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Lecture 4: Basics Of Macroeconomics
& Macroeconomic Model
Dr. Rajeev Dhawan
Director
Given to the
EMBA 8400 Class
South Class Room #600
January 19, 2008
Chapter 26
Saving, Investment
and the Financial System
Investment Rebound Led by the Technology
(% Ch. of 4-Qtr. Mov. Avg.)
($/Barrel)
80
30
20
60
10
40
0
20
-10
-20
1989
1991
1993 1995
1997 1999
2001
Total Producer Durable Equipment
Oil Price (Right)
2003 2005
2007
2009
0
Info Processing Equip.
Tax Cuts have Eased the Oil Price
Shock This Time
Average Effective Income Tax Rates
Federal, State and Local Combined
28%
Bush Tax cuts have absorbed
energy price shocks
Past Oil Price Shock came when
tax rates were rising rapidly
26%
24%
22%
Source: Prof. Larry J. Kimbell, Nov. 2004
2004
2003
2002
2001
2000
1999
1998
1981
1980
1979
1978
1977
1976
1975
1974
1973
20%
Savings And National Income Math
 GDP (as the sum of expenditures) has been defined as:
Y = C + I + G + NX
In a closed economy:
Y=C+I+G
 Rearranging terms gives:
Y-C-G=I
 The left-hand side, which is the nation's income (GDP)
leftover after consumption and government spending, is
defined as National Savings. Since Y - C - G is defined as
being equal to "S":
S=I
Continued..
 This relationship must hold for the economy as a
whole (when the economy is closed). Now, with
S=Y-C-G
 Add and subtract the government's tax revenue (T)
to the right-hand side
S=Y-C-G+T-T
 Then rearrange terms on the right hand side to get
S = (Y - T - C) + (T - G)
Continued..
 This expression breaks down national savings into
two components: private savings and public
savings.
 Private savings (Y - T - C) is the income left in the
economy after taxes and consumption have each
been paid for.
 Public savings (T - G) is equal to the taxes
collected by the government, minus government
spending. This is also an expression for the
government surplus/deficit (surplus if T > G, deficit
if T < G).
Market For Loanable Funds
Interest
Rate
Supply
5%
Demand
0
$1,200
Loanable Funds
(in billions of dollars)
Increase in Supply of Loanable Funds
Policy 1: Saving Incentives
Interest
Rate
Supply, S1
S2
1. Tax incentives for
saving increase the
supply of loanable
funds . . .
5%
4%
2. . . . which
reduces the
equilibrium
interest rate . . .
Demand
0
$1,200
$1,600
3. . . . and raises the equilibrium
quantity of loanable funds.
Loanable Funds
(in billions of dollars)
Increase in Demand of Loanable Funds
Policy 2: Investment Incentives
Interest
Rate
Supply
1. An investment
tax credit
increases the
demand for
loanable funds . . .
6%
5%
2. . . . which
raises the
equilibrium
interest rate . . .
0
D2
Demand, D1
$1,200
$1,400
3. . . . and raises the equilibrium
quantity of loanable funds.
Loanable Funds
(in billions of dollars)
Effect Of A Government Budget Deficit
Policy 3: Budget Deficit
Interest
Rate
S2
Supply, S1
1. A budget deficit
decreases the
supply of loanable
funds . . .
6%
5%
2. . . . which
raises the
equilibrium
interest rate . . .
Demand
0
$800
$1,200
3. . . . and reduces the equilibrium
quantity of loanable funds.
Loanable Funds
(in billions of dollars)
The U.S. Government Debt
Percent
of GDP
120
World War II
100
80
60
Revolutionary
War
Civil
War
World War I
40
20
0
1790
1810
1830
1850
1870
1890
1910
1930
1950
1970
1990
2010
Copyright©2004 South-Western
Chapter 28
Unemployment & Its Natural Rate
Article: Why do Americans Work More Than Europeans?
WSJ; by: Edward Prescott
 Americans aged 15-64, on a per-person basis, work
50% more than French. The French, for example,
prefer leisure more than do Americans or on the other
side of the coin, that Americans like to work more. This
is silliness !!
 Germans and Americans spend the same amount time
working, but the proportion of taxable market time vs.
nontaxable home work time is different
 But marginal tax rates explain virtually all of this
difference. Labor supply is not fixed. People be they
European or American, respond to taxed on their
income.
– Spanish labor supply increased by 12% in 1988
when taxes were cut
Identifying Unemployment
 Natural Rate of Unemployment
– The natural rate of unemployment is unemployment
that does not go away on its own even in the long run.
– It is the amount of unemployment that the economy
normally experiences.
 Cyclical Unemployment
– Cyclical unemployment refers to the year-to-year
fluctuations in unemployment around its natural rate.
– It is associated with short-term ups and downs of the
business cycle.
