Download An Introduction to Macroeconomic Models

An Introduction to
Macroeconomic Models
"Economics has never been a science - and it is even less now than
a few years ago." Paul Samuelson
At this point you should have a good idea of the primary measures of performance in the output and labor
markets, and it is time to look more closely at how the markets function and interact. We’ll begin with an
introduction to a model of the macroeconomy that functions much like the S&D model you learned in your
microeconomics course. The model is the Aggregate Supply – Aggregate Demand model (AS-AD) - that
provides a visual of the output market where suppliers and demanders of “stuff” interact.
National Income Identities
second model is the National Income Identity that is actually just the equilibrium condition in the output
market. The value of aggregate output supplied is defined as Gross Domestic Product (Q), while the value
of aggregate demand is defined as the sum of demand originating in the household sector (Consumption
spending (C)), government (Government spending (G)), business (Investment spending (I)), and foreign
(Export spending (X)).2 Given the nature of the accounting procedures, some of the expenditures by these
buyers will be for imports, so the level of import spending (Imports (M)) is subtracted from total
expenditures to arrive at total, aggregate demand for domestic production. This relationship can be
represented with equation (1).
(1) Q = C + I + G + X - M
Aggregate Supply = Aggregate Demand
An alternative approach to the national income identity is described in equation 2. There is no new
information in this equation; it is simply a repackaging of the initial information. Rather than looking at
demand and supply, this approach focuses on the allocation of income. We begin again with the income
earned in production of "stuff and then just "follow the money." Some of the income leaks out of the
system in the form of net taxes (T), savings (S) and imports (M).
Withdrawals = S + M + T
Offsetting these leakages / withdrawals from the system are the injections of spending by the government
(G), businesses (I), and the rest of the world (X).
Injections = I + X + G
If the income level were sustainable, if the income generated in the production process is eventually
returned to the producers in the form of demand, then injections would need to balance the withdrawals.
The equality of Injection = Withdrawals [equation (2)] is therefore simply a restatement of the Supply =
Demand condition.
(2) I + G + X = M + S + T
Injections = Withdrawals
1
There is a third formulation of the identity that focuses attention on the interdependence between two
important measures of imbalance - the trade balance and budget balance. With a little bit of algebra
equation 2 can be converted into equation 3 with Investment spending (I) on the left side. Investment is the
amount of money spent on increasing a nation's productive capacity - think equipment (computers) and
structures (factories). On the right side we have the sources of funds to finance that investment spending.
The first term (S) represents what households save. The second term (T-G) measures government savings.
This is defined as the budget surplus. When this number is positive the government is running a surplus bringing in more in tax revenues than spending - and the surplus is available for firms to borrow to finance
their spending. If the government were running a budget deficit, then the government would need to
borrow the money and would thus compete with businesses trying to borrow money for investment.
The third term is the trade balance (M-X) that measures the difference between the values of what the US
imports and what it exports. If we have a trade deficit, then the value of imports exceed that of exports
(M>X) so there will be a flow of $s out of the country. So what happens to these $s? Foreigners who
receive those US $s then "lend" them back to the US to help finance investment spending so you could
think of this as foreign savings. We’ll talk much more about this in the 1970s unit.
(3) I = S + (T - G) + (M -X)
Investment = Savings
To see how this works, let's look at the situation in the US where the savings rate is quite low (low S) and
investment spending is substantial (large I). If the government is running a substantial deficit (G>T), then
the only way to sustain this situation is if the country runs a substantial foreign trade deficit (M > X). In
China, on the other hand, a high savings rate has traditionally produced savings that were more than enough
to finance investment spending (S > I) and offset any budget deficit (G>T). Given these domestic
imbalances, China will run a trade surplus (X - M > 0 with the US. The trade and budget deficits are
inextricably interrelated, although not in a direct relationship where a change in one will necessarily
involve an adjustment in the other. What we can expect is that American leaders will continue to blame the
trade deficit with China on restrictive trade policies that limit their imports of US goods, while the Chinese
government will continue to blame the imbalance on the low saving rate and the high budget deficits in the
US.
