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A Review of the Basics 1

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Learning Objectives 1.Understand the concept of the National Income Identities 2.Understand the definition of Unemployment 3.Understand the definition of a price index 4.Understand the concept of Economic equilibrium and how it is influenced by expectations 2

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1. NIE Identities Review GDP defn in Mankiw 2.1 Before we get into models of economic behaviour we need to look some definitions and some issues in measurement Measurement economic quantities may seem boring… – But it can give crucial insight even without a model of behaviour – Example: the current crisis 3

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NIE Identity We measure macroeconomic activity primarily by looking at annual (or quarterly) flows of Output (O), Income (Y) and Expenditure (E). These are different ways of measuring the same thing, so they sum to identical totals – Basic Identity: Y O E Think of why this is the case – Income and Product are identical: Product is Value-Added in Production, i.e sales minus purchases from other firms, which = payment of incomes to Factors (Wages, Interest…) – Expenditure equals Income, because any production not sold is counted as Inventory Investment, and is thus part of Expenditure (the firm purchases its own output from itself) Note this is an identity not an equilibrium condition – An identity holds for all values – An eqm condition holds only for some values i.e. in eqm – Distinction important later 4

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NIE: GDP vs GNP Open economy: GNP v GDP – GNP GDP + NFIA – (NFIA is net factor inc from R.O.W., i.e. inflows minus outflows) – GNY GNP + EUtrasfers – EUtaxes – GNDY GNP + NTA (NTA is all net Transfers from R.O.W. incl EU) – GDP + NFIA + NTA GNDY – Note: Irish GNP was approx 85% of GDP (2007) – For many other countries the distinction is not relevant – Can lead to lots of debate of which is best measure in Ireland 5

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NIE: SAVINGS & INVESTMENT IDENTITY The Income Identity – Y C + S + T – Accounting rule: Income is either spent, saved or taxed The Expenditure Identity – E= C + I + G + NX – Accounting rule: add up the components of expenditure Combine the two – C + I + G + NX C + S + T Thus: (G – T) (S – I) – NX – or: (G – T) + NX (S – I) etc. clearly, adding in net foreign factor and transfer income, including them in the totals for T and S etc as appropriate, and changing signs we get: (T - G) + (S - I) NX BOP Current A/C Note: the 2 left hand expressions are National Savings 6

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NIE: SAVINGS & INVESTMENT IDENTITY This is often known as the twin deficits identity Even though it doesn’t involve any model or description of economic behaviour it can be informative Implication: a current account surplus can only occur if there is an excess of national savings Application 1: The US – The US has trade deficit (esp with China) – This is inescapable given it has insufficient savings – China surplus equates to surplus Chinese savings Application 2: Ireland’s Bubble – We had a bubble (high investment) – Insufficient savings – So high current account deficit 7

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See Mankiw 2.3 The labour force (L) = employed (E) + unemployed (U) The unemployment rate u% = U/L or U/(E + U) Letting the population of Labour-force Age = P, we also have: The Labour force participation rate: LFPR% = L/P Measuring Employment and Unemployment – Surveys: household QNHS in Ireland, quarterly household survey (CPS in USA); business surveys for employment. – Administrative: “Live Register” (Ireland); related to benefit claimants 2. Unemployment 9

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Unemployment The precise details of how surveys and other measures are constructed will differ from country to country. Survey methods are generally more comparable. Key Issue: have to “want” to work to be unemployed as distinct from not working Surveys try to capture this: “active search” – Issue of how active – Discouraged worker effects There is a difference between what economists’ defn of U and rest of society Claimant counts do not – may include people NILF 10

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Mankiw 2.2 Some components of GDP have well-known measures of inflation: the CPI for household consumption For a more comprehensive measure the implicit price deflator for GDP is used: this relates to all items in the GDP A price index is a weighted average measure of price changes Two questions arise: (i) what is included (ii) what kind of weighting system to use – For Consumption the Irish CPI includes a measure of housing costs, the Eurozone HIPC does not (why?) Generally if an index uses base-year weights (Laspeyre), the resulting inflation is higher than if current year weights are used (Paasche) – CPI is Laspeyre 3. Prices 11

