2 Learning ObjectivesUnderstand the concept of the National Income IdentitiesUnderstand the definition of UnemploymentUnderstand the definition of a price indexUnderstand the concept of Economic equilibrium and how it is influenced by expectations
3 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 measurementMeasurement economic quantities may seem boring…But it can give crucial insight even without a model of behaviourExample: the current crisis
4 NIE IdentityWe 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 totalsBasic Identity: Y O EThink of why this is the caseIncome 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 conditionAn identity holds for all valuesAn eqm condition holds only for some values i.e. in eqmDistinction important later
5 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 – EUtaxesGNDY GNP + NTA (NTA is all net Transfers from R.O.W. incl EU)GDP + NFIA + NTA GNDYNote: Irish GNP was approx 85% of GDP (2007)For many other countries the distinction is not relevantCan lead to lots of debate of which is best measure in Ireland
6 NIE: SAVINGS & INVESTMENT IDENTITY The Income IdentityY C + S + TAccounting rule: Income is either spent, saved or taxedThe Expenditure IdentityE= C + I + G + NXAccounting rule: add up the components of expenditureCombine the twoC + I + G + NX C + S + TThus: (G – T) (S – I) – NXor: (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/CNote: the 2 left hand expressions are National Savings
7 NIE: SAVINGS & INVESTMENT IDENTITY This is often known as the twin deficits identityEven though it doesn’t involve any model or description of economic behaviour it can be informativeImplication: a current account surplus can only occur if there is an excess of national savingsApplication 1: The USThe US has trade deficit (esp with China)This is inescapable given it has insufficient savingsChina surplus equates to surplus Chinese savingsApplication 2: Ireland’s BubbleWe had a bubble (high investment)Insufficient savingsSo high current account deficit
9 2. Unemployment 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/PMeasuring Employment and UnemploymentSurveys: household QNHS in Ireland, quarterly household survey (CPS in USA); business surveys for employment.Administrative: “Live Register” (Ireland); related to benefit claimants
10 UnemploymentThe 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 workingSurveys try to capture this: “active search”Issue of how activeDiscouraged worker effectsThere is a difference between what economists’ defn of U and rest of societyClaimant counts do not – may include people NILF
11 3. PricesMankiw 2.2Some components of GDP have well-known measures of inflation: the CPI for household consumptionFor a more comprehensive measure the implicit price deflator for GDP is used: this relates to all items in the GDPA price index is a weighted average measure of price changesTwo questions arise: (i) what is included (ii) what kind of weighting system to useFor 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
12 Laspeyre vs PascheA Laspeyre index of prices uses the quantities prevailing in some base (e.g. survey) year to weight prices. The index takes the form:(p1q0 / p0q0)x100Note: base-year quantities (q0) are used to compare prices in the two years (p1 and p0 )A Paasche index of prices uses the quantities prevailing in the terminal year to weight prices. The index takes the form:(p1q1/ p0q1)x100Note: current-year quantities (q1) are used to compare prices in the two years (p1 and p0)As relatively cheaper are substituted for dearer goods, the Laspeyre index of prices has an upward substitution bias.So CPI inflation is biased upwards
13 4. Equilibrium Key concept in economics illustrate with the simplest possible macro modelMankiw 11Equilibrium is a point of balance or stabilitySpecifically in economics it is a point where economic agents’ plans are mutually consistent and therefore are realisedDisequilibriumplans are inconsistentthen someone’s plans are not realisedSomebody is disappointedBehaviour will changeThe economy will changeso not stable or balanced
14 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 spendThere will also be Aggregate Demand or Planned Expenditure (PE)the amount of Expenditure which agents plan to makeAgents: Households, firms, the Government and foreignersIn equilibrium plans are consistentY = PELater we will see that sometimes Output or Income do not equal planned expenditure: this corresponds to a disequilibriumThe general idea is that in equilibrium the forces acting on some variable (Y) are balanced and hence Y will not change.
15 Planned ExpenditureConventionally 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) ExpenditureOther components of Expenditure are Autonomous: this should be understood as depending on something other than Income.We havean Autonomous component of Consumption (Ca)Investment (I)Government purchases (G)Foreign demand (NX)
16 Consumption Function 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 CaThe 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 < dC/d(Y – T) = c < 1This is a model of consumption insofar as it is a simplified representation of how people make their consumption plansIt doesn’t say that plans will be successfulIt is very simple (even simplistic): no interest rates, future income, life cycle
17 THE CONSUMPTION FUNCTION (2) Note: Ca is “Autonomous” consumption; C/Y (APC) falls as Y increases; c (MPC) is < APC.C45 (C = Y)Ca + c(Y – T)Slope = cCa(Y-T )
18 Equilibrium As always equilibrium is where plans are consistent Specifically in this case planned production is equal to planed demandY = PE,Sub in equation for planned expenditure (“Aggregate Demand”)PE = C + I + G + NXTo get Y = C + I + G + NXSub in consumption functionTo get: Y = Ca + cY – cT + Ip + G + NXNotecY is the one part of Expenditure which depends on IncomeThe 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.
