ec:250 intermediate macroeconomics!

EC:250Intermediate

Macroeconomics!Tutors: Brian DengCourse Coordinator: Steven Song

1

Today’s Schedule

1. Cover each chapter in detail2. Question period3. Exam study tips4. Go over practice questions (if we have

time)

2

Chapters 1 and 2

3

Chapters 1 and 2• Shotgun blast of theory:

– What’s the difference?• Macroeconomics

– Study of the behaviour and performance of the economy as a whole

• Microeconomics– Study of the behaviour and performance of individual parts of the

economy– Gross Domestic Product (GDP)

• The value of all final goods and services produced within Canadian borders over some period

– Basically anything produced in Canada• It is a measure of the aggregate (whole amount of) Output or

Income or Spending– Whatever is Produced creates Income which is then Spent. So all 3 show

GDP!4

shotgun cont…– Gross National Product (GNP)

• The value of all final goods and services produced in Canada or elsewhere by Canadian-owned resources

– Inflation Rate• A measure of how fast prices, in general are rising

– Exchange rate• The rate at which one country’s currency trades for another

– Macroeconomic Models• Simplification of an economy which provides a logical and

consistent framework to help understand an economy• 2 types of variables:

– Endogenous: Value is determined within the model (the output of the model)– Exogenous: Value is determined outside the model (the input into the

model)• 2 type of models:

– Classical (freshwater econ): Prices are flexible and study is of the long run effects

– Keynesian (saltwater econ): Prices are fixed and study is of the short run effects

5

Rules for Calculating GDP1. Don’t count inventories

– Only count any level increases2. Get realistic numbers

– Don’t simply compare prices or quantities– Multiply them to get realistic value

3. Don’t count intermediate goods– Nobody cares if your country is the

leading manufacturer of unfinished iPods4. If there isn’t a price, use imputed value

– Imputed value: Implied value based on the nature of the product• Eg. When calculating income for sailors, a dollar value is imputed for

the cost of food and lodging5. Don’t include any of these:

– Used goods– Home production– Underground economy– Services of durable goods– Environmental effects of production 6

Real vs. Nominal GDP– Nominal GDP

• ∑ P2008Q2008• = # of apples in 2008 * cost per apple in 2008

– Real GDP• Set a base year for pricing, pricing is fixed• ∑ P2002Q2008• = # of apples in 2008 * cost per apple in 2002

– Nominal GDP shows the change in the total value of output produced by a country while real GDP shows the change in volume by fixing the price

– GDP Deflator• Price Index that measures the overall price level

– Nominal GDP/Real GDP * 1007

Apples Oranges2008 2010 2008 2010

Price/unit 2 3 1.50 2.50# of units 400 600 500 450

Example

8

• Nominal GDP in 2010• ∑ P2010Q2010

• = (3*600) + (2.5*450)

• = $2925• Real GDP in 2010, base year 2008

• ∑ P2008Q2010

• = (2*600) + (1.5*450)

• = $1875

• GDP Deflator• =Nominal GDP/Real GDP = 2925/1875 = 156%

Measuring GDP• Measuring with Aggregate Expenditure (Y)

– Consumption (C): Goods and services purchased by consumers– Investment (I): Goods bought for future use– Government Purchases (G)– Net Exports (NX): Total Exports – Total Imports– Add it all up!

• GDP = Y = C + I + G + NX• This is known as the national accounts identity

• Measuring with Aggregate Income– Basically calculate the National Income (3 steps)– Calculate GNP

• = GDP – Net Income of Foreigners• Recall: This is because GNP is Canadian only

– Calculate NNP (Net national product)• = GNP – Depreciation

– Calculate National Income• = NNP – Indirect business taxes (GST, PST)

9

Chapter 17 Consumption

10

Keynes’s Conjectures

11

• First, Keynes conjectured that the marginal propensity to consume – the amount consumed out of an additional dollar of income – is between zero and one.

• Second, Keynes posited that the ratio of consumption to income, called average propensity to consume, falls as income rises.

• Third, Keynes thought that income is the primary determinant of consumption and that the interest rate does not have an important role. (In the short run)

• C=C +c*Y, C >0, 0<c<1C = consumption, Y = disposable income, C = constant, c = marginal propensity to consume.

Keynes cont.

12

• C=C +c*Y, C >0, 0<c<1C = consumption, Y = disposable income, C = constant, c = marginal propensity to consume.

• c = MPC, 0<c<1which means higher income leads to higher consumption and also to higher saving.

• APC = C/Y = C/Y + c, As Y rises, C/Y falls, and so the APC falls.

• Notice that interest rate is not in the equation. • Keynesian consumption function was a good

approximation of how consumer behave.

Keynes cont.

13

APClow income > APChigh income

Keynes cont.

14

• Keynesian consumption predicted that after World War II, the low consumption would lead to an inadequate demand for goods and services, results a long depression of indefinite duration. -> Never happened LOL

• Although incomes were much higher after the war than before, but it did not lead to a large increases in the rate of saving. APC would fall as income rose appeared not to hold.

