Introduction%20to%20Macroeconom[e-mail]

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Introduction to Macroeconomics MSc
InductionSimon HayleySimon.Hayley.1_at_city.ac
.uk
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• What is Macroeconomics?
• Macroeconomics looks at the economy as a whole.
  It studies aggregate effects, such as
• Business cycles
• Living standards (real incomes)
• Inflation
• Unemployment
• The balance of payments.
• It also asks how governments can use their
  monetary and fiscal policy instruments to help
  stabilise the economy.

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• Key Issues
• Why analyse macroeconomics?
• Measuring economic activity
• Building a macroeconomic model
• Macroeconomic problems and policy solutions

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UK Inflation ( per annum)
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• How Can We Measure National Output?
• Key concepts
• Gross domestic product (GDP)
• Gross national income (GNI - used to be called
  GNP)
• in a closed economy GDP GNI
• Aggregate supply and demand
• Controlling inflation and unemployment
• Fiscal and monetary policy

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Avoiding Double Counting

• To avoid double counting, when measuring national
  output via spending on goods, the goods that
  count as part of the economys output are called
  final goods all others are called intermediate
  goods.
• Each firms contribution to total output is equal
  to its value added the gross value of the firms
  output minus the value of all intermediate goods
  and services (the outputs of other firms) that it
  uses.
• The sum of all the values added produced in an
  economy is called gross value added at basic
  prices (the prices received by producers net of
  taxes on products, plus subsidies).

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Three Routes to GDP

• All output is owned by someone, and all output is
  bought by someone. Thus gross domestic product,
  GDP can be calculated in three different ways
• As the sum of value added by all producers of
  both intermediate and final goods
• As the income claims generated by the total
  production of goods and services
• As the expenditure needed to purchase all final
  goods and services produced during the period.
• These three methods reach the same total, so long
  as we add taxes on products minus subsidies to
  the first two in order to measure GDP at market
  prices.

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The Circular Flow of Income, Output, and
Expenditure
Domestic households
Payments
services
for
factor
Saving
goods
Financial System
for
and
Investment
Abroad
paid
services
Government
Income
Total final spending
Total income generated
Domestic producers
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An Example

• Suppose an economy has two firms
• Firm A mines ore it sell 300 worth to firm B,
  pays 200 to its workers, and makes 100 profit.
• Firm B makes consumer goods it buys materials
  for 300 from firm A, pays 300 to its workers,
  sells it output for 800 and makes profit of
  200.
• What is GDP?

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• Value of final goods sold 800
• Value added of two firms Firm A 300, Firm B
  500 so total 800
• Sum of incomes Wages 200 300 profits
  100 200 so total 800

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Types of Final Expenditure

• From the expenditure side of the national
  accounts
• GDP C I G X - M.
• C is private consumption expenditures.
• I is investment in fixed capital including
  residential construction, inventories, and
  valuables.
• G is government consumption.
• (X -M) represents net exports, or exports minus
  imports it will be negative if imports exceed
  exports.also referred to as NX

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Gross value added at current basic prices, by
sector, UK, 2005
Sector million of GDP
Agriculture, hunting, forestry and fisheries 10,241 0.8
Mining and quarrying 25,458 2.1
Manufacturing 148,097 12.2
Electricity, gas and water supply 24,953 2.0
Construction 65,923 5.4
Wholesale and retail trade 132,113 10.8
Hotels and restaurants 33,730 2.8
Transport and communications 81,059 6.6
Financial intermediation and real estate 266,485 21.8
Public administration and defence 54,935 4.5
Education 62,316 5.1
Health and social work 81,518 6.7
Other services 58,807 4.8
Gross value added at current basic prices Plus adjustment to current basic prices (taxes minus subsidies on products) 1,086,859 137,856 11.3
GDP at market prices 1,224,715 100
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Expenditure-based GDP and its components, UK,
2005
Expenditure Categories million of GDP
Individual consumption Household final consumption 760,777 62
Final consumption of non-profit institutions serving households 30,525 2.5
Individual government final consumption 165,655 13.5
Total actual individual consumption 956,957 78.1
Collective government final consumption 101,875 8.3
Total final consumption 1,058,832 86.5
Gross fixed capital formation 205,843 16.8
Change in inventories 3,721 0.3
Acquisition less disposals of valuables -337 0
Total gross capital formation 209,187 17.1
Exports of goods and services 322,298 26.3
Less imports of goods and services -366,540 -29.9
External balance of goods and services (net exports) -44,242 -3.6
Statistical discrepancy Gross domestic product at market prices (money GDP) 938 1,224,715 100

