Download ECO 120- Macroeconomics

ECO 120- Macroeconomics
Weekend School #1
8th April 2006
Lecturer: Rod Duncan
Previous version of notes: PK Basu
Topics for discussion
• Module 1- basic macroeconomic concepts
– Income determination, basic macroeconomic
theory, investment decision
• Module 2- the money market
– The Australian financial system, the role of
money, the market for money
• What will not be discussed
– Answers to Assignment #1 (use the CSU
forum for this)
Forms of economics
• Microeconomics- the
study of individual
decision-making
– “Should I go to college
or find a job?”
– “Should I rob this
bank?”
– “Why are there so
many brands of
margarine?”
• Macroeconomics- the
study of the behaviour
of large-scale
economic variables
– “What determines
output in an
economy?”
– “What happens when
the interest rate
rises?”
Economics as story-telling
• In a story, we have X happens, then Y
happens, then Z happens.
• In an economic story or model, we have X
happens which causes Y to happen which
causes Z to happen.
• There is still a sequence and a flow of
events, but the causation is stricter in the
economic story-telling.
Kobe, the naughty dog
Modelling Kobe
• Kobe likes to unmake the bed.
• Kobe likes treats.
• We assume that more treats will lead to
fewer unmade beds.
(Not a very good) Model:
Treats↑ → Unmaking the bed↓
• We can use this model to explain the past
or to predict the future.
Elements of a good story
•
All stories have three parts
1. Beginning- description of how things are
initially- the initial equilibrium.
2. Middle- we have a shock to the system, and
we have some process to get us to a new
equilibrium.
3. End- description of how things are at the
new final equilibrium- the story stops.
•
“Equilibrium”- a system at rest.
Timeframes in economics
• In economics we also talk in terms of three
timeframes:
– “short run”- the period just after a shock has occurred
where a temporary equilibrium holds.
– “medium run”- the period during which some process
is pushing the economy to a new long run equilibrium.
– “long run”- the economy is now in a permanent
equilibrium and stays there until a new shock occurs.
• You have to have a solid understanding of the
equilibrium and the dynamic process of a model.
What are the big questions?
• What drives people to study macroeconomics?
They want solutions to problems such as:
–
–
–
–
–
–
Can we avoid fluctuations in the economy?
Why do we have inflation?
Can we lower the unemployment rate?
How can we manage interest rates?
Is the foreign trade deficit a problem?
[How can we make the economy grow faster?] Not
taken up in this class. This class focuses on short-run
problems.
Economic output
• Gross domestic product- The total market
value of all final goods and services
produced in a period (usually the year).
– “Market value”- so we use the prices in
markets to value things
– “Final”- we only value goods in their final form
(so we don’t count sales of milk to cheesemakers)
– “Goods and services”- both count as output
Nominal versus real GDP
• We use prices to value output in
calculating GDP, but prices change all the
time. And over time, the average level of
prices generally has risen (inflation).
– Nominal GDP: value of output at current
prices
– Real GDP: value of output at some fixed set
of prices
Nominal versus real GDP
• So how to correct for rising prices over
time?
– Measure average prices over time (GDP
deflator, Consumer Price Index, Producer
Price Index, etc)
– Deflate nominal GDP by the average level of
prices to find real GDP
Real GDP = Nominal GDP / GDP Deflator
Some Australian economic history
Australian GDP 1950-1995
600 000
500 000
Million A$
400 000
GDP
300 000
GDP Change
Real GDP
200 000
100 000
0
1950
1960
1970
1980
1990
2000
Business cycle
• The economy goes through fluctuations over
time. This movement over time is called the
“business cycle”.
– Recession: The time over which the economy is
shrinking or growing slower than trend
– Recovery: The time over which the economy is
growing more quickly than trend
– Peak: A temporary maximum in economic activity
– Trough: A temporary minimum in economic activity.