Now it's time to look at the last macro model, the AS-AD model.
Aggregate Supply-Aggregate Demand
A valuable complement to the Circular Flow Diagram and the National Income Identity is the Aggregate
Supply - Aggregate Demand (AS-AD) graph that is a popular representation of the output market. The
good news is you should find it easy enough to move from your understanding of S-D curves to an
understanding of the AS-AD curves. To use the AS-AD model it is essential to understand what the curves
represent, what factors affect the position and slope of the curves, and how they differ from the Supply and
Demand curves. Let's start with the similarities.
First, there is a "cookbook" approach to making the AS-AD graphs work for you. You begin at the
beginning - the axes on the graph. On the vertical axis we are again measuring price, but in this case it is
the aggregate price level (CPI). When the price rises, you call it inflation. On the horizontal axis we once
again have quantity, but here it is total output in the economy (GDP). Do not make the mistake made by
many who assume aggregate output means the output of all car companies. It means the entire output of the
economy - all of the cars, computers, music CD, and legal services.
2
Second, each of the curves is meant to summarize the behavior of a group of decision makers, and because
we have a graph of the entire output market there are many decisions makers whose behavior is
summarized by these curves. Fortunately, while each of the decision makers is likely to behave in a
"unique" way, there are some common denominators allowing us to move from the behavior of individuals
to the aggregate curves. We are looking for the determinants of behavior.
The AS curve represents the behavior of the firms responsible for producing the "stuff," so the AS curve is
affected by all factors affecting the supply of individual firms. The three primary factors that affect
aggregate supply and shift the AS curve are:
1.
2.
3.
price of inputs - if there was a substantial increase in the price of resources such as labor or energy,
then there would be an increase in the costs of producing “stuff” and that cost would be passed on as
higher prices. This is seen as an inward shift in the AS curve
quantity of inputs - if there was a substantial increase in the number of people working then there
would be an increase in the productive capacity of the country. This would be seen as an outward shift
in the AS curve.
productivity of inputs - if there was a substantial increase in productivity, then there would be an
increase in the productive capacity of the country. This would be seen as an outward shift in the AS
curve
The AD curve, meanwhile, reflects the behavior of all buyers of "stuff," so it is important to identify the
buyers. The buyers of stuff produced in a national economy are the domestic households, firms, and
governments plus the demand of foreigners. The names associated with the separate components of
aggregate demand appeared earlier in the national income identity and the circular flow diagrams and
below the determinants of the behavior of the major actors are specified.
Consumption spending ( C ) is demand of households, so to understand what affects Consumption
spending we must get inside the heads of those people. Included on the short-list of factors affecting
consumption spending would be:
1. size of the population: as the number of households increases so to will consumption spending.
2. consumer confidence: an increase in consumer confidence should increase consumption spending
3. interest rates: a reduction in interest rates will lower the cost of borrowing which could increase
consumption spending as people may buy that new car.
4. income, employment and wealth: the amount households spend depends on how much those
households earn (income), how many of them have jobs, and how much they own (wealth). A rise in
unemployment, a decline in income, or a drop in home prices or stock prices will reduce consumption
spending.
5. taxes: amount households spend depends upon how much those households earn after taxes (after-tax
income), so a cut in taxes should raise household income and increase consumption spending.
Investment spending (I) is demand by businesses,i so to understand what affects Investment spending we
must get inside the heads of those companies. Included on the short-list of factors would be:
3
1.
2.
3.
interest rates: a reduction in interest rates will lower the cost of borrowing which could increase
investment spending as firms decide to build those new factories and offices and new machines. Also,
given the way the government keeps the books, included here would be the household sector’s
purchase of homes, and when those rates drop you would expect to see an increase in home
construction.
taxes: amount businesses spend depends upon how much those businesses earn after taxes (after-tax
profit), so a cut in taxes should raise business income and increase investment spending.
costs of inputs: an increase in the cost of inputs will ‘force’ businesses to pass on those as price
increases.
