Midterm Review - Lectures 1-3 PDF

Midterm Review - Lectures 1 to 3 Lecture 1 - Macroeconomics: An Overview ​ Gross Domestic Product (GDP): a measure of the economic activity occurring within a country’s borders ​ Nominal GDP: a measure of economic activity that does not control for changes in price - not inflation-adj...

Midterm Review - Lectures 1 to 3 Lecture 1 - Macroeconomics: An Overview ​ Gross Domestic Product (GDP): a measure of the economic activity occurring within a country’s borders ​ Nominal GDP: a measure of economic activity that does not control for changes in price - not inflation-adjusted ​ Real GDP: a measure of economic activity that does control for changes in prices - inflation-adjusted ​ Business Cycle: the fluctuations of real GDP around its trend value. They follow a wave-like pattern around the potential GDP ​ Expansions/Recoveries: periods of economic growth ​ Recessions: a period of negative economic growth. Usually defined as two consecutive quarters of falling GDP ○​ They can differ in length, severity, the sectors most affected, the cause, etc. ○​ In our economy, recessions in one country often spill over into others (ex. American 2008 recession really hurt us) ​ Depressions: severe and long recessions ​ Potential GDP (Y*): when all resources (labour, machines, land, resources, etc.) are being fully employed ​ Output Gap: measures the difference between the actual output/actual GDP and the potential GDP ○​ Output Gap = Y - Y* ​ Recessionary Gap: Y < Y* ​ Inflationary Gap: Y > Y* ​ Why are recessions bad? ○​ The main reason: unemployment ○​ Businesses see lower profits ○​ Workers have lower wages/benefits ○​ Retirement savings can be reduced Unemployment ​ Employment: the number of people (15+) currently employed in the economy, either full or part-time ​ Unemployment: the number of people (15+) who are actively looking for work but are not currently employed. Does not include: ○​ Discouraged Workers: not working, want to work and are capable, but have given up looking due to lack of jobs ○​ Marginally Attached Workers: not working, want to work, but are not looking because they are waiting for their job to start  ○​ Underemployment: people who work part-time jobs because they cannot find full-time jobs and people who do not fully use their skills in their current job ​ Unemployment is an indicator of… ○​ An individual’s wellbeing ○​ A nation’s economic wellbeing ○​ The state of the economy ​ Zero percent unemployment is unattainable - unemployment is a natural part of a healthy economy ​ Labour Force: the sum of employment and unemployment ​ Labour Force Participation Rate: the percentage of the population that is in the labour force 𝐿𝑎𝑏𝑜𝑢𝑟 𝐹𝑜𝑟𝑐𝑒 ○​ Labour Force Participation Rate = 𝑃𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛 (𝐴𝑔𝑒 15+) × 100 ​ Unemployment Rate: the percentage of the total number of people in the Labour Force who are unemployed - usually worry when above 7% 𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑 ○​ Unemployment Rate = 𝐿𝑎𝑏𝑜𝑢𝑟 𝐹𝑜𝑟𝑐𝑒 × 100 Types of Unemployment: ★​ Frictional, Structural, and Cyclical Unemployment make up unemployment ★​ NEET is separate from these three types - you can be both NEET and Frictional for example ​ Neither Enrolled in school, nor Employed, nor in Training (NEET): the NEET rate measures the percentage of youth who are at risk of becoming discouraged and disengaged, perhaps leading to reduced educational attainment, lack of satisfactory employment opportunities, and other related social problems as consequences ​ Frictional Unemployment: unemployment due to the time workers spend in job search - could be people who voluntarily or involuntarily left their previous job ○​ The level of frictional unemployment depends on the efficiency of the matching process ○​ It is likely to be relatively short in duration ​ Structural Unemployment: unemployment that results when workers are unable to fill available jobs due to a mismatch in skills or location, or unable to get a job at the prevailing wage ○​ Causes: ​ Lack of suitable jobs ​ Lack of suitable workers for available jobs ​ Geographic Mismatch: jobs are available if