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GDP and GNI by Income type 2005
Income type million of GDP
Operating surplus, gross (profits) 312,026 25.5
Mixed incomes 76,112 6.2
Compensation of employees 684,618 55.9
Taxes on production and imports 162,267 13.2
Less subsidies -9,391 -0.8
Statistical discrepancy -917 0.0
GDP at market prices 1,224,715 100
Employees compensation Receipts from rest of world 1,211
Less payment to rest of world Total -1,137 74
Less taxes on production paid to rest of world Plus subsidies received from rest of world -4,243
Other subsidies on production 3,216
Property and entrepreneurial income Receipts from rest of world 185,826
Less payments to rest of world Total -156,029 29,797
Gross national income (GNI) at market prices 1,253,561
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• Real GDP is calculated to reflect changes in real
  volumes of output and real income. Nominal GDP
  reflects changes in both prices and quantities.
• Thus growth in nominal GDP can be split into real
  GDP growth plus inflation.
• Gross means that no allowance has been made for
  depreciation.
• Personal disposable income is the amount actually
  available for individuals to spend or to save
  (after taxes).

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Building a Macro Model

• Assumptions used in building a macro model
• Key relationships
• consumption
• investment
• The determination of GDP
• The multiplier
• The big idea the Keynesian revolution

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Key Assumptions

• Economy assumed to be one big industry
• Final spending is demand for output of this one
  industry
• Government purchases, consumption, investment and
  exports are all demands for the same output.

Output of goods
Labour
Consumer spending
Investment
Government purchases
Exports- imports
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More Assumptions

• Temporary assumptions
• Prices dont change, so all changes are in real
  (volume) terms
• There is excess capacity in production so output
  is demand determined
• Closed economy with no government
• Focus first on
• GDP C I G (X-M)
• Use symbol Y for GDP
• So first explain GDP using determinants of C and
  I.
• C is an endogenous variable determined within the
  model
• I is an exogenous variable determined outside the
  model

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The Circular Flow of Income, Output, and
Expenditure
Domestic households
Payments
services
for
factor
Saving
goods
Financial System
for
and
Investment
Abroad
paid
services
Government
Income
Total final spending
Total income generated
Domestic producers
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Consumption and Saving

• If personal disposable income rises, households
  spend some of the increase and save the rest.
  This is measured by the marginal propensity to
  consume MPC and the marginal propensity to save
  MPS, which are both positive and sum to one.
• Relation between consumption and income might be
• C a bY
• a is referred to as autonomous consumption.
  It is the amount that consumers spend when income
  is zero.
• b is the marginal propensity to consume.
• This implies a relation for saving
• S -a (1-b)Y

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Consumption and Saving Relationships empirical
example

• C 100 0.8Y
• where C is consumer spending in a period, Y is
  personal disposable income (which in absence of
  taxes and retained profit GDP). Autonomous C
  100 Marginal propensity to consume 0.8.
• S -100 0.2Y
• Marginal propensity to save 0.2

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Consumption and Saving Schedules Million
Disposable Income
Desired consumption
Desired saving
0
100
-100
100
180
-80
400
420
-20
500
500
0
1000
900
100
1500
1300
200
1750
1500
250
2000
1700
300
3000
2500
500
4000
3300
700
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The Consumption and Saving Functions
450
2000
C
1500
500
S
1000
Desired Consumption Expenditure
250
500
0
Desired saving
-100
450
-500
500
1000
1500
2000
500
1000
1500
2000
Real Disposable Income
Real Disposable Income
(i). Consumption Function million
(ii). Saving Function million
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Investment

• Here we treat investment as an exogenous
  variable, that is, it is determined outside the
  model.
• Later we can make investment depend on the
  interest rate.
• In general investment will depend on expectations
  of future demand growth as well as interest
  rates.
• For our numerical example investment is constant
  at 250.

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The Aggregate Expenditure Function in a Closed
Economy With No Government Million
GDP National Income Y
Desired investment expenditure I 250
Desired aggregate expenditure AE C I
Desired consumption expenditure C 100 0.8Y
100
250
180
430
400
250
420
670
500
250
500
750
1000
250
900
1150
1500
250
1300
1550
250
1500
1750
1750
2000
250
1700
1950
3000
250
2500
2750
4000
250
3300
3550
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Equilibrium GDP

• At the equilibrium level of GDP, purchasers wish
  to buy exactly the amount of national output that
  is being produced.
• At GDP above equilibrium, desired expenditure
  falls short of national output, and output will
  sooner or later be curtailed.
• At GDP below equilibrium, desired expenditure
  exceeds national output, and output will sooner
  or later be increased.
• In a closed economy with no government, desired
  saving equals desired investment at equilibrium
  GDP.
• Equilibrium GDP is represented graphically by the
  point at which the aggregate expenditure curve
  cuts the 450 line, that is, where total desired
  expenditure equals total output.
• This is the same level of GDP at which the saving
  function intersects the investment function.