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A Laspeyre index of prices uses the quantities prevailing in some base (e.g. survey) year to weight prices. The index takes the form: ( p 1 q 0 / p 0 q 0 )x100 Note: base-year quantities (q 0 ) are used to compare prices in the two years (p 1 and p 0 ) A Paasche index of prices uses the quantities prevailing in the terminal year to weight prices. The index takes the form: ( p 1 q 1 / p 0 q 1 )x100 Note: current-year quantities (q 1 ) are used to compare prices in the two years (p 1 and p 0 ) As relatively cheaper are substituted for dearer goods, the Laspeyre index of prices has an upward substitution bias. So CPI inflation is biased upwards Laspeyre vs Pasche 12

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4. Equilibrium Key concept in economics – illustrate with the simplest possible macro model – Mankiw 11 Equilibrium is a point of balance or stability – Specifically in economics it is a point where economic agents’ plans are mutually consistent and therefore are realised Disequilibrium – plans are inconsistent – then someone’s plans are not realised – Somebody is disappointed – Behaviour will change – The economy will change – so not stable or balanced 13

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MACROECONOMIC EQUILIBRIUM First, Output (which equals Income) is a function of inputs: for simplicity, Capital (K) and Labour (L) Y = f(K, L) – This is the amount firms plan to spend There will also be Aggregate Demand or Planned Expenditure (PE) – the amount of Expenditure which agents plan to make – Agents: Households, firms, the Government and foreigners In equilibrium plans are consistent Y = PE Later we will see that sometimes Output or Income do not equal planned expenditure: this corresponds to a disequilibrium The general idea is that in equilibrium the forces acting on some variable (Y) are balanced and hence Y will not change. 14

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Conventionally we look at separate components of aggregate (planned) expenditure: C, I, G, NX. This is because they behave differently. Crucially C (Consumption) depends partly on Income: so part of Expenditure depends on Income: hence the term Induced (Consumption) Expenditure Other components of Expenditure are Autonomous: this should be understood as depending on something other than Income. We have – an Autonomous component of Consumption (Ca) – Investment (I) – Government purchases (G) – Foreign demand (NX) Planned Expenditure 15

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An equation that describes consumption plans Very Generally, Consumption depends on Disposable Income (Y minus net taxes, T). More specifically: C = Ca + c(Y – T) – the “Autonomous” and “Induced” elements are on the right-hand side. – For simplicity Mankiw leaves out Ca The coefficient c (The Marginal Propensity to Consume) is > 0 and < 1, implying that for any given increase or decrease in disposable income C will change in the same direction, but by a lesser amount. i.e. 0 < dC/d(Y – T) = c < 1 This is a model of consumption insofar as it is a simplified representation of how people make their consumption plans – It doesn’t say that plans will be successful – It is very simple (even simplistic): no interest rates, future income, life cycle Consumption Function 16

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THE CONSUMPTION FUNCTION (2) Note: Ca is “Autonomous” consumption; C/Y (APC) falls as Y increases; c (MPC) is < APC. 0(Y-T ) C Ca Ca + c(Y – T) 45 (C = Y) Slope = c 17

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As always equilibrium is where plans are consistent Specifically in this case planned production is equal to planed demand Y = PE, Sub in equation for planned expenditure (“Aggregate Demand”) PE = C + I + G + NX To get Y = C + I + G + NX Sub in consumption function To get: Y = Ca + cY – cT + Ip + G + NX Note – cY is the one part of Expenditure which depends on Income – The other components (Ca –cT + I + G + NX) may be termed autonomous planned spending, in that they do not depend in Income (at least for now…) Alternatively we might term them the Endogenous and Exogenous components of planned spending. Equilibrium 18

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We have an accounting identity: Y = C + I + G + NX This different from the equilibrium condition The equilibrium condition describes planned magnitudes – These plans may or may not be realised The identity describes what actually happens – This may or may not have been what was planned Thus the equilibrium condition is true only for certain values of the variables The identity is true always – Best thought of as an account rule Eqm. Vs Idenitity 19

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DISEQUILIBRIUM To illustrate the concept of equilibrium consider a numerical example – Suppose we have Ca = 50, c = 0.8, T = 150, I = 40, G = 150, NX = 60 Suppose we have Y = 600 Is Income at equilibrium? Calculate Planned expenditure (Aggregate Demand) – PE = Ca + c(Y – T) + I + G + NX – = 50 + 0.8(450) + 40 + 150 + 60 – 300 + 360 = 660 So Planned Production (Y) < Planned Expenditure (PE) – Somebody’s plans will not be realised – Production is not sufficient to meet demand 20

