Production of output generates income To measure total output in dollars, we add up the values of the many different goods produced.

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1 Class Notes (1) 4/27/2012 1:54:00 PM LECTURE 1 12/01/12 CHAPTER 19: WHAT MACROECONOMICS IS ALL ABOUT Output and Income Production of output generates income To measure total output in dollars, we add up the values of the many different goods produced. You produce Hockey sticks, Hot dogs, and Halter tops. You can t just add up these items to find your output. But you can add up the dollar-worth of all these products. Aggregate level of income Results in the nominal national income o Sum of all production in one year GDP o Canadian GDP: $ 1.6 Trillion o Quadrupled in the last 40 years In a typical year, the GDP value goes up on average 5% per year. Q goes up more than P (3% and 2% respectively) We re concerned with the level of activity: Q How productivity is increasing, How many people we re hiring, etc. With base-period prices, we get real national income When the P goes up, you know the productivity is going up in [real] terms Recession defined as a period where GDP actually falls; negative growth E.g -3% in 2009 Macroeconomists analyze Long-term growth Short-run fluctuations LECTURE 2 17/01/12 Real GDP fluctuates around a rising trend: The trend shows long run economic growth The short run fluctuations show the business cycle Potential output is what the economy could produce if all resources were employed at their normal levels of utilization Full Employment Output The output gap measures the difference between potential output and actual output Output Gap = Y Y* Y* is Potential Output, Y is Actual Output o When Y < Y* there is a recessionary gap o When Y > Y* there is an inflationary gap

2 Only way to produce more GDP than potential is to produce over capacity (over time drives up wages) Estimates of Potential tend to be debatable because they are based on models. Average annual rate of Canadian real GDP growth over the past 4 decades has been about +3% A very deep recession has an annual growth of about -3% Employment: number of workers (>15) who hold jobs Unemployment: number who are not employed but are actively looking for work Labor Force: # employed + # unemployed Unemployment Rate = Number of People Unemployed Number of People in the Labour Force Even when Y = Y*, some unemployment exists Gap between Labour Force and Employment is Unemployment Rather volatile Unemployment Rate when Y = Y* is called the natural rate of unemployment (NAIRU) NAIRU: unemployment existing at potential output Estimated at below 7% now Some unemployment is desirable as it reflects the time required for workers and firms to find each other so that good matches are made. Some unemployment is however associated with human hardship, especially for those individuals with skills that are not in high demand by firms. Productivity Productivity: measure of output per unit of input GDP per worker GDP per hour of work Increases in productivity are probably the single largest determinant of LR increases in material living standards (GDP per person; average income) Real GDP per worker is measured in thousands of dollars Inflation and the Price Level Price Level: average level of all prices in the economy Consumer Price Index o Based on the price of a typical consumption basket, relative to the price in some base year o Rate of change represents rate of Inflation

3 o Alone is not meaningful. You need two points in time and a difference for it to be representative of Inflation. o CPI = Sum of Pt*Q0 Sum of P0*Q1 Inflation: rate at which the price level is changing Rate of change of prices In Canada today: 3% o Bank of Canada aims for 2% People on fixed income are slowly losing purchasing power because inflation increases but salary doesn t Inflation generates a lot of uncertainty for the economy Interest Rates The interest rate is the price of credit, and the flow of credit is crucial to firms and households in a modern economy. Nominal Interest Rate: rate expressed in money terms Real Interest Rate: rate expressed in terms of purchasing power Burden of borrowing depends on the real interest rate International Economy Why do we trade? Because we want stuff we can t produce. Imports are the things we want. In order to get stuff, we need to sell stuff. Exports are the things we do so that we can afford imports. Foreign Exchange: foreign currencies or claims on foreign currencies Exchange Rate: number of Canadian dollars required to purchase one unit of foreign currency Number of Canadian dollars it takes to buy one American dollar A depreciation of the Canadian dollar means that it is worth less on the foreign-exchange market. a Rise in the exchange rate Today, 1.01 CAD for 1 USD When CAD is low in value (takes many to buy USD), less purchases in US. Balance of Payments: accounts that record all payments made in international transactions goods, services, assets. Trade balance Current accounts balance Capital account balance For Canada, exports and imports are both very large roughly 35% of GDP but the trade balance is usually small. LECTURE 3 19/01/2012 National Output and Value Added

4 Production occurs in stages most firms produce outputs that are other firms inputs. Labour input Material Input (produced by some other firm) Intermediate Product Final Product Hard to know when a product is finalized o Sell a steak Final good for consumer Intermediate good for a restaurant because still need to finalize it Each firm s contribution to total output is its value added Value Added = Revenues Non Labour Costs o Value that the labour of the firm has added to the final product Value added to production o Workers convert value of wood, glue, electricity, into the value of the hockey sticks Summing value added avoids the problem of double counting when measuring total output. o Only add up value added so you don t count inputs in multiple outputs Total value added in the economy is called Gross Domestic Product (GDP) National Income Accounting: The Basis Three methods for measuring national income (output) Total value added from domestic production Total expenditures on domestic output Total income generated by domestic production The Circular Flow of Expenditure and Income