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The Determination of Equilibrium GDP
GDP National Income Y
Desired aggregate expenditure AE C I
100
430
Shortage of goods. Pressure on Y to rise
400
670
500
750
1000
1150
1500
1550
1750
Equilibrium Y
1750
2000
1950
3000
2750
Surplus production. Pressure on Y to fall
4000
3550

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Equilibrium GDP
3000
450 AE Y
S
500
E0
2000
Desired aggregate expenditure (m)
I
250
Desired saving (m)
0
1000
-100
350
-500
450
0
Y0
2000
Y0
1000
3000
3000
2000
1000
Real National Income GDP m
Real National Income GDP m
ii. Saving FunctionS I
i. An Aggregate Expenditure FunctionAE Y
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How Does the Equilibrium Come About?

• For GDP to remain unchanged injections of
  spending and leakages must be just equal
  otherwise GDP would be changing
• Imagine a bath with the tap running and no plug.
  For the water level to be stable the water
  flowing in and the water flowing out must be the
  same.

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The Model Solution

• The model is
• Y C I
• C a bY
• Solve for Y by substituting for C in first
  equation
• Y a bY I
• so Y - bY a I
• or Y (a I)/(1-b)
• Numerical example C 100 0.8Y I 250
• So Y 100 0.8Y 250
• Or Y (100 250)/ (1- 0.8)
• 350 x 5
• 1750

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Changes in GDP

• Equilibrium GDP is increased by a rise in
  exogenous spending or injections or a fall in
  withdrawals.
• Equilibrium GDP is decreased by a fall in
  injections or a rise in withdrawals.
• The magnitude of the effect on GDP of shifts in
  autonomous expenditure is given by the
  multiplier. It is defined as K ?Y/?A, where ?A
  is the change in autonomous or exogenous
  expenditure.
• It is equal to 1/(1 - z), where z is the marginal
  propensity to consume. Thus the larger z is, the
  larger is the multiplier. In the absence of taxes
  and foreign trade the multiplier is
• 1/(1-b) where b is the marginal propensity to
  consume
• If b 0.8 then the multiplier 5.

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The Simple Multiplier
AE Y
AE0
Desired Expenditure
e0
E0
450
0
Y0
Real National Income GDP
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The Simple Multiplier
AE Y
AE1
E1
e1
a
e1
AE0
?A
Desired Expenditure
e0
E0
?Y
450
0
Y0
Real National Income GDP
Y1
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New solution when I rises from 250 to 350

• Old level of GDP was 1750
• Y C I
• Y 100 0.8Y 350
• Y - 0.8Y 450
• Y 450 x 5
• Y 2250
• Increase in Y is change in I times the multiplier
• Change in I is 100 and multiplier is 5
• So change in Y is 500.
• At new level of GDP S -100 (.2 x 2250)
• 350

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The Multiplier Intuition

• If there is an increase of exogenous spending of
  100, this generates 100 of extra income and 80
  gets spent.
• The 80 generates extra income of 80 and 0.8 of
  this gets spent---creating 64 of extra income.
  0.8 of this gets spent generating 51.20 of extra
  income.
• Total income generated is
• 100 80 64 51.2 40.96 32.768
  26.21 20.97 16.78 13.43 10.74 8.59
  6.87 5.5 4.4 3.52 2.82 2.25
  1.8 1.44 1.15 0.92 0.74 0.59
  0.47 0.38 0.3 0.24 0.19 0.15
  0.12 0.1 0.08 0.064
• This sum converges to 500.

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The Multiplier a Numerical Example
500
400
Cumulative spending total million
300
200
100
2
7
0
4
6
3
1
9
10
15
20
8
5
Spending round
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Implications of the Multiplier

• The multiplier comes about because consumer
  spending is a function of household incomes, but
  household incomes are themselves affected by
  consumer spending! (the circular flow of income)
• The result is that a small change in one part of
  our model (eg. I, G, or the MPC) can have a large
  impact on GDP by the time the economy has reached
  a new equilibrium.