Unemployment Rate Since 1960
Percent of
Labor Force
10
Unemployment rate
8
6
Natural rate of
unemployment
4
2
0
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
Copyright©2003 Southwestern/Thomson Learning
How Is Unemployment
Measured?
 Based on the answers to the survey questions, the
Bureau of Labor Statistics (BLS) places each adult
into one of three categories:
– Employed
– Unemployed
– Not in the labor force
 Labor Force
– The labor force is the total number of workers, including
both the employed and the unemployed.
– The BLS defines the labor force as the sum of the
employed and the unemployed.
Breakdown Of The Population In 2004
Employed
(139.3 million)
Adult
Population
(223.4 million)
Unemployed (8.1 million)
Not in labor force
(76.0 million)
Labor Force
(147.4 million)
Unemployment - What is it?
The unemployment rate is calculated as the
percentage of the labor force that is
unemployed.
Number unemployed
Unemployment rate =
 100
Labor force
Labor Force Participation Rate
Labor force participation rate
Labor force

 100
Adult population
Example
 In 2001, 135.1 million people were employed and
6.7 million people were unemployed.
– Labor Force = 135.1 + 6.7 = 141.8 million
– Unemployment Rate
= (6.7 / 141.8) X 100
= 4.7 percent
– Labor Force Participation Rate =
(141.8 / 211.9) X 100 = 66.9 percent
The Labor-Market Experiences of Various
Demographic Groups (2004)
Copyright©2004 South-Western
Figure 3 Labor Force Participation
Rates for Men and Women Since 1950
Labor-Force
Participation
Rate (in percent)
100
80
Men
60
40
Women
20
0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Questions About Unemployment
 Does the Unemployment Rate Measure What We
Want It To?
 How Long Are the Unemployed without Work?
 Why Are There Always Some People
Unemployed?
Unemployment Insurance Claims
and Unemployment Rate
(%)
6.5
(Thou.)
500
6.0
450
5.5
400
5.0
350
4.5
300
4.0
3.5
250
MAY OCT MAR AUG JAN JUN NOV APR SEP FEB JUL DEC MAY OCT MAR AUG JAN
2000
2001
2002
2003
2004
2005
2006
2007
Unem ploym ent Rate
U.I. Claim s
Metro Cities' Unemployment Rate
10.0
8.0
6.0
4.0
2.0
0.0
APR SEP FEB JUL DEC MAY OCT MAR AUG JAN JUN NOV APR SEP FEB JUL DEC
1998
1999
2000
2001
2002
2003
2004
Alpharetta
Peachtree City
Atlanta
Roswell
Decatur
Smyrna
Marietta
Article: The $366 Billion Outrage
Fortune Magazine; by: Janice Revell
Pension plans of 16 million state and local government workers are
taking up a huge share of the budgets. In the 90’s elected officials
allowed workers to dramatically spike their pre-retirement compensation,
to retire on more than 100% of their pay, and to draw both their salaries
and pensions, with guaranteed market returns, simultaneously.
San Diego deferred retirement option plan, or DROP allows pension, deposited into
a special account earn a guaranteed 8% annual rate of interest, plus a 2% annual
cost-of-living adjustment. When the employee actually decides to retire he can either
collect the amount that has accumulated in his special pension account or let it keep
compounding at that generous rate or return indefinitely.
 Result:
 The pension fund is short by billions and counting ($366 Billion so far!). The
generosity of the plan means workers (e.g. in Houston 44% of the city workforce) can
quit without taking a major financial hit => early retirement by qualified employees.
 Solution:
 Raise property tax (is happening)
Cut in city services (is happening)
Cut benefits (?)
Chapter 29
The Monetary System
Money–What is it and what does it do?
Money is the set of assets in an economy that people regularly
use to buy goods and services from one another
 Medium of Exchange –what sellers accept from buyers as
payment for goods and services. Eliminates inefficiencies of
barter.
 Unit of Account – When there is one unit of account, like the
($) in the United States, you don't have to think in relative
terms when valuing goods and services.
 Store of Value – people have the option to hold money over
time as one way of storing their assets. Money is an important
store of value, because it is the most liquid asset in the
economy
Types of Money
 Commodity Money money that takes the form of a
commodity with intrinsic value.
 Fiat Money money without intrinsic value that is
used as money because of government decree
How to Measure Money
Money Stock: The quantity of money circulating in the
economy
Q: Suppose you want to know the size of the U.S.
money stock. What should you count as money?
A: Currency and demand deposits, and a few other
items (detailed below) but not credit cards.
Currency - the paper bills and coins in the hands of the
public
Demand Deposits - balances in bank accounts that
depositors can access on demand by writing a check
(or by using a debit card)
Two Measures of the Money Stock for the U.S.