5 Savings help finance loans (banks) Spendings help finance expenses (companies) GDP from the Expenditure Sid Consider adding up the expenditure needed to purchase the final output produced in any given year. There are four broad expenditure categories Consumption (households) Investment (firms) Government Purchases Net Exports Actual consumption expenditure (Ca) includes expenditure on all final goods during the year. Non durables o Food o Services (70% of output in Canada) Semi durables o Clothing Durables o Furniture Actual investment expenditure (Ia) is expenditure on the production of goods not for present consumption, including: Inventories (producing it now, but not selling it yet) Plant & Equipment (business fixed investment) Residential Housing Investment is an addition to the stock of physical capital o Building and/or acquisition of productive capacity o Do it now to generate benefits long into the future Actual government purchases (Ga) is the purchase of the currently produced goods and services by government Federal Government Budget in 2011: $290BN Excludes transfers to Provinces, Businesses, Individuals Only includes purchases of goods and services Actual net exports (NXa) is the difference between exports and imports NXa = (Xa IMa)

6 Exports are purchases of Canadian-produced goods and services by foreigners. We subtract imports because they are not produced in Canada Since total domestic output must equal total expenditure on domestic output, we have: GDP = Ca + Ia + Ga + NXa o Accounting identity, not causal relationship. GDP from the Income Side GDP is also the sum of factor incomes and other claims on the value of output. Factor incomes include: o Wages o Rent, Interest, Profits Non-Factor payments include: o Indirect taxes (net of subsidies) o Depreciation of existing physical capital Sometimes output is being produced to replace itself, because of the depreciation factor GDP from the income side is therefore equal to GDP = Net Domestic Income + Indirect Taxes (less subsidies) + Depreciation National Income Accounting: Some Extra Issues For the practical measurement of GDP, statisticians add up the producer s value added across all producers. Suppose Y is given, and there is a sudden reduction in consumption expenditure. To maintain the national income accounting identity, there will likely be an unanticipated increase in GDP and GDP A measure of national output closely related to GDP is Gross National Product (GNP) The difference between GDP and GNP is the difference between income produced and income received. Stuff that Bombardier produces in Canada accounts for GDP in Canada Bombardier also has plants in other countries. The stuff they produce abroad is part of the other countries GDPs. However the profits earned here by the production abroad come back to a Canadian shareholder (earned from production and sales made elsewhere). This increases the GNP higher than the GDP in Canada. The production made by foreigners in Canada reduces GNP here. Canadian GDP > GNP GDP is superior as a measure of domestic economic activity GNP is superior as a measure of living standards of residents. A more refined measure is disposable personal income: GNP minus

7 o o o Any part not actually paid to households Personal income taxes plus transfer payments received by households LECTURE 4 24/01/2012 Real and Nominal GDP GDP: value of goods and services produced in the country GNP: amount of income accruing to domestic residence GDP that is valued at constant base period prices is real national income. Real = Quantity Nominal = $ value Q goes up, and P is going up. We want to find out if GDP goes up because of P or Q Nominal GDP can increase either because prices go up or because activity goes up Real GDP locks in the price and only tracks activity GDP Deflator = Nominal GDP Real GDP o Comprehensive price index because includes prices of all goods and services produced in the country. Since 2002, prices in the Canadian economy have gone up approximately 21% Omissions from GDP National income accountants cannot measure economic activity that takes place outside of regular, legal markets. Transactions are not tracked Illegal activities (drugs, prostitution, etc.) o If was legalized, GDP would go up. Leisure (e.g. homemade pizza you spend time doing economic labour but there isn t a transaction for it) Home Production ^ o No actual transactions The Underground Economy o Undeclared income Economic bads o Cut a tree, Soil erosion, Dirties rivers, Poisons fish Pollution. o Not tracked. Only the value from chopping down the tree is tracked.

8 Unless the unmeasured economic activity changes rapidly, changes in GDP will do a reasonable job of measuring changes in material living standards. GDP and Living Standards Well-being is a broader concept than material living standards: GDP is not a complete measure of economic well-being But income is a very important part of well-bring and GDP is a good measure of income. Per Capita GDP = measure of average income Increases with time because of long run productivity growth Not a great measure of our well-being or happiness Some things make you happy and are not counted in the GDP o Freedoms, Democracy, etc. o Relationships o Religion beliefs o Gender equality o Income Distribution LECTURE 5 26/01/2012 CHAPTER 21 The Simplest Short Run Macro Model Y = C + I + G + NX should never be used as a cause-effect relationship. It is solely an accounting identity. Two possible uses of disposable income: Consumption (C) Saving (S) In the simplest theory, consumption is determined primarily by current disposable income (YD) In more advanced theories individuals are forward looking and so consumption depends more on lifetime income. Current income drives current consumption but it s not the only thing that does. Real per Capita Savings are getting smaller over time, because individuals are gradually spending a greater portion of their disposable income. The simple consumption function: C = a + byd Note: slope b is positive, but less than one