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The Classical View of Unemployment

• Economists used to regard the labour market as
  just like any other market. If there was an
  excess supply of labour, this must mean that the
  price (wages) is too high.
• But this theory left economists unable to come up
  with a satisfactory explanation of the great
  depression...
• ...let alone come up with any solutions!

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The Classical View of Unemployment
S
D
Z
Z
Y
Y
X
X
Wages
W
W
V
V
U
U
Employment
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The Big Idea Keynesian Revolution

• Unemployment is mainly determined by aggregate
  spending. Thus the economy can get stuck in a
  vicious circle (low aggregate spending gt low GDP
  gt high unemployment gt low aggregate spending).
• Cutting wages would make matters worse by further
  reducing consumer demand!
• One solution is for government to use its own
  spending (and tax changes) to boost demand. The
  budget then became a tool for managing the
  economy (discretionary fiscal policy).

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The Circular Flow of Income, Output, and
Expenditure
Domestic households
Imports
Payments
services
for
factor
Saving
goods
Financial System
for
and
Investment
Abroad
paid
services
Government
Taxes
Spending on current production
income
Exports
After-tax
Total
Total income generated
Domestic producers
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The Keynesian Revolution
AE Y
AE0
Desired Expenditure
e0
E0
450
0
Y0
Real National Income GDP
Y
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Effect on GDP of change in exogenous spending
AE Y
AE1
E1
e1
a
e1
AE0
?A
Desired Expenditure
e0
E0
?Y
450
0
Y0
Real National Income GDP
Y1
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Aggregate Demand and Supply

• So far we have assumed that GDP is determined by
  demand. This is the case if there is excess
  capacity in the economy (no supply-side
  constraints).
• Our model also has no role for prices, so it
  cannot explain inflation. So next we incorporate
  the price level and derive the aggregate demand
  curve.
• We then add the aggregate supply curve, which
  enables us to determine both real GDP and the
  price level.

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Aggregate Demand

• What happens to AE as we change the price level?
• A fall in the price level shifts the AE curve
  upwards
• A rise in the price level shifts the AE curve
  downwards.
• The reasons
• A rise in the price level lowers exports because
  it raises the relative price of domestic goods
• A rise in the price level lowers private
  consumption spending because it decreases the
  real value of consumers wealth.
• Both of these changes lower equilibrium GDP and
  cause the aggregate demand curve to have a
  negative slope.
• The AD curve plots the equilibrium level of GDP
  that corresponds to each possible price level. A
  change in equilibrium GDP following a change in
  the price level is shown by a movement along the
  AD curve.

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The AD Curve and the AE Curve
AE Y
AE0
E0
AE1
E1
AE2
Desired Expenditure
E2
45o
0
Real National Income GDP
Y2
Y1
Y0
i. Aggregate expenditure
E2
P2
Price Level
E1
P1
E0
P0
AD
Real National Income (GDP)
Y2
Y1
Y0
0
ii. Aggregate Demand
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AD Meaning and Shifts

• The AD curve is drawn for given values of all
  exogenous expenditures and other parameters
• Each point on AD shows, for each P, the level of
  real GDP that is consistent with
• desired spending actual output
  (as determined by spending decisions)
• injections withdrawals
• When an exogenous variable changes, the AD curve
  shifts at each price level by the shift in
  spending times the multiplier.

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Shifts in Aggregate Demand

• The AD curve shifts when any element of exogenous
  expenditure changes.
• The multiplier times the shift in exogenous
  spending measures the magnitude of the shift.
• An increase in a, G, I, X, or a fall in T shift
  AD to the right.
• A fall in a, G, I, X, or a rise in T shift AD to
  the left.

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The Simple Multiplier and Shifts in the AD Curve
AE Y
AE1
E1
AE0
E0
Desired Expenditure
?A
i. Aggregate Expenditure
45o
Real GDP
0
Y1
Y0
Price Level
E0
E1
P0
?Y
AD1
AD0
ii. Aggregate Demand
Y0
Real GDP
Y1
0
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Aggregate Supply

• The short-run aggregate supply (SRAS) curve is
  drawn for given input prices, given technology
  and fixed capital stock.
• It is positively sloped because unit costs rise
  with increasing output and because rising product
  prices make it profitable to increase output.
• An increase in productivity or a decrease in
  input prices shifts the SRAS curve to the right.
• A decrease in productivity or an increase in
  input prices shifts the SRAS curve to the left.