Keynes cont.

15

• Other economists later discovered that APC did not vary systematically with income. This relationship is called the long-run consumption function.

• Notice that the short-run consumption function has a falling APC (Just like Keynes predicted), whereas the long-run consumption has a constant APC.

Long- run

Short- run

Fisher’s model

16

• The economist Irving Fisher developed the model with which economists analyze how rational, forward-looking consumers make intertemporal choices – that is, choices involving different periods of time.

• Fisher’s model illuminates the constraints consumers face, the preferences they have, and how these constraints and preferences together determine their choice about consumption and saving.

Fisher’s model cont.

17

• The reason that people consume less than they desire is that their consumption is constrained by their income.

• In other words, consumer face a limit on how much they can spend, called a Budget Constraint.

• When people are deciding how much to consume today Vs. how much to save for the future, they face an intertemporal budget constraint, which measures the total resources available for consumption today and in the future.


18

• Consider how the consumer’s income in the two periods constrains consumption in the two periods. In the first period, saving equals income minus consumption. That is

S = Y1-C1 S = saving. In the second period, consumption equals the accumulated saving, including the interest earned on that saving, plus second-period income. That is

C2= (1+r)S+Y2

r = real interest rate, and r = int rate for borrowing = int rate for saving.


19

• To derive the consumer’s budget constraint, combine the two equations above. Sub the first equation for S into the second equation and we get

C2=(1+r)(Y1-C1)+Y2

To make the equation easier to interpret, we have to rearrange terms, put all the consumption terms together, bring (1+r)C1to the left-hand side of the equation and divided by (1+r) both side we get

C1+(C2/1+r) = Y1 + (Y2/1+r)


20

• C1+(C2/1+r) = Y1 + (Y2/1+r), This is the standard way of expressing the consumer’s intertemporal budget constraint.

• To draw the budget constraint, we set C1 = 0, C2 = 0 and solve for C2 C1 to get the x-axis and y-axis intercepts.

• When C1 = 0, C2 = (1+r)Y1+Y2

• When C2 = 0, C1 = Y1+Y2/(1+r)


21


22

• The consumer’s preferences regarding consumption in the two periods can be represented by indifference curves.

• An indifference curve shows the combinations of two periods consumption that make the consumer equally happy.


23


24

rMRS cc 1',

• Having discussed the consumer’s budget constraint and preferences, we can consider the decision about how much to consume in each period of time.

• The consumer would like to end up with the best possible combination of consumption in the two periods – that is, on the highest possible IS curve but also end up on or below the budget line.

• This condition is called Optimization.


25

A Consumer Who Is a BorrowerA Consumer Who Is a Lender


26

• An increase in either first-period income or second-period income shifts the budget constraint outward. If consumption in both period are both normal goods, this increase in income raises consumption in both periods.


27

A change in real interest r


28

• A increase in r leads to an increase in future consumption for sure, but uncertain for current consumption and current saving.

• Income effect states that a increase in r would increase both current and future period consumption, but substitution effect states that a increase in r decrease current consumption and increase future consumption

Life – cycle hypothesis

29

• To explain the apparently conflicting pieces of evidence that came to light when Keynes’s consumption function was confronted with data.

• According to Fisher’s model, C is depends on person’s lifetime income. Franco founder of the life – cycle hypothesis emphasized that income varies systematically over people’s lives and that saving allows consumers to move income from those times in life when income is high to those times when it is low. – This interpretation of consumer behavior formed the basis for his life – cycle hypothesis.

Life – cycle hypothesis cont.

30

• Consider a consumer who expects to live another T years, has wealth of W, and expects to earn income Y until she retires R years from now. What level of consumption will the consumer choose if she wishes to maintain a smooth level of consumption over her life?

• W = initial wealth, R*Y = life time earnings (we assume interest rate is zero).

• The consumer can divide up her lifetime resources among her T remaining years of life. We assume that she wishes to achieve the smoothest possible path of consumption over her life time. Therefore, she divides W+R*Y equally among the T years and for each year consumes:

C = (W + R*Y)/T


31

• C = (W + R*Y)/T, we can write this person’s consumption function as C = 1/T*W + R/T*Y.

• For example, if the consumer expects to live for 50 more years and work for 30 of them, then T=50, R=30, so her consumption function is

C=0.02W+0.6Y

This equation says that consumption depends on both income and wealth. An extra $1 of income per year raises consumption by $0.60 per year, and an extra $1 of wealth raises consumption by $0.02 per year.


32

• In general we can write this function as C = a*W + b*Y, where a = marginal propensity to consumer out of wealth, and b = marginal propensity to consume out of income.

• According to the life – cycle consumption function, the APC is C/Y = a*(W/Y)+b

• Because wealth does not vary proportionately with income from person to person or from year to year, we should find that high income corresponds to a low APC when looking at data across individuals or over short periods of time.

• At long run, wealth and income grow together, resulting in a constant ratio W/Y and thus a constant APC.