Economy (2004)
Billions
of Dollars
M2
$6,398
• Savings deposits
• Small time deposits
• Money market
mutual funds
• A few minor categories
($5,035 billion)
M1
$1,363
0
• Demand deposits
• Traveler’s checks
• Other checkable deposits
($664 billion)
• Currency
($699 billion)
• Everything in M1
($1,363 billion)
Continued…
Q: How is the U.S. money stock measured and reported?
A: Two most important measures – M1 and M2
M1 = Currency, Traveler's checks, Demand Deposits and Other
Checkable Deposits
Here is a breakdown of M1 for 1996:
Item$ (Billions) % of total
Currency
Traveler's Checks
Demand Deposits
Other Checkable Deposits
$1076.8
395.7
8.6
400.7
271.8
100.0%
36.7
0.8
37.2
25.3
M2 = Everything in M1 plus Savings deposits, Small Time
Deposits, Money Market Mutual Funds and a few minor
categories. M2 for 1996 was $3657.4 billion.
Banks & Money Supply
Q: How do banks operate?
A: Banks accept deposits from people. That money is in an
account until the depositor makes a withdrawal or writes a
check on their account.
Q: Do banks keep all of your money in their vault?
A: No. Our banking system is called fractional reserve
banking. Bankers understand that it is not necessary to
keep 100 percent of a depositors money on hand at all
times. As a result, bankers take some of your money and
loan it out to other people.
Continued..
Fractional reserve banking - a banking
system in which banks hold only a fraction
of deposits as reserves
Reserve ratio - the fraction of deposits that
banks hold as reserves. Minimum reserve
ratios are set by the Fed.
Money Creation with
Fractional-Reserve Banking
When a bank makes a loan from its
reserves, the money supply increases.
The money supply is affected by the amount
deposited in banks and the amount that
banks loan.
– Deposits into a bank are recorded as both assets
and liabilities.
– The fraction of total deposits that a bank has to
keep as reserves is called the reserve ratio.
– Loans become an asset to the bank.
Money Creation with FractionalReserve Banking
This T-Account shows a bank that…
– accepts deposits,
– keeps a portion
as reserves,
– and lends out
the rest.
– It assumes a
reserve ratio
of 10%.
First National Bank
Assets
Reserves
$10.00
Liabilities
Deposits
$100.00
Loans
$90.00
Total Assets
$100.00
Total Liabilities
$100.00
Money Creation with
Fractional-Reserve Banking
When one bank loans money, that money is
generally deposited into another bank.
This creates more deposits and more
reserves to be lent out.
When a bank makes a loan from its
reserves, the money supply increases.
The Money Multiplier
Suppose that the Fed requires banks to keep 20 percent of their
demand deposits on reserve.
Q: What happens when somebody brings in $100 and deposits it
in a bank?
A: The bank is required to keep $20 (20 percent) on reserve.
Q: What does the bank do with the remaining $80?
A: The bank will turn around and lend it to somebody else,
earning interest income for the bank.
Q: What did that $80 loan do to the size of the money supply?
A: The money supply increased by $80 when the loan was made.
Here's how:
Continued…
 When the first depositor arrived with $100 in cash, the money
supply included that $100 of currency in the depositor's wallet
 After the deposit, the currency was in the bank vault and not
circulating (so out of the money supply)
 However, demand deposits increased by $100, so the money
supply was unchanged (currency fell by $100, deposits
increased by $100)
 When the bank made the $80 loan, $80 in currency reentered
the money supply
 Added to the $100 demand deposit, that original $100 has
grown to $180.
Continued…
 Now suppose that the person who received the $80 loan
deposits that money into their checking account.
 Q: What does the bank have to do with the $80?
 A: Keep 20 percent on reserve (20 percent of $80 = $16).

 Q: What does the second bank do with the remaining $64?
 A: They can lend that out to somebody else
The Money Multiplier
First National Bank
Assets
Liabilities
Reserves
$10.00
Deposits
$100.00
Loans
Second National Bank
Assets
Reserves
$9.00
Liabilities
Deposits
$90.00
Loans
$90.00
Total Assets
Total Liabilities
$100.00
$100.00
$81.00
Total Assets
$90.00
Total Liabilities
$90.00
Money Supply = $190.00!
Money Multiplier
Q: How far does this process of money creation go?
A: The process of bank money creation continues until there are no more
excess reserves to be lent out.
Money multiplier - the amount of money the banking system generates with
each dollar of reserves. The money multiplier is the reciprocal of the
reserve ratio:
M = 1/R
With a reserve requirement, R = 20% or 1/5,
The multiplier is 5. Therefore, the original $100 deposit will eventually
turn into $500 of deposits.
Q: The banking system can create money, but can it also create real wealth?
A: No. Each loan has two parts. Recall that the first $80 loan generated $80 in
new money. At the same time, that $80 loan also created a new $80
liability for the person borrowing the money. The banking system cannot
create real wealth.
The Federal Reserve System
The Federal Reserve (Fed) serves as the
nation’s central bank.