people are willing to move ​ Minimum wages: companies may not be able to pay as many workers  ​ Unions: bargain collectively for higher wages - may cause if wages are set above what the market would otherwise dictate ○​ These mismatches occur because economies are constantly changing ○​ Efficiency Wages: wages that employers set above the equilibrium wage as an incentive for workers to perform better ​ Cyclical Unemployment: unemployment that arises due to the business cycle downturns (recessions); it is a deviation in the actual Rate of Unemployment from the natural rate ○​ One we think we can target/change ○​ Actual Unemployment = Natural Unemployment + Cyclical Unemployment ○​ Ex. people getting laid off from a gold mine because the price of gold has fallen ​ The Natural Rate of Unemployment: the normal unemployment rate which the actual unemployment rate fluctuates ○​ Natural Unemployment = Frictional Unemployment + Structural Unemployment ○​ What can be done to change it? ​ Policy changes can make unemployment less pleasant: workfare vs. welfare ​ Allow markets to adjust quickly. If an industry is no longer profitable in a region, do not provide support to it. Economy ​ Economies tend to be self-regulating - if you wait long enough, they solves their own issues ​ Laissez-Faire: leaving the market alone to solve its own problems ​ Keynesian economists argue that there is no need for the economy to stuff since the government can intervene to solve the problem faster ​ The government could use a… ○​ Fiscal Policy: involves changing the tax level or amount of government spending to spur economic activity ○​ Monetary Policy: involves changing the amount of money in the economy and interest rates to encourage economic activity - done by the Central Bank of the country ​ These policies are used to control the business cycle ​ Worst Economic Event in Canada: The Great Depression in the 1930s ○​ Unemployment was high and economic output was low ○​ Looked very similar to the 2008 Financial Crisis ○​ Government action made things much worse - they raised the interest rate and cut government spending ○​ Opposite actions were taken in 2008 ​ The Great Moderation: when economists thought they knew everything from 1985 to 2008  ​ 2008 Recession: ○​ Caused by a crisis in the US sub-prime mortgage market ○​ The Canadian recession was shorter and less severe ○​ The Canadian economy is powered by the natural resource sector ○​ Global demand for resources, especially from China, remained strong ​ Productivity: the measure of output per worker ​ GDP per Capita: the total amount of output of an economy divided by the population ○​ It gives a measure of the average income for a country ​ Economic Growth: the sustained upward trend in aggregate output over time ○​ The process that makes our lives better than they were 20 years ago ​ Causes of Long-Run Growth: ○​ An increase in people’s income (they can afford more) ○​ Technological improvement/innovation History of Growth ​ Economic growth has not always been a fact of life ​ It started after the Industrial Revolution ​ Now, our standard of living doubles every 41 years ​ The cost: environmental degradation ​ Different countries experience different rates of growth: Canada vs. Argentina ○​ Instability and bad economic policies are usually blamed for Argentina's failure Inflation ​ To be able to compare dollar values across time, we need to adjust for these changes in price ​ Money payments that have been adjusted for changing prices are in Real terms ​ Money payments that have not been adjusted are in Nominal or Current terms ​ Price Level: the average level of all prices in the economy expressed as an index number ​ Inflation: a rise in the price level ​ Deflation: a fall in the price level ​ Inflation Rate: the annual percentage change in the price level 𝑃𝑟𝑖𝑐𝑒 𝐼𝑛𝑑𝑒𝑥 𝑖𝑛 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑌𝑒𝑎𝑟 − 𝑃𝑟𝑖𝑐𝑒 𝐼𝑛𝑑𝑒𝑥 𝑖𝑛 𝑃𝑟𝑖𝑜𝑟 𝑌𝑒𝑎𝑟 ○​ Inflation Rate = 𝑃𝑟𝑖𝑐𝑒 𝐼𝑛𝑑𝑒𝑥 𝑖𝑛 𝑃𝑟𝑖𝑜𝑟 𝑌𝑒𝑎𝑟 × 100 ​ Note: not all prices have to increase for there to be inflation ​ Inflation matters because it determines how much we can buy ​ Inflation causes uncertainty - the value of money