9 Even at very low levels of income, there is substantial level of desired consumption. As income goes up by X, consumption goes up by less than X. Difference goes into savings. The Marginal Propensity to consume (MPC) relates the change in desired consumption to the change in disposable income that brings it about How much are you going to consume out of your next dollar of income? If you earn one more dollar, how much is your desired consumption going to change? MPC = C / YD o MPC is the slope of the consumption function o Same at any level of income The Average Propensity to Consume (APC) is equal to total consumption divided by total disposable income Over all your income, how much is your desired consumption APC = C/YD o APC falls as the level of income rises o Constant because assume constancy of MPC Every dollar that doesn t go to C, goes to S The Savings Function is the compliment to the Consumption Function. Both slopes = 1 Since all of disposable income is either consumed or saved, we have APC + APS = 1 MPC + MPS = 1 In a world without taxes and foreign trade, all of GDP goes to the people. Shifts in the Consumption Function If consumption function shifts upward, the saving function must shift downward. If you want to consume more, you must save less Reduction in Interest Rate (can purchase more on a loan) Wealth How you foresee the future *Wealth is a stock; It s an accumulation *Income is a flow; per month, per year, Desired Investment Expenditure Investment expenditure is the most volatile component of GDP Changes in investment expenditure are associated with SR fluctuations I is the most volatile of all components (desired)

10 Investment is the accumulation of physical capital Three important determinants (drivers) of aggregate investment expenditures are The real interest rate o Opportunity cost to borrowing Changes in the level of sales o Not sales Change. o Inventories Business Confidence Desired investment this year is not a function of GDP this year. Expectations about future GDP plays a part though The Real Interest Rate The real interest rate is the opportunity cost for Investment in new plants and equipment Investment in inventories Investment in residential construction The Aggregate Expenditure Function The AE Function Relates desired aggregate expenditure to actual national income Without government and international trade, desired aggregate expenditure is AE = C+I Example: C = 30 + (0.8) Y I = 75 AE = C + I = 30 + (0.8)Y + 75 AE = (0.8)Y o Slope of AE comes from C function, because I has none. * Current real GDP does not influence desired investment spending Equilibrium National Income If desired aggregate expenditure exceeds actual output What is happening to inventories? There is pressure for GDP to rise. If desired aggregate expenditure is less than actual output What is happening to inventories There is pressure for GDP to fall. Looking for a value of GDP such that GDP = C + I Equilibrium Condition

11 We re looking for a point on the AE function that satisfies the Equilibrium Condition Cross Point o Y = AE(Y) The Y satisfying this equation is the Equilibrium value of GDP Output is demand determined. Changes in Equilibrium National Income Shifts in the AE Function The AE function can shift parallel to itself o Autonomous variables change (Investment change along the Y axis, shifts line up because of different intercept) The slope of the AE function can change Movement along the AE curve Caused by a change in one of the variables on the axes Shift of the AE curve Caused by one of the functions The Multiplier A measure of the size of the change in equilibrium Y that results from a change in autonomous expenditure. APPLIES ONLY TO SHOCKS OR EVENTS THAT CAUSE A PARALLEL SHIFT UP OR DOWN IN AE. Exceeds 1 Simple Multiplier = Y = _1_ A 1-z Where z the slope is the MPC out of national income and A is the change in autonomous expenditure The larger is z, the steeper is the AE curve and the larger is the simple multiplier. If demand suddenly increases, production increases too. In this case, National Income goes up by the same rate; meaning Desired Consumption goes up similarly, but slightly less. GDP has now increased. Desired Consumption goes up again. Etc. LECTURE 6 31/01/2012 (substitute noob) CHAPTER 21 REVIEW Desired Aggregate Expenditure The national accounts divide actual GDP into its components: Ca, Ia, Ga, and NXa

12 Total desired expenditure is divided into the same categories: Desired consumption, C Desired investment, I Desired government purchases, G Desired net exports, NX The sum is called desired aggregate expenditure: AE = C + I + G + NX Two types of expenditures o Autonomous: do not depend on the level of national income o Induced: depend on the level of national income o In the early 80s, consumers were very concerned about their futures (seen through large savings). Savings have become smaller over time. This is an indication of either Foolishness Consumer confidence Savings however begin to increase too late. Need to be forward looking. *If consumption shifts up, saving must shift down. Every [slope] or [marginal ] indicates the rate of a function. (Housing enters the function only the first time it enters the economy) Disposable income is national income The slope of the AE is the slope of the Consumption function The choices I make about consuming or investing really depend on my vision of what the future holds. Consumer Confidence Economic fluctuations as self-fulfilling prophecies CHAPTER 22 ADDING GOVERNMENT AND TRADE TO THE SIMPLE MACRO MODEL Now, we introduce government. By introducing government, we also introduce taxes. We are also including trade; open economy.