Export spending (X) is demand of foreign businesses and households, so to understand what affects export
spending we must “get inside the heads” of those foreign companies and households. In general they
respond to the same incentives as American households and businesses, so you simply look to the same set
of determinants. For example, if Europe falls into a recession and income falls and unemployment rises,
then its households and businesses are likely to buy less – and some of that reduced spending will be on
what they buy from the US. This means the recession in Europe translates into reduced spending on
American exports. Also affecting export demand would be exchange rates – the price of the US$. If the
price of the US$ goes up, then US goods are more expensive to foreign buyers so export spending in the
US would fall.
Import spending (M) is the demand for foreign goods and services of Americans, so to understand what
affects import spending we must get inside the heads of those American companies and households –
which we have already done. For example, if American consumers increase their purchase of Chinese toys
in December, this will show up as an increase in import spending that actually reduces aggregate demand
(AD) for American products. This is why it shows up with a negative sign in the AD equation. Also
affecting import demand would be exchange rates. If the price of the US$ goes up, then foreign goods are
less expensive so import spending in the US would rise.
Government spending (G) is demand for “stuff” from the government. An increase in defense spending,
such as that which occurred during the US war in Iraq and the Obama stimulus package both represent an
increase in government spending.
Now we are ready to translate those news stories into the AS-AD model. A change in any of the factors
affecting C, I, G, X, and M will shift the AS or AD curves – you just have to decide which curve shifts and
in which direction. As you work through the problems it makes life easier if you think of all the shifts as
inward and outward shifts and not up and down. When you say there is an increase in either AS or AD,
then it shows up as an outward shift, and when you say there is a decrease, then it shows up as an inward
shift. I also suggest that when you see an AS - AD graph be sure to illustrate the graph as I have done here.
The AD curve should be amended to include the equation AD = C + I + G + X - M. This helps you focus
on the factors that might shift the AD curve. If the "shock" does not directly affect one of the components
of AD, then the curve does not shift.
The AS curve should be amended to include (inputs, productivity) so you realize what factors cause the AS
curve to shift. This curve will shift if there is a change in the supply of inputs (increased immigration to the
US would increase AS), the price of those inputs (the price of oil would decrease AS), and changes in
productivity (an increase in labor productivity would increase AS).
4
AS – AD Model
Before we move on, let's look at how we might use the AS-AD graph to interpret the news by looking at
a situation similar to the dramatic oil price increases in the 1970s. From the previous discussion we know
this is a supply-side effect because oil is an important resource (input). As a result of the increase in the
price of the input, you should expect to see a decrease in the AS - an inward shift in the AS curve. In this
situation the economy will move toward the new equilibrium - a higher level of prices and a lower level of
output. This shift in the curve is likely to show up in headlines of higher inflation (the vertical intersection
of the new curves is higher) and a recession with lower output (the horizontal intersection of the new
curves is lower). The lower output story is also likely to be accompanied by stories of increased
unemployment - if you are producing less you will need fewer workers.ii
AS-AD: Impact of Adverse Supply Shock
What about that big stimulus package of increased government spending (G) and tax cuts (T)? These would
increase aggregate demand, which would show up in the AS-AD model as an outward shift in the AD
curve. In this situation the economy will move toward the new equilibrium - a higher level of prices and a
higher level of output. This shift in the curve is likely to show up in headlines of higher inflation (the
vertical intersection of the new curves is higher) and an expansion with higher output (the horizontal
intersection of the new curves is higher). The higher output story is also likely to be accompanied by stories
of decreased unemployment - if you are producing more you will need more workers
AS-AD: Impact of Fiscal Stimulus
5
Now it is time to put this model to work as we shift gears to the evolution of macroeconomic theory and
policy by looking back at the 1920s and 1930s.
6
Macro Intro
i
Investment spending is actually not exclusively spending originating in the business sector. An important component
of investment spending is residential construction, which is spending originating in the household sector. There will be
a more thorough discussion of aggregate demand in the 1960s unit.
ii
What has not been included here, but could have been, would be a demand-side effect. It is possible that as a result of
higher energy prices the level of imports would rise since the US imports much of its oil and because demand for oil is
inelastic - when the price rises we still by it. If we included this effect then the AD curve would shift left because the
higher demand for imports meant there was less demand for US output.
7