becomes uncertain ​ High Inflation causes… ○​ The value of savings to quickly erode - people avoid holding money as it quickly loses value ○​ Hard to plan future purchases  ○​ High Inflation is good for borrowers and bad for lenders ​ Deflation is bad as it encourages people to hold onto money and not spend it ​ Governments want Price Stability ​ Shoe-Leather Costs: the increased costs of transactions caused by inflation ​ Menu Costs: the costs of changing listed prices ​ Arbitrary Redistribution: another consequence of inflation ○​ Contracts often specify future money payments ○​ Inflation reduces the value of these payments ○​ With debt, lenders lose and borrowers gain ○​ With wages, workers lose and employers gain ​ Hyperinflation: occurs when inflation gets out of control ○​ Ex. Germany post World War I Anticipated Inflation ​ Inflation in Canada is usually around 2% for the past two decades, so households and firms assume this will stay the same ​ Unanticipated inflation will lead to changes in the real values Consumer Price Index ​ Most countries measure inflation using the CPI ​ Market Basket: a basket that best represents what consumers buy ​ Every month they go and determine what it would cost to purchase this basket of goods ​ They compare it to a Base Year to measure how inflation is changing ​ A Price Index is the ratio of the current cost of that market basket to the cost in the base year, multiplied by 100 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑎 𝑀𝑎𝑟𝑘𝑒𝑡 𝐵𝑎𝑠𝑘𝑒𝑡 𝑖𝑛 𝑎 𝐺𝑖𝑣𝑒𝑛 𝑌𝑒𝑎𝑟 ○​ Price Index in a Given Year = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑎 𝑀𝑎𝑟𝑘𝑒𝑡 𝐵𝑎𝑠𝑘𝑒𝑡 𝑖𝑛 𝑎 𝐵𝑎𝑠𝑒 𝑌𝑒𝑎𝑟 × 100 ​ Percent Change Formula: 𝐸𝑛𝑑 − 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 ○​ Percent Change = 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 × 100 ​ Core CPI: removes the more volatile items - such as fruits, vegetables, gasoline, fuel oil, tobacco, mortgage interest costs, natural gas, and intercity transportation- as they are prices that fluctuate a lot. We remove them to make the Core CPI more reliable. ​ The Core CPI is a more reliable measure of inflation Interest Rates ​ Interest Rate: the price paid per dollar borrowed per period of time ​ Usually expressed as a yearly percentage ○​ If interest rate is 5%, then you must pay 5 cents a year for every dollar borrowed ​ Nominal interest Rate: the interest rate expressed dollar terms  ​ Real Interest Rate: the nominal interest rate adjusted for the change in the purchasing price of money ○​ Real Interest Rate = Nominal Interest Rate - Rate of Inflation ​ If your student loan has a nominal interest rate of 5% and the rate of inflation is 2%, then the real interest rate you are paying is 3% ​ Can have a negative interest rate if the nominal interest rate is smaller than the rate of inflation International Macroeconomics ​ Open Economy: country trades goods, services, and money with other countries ​ Closed Economy: country does not trade goods, services, and money with other countries ​ Trade Balance: the difference between the value of a country’s exports and its imports ​ Trade Surplus: when the value of what we sell to another country is more than the value of what we buy from them ​ Trade Deficit: when the value of what we sell to another country is less than the value of what we buy from them Exchange Rates ​ Exchange Rate: the number of units of domestic currency required to purchase one unit of foreign currency ​ A rise in the exchange rate means that it takes more Canadian dollars to purchase one unit of foreign currency. This is a depreciation of the Canadian dollar. ​ A fall in the exchange rate means that it takes fewer Canadian dollars to purchase one unit of foreign currency. This is an appreciation of the Canadian dollar. Lecture 2 - Gross Domestic Product (GDP) Measuring Economic Output ​ Helpful to measure output as it allows for… ○​ Comparisons across time ○​ Comparisons between countries ​ Option 1: Simply sum up the total value of the output of all firms ○​ Problem: it results in double counting ​ Example: ○​ A cotton farmer grows cotton and sells it to a textile mill ○​ The textile mill takes this cotton and turns it into fabric ○​ A clothing factory takes this fabric and turns it into a sweater ○​ If we simply sum up the value of output of these three firms, we are in a sense counting the value of the cotton three times and counting the value of the fabric twice!  ​ We need to make a distinction between… ○​ Intermediate Goods: inputs used by other firms in the production of the final goods ○​ Final Goods: goods that are sold for consumption to consumers, the government, 😞 or foreigners ​ It is hard to make this distinction ​ To solve the problem of double-counting, we use: ​ Value-Added: the value of the firm’s output less the value of the inputs that it purchased from other firms ○​ Value Added = Sales Revenue - Cost of Intermediate Goods ​ Since all money from sales that is not spent on intermediate goods goes to the firm’s factors of production, it must also be the cast that: ○​ Value Added = Payments to the Firm’s Factors of Production Modelling an Economy ​ Two basic agents in the economy are Households and Firms ​ Consumer Spending (C): when households buy goods and services from firms ​ The Goods and Services Market is where firms exchange goods and services for money ​ The Factor Market is where firms purchase labour and capital for money ○​ Firms buy factors of production from households ○​ Payments include: wages, rent, interest, and profit ​ Suppose Firms want to expand their output capabilities by investing in a new piece of machinery ​ They can acquire the necessary funds from a Financial Market to do so ○​ Bonds: money is exchanged for promises of future repayment ○​ Stocks: shares in ownership of a firm ​ The money comes from Households’ Private Savings (S) ​ Firms take this money and make Investments (I) into their production capabilities ​ Since all the money that is borrowed by firms will be used to purchase capital in the Market for Goods and Services, we can simply measure the flow out of this market as ○​ GDP = C + I ○​ Consumer Spending (C) ○​ Investments (I) ​ You could also measure by tracking the payments out of the firms into the Factor Markets ○​ The size of these flows will be equal ​ The Government also plays a large role in the economy ​ It Taxes and provides Transfers to Households ​ It also purchases goods and services from Firms (G) ​ Now government purchases will be included in our measure of GDP ○​ GDP = C + I + G ○​ Consumer Spending (C) ○​ Investments (I) ○​ Government Purchases (G) ​ This spending will eventually become payments to factors as well ​ Exports (X): foreigners purchase goods from Canada ​ Imports (IM): Canada purchases goods from foreign countries Measuring GDP The Expenditure Approach: Consumption ​ GDP can be calculated in a given year by simply adding up the expenditures needed to purchase the final output produced in a year 1.​ Consumption Expenditure (C) ​ This is household expenditure on all goods and services ​ In our diagram, it is the flow out of households and towards the Market for Goods and Services ​ It’s the largest component of GDP ​ Examples: ○​ Durable goods: things that last (couches, fridges, etc.) ○​ Semi-Durable Goods: used to describe products that do not last for a very long time, for example, clothes: Retailers are planning to slash prices on semi-durable goods for the Christmas season ○​ Non-durable Goods: things that are consumed quickly (ex. food) ○​ Services: accounting services, restaurant, etc. ○​ Non-Profits 2.​ Investment Expenditure (I) ​ MOST VOLATILE CATEGORY ​ Investment is spending on the production of goods and services, not on present consumption ​ When a firm buys a machine, it is expected to produce a lot of future output  ​ Included in this measure are Inventories: goods that will be used/sold at a future date ​ Drawing down inventories results in a negative investment ​ Investment also includes new factories, equipment, and housing. ​ Note: the re-sale of a house does not impact GDP ​ Capital Stock: the economy’s total quantity of capital goods ​ Gross Investment: the total investment that occurs in the economy ​ Note: over time, as capital is used, it becomes depleted and cannot produce as much ​ This is called Depreciation ​ Net Investment: equal to gross investment minus depreciation, and is the measure we ultimately care about 3.