Australian business cycle
Aust Business Cycle
10
8
6
4
% Ch RGDP
2
0
1950
-2
-4
1960
1970
1980
1990
2000
Unemployment
• To be officially counted as “unemployed”,
you must:
– Not currently have a job; and
– Be actively looking for a job
• “Labour force”- the number of people
employed plus those unemployed
• “Unemployment rate”
– (Number of unemployed)/(Labour force)
Unemployment
• Working age
population = Labour
force + Not in labour
force
• Labour force =
Employed +
Unemployed
Unemployment
Unemployment over the Business Cycle
12
10
Percent (%)
8
6
Unemployment
4
Change in GDP
2
0
1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995
-2
-4
Inflation
• Inflation is the rate of growth of the
average price level over time.
• But how do we arrive at an “average price
level”?
– The Consumer Price Index surveys
consumers and derives an average level of
prices based on the importance of goods for
consumers, ie. a change in the price of
housing matters a lot, but a change in the
price of Tim Tams does not.
Consumer Price Index
• Then the CPI expresses average prices
each year relative to a reference year,
which is a CPI of 100.
CPIt = (Average prices in year t)/(Average
prices in reference year) x 100
• Inflation can then be measured as the
growth in CPI from the year before:
– Inflationt = (CPIt – CPIt-1) / CPIt-1
2.0
0.0
-2.0
Sep-04
Sep-02
Sep-00
Sep-98
Sep-96
Sep-94
Sep-92
Sep-90
Sep-88
Sep-86
Sep-84
Sep-82
Sep-80
Sep-78
Sep-76
Sep-74
Sep-72
Sep-70
Inflation
Consumer Price Inflation
20.0
18.0
16.0
14.0
12.0
10.0
8.0
6.0
4.0
Inflation
Calculating GDP
• Gross domestic product- The total market value
of all final goods and services produced in a
period (usually the year).
• Alternates methods of calculating GDP
– Income approach: add up the incomes of all members
of the economy
– Value-added approach: add up the value added to
goods at each stage of production
– Expenditure approach: add up the total spent by all
members of the economy
• The expenditure approach forms the basis of the
AD-AS model.
Expenditure approach
• GDP is calculated as the sum of:
– Consumption expenditure by households (C)
– Investment expenditures by businesses (I)
– Government purchases of goods and services
(G)
– Net spending on exports (Exports – Imports)
(NX)
Aggregate Expenditure: AE = C + I + G + NX
Consumption and savings
• We assume consumption (C) depends on
household’s disposable income:
– Disposable income YD = (Income – Taxes)
• The consumption function shows how C
changes as YD changes.
• Household savings (S) is the remainder of
disposable income after consumption.
• The savings function shows how S
changes as YD changes.
Consumption function
• Consumption is a function of YD or C =
C(YD). We assume that this relationship
takes a linear (straight-line) form
C = a + b YD
where a is C when YD is zero and b is the
proportion of each new dollar of YD that is
consumed.
• We assume that C is increasing in YD, so 0
< b < 1.
Savings function
• Household savings is a function of YD or S =
S(YD). We assume
S = c + d YD
where c is S when YD is zero and d is the
proportion of each new dollar of YD that is saved.
• We assume that S is increasing in YD, so 0 < d <
1.
• But also households must either consume or
save their income, so C + S = YD. This can only
be true if c = -a and b +d = 1.
More terms
• Average Propensity to Consume (APC)
is consumption as a fraction of YD:
APC = C / YD
• Average Propensity to Save (APS) is
savings as a fraction of YD:
APS = S / YD
• Since all disposable income is either
consumed or saved, we have:
APC + APS = 1
More terms
• Marginal Propensity to Consume (MPC) is the
change in consumption as YD changes:
MPC = (Change in C) / (Change in YD)
• Marginal Propensity to Save (APS) is the
change in savings as YD changes:
MPS = (Change in S) / (Change in YD)
• For our linear consumption and savings
functions, MPC = b and MPS = d. If YD
changes, then consumption and savings must
change to use up all the change in YD , so
MPC + MPS = 1.
Graphing the functions
• When YD = 0, C + S = 0,
so at point A, the
intercept terms are both
just below 2 and of
opposite sign.
• The 45 degree line in the
top graph shows the level
of YD. At point D, C is
equal to YD, so S = 0.
• MPC = 0.75 is the slope
of the C function.
• MPS = 0.25 is the slope
of the S function.
What else determines C?