– It is designed to oversee the banking system.
– It regulates the quantity of money in the
economy.
The primary elements in the Federal
Reserve System:
1) The Board of Governors
2) The Regional Federal Reserve Banks
3) The Federal Open Market Committee
The Federal Reserve System
Copyright©2003 Southwestern/Thomson Learning
The Fed’s Organization
 The Federal Open Market Committee (FOMC)
– Serves as the main policy-making organ of the Federal
Reserve System.
– Meets approximately every six weeks to review the
economy.
 The FOMC is made up of the following voting
members:
– The chairman and the other six members of the Board
of Governors.
– The president of the Federal Reserve Bank of New
York.
– The presidents of the other regional Federal Reserve
banks (four vote on a yearly rotating basis).
The Fed’s Tools of Monetary Control
The Fed has three tools in its monetary
toolbox:
– Open-market operations
– Changing the reserve requirement
– Changing the discount rate
The Fed’s Tools of Monetary Control
Open-Market Operations
– The Fed conducts open-market operations when it
buys government bonds from or sells government
bonds to the public:
– When the Fed buys bonds, the money supply is
increased. Here is why: The Fed pays for the bonds it
buys with money that was not currently a part of the
money supply, hence, when the Fed buys bonds it
simply increases the total amount of money in
circulation.
– When the Fed sells bonds, the money supply is
decreased. Here is why: The Fed sells bonds in the
market and receives cash in return for the bonds it
sells. Once the Fed receives the cash, this cash is
taken out of circulation – therefore, the size of the
money supply is decreased.
The Fed’s Tools of Monetary Control
Reserve Requirements
– The Fed also influences the money supply with
reserve requirements.
– Reserve requirements are regulations on the
minimum amount of reserves that banks must
hold against deposits.
The Fed’s Tools of Monetary Control
Changing the Discount Rate
– The discount rate is the interest rate the Fed
charges banks for loans.
Increasing the discount rate decreases the money
supply.
Decreasing the discount rate increases the money
supply.
Problems in Controlling the
Money Supply
The Fed must wrestle with two problems
that arise due to fractional-reserve banking.
– The Fed does not control the amount of money
that households choose to hold as deposits in
banks.
– The Fed does not control the amount of money
that bankers choose to lend.
Chapter 30
Money Growth and Inflation
The Classical Theory of Inflation
 Inflation is an increase in the overall level of prices.
 Hyperinflation is an extraordinarily high rate of
inflation.
 Historical Aspects
– Over the past 60 years, prices have risen on average about
5 percent per year.
– In the 1970s prices rose by 7 percent per year.
– During the 1990s, prices rose at an average rate of 2
percent per year.
– Deflation, meaning decreasing average prices, occurred in
the U.S. in the nineteenth century.
– Hyperinflation refers to high rates of inflation such as
Germany experienced in the 1920s.
The Classical Theory of Inflation
Inflation is an economy-wide phenomenon
that concerns the value of the economy’s
medium of exchange.
When the overall price level rises, the value
of money falls.
Money Supply, Money Demand
and Monetary Equilibrium
 The money supply is a policy variable that is controlled by
the Fed.
– Through instruments such as open-market operations,
the Fed directly controls the quantity of money
supplied.
 Money demand has several determinants, including interest
rates and the average level of prices in the economy.
 People hold money because it is the medium of exchange.
– The amount of money people choose to hold depends
on the prices of goods and services.
 In the long run, the overall level of prices adjusts to the
level at which the demand for money equals the supply.
Money Supply, Money Demand, and the Equilibrium
Price Level
Value of
Money, 1/P
(High)
Price
Level, P
Money supply
1
1 (Low)
3
1.33
/4
12
/
Equilibrium
value of
money
(Low)
A
2
Equilibrium
price level
14
4
/
Money
demand
(High)
0
Quantity fixed
by the Fed
Quantity of
Money
Copyright © 2004 South-Western
Figure 2 The Effects of Monetary Injection
Value of
Money, 1/P
(High)
MS1
MS2
1 (Low)
1
1. An increase
in the money
supply . . .
3
2. . . . decreases
the value of
money . . .
Price
Level, P
/4
12
/
1.33
A
2
B
14
/
3. . . . and
increases
the price
level.
4
Money
demand
(High)
(Low)
0
M1
M2
Quantity of
Money
Copyright © 2004 South-Western
The Classical Theory of
Inflation
The Quantity Theory of Money
– How the price level is determined and why it
might change over time is called the quantity
theory of money.
The quantity of money available in the economy
determines the value of money.
The primary cause of inflation is the growth in the
quantity of money.
The Classical Dichotomy and
Monetary Neutrality
 Nominal variables are variables measured in monetary
units.
 Real variables are variables measured in physical units.
 According to Hume and others, real economic variables
do not change with changes in the money supply.
– According to the classical dichotomy, different forces influence
real and nominal variables.
