market. The set of (Y,R) pairs that ensure equilibrium on the money market forms the LM curve. This curve is increasing. Cf : course manuscript F3 -> D Economic application: Equilibrium is assumed in the money market initially, and Y is assumed to increase. The demand for money for transactions purposes then increases, and the money market is then in excess demand for money. To obtain the extra money, households sell securities, so their demand for securities decreases (so the supply of loanable funds decreases). If the securities market is initially in equilibrium, then it is in the following configuration: D SECURITIES < O SECURITIES R must therefore increase, which is the inverse relationship between the price of securities and the interest rate. This mechanism reflects a shift along the LM curve.

Thus, any change in M(bar) or P leads to a shift in LM. Specifically, when P increases, the LM curve moves up. Similarly, when M(bar) increases, LM moves downward.

4.3/ The IS-LM model If we assume that prices P and wages W are exogenous, and if we assume that the level of demand constrains the level of supply, Then the resolution of the system composed of the IS and LM equations allows us to define the income and the interest rate of this model, i.e. the only couple (Y,R) compatible with the equilibrium on the goods market, and on the money market. 4.4/ Market for the security Cf: course manuscript F3 -> D'. This relationship (cf. Walras's quasilaw) shows the market for goods, the market for money, and the market for securities. It indicates that an imbalance on a particular market tends to be compensated 8

by an imbalance of opposite sign on another market. For example, when firms increase their investment I, they contribute to an excess demand on the market for the good; at the same time, to finance this investment, they issue securities. Thus, excess demand in the market for the good is offset by excess supply in the market for the security. This relationship also indicates that if equilibrium is achieved in two markets, it is necessarily achieved in the third; it is therefore possible to ignore one of the markets. In the IS-LM model, the securities market is ignored. Nevertheless, we consider this market in order to highlight the financial mechanisms. This requires defining the supply and demand of securities, which will be obtained from the agents' CBs and behavioral functions. We must therefore find: 1/ the government's offer of securities2/ the companies' offer of securities Cf : course manuscript F3 -> D''. Firms: The supply of securities (or the demand for PS) depends negatively on the expected interest rate RPI, and positively on the initial debt level Be0 / P. Government: It has four instruments at its disposal when it wishes to conduct economic policy: taxation T, government spending G, money creation, and the issuance of securities. These four instruments are linked, but only three are independent. These three independent instruments are assumed to be C, G and M(bar). The supply of government securities can then be deduced as a balance. This also means that the government debt grows with the part of the budget deficit that is not financed monetarily. The demand for securities comes from households and is obtained from the CB. Cf : course manuscript F3 -> E It appears that the demand for securities is an increasing function of the nominal interest rate R, and a decreasing function of the tax T. The effect of a change in income is indeterminate: an increase in income increases savings, but there is no evidence that this additional savings is not primarily allocated to holding money. Cf : course manuscript F4 -> E'. As for the influence of initial wealth (B0+M0)/P, it is not easy to determine the influence of a change in real household wealth due to a decline in the value of securities.

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It is quite plausible that the change in initial real household wealth affects consumption and money holding. We will neglect its effects here, and we will have that a change in the initial real wealth of households leads to an increase in the demand for securities of the same amount. Cf : course manuscript F4 -> E'' At equilibrium in the securities market, the supply of loanable funds and the demand for loanable funds equalize (i.e. demand for securities = supply of securities) An infinite number of pairs (Y,R) ensure the equilibrium on the market of the security, solving : Cf : course manuscript F4 -> F We are interested in the impact of a variation in Y on R, all other things being equal (i.e. G, P, PI, T, M(bar) unchanged). FP is less steep than IS (see: demonstration in the course supplement, paragraph 1.9, p4). The demand for securities is affected by variations in Y (not the supply, see equations). E.g.: following the increase in Y, the demand for securities increases, and the demand for securities then becomes greater than the supply of securities. Note: Walras' quasi law implies that the curves FP, IS and LM intersect at a point.

4.5/ The labour market At labor market equilibrium, labor supply and labor demand equalize. Thus: Ns (W/P) = Nd (W/P)

5/ The balances An equilibrium is a situation in which each agent satisfies his or her interests to the best of his or her ability, taking into account the constraints that he or she faces. It is a situation from which no one has an interest in deviating, and supply is equal to demand on each of the markets. These two definitions can be reconciled, by pointing out that in an economy whose mar...