• Household consumption will also depend
on:
– Household wealth
– Average price level of goods and services
– Expectations about the future
• Changes in these factors will produce a
shift of the whole C and S functions.
Shifts of C and S functions
• A rise in household
wealth will increase C
for every level of YD,
so C shifts up.
• A rise in average
prices will lower the
real wealth of
households and so
lower C for every
level of YD, so C shifts
down.
Exogenous variables
• Exogenous variables are variables in a
model that are determined “outside” the
model itself, so they appear as constants.
• For the aggregate expenditure model, we
treat as exogenous:
– Investment (I)
– Government consumption (G)
– Taxes (T)
– Net Exports (NX)
Aggregate expenditure
• In a closed (no foreign trade) economy:
AE = C(Y) + I + G
• In an open economy:
AE = C(Y) + I + G + NX
• Changes in a or the exogenous variables
(I, G, T or NX) will shift the AE curve. A
change in b will tilt the AE curve.
• Equilibrium occurs when goods supply, Y,
is equal to goods demand, AE.
Equilibrium in the AE model
• Supply of goods equals demands of goods (in
the closed economy):
Y=C+I+G
Y = a + mpc(Y – T) + I + G
(1 – mpc)Y = a – mpcT + I + G
• Finally we get:
1
Y
[a  mpcT  I  G]
1  mpc
Expenditure multiplier
• Imagine the government
wishes to affect the
economy. One tool
available is government
consumption, G, or
government taxes, T.
This is called “fiscal
policy”.
• Any change in G (∆G) in
our AE model will
produce:
1
ΔY 
ΔG
1 - mpc
Multiplier
• If mpc=0.75, then the
multiplier is (1/0.25) or 4,
so $1 of new G will
produce $4 of new Y.
• Our multiplier is equal to
1/(1-MPC).
• Since 0<MPC<1, our
multiplier will be greater
than 1.
• The larger is the MPC,
the larger is our multiplier.
Deriving aggregate demand
• How do average prices affect demand for goods
and services?
– Wealth effect: higher prices means our assets have
less value so people are poorer and consume less.
– Interest rates: higher prices drive up the demand for
money and so drive up interest rates, at higher
interest rates, investment falls (see later)
– Net exports: at higher Australian prices, foreign goods
are cheaper, so net exports falls (see later)
• As the average price level rises, demand for
goods and services should fall, with all else held
constant.
Aggregate demand
• We would like to have
a relationship
between the demand
for goods and
services and the price
level. We call this the
“aggregate demand”
(AD).
• The AD curve is
downward-sloping in
prices.
Shifts of the AD curve
• Factors that affect the AE curve will affect the AD
curve. For example, if household wealth rose,
then C would increase for all levels of
disposable income. Demand would be higher
for all levels of prices, so the AD curve shifts to
the right.
– C: household wealth, household expectations about
the future
– I: interest rates, business expectation about the
future, technology
– G and T: changes in fiscal policy
– NX: the currency exchange rate, change in output in
foreign countries
AD and the multiplier
• A change in I will shift
the AE curve up. This
will produce a shift to
the right of the AD
curve.
• The shift in the AD
curve will be the
change in I times the
multiplier.
Aggregate supply
• Likewise, there must be a relationship between
goods supply and the average level of pricesthe aggregate supply (AS) curve.
• How do prices affect goods supply?
– Short-term: Since wages are determined by contracts,
wages do not change in the short-term. A rise in
prices holding wages fixed means that firms are
making higher profits on production, so firms will
expand supply of goods.
– Long-term: Wage contracts will be renegotiated if
prices rise. In the long-term, we would expect that
there is no relationship between goods supply and
prices.
Aggregate supply
• There will be a short-run AS curve which is
upward-sloping in prices.
• The long-run AS curve is vertical at the level of
potential output, since wages will change
proportionately to price changes.
• What factors will shift the AS curves?
– Changes in prices of inputs, like land, capital energy
or entrepreneurial skill
– Changes in technology that affect productivity
– Changes in taxes, subsidies or laws affecting
business productivity
Shift in AD
Shift in AD in the SR
• The price level rises,
which pushes the AE
curve back down to
where the AD-AS curves
intersect.