 Changes in the money supply affect nominal variables
but not real variables.
 The irrelevance of monetary changes for real variables is
called monetary neutrality.
Velocity and the Quantity Equation
 The velocity of money refers to the speed at
which the typical dollar bill travels around the
economy from wallet to wallet.
V = (P  Y)/M
Where: V = velocity
P = the price level
Y = the quantity of output
M = the quantity of money
 Rewriting the equation gives the quantity
equation:
MV=PY
Velocity & Quantity Equation
 Velocity ( V )
= Nominal GDP/ Money Supply
=(PxY)/M
 Example: V
= ($10 x 100 ) / $ 50
= 20
Velocity & Quantity Equation
 The quantity equation relates the quantity of
money (M) to the nominal value of output
(P  Y).
 The quantity equation shows that an increase in
the quantity of money in an economy must be
reflected in one of three other variables:
– the price level must rise,
– the quantity of output must rise, or
– the velocity of money must fall.
Nominal GDP, the Quantity of Money,
and the Velocity of Money
Indexes
(1960 = 100)
2,000
Nominal GDP
1,500
M2
1,000
500
Velocity
0
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
Velocity and the Quantity
Equation
The Equilibrium Price Level, Inflation Rate,
and the Quantity Theory of Money
– The velocity of money is relatively stable over
time.
– When the Fed changes the quantity of money, it
causes proportionate changes in the nominal
value of output (P  Y).
– Because money is neutral, money does not
affect output.
Velocity of Money (M2)
2.40
2.20
2.00
1.80
1.60
1.40
1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003
Velocity of Money (M1)
12
10
8
6
4
2
1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003
The Inflation Tax
When the government raises revenue by
printing money, it is said to levy an
inflation tax.
An inflation tax is like a tax on everyone
who holds money.
The Fisher effect refers to a one-to-one
adjustment of the nominal interest rate to
the inflation rate.
The Nominal Interest Rate and the
Inflation Rate
Percent
(per year)
15
12
Nominal interest rate
9
6
Inflation
3
0
1960
1965
1970
1975
1980
1985
1990
1995
2000
Costs of Inflation
1.
2.
3.
4.
Shoeleather Costs – resources wasted when inflation encourages
people to reduce their holdings of money.
Menu Costs – the costs involved in actually changing prices
around the economy.
Relative Price Variability and the Misallocation of Resources
– If firms only occasionally change their prices (like once per
year), then they have to guess at the future level of inflation. Their
prices will be too high early in the year and too low late in the
year, resulting in sales that are artificially low early in the year
and artificially high late in the year.
Inflation-Induced Tax Distortions – Taxes like capital gains and
interest income taxes are imposed on the nominal value of assets
or on interest income. From studying real versus nominal interest
rates, you know that part of the nominal interest rate exists to
compensate people for the effects of inflation. The higher is the
rate of inflation, the higher is this distortion caused by these taxes.
Continued..
5. Confusion and Inconvenience – Money, being the economy's
unit of account, is used to quote prices for goods and services
throughout the economy. Confusion and inconvenience arise as
a cost of inflation because inflation makes valuing dollars over
time difficult. Many important items in the economy are
measured over time (like the value of a firm, for instance), and
inflation creates difficulties in the valuation of assets or debts
that occur over time.
6. Arbitrary Redistributions of Wealth – "Inflation is good for
borrowers and bad for lenders" is a common phrase that rings
out in economics principles courses. Here's a personal example
for you to consider (and a personal example for your website
author as well). When you graduate from college, you will
likely owe money on student loans that you took out during
your college years. Between the time you borrowed the money
and the time when you repay the loan, you will be better off if
inflation is high.
Important Macro Lessons To
Be Learnt Today
 GDP cannot grow beyond its potential in the long run
 Loose Monetary Policy can create only a short-run stimulus in
GDP. In long-run it only creates inflation! Net-Net money growth
determines inflation
 Government spending can create only a short-run stimulus in
GDP. In the long-run it leads to a rise in the real interest rate
with no gain in GDP but higher deficits
 Balanced budget spending just redistributes the share of GDP
attributed to consumption & government spending
~Typical Macro-Model~
world
interest
rate
world
price
price
level lag 1
world
GDP
IMPORTS
inflation
lag 1
EXPORTS
EXCHANGE RATE
NET
EXPORTS
money
PRICE
LEVEL
INTEREST RATE
INFLATION
government
INVESTMENT
REAL GDP
CONSUMPTION
tax
rate
capital stock
lag 1
TAX REVENUES
investment
lag 1
DISPOSABLE INCOME
CAPITAL STOCK
EXPECTED
INFLATION
UNEMPLOYMENT
POTENTIAL GDP
labor force
Macroeconomic Model
The Macroeconomic Model simulates
the working of the US Economy using
explicit equations to model
consumption, investment, exports,
imports, exchange rate, price level and
inflation rate.