13 MPC vs MPS All of this influences the simple multiplier Government Purchases Government purchases of goods and services (G) are part of desired aggregate expenditures In terms of function, no difference between consumers, businesses, and government. o Difference: concept of authority Government spending is autonomous does not depend on National Income Not including transfer payments Net Tax Revenues Tax rate is once transfers are removed o Transfers: take money from one side of the economy and send it over to another What the government charges us minus what they give back T = ty depend directly on level of national income (induced) o t : rate of taxation/slope of the taxation function/mpt autonomous; net tax rate Budget Balance: it s the difference between G and T G < T: budget surplus G > T: budget deficit When measuring the overall contribution of government to desired aggregate expenditure, all levels of government must be included Particularly in Canada Combined purchases of provincial and municipal governments are larger than those of the federal government o No distinction between tiers of government; one government == FOREIGN TRADE == Net Exports We make two central assumptions: Canada s exports are autonomous with respect to Canadian GDP o They don t depend on Canadian national income; They depend on foreign nation s national incomes Canada s imports rise as Canadian GDP rises Exports Intercept of the line Rate of importation Slope Increasing with respect to Y Negatively sloped in respect to national income Imports IM = my where m = marginal propensity to import (MPI)

14 Net Exports are given by: NX = X my Exports are a constant line. Imports enter negatively into the NX equation, so they are a downward slope Ceteris paribus, changes in domestic GDP lead to changes in net exports: As Y rises, NX falls As Y falls, NX rises The relationship between Y and NX is shown by the net export function The NX function is drawn holding constant: Foreign GDP Domestic and Foreign prices Exchange Rate Parallel shift only if rise in demand. Otherwise, ANGLE shit. Shifts in the Net Export Function An increase in foreign income leads to more foreign demand for Canadian goods: o Increases X and shifts NX function upward A rise in Canadian prices (holding foreign prices constant): o Decreases X o IM function rotates up as Canadians switch toward foreign goods NX function shifts down and gets steeper Equilibrium National Income Desired Consumption and National Income With taxation, YD is less than Y Since rate of taxation is 10%, what we retain of national income is 90% If T = (0.1)Y, then YD = (0.9)Y The MPC out of national income (0.72) is less C = 30 + (0.8) YD than the MPC out of disposable income (0.8) C = 30 + (0.8) (0.9) Y C = 30 + (0.72) Y AE becomes flatter MPC is largely dependent on tastes. Everybody consumes at 80% of their income. Government comes in and increases taxes to 10%. Do tastes for consumer goods change? No. Because we will still be consuming 80%, it s just worth less. So 90% of the 80% is retained.

15 The AE Function AE = C + I + G + NX Recall that the slope of the AE function is the marginal propensity to spend out of national income we call this z. In this model, we get z = MPC (1 t) m Now the slope of AE is the sum of the slopes of the induced functions ^ ** Introducing government and creating an open economy, the MPC out of national income (MPS) decreases, due to the leakages that occur appropriately through each of those things (T & NX). MPC disposable income Slope of C function MPC national income MPS Equilibrium National Income As before, output is assumed to be demand determined in this model: Equilibrium condition is Y = AE (Y) In words, equilibrium Y occurs where desired aggregate expenditure equals actual national income. Whenever AE is not equal to Y, there are unintended changes in inventories and firms have an incentive to change production. When the AE function is flat, and there is an increase by 1 unit, the impact on the equilibrium will also be 1 unit. The Multiplier with Taxes and Imports Imports and taxes make z smaller Impact of policies reduced Without G and T, bigger impact because greater z The simple multiplier is also smaller z = MPC (1 t) m o Canada s Simple Multiplier [SEE EXTRA SHEETS] Fiscal Policy The use of government s spending and tax policies Any policy that attempts to stabilize Y at or near Y* is called stabilization policy It is often clear in which direction fiscal policy could be adjusted, but less clear how much is necessary.

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17 Class Notes (2) 1/12/2012 2:06:00 PM LECTURE 7 07/02/2012 CHAPTER The Demand Side of the Economy Exogenous Changes in the Price Level Increase in P reduces the real value of money holdings Fall in P raises the real value of money holdings Changes in P also affect the wealth of bondholders and bond issuers Complimentary balance between bondholders and borrowers No effect on aggregate wealth. Increase in P thus reduces private-sector wealth Reduction in desired consumption Downward shift in AE curve Effect on Net Exports: NX function shifts down Further downward shift in AE curve Price level falls. Increase in P reduces desired aggregate expenditure AE shifts down Equilibrium Y falls Aggregate Demand Curve The aggregate demand (AD) curve relates equilibrium real GDP to the price level. For any give P, the AD curve shows the level of real GDP for which desired aggregate expenditure equals actual GDP. Price of all goods AE curve shift down, but we move along the AD curve. Shifts in the AD curve Any shock that increases equilibrium GDP at a given price level (i.e. except changes in P) shifts the AD curve to the right. Horizontal shift of the AD curve is the simple multiplier times the change in autonomous spending.

18 23.2 The Supply Side of the Economy The Aggregate Supply Curve The AS curve relates the price level to the quantity of output that firms would like to produce and sell. The AS curve is drawn for a given: Level of technology Set of factor prices As unit costs rise with output, firms will produce more output only if prices increase: AS curve is upward sloping. Shifts in the Aggregate Supply Curve Anything that increases firms costs cuases the AS curve to shift up: o Factor prices o Technology The slope of the AS curve is increasing as output rises: When output is low, firms typically have excess capacity Costs do not rise quickly When output is nearer Y*, costs rise as output rises. Firms need higher prices 23.3 Macroeconomic Equilibrium Demand behaviour is consistent with supply behaviour only at the intersection of two curves. E 0 is the macroeconomic equilibrium. Changes in the Macroeconomic Equilibrium Demand shocks can either be expansionary or contractionary Direction of AD shift Supply shocks can either be expansionary or contractionary Direction of the AS shift In both cases, expansionary or contractionary refers to the effect on equilibrium output. Aggregate Demand Shocks Demand shocks causes P and Y to change in the same direction. Possible causes o Change G > 0

