Week 16 - GDP - Chapter 13 of core PDF

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MCQ "cheat sheet" for Econ 2 all and relevant notes. - week 16 GDP...

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Week 16 – Gross Domestic Problem Unit 13 of The Economy

Terms Business Cycle  Alternating periods of faster and slower (or even negative) growth rates. The economy goes from boom to recession and back to boom. Recession  Output is declining, there is a fall in national output and national income. Or some say a recession can be when growth slows to below normal levels.  

In the UK is defined as a period of negative economic growth for two consecutive quarters. Inevitably a recession will involve higher unemployment and an increase in government borrowing.

Okun’s Law  Changes in the rate of growth of GDP are negatively correlated with the rate of unemployment.  

When GDP and a country’s output growth is high, unemployment is low. Conversely when country’s output growth is low, unemployment is high. Okun’s coefficient defines this as relationship as the change in the unemployment rate in percentage points predicted to be associated with a 1% change in the growth rate of GD . o For example in the US it is predicted that a 1% increase in the output growth rate decreases the unemployment rate by roughly 0.38%

 Circular Flow

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The circular flow of income is the relationship between firms and households that represents the whole economy. House hold supply firms with labour, capital and enterprise and firms return households with incomes and profit. Households then spend money as expenditure and receive goods and services from firms. He circular flow shows the ways of measuring the economy: o Expenditure – Money spent of goods and services. o Income – Money received in wages and profits from production.

Production- In the form of value added. The value of output minus the value of all inputs (called intermediate goods). The capital goods and labour used in production are not intermediate goods. The value added is equal to profits before taxes plus wages. Governments play a role in the circular flow model: Households pay taxes, these taxes pay for the production of public services used by households. o

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Gross Domestic Product  Measures the market value of the output of an economy in a given period. Aggregate Demand  Aggerate total demand for everything we produce in the economy. Total of all Consumption, investment, government spending and Net exports (Imports minus exports) Consumption  Expenditure on consumer good and services. o Sale of older goods like second hand cars is not included.  Includes both short-lived goods and services like food and drink. As well as, long-lived goods , like cars, household appliances, and furniture that last for three years which are called consumer durables. 

In most countries is the largest component of GDP, 56% in Europe and 68% in America.

Government Spending  Consumption and investment purchases by the government. This includes purchases are of goods like office equipment and cars, services like s wages of civil servants, armed services, police and teachers, as well as, Government investment spending is on the building of roads, schools, and defence equipment.  Most of government spending is on health and education.  Does not include spending on transfers such as pensions and unemployment benefits. This comes under government transfers. o Government transfers is Spending by the government in the form of payments to households or individuals. Unemployment benefits and pensions. not included in G because households receive them as income: when they are spent, they are recorded in C or I. It would be double counting to record this spending in G too. Investment  Expenditure on capital goods. o For example, Equipment, machines and buildings. Also Includes the building of new houses and inventories. (anything produced that we don’t sell)  Level of investment is more volatile in recessions as people always need to consume but firms don’t need to invest and won’t if they don’t expect there to be future demand.  Determined a lot by business confidence.  Isn’t generally the largest components but is in China. Exports  Domestically produced goods and services that are purchased by households, firms, and governments in other countries. Imports  Goods and services purchased by households, firms, and governments in the home economy that are produced in other countries. Net exports  The difference between the value of exports and the value of imports. (X-M) Exports minus imports. Sometimes referred to as trade balance.

Trade deficit and surplus  Trade deficit if the value of exports is greater than the value of imports and negative.  Trade surplus if the value of imports is greater than the value of exports and positive. Consumption Smoothing  In good times consumers save or pay off debt and bad times they use the savings or borrow, in order to maintain consumption level over time.  Do not change long-run consumptions and overcome shocks through borrowing and saving  In terms of the life cycle:

Self-insurance  Personal saving and borrowing to deal with shocks to income and consumption smooth. Other households, networks or government is not involved Co-insurance  Support from social networks like family and friends, food banks, savings groups or government like benefits to deal with shocks to income and consumption smooth. Weakness of Will  The inability to commit to beneficial future plans. So a house hold is able to smooth consumption by saving but decides not to and may regret it later.  In both figures there is a shock and decrease in income. The Blue line.  A consumption smoothing household will start to save when it hears news about incomes falling to supplement consumption in the future. Top figure.  A weak-willed household won’t react to news and save but keep consuming high until income falls. They will be hit be the fall in incomes more.

Coordination Game

A coordination game is one which has two Nash equilibrium, but one may be pareto superior to the other. Examples include:  Crop specialization coordination game in Unit 4, it is better for both farmers to specialize in the crops best suited for their land and a different crop for the two farmers, is better for both than the ‘wrong specialization’. 

 Investment coordination game, an outcome when both firms invest is better for both than neither investing.

Capacity Utilisation

Models Explain how the constrained optimisation model can be used to demonstrate a preference for consumption smoothing. 

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House holds will want to a need to keep their consumption constant so are inclined to consumption smooth. They save and borrow to smooth out bumps in their income. A house can consume Y amount now and Y amount later by saving at an interest rate. If interest rate is r then a household can borrow to consume now at any point along the budget constraint. Which is the red line and has a slope of – (1+r). The more goods a household has in the present, the less they values an additional one now relative to more in the future. So there is a sloping down indifference curve tangent to the budget constraint for their optimum amount to borrow. Let suppose the household experiences a shock in income, such as a bad harvest. This would lower their income now but next years income would return to normal. Thus consumption now decreases to y′ but consumption later is unchanged. This is shown as an inward shift of the indifference curve. Without consumption soothing they would consume y’ now and y later. However, this is no optimal, the highest indifference cure now is IC2to the budget constraint at Point A’’ if it can borrow. The household consumes c’ now by borrowing c′ − y′ now and repays (1 + r)(c′ − y′ ) next period following the shock.

Consumption smoothing over time as related to GDP

Coordination games in 2x2 normal form grids 

A coordination game is one which has two Nash equilibrium but one may be pareto superior to the other.

The game rules: Actors – The two firms Actions – Invest / Don’t They decide simultaneously Pay off – Profit from investment

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Modelling firms investing in a 2x2 normal grid helps explain why investment is so volatile. This coordination game entails whether investment is the best response to another firms’ investment. One firms decision to invest or not will affect the outcome of the other firm. If both firms invest both firms will do well and both make a profit of 100. If neither firms invest they both still make a profit but not a great amount 10 each. If one firm invests and the other doesn’t then one firm has an advantage and

Explain how the constrained optimisation model can be used to demonstrate a preference for consumption smoothing.    

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Households will want to a need to keep their consumption constant so are inclined to consumption smooth. They save and borrow to smooth out bumps in their income. A house can consume Y amount now and Y amount later by saving at an interest rate. If interest rate is r then a household can borrow to consume now at any point along the budget constraint. Which is the red line and has a slope of – (1+r). The more goods a household has in the present, the less they values an additional one now relative to more in the future. So there is a sloping down indifference curve tangent to the budget constraint for their optimum amount to borrow. Let suppose the household experiences a shock in income, such as a bad harvest. This would lower their income now but next years income would return to normal. Thus consumption now decreases to y′ but consumption later is unchanged. This is shown as an inward shift of the indifference curve. Without consumption soothing they would consume y’ now and y later. However, this is no optimal, the highest indifference cure now is IC2to the budget constraint at Point A’’ if it can borrow. The household consumes c’ now by borrowing c′ − y′ now and repays (1 + r)(c′ − y′ ) next period following the shock....