Classification and Listing of Equations
1. Accounting Identities:
Real GDP (GDP); Tax Revenues (T)
Disposable Income (YDP), Net Exports (NETEX)
Price Level (P)
Example: Disposable Income (YDP) = GDP – Tax Revenues (T)
Accounting Identities have the following properties:
 As forecasting equations, they are PERFECT!
 Don’t have parameters to be fitted
 No error term
 No theoretical disputes about their truth, only about their
relevance
2. Behavioral Equations:
Consumption (C), Real Interest Rate (R),
Investment (I), Exchange Rate (EXCH),
Exports (EX), Imports (IM),
Inflation (P%)
Example: Consumption (C) = α0 * Disposable income (YDP)
(Where α0 = marginal propensity to consume = 0.9215686)
Behavioral Equations have the following properties:
Estimated parameter values change as behavior changes
Source of all forecasting errors
Theoretical disputes concerning these equations, e.g., are
consumers myopic or forward looking?
Endogenous and Exogenous Variables
Accounting Identity
 Define: A = B + C ……………………(1)
 Where B = A/2
………………..…..(2)
 and C = 5 (given)
Behavioral Equation
 Then equation (1) becomes A = B +5 which
using definition of B becomes the following:
 A = (A/2) + 5
 Thus, A/2 = 5 or A = 10 and using (2) B=5
 In the above example, A & B are endogenous
variables and C is an exogenous variable
Macroeconomic Model
The Exogenous Factors in the model are:
– GDP Potential (GDP@FULL) which is GDP value
at full employment level
– Domestic Policy Variables:
 Money Supply (M)
 Government Spending (G)
 Tax Policy (T%)
– Rest-of-the-World (ROW) factors such as
 Foreign Interest Rate (R@ROW)
 Foreign Price Level (P@ROW)
 ROW GDP Potential (GDP@ROW)
Model Simulation Approach
1.
2.
3.
4.
5.
6.
7.
8.
State macroeconomic theory as a complete set of algebraic
equations.
Estimate/postulate numerical values of all parameters.
Assume initial conditions for the history of all lagged
variables.
Assume “base case” values over future time periods for all
exogenous variables.
Solve the model under base case assumptions.
Change some of the exogenous variable assumptions.
Solve the model again under alternative assumptions.
Compare model solutions
 Base Case and the alternative policy Simulation.
Advantages of the Model Simulation Approach
1. Integrates short run and long run analysis into one coherent
story of the dynamic reactions of an economy to
macroeconomic policy.
2. Traces the complete logic of the model, step-by-step, instead
of trying to condense model into a two-dimensional diagram,
such as IS-LM diagram.
3. Extends to real-world macroeconomic policy issues.
4. Same process applies to realistic models of actual
economies, such as U.S. forecasting models, oil shocks, or
world slowdown.
Listing Of Variables in the Model
 12 Endogenous Variables
– GDP, C, I, EX, IM, NETEX, R, P, YDP, T, EXCH, P%
(requires 12 equations in 12 unknowns)
 7 Exogenous Variables
– 3 Policy Variables: M, G, TAX%
– 3 ROW Variables: P@ROW, R@ROW, GDP@ROW
– 1 Other Variable: GDP@FULL
Listing of 12 Equations in the Model
 12 Endogenous Variables
– One GDP Equation/Accounting Identity
Accounting Identity
– Three Consumption Related Equations
Accounting Identity
Accounting Identity
Behavioral Equation
– Two Interest Rate and Investment Equations
Behavioral Equation
Behavioral Equation
– Four Exchange Rate, Export, Import and Net Export Equations
Behavioral Equation
Behavioral Equation
Behavioral Equation
Accounting Identity
– Two Price Inflation Equations
Behavioral Equation
Accounting Identity
Glossary of Variables
Type
Variable
Meaning
Units
Endogenous
C
Consumption
Billions of $
Endogenous
EX
Exports
Billions of $
Endogenous
EXCH
Exchange Rate
Index
Exogenous
G
Government Purchases
Billions of $
Endogenous
GDP
Gross Domestic Product
Billions of $
Exogenous
GDP@FULL
GDP @ Full Employment
Billions of $
Exogenous
GDP@ROW
GDP in Rest of the World
Billions of $
Endogenous
I
Investment
Billions of $
Endogenous
IM
Imports
Billions of $
Exogenous
M
Money supply
Billions of $
Endogenous
NETEX
Net Exports
Billions of $
Endogenous
P
Price Level
Index
Endogenous
P%
Inflation
Percent
Exogenous
P@ROW
Price
Level,
Rest
of
the
Index
World
Endogenous
R
Real Interest Rate
Percent
Exogenous
R@ROW
Real Interest Rate, Rest of
Percent
the World
Endogenous
T
Tax Revenues
Billions of $
Exogenous
TAX%
Tax Rate
Fraction
Endogenous
YDP
Disposable Income
Billions of $
Additional Definitions
The model variables are in real terms (except of course the price
variable). We need three other variables in nominal terms to
complete our understanding. These are like “derived” accounting
identities.