19 o Change I > 0 o Change X > 0 o Change C > 0 The Mechanics of an AD Shift The shock causes the AE curve to shift upward, but the rise in the price level causes it to shift down. The effect of any given shift of the AD curve will depend on the slope of the AS curve. Aggregate Supply Shocks Aggregate supply shocks cause P and Y to change in opposite directions Possible causes o Change in Price of Inputs Word of Warning Many economic events (especially change sin the world prices of raw materials) cause both aggregate demand and aggregate supply shocks. The overall effect on the economy depends on the relative importance of the two separate effects. LECTURE 8 9/02/2012 CHAPTER 24: FROM THE SHORT RUN TO THE LONG RUN: THE ADJUSTMENT OF FACTOR PRICES As of now, we don t really know where monetary policy comes from, and can t talk about where exchange rates are determined. The Shorts Run In Micro, SR is a span of time over which there is some fixed factor of production. Long run, everything is variable In Macro Factor prices are assumed to be constant Technology and factor supplies are assumed to be constant The Adjustment of Factor Prices Factor prices are flexible Technology and factor supplies are constant The Long Run Factor prices have fully adjusted Technology and factor supplies are changing

20 What is causing changes in GDP? Aggregate Demand and Aggregate Supply shocks. Following some shocks, Y eventually returns to Y* The Adjustment Process Potential Output and the Output Gap Output Gap = Y Y* How do you have output above potential? Work your factors over. Output below potential? Idle resources. Don t fully use your factors of production. Factor Prices and the Output Gap When Y > Y*, the demand for labour (and other factor services) is relatively high Inflationary output gap. During an inflationary output gap there are high profits for firms and unusually large demand for labour Wages and unit costs tend to rise. When Y < Y*, the demand for labour (and other factor services) is relatively low Recessionary output gap During a recessionary gap, there are low profits for firms and low demand for labour. Wages and unit costs tend to fall. o Assuming no inflation and productivity growth Unrealistic, but wtv. Adjustment Asymmetry Inflationary output gaps typically raise wages rapidly Recessionary output gaps often reduce wages only slowly Wages rise faster during inflation than they fall during recession This general adjustment process from output gaps to factors prices is summarized by the Phillips Curve. The Phillips Curve was originally drawn as a negative relationship between the unemployment rate and the rate of change in nominal rages. When unemployment is higher than normal, wages tend to rise. When unemployment is lower than normal, wages tend to fall. Y > Y* Excess demand for labour wages rise

21 Y < Y* Excess supply for labour wages fall Y = Y* No Excess supply/deman wages constant Potential Output as an Anchor Suppose an AD or AS shock pushes Y away from Y* in the short run As a result, wages and other factor prices will adjust, until Y returns to Y* Y* is an anchor for output When Y=Y*, the unemployment rate equals NAIRU, U* There is both structural and frictional unemployment. If you just let the economy deal with itself, Y comes back to Y* eventually Aggregate Demand and Supply Shocks Expansionary AD Shocks Starting where GDP is at potential The economy s adjustment process eventually eliminates any boom caused by a demand shock, returning Y to Y*. Contractionary AD Shocks The economy s adjustment process works following negative demand shocks, too. Although it may be slower because of sticky wages How long does it take back to get back to Y*? Depends on how fast the wages fall If in response to shocks the wages adjusted quickly and the curve did too, finance ministers would be massively under employed. Aggregate Supply Shocks SR equilibrium at Y* (which happens to be LR equilibrium, because with no shocks will remain the same) Negative Aggregate Supply Shocks: Increase in the price of oil. Shifts left. Impact creating a recessionary gap, pushing up the price. When the AD shifts, prices and output move in the same direction. After a negative supply shock, the adjustment of factor prices reverses the AS shift and returns real GDP to Y* It Matters How Quickly Wages Adjust! Following either a demand or supply shocks, the speed that output returns to Y* depends on wage flexibility Flexible wages provide an adjustment process that quickly pushes the economy back toward potential output.

22 But if wages are slow to adjust, the economy s adjustment process is sluggish and thus output gaps tend to persist. It s the speed of wage adjustment that determines how quickly we get back to potential. Motivation for stabilization policies comes from the slowness of wage adjustment. Long Run Equilibrium The economy is in a state of long run equilibrium when factor prices are no longer adjusting to output gaps: Y = Y* The vertical line at Y* is sometimes called: The long-run aggregate supply curve, or The classical aggregate supply curve. o Basically vertical line at Y* There is no relationship in the long run between the price level and potential output. In the LR, Y is determined only by potential output aggregate demand determines P. For a given AD curve, the LR growth in Y* results in a lower price level 24.3 Fiscal Stabilization Policy The motivation for fiscal stabilization policy is to reduce the volatility of aggregate outcomes. The Basic Theory of Fiscal Stabilization A recessionary gap may be closed by a rightward shift in AD or by a (possibly slow) rightward shift in the AS curve. An inflationary gap may be removed by a leftward shit in the AD, or by a leftward shift of AS. The Paradox of Thrift In the SR, an increase in desired saving leads to a reduction in GDP and possibly no change in aggregate saving! What is true at the level of individuals saving more is good ends up being bad when everybody does it together, because it drives down our full economy. In the LR, an increase in desired savings has the following effects: the price level falls investment rises aggregate output returns to Y