• But output is above the
potential rate of output at
point C. This means that
there is a shortage of
labour and will push up
wages.
Shift in AD in the LR
• In the long-run, workers
renegotiate wages based
on the higher prices. This
raises the cost of
production to firm and
shifts the short-run AS
curve to the left.
• It is only when we get
back to potential output
that wages stop rising, at
point A’.
Investment
• Investment refers to the purchase of new
goods that are used for future production.
Investment can come in the form of
machines, buildings, roads or bridges.
• What determines investment?
– Businesses make an investment if they expect
the investment to be profitable.
Investment decision-making
• How to determine profitability of investment?
• Example: An investment involves the current
cost of investment (I). The investment will pay
off with some flow of expected future profits.
The future stream of profits is R1 in one year’s
time, R2 in two year’s time, … up to Rn at the nth
year when the investment ends.
• Net Present Value (NPV) = Present Value of
Future Profits (PV) – Investment (I)
Interest rates
• Interest rates are a general term for the
percentage return on a dollar for a year:
– that you earn from banks for saving
– that you pay banks for borrowing or investing
• For example, the interest rate might be
10%, so if you put $1 in the bank this year,
it will become $(1+i) in one year’s time.
• Or if you borrow $100 today, you will have
to repay $(1+i)100 next year.
Interest Rates
18.00
16.00
14.00
12.00
10.00
Bank Interest Rates
8.00
6.00
4.00
2.00
Jan-03
Jan-00
Jan-97
Jan-94
Jan-91
Jan-88
Jan-85
Jan-82
Jan-79
Jan-76
Jan-73
Jan-70
0.00
Discounting future values
• How do we place a value today on $1 in t years’
time?
• This is called “discounting” the future value.
One way to think about this question is to ask:
– “How much would we have to put in the bank now to
have $1 in t years’ time?”
– Money in the bank earns interest at the rate at the
rate i, i>0. If I put $1 in the bank today, it will grow to
be $(1+ i)1 in one year’s time, will grow to be
$(1+i)(1+i)1 = $(1+i)2 in two years’ time and will grow
to $(1+i)n in n years’ time.
How much is a future $1?
• In order to have $1 next year, we would have to
put x in today:
$1 = (1+ i) $x
x = 1/(1+i)
• $1 next year is worth 1/(1 + i) today. Since i>0,
$1 next year is worth less than $1 today.
• In order to have $1 in n years’ time, we would
have to put x in today:
x = 1/(1+i)n
• $1 in n years’ time is worth 1/(1+i)n < 1 today.
Net present value
• NPV = R1/(1+i) + R2/(1+ i)2 + … + Rn/(1+ i)n – I
• If NPV >=0, then go ahead and make the
investment. If NPV < 0, then the investment is
not worthwhile.
• As i rises, the PV of future profits will drop, so
the NPV will fall. If we imagine that there are
thousands of potential investments to be made,
as i rises, fewer of these potential investments
will be profitable, and so investment will fall.
• We expect then that I falls as i rises.
Investment
• If we graphed the investment demand for
goods and services (I), it would be
downward-sloping in i.
• What can shift the I curve? Factors that
affect current and expected future
profitability of projects:
– New technology
– Business expectations
– Business taxes and regulation
Money
•
Money has three main functions in the
economy.
1. Money is a medium of exchange. We use exchange
money when we buy/sell to each other.
2. Money is a unit of account. Money is an agreed
measure for stating the value of other goods and
services.
3. Money is a store of value. Money can be kept under
the bed or inside a jar and used to exchange for
goods and services in the future.
Official measures of money
• M1 is the amount of notes and coins
(“currency”) in circulation plus current
deposits with banks.
• M3 is M1 plus all other bank deposits.
• Credit cards are not counted as money,
since using a credit card is accumulating
debt, whereas deposits at a bank can be
turned into money without accumulating
debt.
Money multiplier
•
What happens when you take $1 cash to a bank to
deposit it?
(1) You deposit the cash in the bank, and the bank creates an
account for you with $1 in it.