Econ 101 Rule
Econ 101 Rule
“Given the values of
exogenous variables for a
given economy, if the
values of inflation (P%)
= 0.00% & nominal
exchange rate (EXCH) =
1.00, then the economy is
in equilibrium or steady
state in such a way that
actual GDP is exactly
equal to potential GDP”.
ENDOGENOUS VARIABLES
ACCOUNTING IDENTITIES
Gross Domestic Product
Tax Revenues
Disposable Income
Net Exports
Price Level
GDP
T
YDP
NETEX
P
2006
$ 7,000.00
$ 1,050.00
$ 5,950.00
$ (248.25)
1.000
C
R
I
EXCH
EX
IM
P%
EXCH(N)
$ 5,483.33
4.00
$
999.99
1.000
$ 1,764.29
$ 2,012.53
0.000
1.000
POLICY VARIABLES
Money
M
$ 3,500.00
Government Purchases
G
$
BEHAVIORAL EQUATIONS
Consumption Expenditure
Real Interest Rate
Investment
Real Exchange Rate
Exports
Imports
Inflation
Nominal Exchange Rate
EXOGENOUS VARIABLES
Tax Rate
TAX%
REST-OF-WORLD VARIABLES
Price Level, ROW
P@ROW
Real Interest Rate, ROW
R@ROW
GDP@ROW
GDP @ Rest of World
OTHERS
Price Level % (t-1)
Price Level (t-1)
Potential GDP
764.92
0.15
1.00
4.00
$ 7,000.00
P%(t-1)
0.00
P(t-1)
1.00
GDP@FULL $ 7,000.00
Equal
Base Case
The Base Case is the state of the
economy where for the given values of
exogenous variables, the ECON 101 rule
applies and the values of endogenous
variables solved in the first year remain
constant for all subsequent years
Base Case
This means that GDP will be equal to its potential value for all the
years in the base case.
Inflation will be equal to ZERO percent
And the exchange rate will be at one for all the years
Cont…
This also implies that values of all other
endogenous variables will also be
constant for the subsequent years.
Why? Endogenous variables P and P%
from today become the exogenous
variables for subsequent years’
endogenous value calculations as seen
from equations 11 and 12.
Name of Experiment:
Base Case
History
2006
ENDOGENOUS VARIABLES
ACCOUNTING IDENTITIES
Data Table
1
****
2007
Short Run
2008
2009
****
2010
****
2017
Long Run
2022
2027
****
2032
Gross Domestic Product (GDP)
New Sim
Base Case
Diff
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
Taxes (T)
New Sim
Base Case
Diff
$1,050.0
$1,050.0
$0.0
$1,050.0
$1,050.0
$0.0
$1,050.0
$1,050.0
$0.0
$1,050.0
$1,050.0
$0.0
$1,050.0
$1,050.0
$0.0
$1,050.0
$1,050.0
$0.0
$1,050.0
$1,050.0
$0.0
$1,050.0
$1,050.0
$0.0
$1,050.0
$1,050.0
$0.0
Disposable Income (YDP)
New Sim
Base Case
Diff
$5,950.0
$5,950.0
$0.0
$5,950.0
$5,950.0
$0.0
$5,950.0
$5,950.0
$0.0
$5,950.0
$5,950.0
$0.0
$5,950.0
$5,950.0
$0.0
$5,950.0
$5,950.0
$0.0
$5,950.0
$5,950.0
$0.0
$5,950.0
$5,950.0
$0.0
$5,950.0
$5,950.0
$0.0
Net Exports (NETEX)
New Sim
Base Case
Diff
($248.2)
($248.2)
$0.0
($248.2)
($248.2)
$0.0
($248.2)
($248.2)
$0.0
($248.2)
($248.2)
$0.0
($248.2)
($248.2)
$0.0
($248.3)
($248.2)
$0.0
($248.2)
($248.2)
$0.0
($248.2)
($248.2)
$0.0
($248.2)
($248.2)
$0.0
Price Level (P)
New Sim
Base Case
Diff
1.00
1.00
0.00
1.00
1.00
0.00
1.00
1.00
0.00
1.00
1.00
0.00
1.00
1.00
0.00
1.00
1.00
0.00
1.00
1.00
0.00
1.00
1.00
0.00
1.00