23 LECTURE 9 14/02/2012 z = MPC*(1-t) - MPI If GDP goes up by a dollar, how much does disposable income go up? 1 t What is left is MPC LECTURE 10 16/02/2012 CHAPTER 24: FROM THE SR TO THE LR: THE ADJUSTMENT OF FACTOR PRICES Fiscal Policy in the Great Depression Fiscal Policy did exactly the wrong thing in G20 countries during the Great Depression. Collapse of Confidence + Collapse in Investment + Collapse in Spending Leftward shift of AD curve Reduce Equilibrium GDP and increase Unemployment GDP fell and drove down government tax revenues fell budgets went into deficit o Government Response: Reduce Spending Destabilized Output in the SR is demand determined Output in the LR comes back to equilibrium Changes in Demand can lead to change in economic activity Foreign concept in the 1930s Fiscal Policy exacerbated the recession Automatic vs. Discretionary Fiscal Policy Discretionary fiscal stabilization policy occurs when the government actively changes G and/or T in an effort to steer real GDP. You actually change your policies on either the Spending or Tax sides as a way to shift the AD curve. Acts slowly because required parliamentary action Automatic fiscal stabilization occurs because of the design of the tax and transfer system: As Y changes, transfers and taxes both change The size of the simple multiplier is reduced The output response to shocks is dampened This tax function provides more stabilization o Reduces the size of the multiplier o Shocks will have smaller effects Real stabilization in the world is in the tax system Net of transfers o When Real GDP goes up, income taxation increases, and dampens the multiplier Less money taken away, More to spend

24 Most countries have automatic fiscal stabilization, because they have tax functions dealing with Practical Limitations of Discretionary Fiscal Policy Most economists agree that automatic fiscal stabilizers are desirable and generally work well, but they have concerns about discretionary fiscal policy. Limitations come from Long and uncertain lags o Usually projects are long-term and take quite a bit to complete [+design] o Many politics involved o When you need stabilization, you need it now. It s not something discretionary policies are good with Temporary versus permanent changes in policy The impossibility of fine tuning o Due to delays, impossible to predict extent of action at the time it will be ready Fiscal Policy and Growth Fiscal stabilization policy will generally have consequences for economy growth. For example An increase in G temporarily increases real GDP Investment is lower in the new LR equilibrium This may reduce the rate of growth of potential output We think of stabilization as a SR thing, but we want to keep an eye on the LR CHAPTER 25: THE DIFFERENCE BETWEEN SR AND LR MACROECONOMICS We want to get back to Y*, but in the meanwhile, where is it going? 25.1 Two Examples from Recent History Inflation and Interest Rates in Canada Ceteris paribus, an increase in inflation pushes up nominal interest rates. (Higher inflation drives up nominal interest rates) Changes in inflation tend to move 1:1 with nominal interest rates The Bank of Canada argues that: in order to reduce inflation and interest rates, the Bank must take actions which raise the interest rate immediately. Why? Beneficial in the LR Big effect in the SR Create a recession to reduce inflation. Recognize the different SR and LR effects of monetary policy. In the SR, the rise in interest rates causes aggregate expenditure to fall, reducing output.

25 But in the LR, the downward pressure on wages (recessionary gap) causes inflation to fall, and interest rates too. Saving and Growth in Japan For the decade following 1990, Japan s economy was stagnant. Some argue there was too much saving (and too little spending) Referred to as Japan s Lost Decade Many also argue that Japan s economic success since WW2 was due in part to its high saving rate. In the SR, an increase in desired saving leads to less aggregate desired spending economic slump. But in the LR, greater saving expands the pool of funds, drives down interest rates, and makes investment more attractive. Big correlation between countries that save a lot and countries that grow quickly (LR) More investment in capital leads to increases in the economy s LR productive potential economic growth. A Need to Think Differently Short Run Emphasizes changes in output as deviations from potential Limited price and wage adjustment Long Run Emphasizes changes in output as changes of potential Considerable wage and price adjustment takes place 25.2 Accounting for Changes in GDP GDP Accounting: The Basic Principle Consider the following identity GDP = F x (F E/F) x (GDP/F E) o F is the amount of factors o F E is the amount of employed factors F is the factor supply F E/F is the factor utilization rate GDP/F E is a simple measure of productivity Any change in GDP must be associated with a change in one or more of these things How do they change over time? 1. Factor Supplies o supplies of labor and capital change only gradually 2. Productivity o productivity changes only gradually 3. Factor Utilization Rate o fluctuates a lot in the SR

26 o but very little in the LR GDP Accounting: An Application Consider just one factor of production labor. The identity becomes GDP = L x (E/L) x (GDP/E) o L is the labor force o E/L is the employment rate o GDP/E is a simple measure of labor productivity ** To understand long run changes in GDP Need to understand labor force growth and productivity growth To understand short run changes in GDP Need to understand changes in the utilization rate of labor the employment rate 25.3 Policy Implications Fiscal and monetary policies affect the SR level of GDP because they alter the level of aggregate demand. But unless they are able to affect the level of potential output, they will have no effect on LR GDP. Broad consensus that monetary policy has only limited effects on Y* Fiscal policy probably has more effects on Y*

27 Class Notes (3) 1/12/2012 2:06:00 PM CHAPTER 26: LONG RUN ECONOMIC GROWTH 26.1 The Nature of Economic Growth Sustained increases in Y* are a more powerful method of raising material living standards than the removal of recessionary gaps. Even small differences in annual growth rates can result in large changes in living standards after many years. Consider GDP, per capita GDP, and GDP per worker.