​ Government Purchases (G) ​ The government makes purchases of goods and services from the market as well ​ Note that the government also sometimes transfers money directly to households, without anything given in return ​ We call these Transfer Payments and they are not included in this category ​ Ultimately, these transfers will be spent by consumers through Consumption (C) or invested in Firms (I) ​ The government also taxes households. These can be treated as negative transfer payments. 4.​ Net Exports (NX) ​ When our firms sell goods and services to foreigners, these are called Exports ​ They contribute positively to GDP as they represent goods or services purchased domestically ​ When consumers or firms purchase goods or services from foreigners, these are called Imports ​ We must subtract this spending from GDP, as these goods and services were not produced domestically ​ Net Exports are simply the difference between exports and imports FINAL FORMULA ​ GDP = C + I + G + X - IM OR GDP = C + I + G + NX ○​ Consumer Spending (C) ○​ Investments (I) ○​ Government Purchases (G)  ○​ Exports (X) ○​ Imports (IM) ○​ Net Exports (NX) The Income Approach: Factor Income ​ GDP can be calculated in a given year by simply adding up factor incomes and other claims on th evalye of output ​ PROBABLY ON THE EXAM 1.​ Factors Income ​ These are payments for factors of production ​ Generally, its broken up into three components: ○​ Wages and salaries ○​ Interest ○​ Business Profit (Dividends and retained earnings) 2.​ Non-Factor Payments ​ This comprises many different things, that are not related to another ​ One component is called Indirect Taxes and Subsidies ○​ This includes consumption taxes like GST/HST/PST ○​ Governemnt subsidies are also included ​ A second component is Depreciation ○​ Some current output is used to replace worn-out capital ○​ We must add depreciation here since it is a part of a firm’s gross profit The Value-Added Approach ​ Value-Added = Sales Revenue - Cost of Intermediate Goods  ​ The Expenditure Approach: ○​ AE = C + I + G + NX ○​ AE = $21,500 ​ The Income Approach: ○​ Total Payments to Factors = 15,700 + 2,600 +1,000 + 2,200 ○​ Total Payments to Factors = $21,500 ​ The Value-Added Approach: ○​ Value-Added = Sales Revenue - Intermediate Cost of Goods ○​ Value-Added = 4,200 + 9,000 + 21,500 - (4,200 + 9,000) ○​ Value-Added = $21,500 ​ All three methods have one result: GDP is $21,500 GDP: Various Issues ​ GDP includes: ○​ Domestically produced final goods and services (including capital goods) ○​ New productive physical capital ○​ Changes to inventories ​ GDP does not include: ○​ Intermediate goods and services ○​ Used goods ○​ Financial assets (stocks and bonds)  ○​ Foreign-produced goods and services ○​ Household production (washing dishes, vacuuming, childcare), unless purchased on a market ○​ Volunteer work ○​ Black market transactions ○​ Environmental degradation ​ GDP is useful for monitoring business cycles ​ Useful for charting long-run changes in an economy ​ It misses a number of items that measure well-being, thus it is not the best measure for the well-being/happiness of a nation ​ Comparing across countries is difficult since some countries rely on more subsistence agriculture, while others have large underground economies ​ GDP growth at the cost of destroying the environment, may not be real growth Gross National Income ​ Gross National Income (GNI): a measure that is related to GDP ○​ GNI = GDP - factor payments paid to foreigners + earnings/payments of domestic firms earned abroad ​ Whereas GDP is a measure of economic activity within a country, GNI is a measure of the economic well-being of those people living within a country ​ GNI is equal to all of the factor payments earned by residents of a country GDP Growth ​ GDP Deflator: an index number that measures the average change in price of all items in the GDP 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 ○​ GDP Deflator = 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 × 100 ​ We can use this deflator to calculate inflation ○​ Suppose the GDP deflator for 2010 is 105, and the GDP deflator for 2011 is 107.8 ○​ Then inflation between 2011 and 2010 can be calculated as: 107.8−105 ​ Inflation = 105 × 100 = 2. 