Money = $1
(2) The bank doesn’t keep the cash. Instead the bank has to keep
R, called the “reserve ratio” (0 < R < 1), of the $1 as reserves
and then loans out $(1 - R).
(3) The person who receives the loan of $(1-R) spends the cash,
and the merchant who receives the $(1-R) puts that in his bank.
This increases the merchant’s account by $(1-R).
Money = $1 + $(1-R)
Money multiplier
(4) The second bank keeps $R(1-R) as reserves and loans out
$(1-R)(1-R) = $(1-R)2 as new loans.
Money = $1 + $(1-R) + $(1-R) 2 + …
•
•
If this process continues, the value of money
created is 1/R = 1 + (1-R) + (1-R)2 + ...
So for every $1 floating in the economy in
currency, we have $1/R in currency plus
deposits in the economy. This ratio m = 1/R is
called the “simple money multiplier”. For every
$1 in currency that the government prints, the
money supply increases by m.
Equilibrium in the money market
• Equilibrium in the money market means supply
of money equals demand for money.
• Supply of money
– The supply of money depends on the level of
currency in the economy and the money multiplier.
The supply of money does not depend on the interest
rate.
• Demand for money
– People require money to make purchases, ie. How
much currency is in your pocket?
Demand for money
• The higher is income and prices, the greater the amount
of money required to make the purchases people will
wish to make.
• But a $1 in your pocket is a $1 not in the bank. In the
bank, that $1 would be accumulating interest, but in your
pocket, it accumulates no interest. So the interest rate is
the price of holding money as currency rather than as a
deposit in the bank. So we would expect that as the
interest rate rises, people will lower the level of currency
that they hold.
• The demand for money is downward-sloping in the
interest rate, i, and increases in income and prices.
Equilibrium in the money market
• The supply of money
does not depend on
the interest rate, so it
is vertical.
• The interest rate is
the price of holding
wealth as currency,
so money demand
falls as i rises.
Monetary policy
• The government can control the supply of
money and thus the interest rate. These actions
are called “monetary policy”.
• “Open market operations” are a means of the
government controlling the supply of money.
The government (in our case the Reserve Bank
of Australia or RBA) buys and sells government
securities, such as government bonds to control
the amount of money in the economy.
• If the RBA buys a bond with currency, the RBA
increases the money supply (by the change in
currency times the money multiplier).
Monetary policy
• If the RBA sells bonds
for currency, it
decreases the supply
of money.
• Monetary policy shifts
the money supply
curve and so changes
the equilibrium
interest rate.
Resources
• There are many resources available to you.
Often students hurt themselves by not taking
advantage of the resources they have.
• Books: There are plenty of macroeconomics
principles books. If you don’t understand
Jackson and McIver’s coverage, get to a library
and read a different textbook. There is also a
study guide by Bredon and Curnow referenced
in the subject outline.
• Online: There is an enormous amount of
material on the Web. Just use a search engine
and look around.
Resources
• Forum: Get into a habit of reading the CSU
forums once a week. Post questions on the
forum and join in the discussion.
• Official websites: Have a look at the websites for
government agencies like the Reserve Bank of
Australia or the Australian Bureau of Statistics.
• CSU help: Student Services at CSU has a lot of
help it can provide students with problems- look
at http://www.csu.edu.au/division/studserv/.
Tips for preparing for the exam
•
•
•
Practice. Do the problems in the back of the
book chapters. Do the problems on the book’s
website. Do the problems in the study guide.
Read the question. Read carefully.
Answer the question. Don’t answer the
question you think was asked. Answer the
question that actually was asked. Most exam
errors happen here. Remember to read the
question.
Tips for preparing for the exam
•
•
•
Be sure to answer all of the question.
Don’t put down too much. Don’t provide a
whole background of a model unless the
question asks for it. If the question asks you to
analyse a scenario, go straight into the
scenario.
Don’t put down too little. In an essay
question, provide your reasoning and analysis.
Draw a relevant graph and talk about the
graph. Don’t just say “Yes.”
Final exam tip
• Don’t panic! Relax and breath. You do
not need to write for 3 hours to do well in
an economics exam. Often a well-ordered
sentence is worth more than 2 pages of
semi-coherent babbling. Stop and think
about your answer.