28 Class Notes (4) 1/12/2012 2:06:00 PM LECTURE 1/03/ The Nature of Economic Growth Sustained increases in Y* are more powerful method of raising material living standards than the removal of recessionary gaps. Even small differences in annual growth rates can result in large changes in living standards after many years. Consider GDP, per capita GDP, and GDP per worker. Benefits of Economic Growth 1. Rising average living standards 2. Alleviation of Poverty a. Many do not share directly in the growth b. But redistribution is easier in a growing economy Costs of Economic Growth 1. Sacrifice of Current Consumption a. Growth is often encouraged by increasing investment and saving b. Which requires less consumption 2. Social Costs of Growth a. Growth usually involves the displacement of some firms and workers i. Because growth never happens evenly over everywhere b. This process involves real transition costs Sources of Economic Growth The four fundamental sources of economic growth are: Growth in the Labor Force Growth in Human Capital Growth in Physical Capital Technological Improvement Different theories emphasize different sources of growth 26.2 Established Theories of Economic Growth Focus on the Long Run We focus on the LR, when real GDP is equal to potential output, Y* We assume Adjustment Process is done We hold Y* constant and let the interest rate be determined endogenously

29 By desired saving and desired investment Investment, Saving, and Growth Our model has two parts: Investment increases in the stock of capital lead to increases in the future level of Y*. Saving by households (and firms) is used to finance this investment. Interest rate is the price that equilibrates this market Firms investment demand is negatively related to the real interest rate. National Saving = Private Saving + Public Saving NS = Y* - T C + (T G) NS = Y* - C G If C is negatively related to the interest rate, then NS is positively related to the interest rate. Consumer durables are highly interest sensitive o House: more sensitive. With Y=Y*, the condition that desired national saving equals desired investment determines the equilibrium interest rate. At point E, the market for loanable funds clears and the equilibrium real interest rate is i*. Suppose the supply of national saving increases The NS curve shifts to the right Increased NS reduces the real interest rate and encourages more investment. Greater flow of investment leads to a higher growth rate of potential output. LECTURE 06/03/2012 Potential GDP per capita + Productivity Growth (technological knowledge) indicate growth in quality of life. SR fluctuations driven by rate of factor utilization Rule of 72: Annual Growth Rate/72 = # Years for Sum to double If G increases, NS decreases + Interest Rate increases + Investment decreases

30 Now suppose that investment demand increases The curve I shifts to the right. Increased investment demand pushes up the interest rate and encourages more saving by households. Empirically, countries with high investment rates also have high growth rates. Neoclassical Growth Theory This theory begins with the idea of an aggregate production function: GDP = F T(L,K,H) o L is the total amount of labour o L is the stock of physical capital o H is the quality of human capital o T is the state of technology The key assumptions about the aggregate production function are: 1. Diminishing marginal product of both K and L When either factor is changed in isolation 2. Constant returns to scale When both K and L are changed in equal proportions o If I double all inputs, will double my output. Holding K constant, increases in L generate positive but diminishing increments to output. What are the central predictions for this model? According to the law of diminishing returns, the MP of L eventually falls as each successive unit of L is used (for a fixed amount of other factor). o Increases in population lead to increases in GDP but eventually to reductions in per capita GDP Similarly, diminishing MP of K means that capital accumulation on its own brings smaller and smaller increases in real per capita GDP Finally, the assumption of constant returns to scale means that if L and L grow at the same rate there will be no improvements in material living standards. In the Neoclassical growth model, technological change is necessary for sustained growth in living standards. It is the only way. Much technological change is embodied in new capital equipment Investment is crucial Measuring the extent of technological change is difficult because it is not directly observable. Robert Solow

31 His growth accounting method estimates technical change as the part of growth that is unexplained by capital accumulation or labour-force growth The Solow Residual 26.3 New Growth Theories [READ!!!] 26.4 Are There Limits to Growth? Resource Exhaustion Current technology and resources could not support the entire world s population at the average Canadian standard of living. But absolute limits to growth may not be relevant Technology is constantly improving, suggesting that living standards can continually improve But technological improvements are not automatic they do not just happen Environmental Degradation Conscious management of pollution was unnecessary when the world s population was one billion people, but such management has now become a pressing matter. Growth can help the world address many problems. But further growth must be sustainable growth, which should be based on knowledge-driven technological change. LECTURE 08/03/ The Nature of Money What is Money? Money is a medium of exchange. If there were no money, goods would have to be exchanged in a system of barter. Barter is very inefficient due to the double coincidence of wants o If you have chickens and want piano lessons, you d need to find someone who gives piano lessons and wants chickens. Money is also used as a store of value Without high inflation, money retains its value well Value maintained pretty much over time Even more so now that our CADs are plastic Money is used as a unit of account Used to keep our financial accounts The Origins of Money