67% ​ Both GDP Deflator and CPI measure inflation in an economy ​ Though they likely move in the same direction, they are unlikely to give the same measure of inflation ​ CPI measures the change in the price of consumer goods ​ The GDP Deflator measures the change in the average price of all goods produced in Canada ​ Countries with a larger population will have more economic activity and thus higher GDP ​ GDP per Capita: GDP divided by the population of a country  ○​ The average GDP per person ○​ Does not reflect the distribution of income within a country ​ Income distributions tend to be skewed to the right, meaning the median income is below the mean income ○​ Canada's GDP per Capita vs Mean Salary (2023): $73,403 vs $62,661 ○​ Alberta GDP per Capita vs Mean Salary (2023): $96,955 vs $66,740 ○​ Ontario’s GDP per Capita vs Mean Salary (2023): $71,855 vs $64,061 Lecture 3 - A Simple Short-Run Macroeconomics Model ​ Desired Level of Spending: what households and firms would like to purchase, already accounting for their constrained resources ​ Actual Level of Spending: what they actually end up spending ​ Aggregate Expenditure: the sum of desired or planned spending on domestic output by households, firms, government, and foreigners ○​ AE = C + I + G + NX ​ We will be examining the relationship that aggregate expenditure has with national income (GDP) ​ We break down aggregate expenditure into two components: 1.​ Autonomous Expenditures: the elements of aggregate expenditure that do not change systematically with changes to national income 2.​ Induced Expenditure: any component of expenditure that is systematically related to national income ​ To begin our model we make the following simplifying assumptions: 🦅 1.​ We are examining a Closed Economy (no international trade) - NX = 0 😁 2.​ There is no Government - G = 0 - NO TAXES 3.​ The price level is constant - no inflation ​ The amount of consumption done by households depends on their disposable income ​ Disposable Income (YD): income received after taxes have been paid ○​ Since there is no taxes national income (Y) is equal to disposable income (YD) ○​ YD = C + S ○​ Consumption (C) ○​ Savings (S) ​ Real per Capita Disposable Income = Inflation adjusted Income an Average Canadian Earned ​ Ceteris paribus, an increase in disposable income will lead to an increase in consumption spending ​ Permanent-Income Hypothesis: ○​ This theory states that a consumer’s spending is more closely related to what their expected lifetime income will be, rather than their current income  ○​ We ignore this complication 😁 ​ Example: ○​ Suppose that in our economy, people will consume 100 billion dollars worth of goods, even if their income is zero ○​ Additionally, for each additional dollar of income earned in the economy, desired consumption increases by 90 cents ○​ We could write this consumption function as follows: ​ C = 100 + 0.9YD ○​ Note that the $100 billion represents autonomous consumption ○​ The 90 cents per dollar represents the induced consumption ​ C > YD : negative savings ​ C < YD : positive savings ​ C = YD : savings is zero ​ The 45o line shows all the points where C = YD ​ Average Propensity to Consume: the desired consumption divided by the level of disposable income 𝐶 ○​ APC = 𝑌𝐷 ​ Marginal Propensity to Consume: the change in desired consumption divided by the change in disposable income that brought it about ∆𝐶 ○​ MPC = ∆𝑌𝐷 ​ The MPC is equal to the slope of the consumption function 😀 ​ When you choose how much to consume, you automatically choose how much you are saving as C + S is equal to your savings ​ We can calculate their savings function and graph it:  ○​ YD = C + S ○​ S = YD - C ○​ S = YD - (100 + 0.9YD) ○​ S = -100 + 0.1YD ​ Average Propensity to Save: the desired saving divided by the level of disposable income 𝑆 ○​ APS = 𝑌𝐷 ​ Marginal Propensity to Save: the change in desired savings divided by the change in disposable income that brought it about ∆𝑆 ○​ MPS = ∆𝑌𝐷 ​ The MPS is equal to the slope of the Savings Function ​ All disposable income is either spent of saved. Therefore… ○​ APC + APS = 1 ○​ MPC + MPS = 1 ​ As YD increases, we move upwards along the consumption function line ​ As YD decreases, we move downwards along the consumption function line ​ If wealth increases in the economy, ○​ The consumption function shifts upwards ○​ The savings function shifts downwards ​ Durable Goods: like cars, furniture, and appliances, that last many years ​ If interest rates decrease ○​ The consumption function shifts upwards ○​ The savings function shifts downwards ​ Consumer Confidence is an important measure of the economy ○​ If consumers feel the future is bad, their consumption function will shift downwards and their savings function will shift upwards ​ Three general categories of investment: 1.​ Inventory accumulation 2.​ Residential construction 3.​ New plant and equipment ​ Investmnet expenditure is much more VOLATILE component of GDP than the other components ​ We will focus on the following three determinants of desired investment expenditure 1.​ Real interest rate 2.​ Changes in the level of sales 3.​ Business confidence ​ There is a strong link between investment and the real interest rate ○​ Firms often borrow money to invest in new capital. If interest rates are high, the cost of borrowing is high, so investment will be low  ○​ If the real interest rates are high, there is a larger opportunity cost facing firms wishing to invest ​ If interest rates are high, ○​ Holding excess inventories becomes very costly (opportunity cost) ○​ Fewer people can afford mortgages, so residential construction will fall ○​ The cost of borrowing for new machines is high, so new plant and equipment investment will fall ​ Firms hold inventories to be able to meet consumer demand ○​ If there is an increase in sales, firms may decide to invest in holding more inventories in order to meet this demand and not be caught with no inventories to sell ○​ Firms will also invest in new equipment to produce the goods to sell to meet this new demand ​ If firms are optimistic about the future state of the economy, they may invest today to be ready to capitalize on future potential sales ​ If firms are pessimistic about the future state of the economy, they may hold off on investing today to see what the state of the economy will be Desired Investment Function ​ Our simple model will assume that that desired investment spending is completely Autonomous 😦 ​ For now, let us assume that regardless of national income, firms will wish to invest $200 billion ○​ I = 200 ​ Our desired investment function is this just a flat line ​ The line will shift up if… ○​ Real interest rates fall ○​ Sales increase ○​ Firms become more optimistic about the future  ​ The line will shift down if… ○​ Real interest rates rise ○​ Sales fall ○​ Firms become more pessimistic about the future ​ The Aggregate Expenditure Function relates the level of desired aggregate expenditure to the actual level of national income ​ In our model it is simply: ○​ AE = C + I ○​ AE = 100 + 0.9Y + 200 ○​ AE = 300 + 0.9Y ​ Note that this slope is equal to the marginal propensity to spend (MPC) ​ This is the change to desired aggregate expenditure that comes from a change to national income ​ In our simple model, this is equal to the marginal propensity to consume, since the desired level of investment expenditure is not related to the amount of disposable income Equilibrium ​ Recall that we have been talking about the desired level of consumption spending and the desired level of investment spending ​ In our model, Equilibrium will be achieved when the desired level of aggregate expenditure is equal to the actual national income (GDP) ​ If AE > Y, this implies that Y will go up - as there is more spending so firms are pressured to produce more (duh)hb ​ If AE = Y, this implies that Y will stay the same ​ If AE < Y, this implies that Y will go down  ​ Graphically, we can see that equilibrium occurs where our desired aggregate expenditure function intersects the 45o line ​ If actual national income/output is lower than this equilibrium amount, there