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A Short-run Aggregate Supply Curve
SRAS
Price level
P1
P0
Y0
Y1
Real GDP
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Macroeconomic Equilibrium

• Macroeconomic equilibrium is where the AD and
  SRAS curves intersect.
• Shifts in the AD and SRAS curves, called
  aggregate demand shocks and aggregate supply
  shocks, change the equilibrium values of real GDP
  and the price level.
• When the SRAS curve is positively sloped, an
  aggregate demand shock causes the price level and
  real GDP to move in the same direction, the
  division between these effects depending on the
  shape of the SRAS curve.
• The main effect is on real GDP when the SRAS
  curve is flat and on the price level when it is
  steep.

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Macroeconomic Equilibrium
AD
SRAS
Price Level
E0
P0
Y0
0
Real GDP
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Supply Shocks

• An aggregate supply shock moves equilibrium real
  GDP along the AD curve, causing the price level
  and output to move in opposite directions.
• A leftward shift in the SRAS curve causes
  stagflation rising prices and falling output.
• A rightward shift causes an increase in real GDP
  and a fall in the price level.
• The division of the effects of a shift in SRAS
  between a change in real GDP and a change in the
  price level depends on the shape of the AD curve.
  

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Aggregate Supply Shift
AD
SRAS
Price Level
E0
P0
P1
Y0
0
Y1
Real GDP
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• Starting from AD SRAS there can be two types of
  shock
• Aggregate demand shock involves a change in some
  exogenous spending category a, I, G (or T) and
  X.
• An increase in a, I, G, or X shifts AD left or
  right by size of change times the multiplier.
• Price level then changes and makes multiplier
  smaller, but P and Y respond to AD shock in same
  direction.
• When there is an aggregate supply shock, P and Y
  move in opposite directions.
• There are some special cases.

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Keynesian SRAS Curve
AD
Price Level
SRAS
E0
P0
Y0
0
Real GDP
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Classical or Monetarist SRAS
AD
SRAS
Price Level
P0
Y0
0
Real GDP
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General Case
AD
SRAS
Price Level
P0
Y0
0
Real GDP
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Lessons of the 1970s and 1980s

• Inflation is persistent
• Expected inflation rises, so workers demand
  higher wage increases (wage-price spiral).
• If inflation is high, employees demand high wage
  rises. Firms then raise prices to maintain
  margins.
• Inflation expectations are important.
• Unemployment is persistent
• The long-term unemployed become less attractive
  to employers.
• Hence wage inflation tends to increase even when
  unemployment relatively high.

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What About The Money Supply?

• Monetarists argued that inflation is always and
  everywhere a monetary phenomenon, so if you can
  control the money supply, you can control
  inflation.
• But although money is involved in every
  transaction, it is seldom the cause of the
  transaction. The relationship between money and
  inflation is not stable, so it is not a reliable
  means of controlling inflation.
• Furthermore, in a modern economy, the money
  supply (largely in the form of bank accounts) is
  hard to control, or even measure.

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Evolution of macro-economic policymaking

• Classical (1776 - 1930s)
• Free markets with no government interference
• Keynesian (1930s 1970s)
• Discretionary demand management used to regulate
  economy
• Monetarist (1970s 1980s)
• Control money supply to control inflation
• Supply-side measures to help markets move to
  equilibrium
• Markets should then clear to achieve full
  employment
• Instead the economy entered deep recession in
  early 1980s. Monetarist theory discredited.
• Current pragmatic system
• Inflation expectations are important, so
  objectives must be clear and credible
• Independent central bank avoids political motives

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Stabilisation Policies

• Fiscal policy
• Budget deficit boosts demand
• But cyclical adjustment is needed to be sure
• Substantial lags obtaining data, implementation
  and impact of policy shift. Hence net effect
  could be destabilising.
• Monetary policy
• Interest rates affect investment and consumer
  spending
• Governments now generally set fiscal policy and
  leave the central bank to use monetary policy to
  stabilise the economy.

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Macroeconomics summary

• Measuring GDP
• Value added
• Income
• Expenditure
• Circular flow of income
• Keynesianism overthrows classical view of
  unemployment
• Model building
• Multiplier
• Supply and demand shocks
• Different view of aggregate supply
• Macroeconomic policy
• Classical
• Keynesianism
• Monetarism
• Pragmatic view. Independent central banks

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Reading

• Lipsey Chrystal Economics Eleventh Edition,
  Oxford University Press, 2007.
• This is the source of most of the material
  presented in these lectures.