32 Money has evolved over time, taking various different forms: Metallic Money o Years ago the market value of the metal was equal to the face value of the coin o Led to debasing Gresham s Law Scraping metal off of gold coins. Use slivers for economic benefit. Use the coin for its worth while its lost part of his value Bad money ends up in circulation Paper Money o Paper money was initially backed by precious metal o Often referred to as bank notes (issued by banks) Kind of like individual receipts Fractionally backed paper money o Goldsmiths and banks began to issue more notes than the amount of gold held in their vaults Fiat money o Money that is neither backed by nor convertible into anything else o Decreed by the government to be legal tender Today, almost all currency is fiat money. Modern Money: Deposit Money Money held as deposits with commercial banks and other financial institutions is called deposit money Bank deposits are an important part of the money supply As in the past, banks create money by issuing more promises to pay (deposits) than they have in cash reserves The Canadian Banking System Most banking systems have: A central bank Many commercial banks A central bank acts as a bank to the banking system: Usually a government-owned institution And the sole money-issuing authority The Bank of Canada Created in 1935 Formally accountable to the Minister of Finance and Parliament System of joint responsibility maintains day-to-day independence The basic functions of the Bank of Canada are to: Act as a banker to the commercial banks

33 Act as a fiscal agent of the federal government Regulate the money supply Regulate, support, and monitor financial markets Interest Rates on Loans to Commercial Banks in Canada A commercial bank is a privately owned, profit-seeking institution that provides a variety of financial services: Accepts deposits Makes loans Provides credit-card services Offers wealth management services Banks are important financial intermediaries and are crucial for the smooth operation of credit markets LECTURE 13/03/2012 Commercial banks Accept deposits Make loans Provide credit-card services Offer wealth-management services Crucial for the smooth operation of credit markets Reduce assets Sell government bonds on the open market Increase assets Purchase government bonds Reserves Banks cash reserves are normally quite small because only a small fraction of depositors want their money at any time A banks reserve ratio is the fraction of its deposit liabilities that it actually holds as reserves Either vault cash or deposits with the central bank A banks target reserve ratio is the fraction of its deposits it wishes to hold as reserves The Canadian banking system is a fractional-reserve system In march 2006 they held less than 1% of their deposits 27.3 Money Creation by the Banking System Suppose Banks invest only in loans There are only demand deposits A fixed target reserve ratio

34 No cash drain from the banking system Deposit creation does not happen automatically; it depends on the decisions of bankers LECTURE 15/03/2012 Chapter 28: Money, Interest Rates, and Economic Activity 28.1 Understanding Bonds Holding More Bonds = Holding Less Cash People have two types of financial assets Money (earns no interest) Bonds (earn interest) Present Value and the Interest Rate Present Value: the value of one or more payments or receipts made in the future Condiser an asset that pays $X in one year s time. If the interest rate is i% per year the PV of the asset is o PV = $X / (1+i) Notice that the PV is negatively related to the interest rate A Sequence of Future Payments? Suppose a $1000 bond pays 10% at the end of each of three years, at which point it is redeemed. What is the PV if the interest rate is 7%? PV = 100/ /(1.07^2) + 100/(1.07^3) More generally PV = R 1/(1+i) + R 2/(1+i) 2 + R 3/(1+i) R T/(1+i) T Present Value and Market Price Consider a competitive market for bonds: Buyers should be prepared to pay no more than the bond s PV Sellers should be prepared to accept no less than the bond s PV Interest Rates, Market Prices and Bond Yields This discussion leads to two important propositions: 1) The PV of a bond is negatively related to the market interest rate 2) The market price for a bond should equal its PV Since a bond s yield inversely relate to its price, we conclude that: 3) Market interest rates and bond yields tend to move together Bond Riskiness An increase in the riskiness of any bond leads to a decline in its expected PV, and thus to a decline in the bond s price

35 High risk leads to high yield 28.2 The Demand for Money Three Reasons for Holding Money The amount of money that everyone wishes to hold is the demand for money The opportunity cost of holding money is the interest that could have been earned if the money had been used to purchase bonds Three Reasons o The transactions motive o The precautionary motive o The speculative motive The Determinants of Money Demand We focus on 3 variables Real GDP (+) Price Level (+) Interest Rate (-) This money demand (MD) curve is sometimes called the liquidity preference function. Changes in Y or P cause the MD curve to shift 28.3 Monetary Equilibrium and National Income Monetary Equilibrium Monetary equilibrium occurs when the quantity of money demanded equals the quantity of money supplied Equilibrium Interest Rate The Monetary Transmission Mechanism Connects chances in MD and/or MS with aggregate demand Three stages 1. Change MD or Change MS Change Equilibrium Interest Rate 2. Change in Interest Rate Change in Desired Investment Expenditure 3. Change in Investment of Durables (ID) Change in AD Steps Stage 1

36 o Shifts in the MS or MD curves cause the equilibrium interest rate to change Stage 2 o Changes in the equilibrium interest rate lead to changes in desired investment Stage 3 o Changes in desired investment lead to a shift in the AE function, and thus a shift in the AD curve