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Disequilibrium Plans must be updated – How? – We will assume that production will be increased to meet demand – Note we assume prices don’t change – Will provide empirical evidence later Note this is a key assumption – We will spend much of the course looking at how plans are updated – This will depend on expectations and timeframe (LO 3) – In this simple model we assumes that plans cannot be updated by changing prices – This turns out to be valid in the short term but not in the long term 21

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EQUILIBRIUM What is Equilibrium Y in this case? We could try by trial and error Or we could solve the equations By definition equilibrium is where planned production equals planned expenditure: Y = PE Y = Ca + c(Y – T) + I + G + NX Y – cY = Ca – cT + I + G + NX Y(1-c) = Ca – cT + I + G + NX Y(1 – c) = PA Where PA = Autonomous planned spending = Ca – cT + I + G + NX Plug in numbers – Y = PA/(1 –c) = (50-120+40+150+60)/(0.2) = 180/0.2 = 900 One can re-check by plugging in all the components of PE when Y = 900 and getting PE = 900, i.e. equilibrium 22

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EQUILIBRIUM This can all be illustrated graphically When PE > Y, Y < Ye hence Y rises: similarly when PE < Y….. 0Y Ep Ap PE = PA + c(Y – T) 45 (PE = Y) Ye 23

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Comment The process is self sustaining – If we are not at equilibrium there is an automatic adjustment process that will bring us into equilibrium – If this were not the case no point in studying eqm If not at eqm we are heading there We assume for the moment that the adjustment process works by producers changing out put to meet demand We also assume that prices don't change – Seems counter intuitive – This model effectively assumes that prices are fixed We will – provide empirical evidence alter that this is approximately true in the short run – and spend much of the rest of the course discussing when and how it isnt true 24

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A CHANGE IN AGGREGATE SPENDING (1) Suppose Ip and therefore PA fall by 40, Ye 1 falls to Ye 2 by a multiple of 40 ( Ye > PA) 0Y Ep PA 1 PE 1 = PA 1 + c(Y – T) 45 (PE = Y) Ye 1 PE 2 = PA 2 + c(Y – T) PA 2 Ye 2 25

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A CHANGE IN AGGREGATE SPENDING (2) Initial Equilibrium is: Y 1 = PA 1 + c(Y 1 – T) Following Shock to PA: Y 2 = PA 2 + c(Y 2 – T) Subtracting: Y 2 – Y 1 = PA 2 – PA 1 + c(Y 2 – Y 1 ) i.e. Y = PA + c Y so Y(1 – c) = PA And thus: Y/ PA = 1/(1 – c) or 1/s So if c = 0.8, s = 0.2, multiplier = 5: etc…. Intuitively: an increase in PA (say G) is spent: it becomes income to someone who re-spends c times the increase, etc… Y = G(1 + c + c 2 + c 3 + ….. + c n ) c Y = G( c c 2 c 3 + ….. + c n+1 ) then adding And Y(1 c) = G(1) (the other terms cancel) So Y/ G = 1/(1-c) You should have seen this before. If note review it in your fits year book or in Mankiw 26

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CHANGES IN SAVINGS, TAXES In the previous example, an increase in G of 100 produced an increase of 500 in Y. As T is given this means that (Y – T) increased by 500, and C increased by c. Y so savings increased by s. Y = 100 Financing the increased G by selling Bonds to Savers?? Now what happens if T were reduced by 100 instead of increasing G? Initial Equilibrium is: Y 1 = PA + c(Y 1 – T 1 ) Following cut in T: Y 2 = PA + c(Y 2 – T 2 ) i.e. Y = c. Y – c. T So Y(1 – c) = – c. T Y/ T = – c/(1 – c) Thus if c = 0.2, –c/(1 – c) = – 0.8/0.2 = – 4. Note sign, magnitude (intuition of this) 27

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Conclusions 1.Understand the concept of the National Income Identities – Accounting rule so true by definition for all values 2.Understand the definition of Unemployment – NILF vs U 3.Understand the definition of a price index – CPI inflation biased upwards 4.Understand the concept of Economic equilibrium and how it is influenced by expectations – Plans are consistent – What adjusts when plans are not consistent? 28

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What’s Next? We will spend the rest of the course expanding on L.O. 4 – We will add more detailed accounts of how plans are formed – Progressively more complicated models – We will also carefully consider what adjusts when plans are inconsistent Next topic provides more detail on how consumption and investment plans are made specifically we take into account interest rates. 29

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