will be pressure for it to rise ​ If actual national income/output is higher than this equilibrium amount, there will be pressure for it to fall ​ What causes the equilibrium to change: ○​ An increase in autonomous spending → shifts curve upwards ○​ A decrease in autonomous spending → shifts curve downwards ○​ An increase to the marginal propensity to spend → make curve steeper ○​ A decrease to the marginal propensity to spend → make curve flatter The Multiplier ​ Simple Multiper: the ratio of the ultimate change in equilibrium national income to the change in autonomous spending that brought it about ​ We want to derive the formula for the simple multiplier ​ Let us begin by re-stating our aggregate expenditure formula in the following way: ○​ AE = A + zY ○​ A represents autonomous spending. ○​ z is the marginal propensity to spend (induced spending) ​ Recall our equilibrium condition that desired aggregate expenditure equals actual national income: ○​ AE = Y ​ Combine these two equations to get the following: ○​ Y = A + zY ​ Isolate for Y: ○​ Y - zY = A ○​ Y(1 - z) = A 𝐴 ○​ Y = 1−𝑧 ​ Now we want to know how much Y will change given a change in A ∆𝐴 ○​ ∆𝑌 = 1−𝑧 - z is a constant, its not changing ∆𝑌 1 ○​ ∆𝐴 = 1−𝑧 1 ​ Thus, the value of the simple multiplier is 1−𝑧 ​ For every dollar increase in autonomous spending, GDP will eventually increase by this amount ​ If you are poor, you would save less (your z would be higher) ​ Give tax breaks to poor people as they have more induced spending ​ Self-Fulfilling Prophecy: the belief that good or bad times are approaching may lead to these expectations being realized ​ Paradox of Thrift: when a household thinks difficult economic times are approaching, they may begin to spend less and save more ○​ This means that the economy will not grow as fast as expected, creating the very economic hardship that they were anticipating Formulas 𝐿𝑎𝑏𝑜𝑢𝑟 𝐹𝑜𝑟𝑐𝑒 ​ Labour Force Participation Rate = 𝑃𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛 (𝐴𝑔𝑒 15+) × 100 𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑 ​ Unemployment Rate = 𝐿𝑎𝑏𝑜𝑢𝑟 𝐹𝑜𝑟𝑐𝑒 × 100 ​ Natural Unemployment = Frictional Unemployment + Structural Unemployment 𝑃𝑟𝑖𝑐𝑒 𝐼𝑛𝑑𝑒𝑥 𝑖𝑛 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑌𝑒𝑎𝑟 − 𝑃𝑟𝑖𝑐𝑒 𝐼𝑛𝑑𝑒𝑥 𝑖𝑛 𝑃𝑟𝑖𝑜𝑟 𝑌𝑒𝑎𝑟 ​ Inflation Rate = 𝑃𝑟𝑖𝑐𝑒 𝐼𝑛𝑑𝑒𝑥 𝑖𝑛 𝑃𝑟𝑖𝑜𝑟 𝑌𝑒𝑎𝑟 × 100 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑎 𝑀𝑎𝑟𝑘𝑒𝑡 𝐵𝑎𝑠𝑘𝑒𝑡 𝑖𝑛 𝑎 𝐺𝑖𝑣𝑒𝑛 𝑌𝑒𝑎𝑟 ​ Price Index in a Given Year = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑎 𝑀𝑎𝑟𝑘𝑒𝑡 𝐵𝑎𝑠𝑘𝑒𝑡 𝑖𝑛 𝑎 𝐵𝑎𝑠𝑒 𝑌𝑒𝑎𝑟 × 100 𝐸𝑛𝑑 − 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 ​ Percent Change = 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 × 100 ​ Real Interest Rate = Nominal Interest Rate - Rate of Inflation ​ Value-Added = Sales Revenue - Cost of Intermediate Goods ​ Value-Added = Payments to the Firm’s Factors of Production ​ GDP = C + I + G + X - IM OR GDP = C + I + G + NX ​ The Income Approach = total payments to factors of production ​ GNI = GDP - factor payments paid to foreigners + earnings/payments of domestic firms earned abroad 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 ​ GDP Deflator = 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 × 100 𝐺𝐷𝑃 ​ GDP per Capita = 𝑃𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛 ​ YD = C + S 𝐶 ​ APC = 𝑌𝐷 ∆𝐶 ​ MPC = ∆𝑌𝐷 𝑆 ​ APS = 𝑌𝐷 ∆𝑆 ​ MPS = ∆𝑌𝐷 ​ APC + APS = 1 ​ MPC + MPS = 1 ​ AE = A + zY 1 ​ Multiplier = 1−𝑧 Midterm Questions ​ If income goes up, how will consumption and savings change? Both will increase 😀 Covers the first three lecture topics 50 multiple choice - 80 mins to write (2 mins per question) Need student ID - will have a sign-in sheet Scantron This model will be on the midterm We are starting with a quiz on Wednesday - it will have the same questions as midterm -​ 13 answer: increase and decrease -​ Going to have a question about C + I -​ Ex -​ C = 100 + 0.8Y -​ I = 500 -​ What is desired expenditure level? -​ AE = 100 + 0.8Y + 500 -​ AE = 0.8Y + 600 -​ Autonomous vs induced?? -​ Ex. -​ Part 1: write AE formula -​ Solve for equilibrium -​ Given the equilibrium how much i consumed -​ Desired savings level -​ Question 1: B