19 Eqm. Vs Idenitity We have an accounting identity: Y = C + I + G + NX This different from the equilibrium conditionThe equilibrium condition describes planned magnitudesThese plans may or may not be realisedThe identity describes what actually happensThis may or may not have been what was plannedThus the equilibrium condition is true only for certain values of the variablesThe identity is true alwaysBest thought of as an account rule
20 DISEQUILIBRIUMTo illustrate the concept of equilibrium consider a numerical exampleSuppose we have Ca = 50, c = 0.8, T = 150, I = 40, G = 150, NX = 60Suppose we have Y = 600Is Income at equilibrium?Calculate Planned expenditure (Aggregate Demand)PE = Ca + c(Y – T) + I + G + NX= (450)= 660So Planned Production (Y) < Planned Expenditure (PE)Somebody’s plans will not be realisedProduction is not sufficient to meet demand
21 Disequilibrium Plans must be updated Note this is a key assumption How?We will assume that production will be increased to meet demandNote we assume prices don’t changeWill provide empirical evidence laterNote this is a key assumptionWe will spend much of the course looking at how plans are updatedThis will depend on expectations and timeframe (LO 3)In this simple model we assumes that plans cannot be updated by changing pricesThis turns out to be valid in the short term but not in the long term
22 EQUILIBRIUM What is Equilibrium Y in this case? We could try by trial and errorOr we could solve the equationsBy definition equilibrium is where planned production equals planned expenditure:Y = PEY = Ca + c(Y – T) + I + G + NXY – cY = Ca – cT + I + G + NXY(1-c) = Ca – cT + I + G + NXY(1 – c) = PAWhere PA = Autonomous planned spending = Ca – cT + I + G + NXPlug in numbersY = PA/(1 –c) = ( )/(0.2) = 180/0.2 = 900One can re-check by plugging in all the components of PE when Y = 900 and getting PE = 900, i.e. equilibrium
23 EQUILIBRIUM This can all be illustrated graphically When PE > Y, Y < Ye hence Y rises: similarly when PE < Y…..Ep45 (PE = Y)PE = PA + c(Y – T)ApYeY
24 Comment The process is self sustaining If we are not at equilibrium there is an automatic adjustment process that will bring us into equilibriumIf this were not the case no point in studying eqmIf not at eqm we are heading thereWe assume for the moment that the adjustment process works by producers changing out put to meet demandWe also assume that prices don't changeSeems counter intuitiveThis model effectively assumes that prices are fixedWe willprovide empirical evidence alter that this is approximately true in the short runand spend much of the rest of the course discussing when and how it isnt true
25 A CHANGE IN AGGREGATE SPENDING (1) Suppose Ip and therefore PA fall by 40, Ye1 falls to Ye2 by a multiple of 40 (Ye > PA)Ep45 (PE = Y)PE1 = PA1 + c(Y – T)PE2 = PA2 + c(Y – T)PA1PA2Ye2Ye1Y
26 A CHANGE IN AGGREGATE SPENDING (2) Initial Equilibrium is: Y1 = PA1 + c(Y1 – T)Following Shock to PA: Y2 = PA2 + c(Y2 – T)Subtracting: Y2 – Y1 = PA2 – PA1 + c(Y2 – Y1)i.e Y = PA + c Yso Y(1 – c) = PAAnd thus: Y/PA = 1/(1 – c) or 1/sSo 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 + c2 + c3 + ….. + cn) cY = G(c c2 c3 + ….. + cn+1) then addingAnd 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
27 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 = 100Financing the increased G by selling Bonds to Savers??Now what happens if T were reduced by 100 instead of increasing G?Initial Equilibrium is: Y1 = PA + c(Y1 – T1)Following cut in T: Y2 = PA + c(Y2 – T2)i.e Y = c.Y – c.TSo 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)
28 Conclusions Understand the concept of the National Income Identities Accounting rule so true by definition for all valuesUnderstand the definition of UnemploymentNILF vs UUnderstand the definition of a price indexCPI inflation biased upwardsUnderstand the concept of Economic equilibrium and how it is influenced by expectationsPlans are consistentWhat adjusts when plans are not consistent?
29 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 formedProgressively more complicated modelsWe will also carefully consider what adjusts when plans are inconsistentNext topic provides more detail on how consumption and investment plans are made specifically we take into account interest rates.