1.00
0.00
Consumption Expenditure ( C)
New Sim
Base Case
Diff
$5,483.3
$5,483.3
$0.0
$5,483.3
$5,483.3
$0.0
$5,483.3
$5,483.3
$0.0
$5,483.3
$5,483.3
$0.0
$5,483.3
$5,483.3
$0.0
$5,483.3
$5,483.3
$0.0
$5,483.4
$5,483.3
$0.0
$5,483.3
$5,483.3
$0.0
$5,483.3
$5,483.3
$0.0
Real Interest Rate ( R)
New Sim
Base Case
Diff
4.0
4.0
0.0
4.0
4.0
0.0
4.0
4.0
0.0
4.0
4.0
0.0
4.0
4.0
0.0
4.0
4.0
0.0
4.0
4.0
0.0
4.0
4.0
0.0
4.0
4.0
0.0
Investment (I)
New Sim
Base Case
Diff
$1,000.0
$1,000.0
$0.0
$1,000.0
$1,000.0
$0.0
$1,000.0
$1,000.0
$0.0
$1,000.0
$1,000.0
$0.0
$1,000.0
$1,000.0
$0.0
$1,000.0
$1,000.0
$0.0
$1,000.0
$1,000.0
$0.0
$1,000.0
$1,000.0
$0.0
$1,000.0
$1,000.0
$0.0
Real Exchange Rate (EXCH)
New Sim
Base Case
Diff
1.00
1.00
0.00
1.00
1.00
0.00
1.00
1.00
0.00
1.00
1.00
0.00
1.00
1.00
0.00
1.00
1.00
0.00
1.00
1.00
0.00
1.00
1.00
0.00
1.00
1.00
0.00
Exports (EX)
New Sim
Base Case
Diff
$1,764.3
$1,764.3
$0.0
$1,764.3
$1,764.3
$0.0
$1,764.3
$1,764.3
$0.0
$1,764.3
$1,764.3
$0.0
$1,764.3
$1,764.3
$0.0
$1,764.3
$1,764.3
$0.0
$1,764.3
$1,764.3
$0.0
$1,764.3
$1,764.3
$0.0
$1,764.3
$1,764.3
$0.0
Imports (IM)
New Sim
Base Case
Diff
$2,012.5
$2,012.5
$0.0
$2,012.5
$2,012.5
$0.0
$2,012.5
$2,012.5
$0.0
$2,012.5
$2,012.5
$0.0
$2,012.5
$2,012.5
$0.0
$2,012.5
$2,012.5
$0.0
$2,012.5
$2,012.5
$0.0
$2,012.5
$2,012.5
$0.0
$2,012.5
$2,012.5
$0.0
Inflation (P%)
New Sim
Base Case
Diff
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
BEHAVIORAL EQUATIONS
Second half of the data Table 1
EXOGENOUS VARIABLES
POLICY VARIABLES
Money Supply (M)
New Sim
Base Case
Diff
$3,500.0
$3,500.0
$0.0
$3,500.0
$3,500.0
$0.0
$3,500.0
$3,500.0
$0.0
$3,500.0
$3,500.0
$0.0
$3,500.0
$3,500.0
$0.0
$3,500.0
$3,500.0
$0.0
$3,500.0
$3,500.0
$0.0
$3,500.0
$3,500.0
$0.0
$3,500.0
$3,500.0
$0.0
Government Purchases (G)
New Sim
Base Case
Diff
$764.9
$764.9
$0.0
$764.9
$764.9
$0.0
$764.9
$764.9
$0.0
$764.9
$764.9
$0.0
$764.9
$764.9
$0.0
$764.9
$764.9
$0.0
$764.9
$764.9
$0.0
$764.9
$764.9
$0.0
$764.9
$764.9
$0.0
Tax Rate (TAX%)
New Sim
Base Case
Diff
15%
15%
0%
15%
15%
0%
15%
15%
0%
15%
15%
0%
15%
15%
0%
15%
15%
0%
15%
15%
0%
15%
15%
0%
15%
15%
0%
Price Level, ROW
New Sim
Base Case
Diff
1.0
1.0
0.0
1.0
1.0
0.0
1.0
1.0
0.0
1.0
1.0
0.0
1.0
1.0
0.0
1.0
1.0
0.0
1.0
1.0
0.0
1.0
1.0
0.0
1.0
1.0
0.0
Real Interest Rate, ROW
New Sim
Base Case
Diff
4.0
4.0
0.0
4.0
4.0
0.0
4.0
4.0
0.0
4.0
4.0
0.0
4.0
4.0
0.0
4.0
4.0
0.0
4.0
4.0
0.0
4.0
4.0
0.0
4.0
4.0
0.0
GDP @ Rest of World
New Sim
Base Case
Diff
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
New Sim
Base Case
Diff
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
REST-OF-WORLD VARIABLES
OTHERS
Potential GDP (GDP@FULL)
4 Important Guidelines to Use the Model
1.
Tools/Options/Calculations/Iterations=100
2.
Use Graph Button to Generate New Graphs for the
experiment performed
3.
Use Print Button for Printing the Results
4.
To Reset the Model, Press the Base Case Button,
and run the model once using the Calculations
Button