33

Income Y

aW


34

Income Y

aW

aW2

If consumption depends on wealth, then an increase in wealth shifts the consumption function upward

Permanent income Hypothesis

35

• Milton Friedman proposed the permanent income hypothesis to explain consumer behavior.

• He argues that consumption should not depend on current income alone. But unlike the life – cycle hypothesis, which emphasizes that income follows a regular pattern over a person’s lifetime, the permanent income hypothesis emphasizes that people experience random and temporary changes in their incomes from year to year.

Permanent income Hypothesis cont.

36

• Friedman suggested that we view current income Y as the sum of two components, permanent income Yp and transitory income Yt ,that is

Y = Yp+Yt

Permanent income is the part of income that people expects to persist into future. Transitory income is the part of income that people do not expect to persist.


37

• Friedman found that consumers spend their permanent income, but they save rather than spend most of their transitory income.

• Friedman concluded that we should view the consumption function as approximately

C = a*Yp

Where a is a constant that measures the fraction of permanent income consumed. The permanent – income hypothesis, as expressed by this equation, states that consumption is proportional to permanent income.


38

• Friedman’s hypothesis suggesting that the standard Keynesian consumption function uses the wrong variable. According to permanent income hypothesis, consumption depends on permanent income Yp

• APC = C/Y = aYp/Y

• PIH states the APC depends on the ratio of permanent income to current income. When current income temporarily rises above permanent income, the APC temporarily falls; when current income temporarily falls below permanent income, the APC temporarily rises.

Ch.18 Investment

39

Ch.18 Investment

40

• There are Three types of investment spending: 1. Business fixed investment2. Residential investment3. Inventory investment

BFI: includes the machinery, equipment, and structures that business buy to use in production.

RI: includes the new housing that people buy to live in and that landlords buy to rent out.

Ii: includes those goods that business put aside in storage, including materials and supplies, work in process, and finished goods.

Business Fixed Investment• The standard model of business fixed investment is called

Neoclassical model of investment.

• The neoclassical model examines the benefits and costs to firms of owning capital goods. The model shows how the level of investment – the addition to the stock of capital – is related to the marginal product of capital, the interest rate, and the tax rules affecting firms.

• In the model we imagine that there are two kinds of firms; production firms produces goods using capital they rent. Rental firms make all the investments in the economy; they buy capital and rent it out. (*draw graph)

41

The rental price of capital• To see what variables influence the equilibrium

rental price, we use a particular production function – Cobb – Douglas (ch.3) production function to see how the actual economy turns capital and labour into goods and services.

Y=A*K^(a) * L^(1-a)

Where Y is output, K is capital, L is labour, A is a parameter measuring the level of technology, and a is a parameter between zero and one that measures capital’s share of output

42

The rental price of capital• The marginal product of capital for the Cobb – Douglas

production function is MPK = a*A(L/K)^1-a

• Because the real rental price equals the marginal product of capital in equilibrium we can write R/P = a*A(L/K)^1-a, where R = rental rate, P = selling price, R/P = the real cost of a unit of capital to the production firm. (* Show in the graph)

• The lower the stock of capital, the higher the real rental price of capital

• The greater the amount of labour employed, the higher the real rental price of capital

• The better he technology (A), the higher the real rental price of capital

43

The cost of capital• Rental firm borrows to buy a unit of capital, it must

pay interest on the loan, Pk is the purchase price, and i is the nominal interest rate, then i*Pk is the interest cost.

• While the rental firm is renting out the capital, the price of the capital might change. If the price of capital falls, the firms loses. -∆Pk represents the loss or gains in capital (minus sign is here bec we are measuring costs not benefits, and in this case we assume the company has a gain)

• Depreciation also exists, if ∂ is the rate of depreciation, then the dollar cost of depreciation is ∂Pk

44

The cost of capital• The total cost of renting out a unit of capital for one

period is therefore

Cost of Capital = iPk - ∆Pk + ∂Pk

= Pk(i- ∆Pk /Pk+∂)To make it simple, we assume that the price of capital goods rises with the price of other goods, in this case ∆Pk/ Pk equals the overall rate of inflation ∏. i - ∏ equals the real interest r, we can write the cost of capital as

Cost of Capital = Pk (r+∂) 45

The cost of capital• Cost of Capital = Pk (r+∂), this equation states that

the cost of capital depends on the price of capital, the real interest rate, and the depreciation rate.

• Finally, we want to express the cost of capital relative to other goods in the economy. The real cost of capital – the cost of buying and renting out a unit of capital measured in units of the economy’s output – is

Real cost of capital = (Pk/P)*(r+∂), P = price of other goods

46

The determinants of investment

• Now consider a rental firm’s decision about whether to increase or decrease its capital stock. For each unit of capital, the firm earns real revenue R/P and bears the real cost (Pk/P)*(r+∂). The real profit per unit of capital is

Profit rate = revenue – cost = R/P – (Pk/P)*(r+∂)

Because the real rental price in equilibrium equals the marginal product of capital, we can write the profit rate as

Profit rate = MPK – (Pk/P)*(r+∂) *show in graph

We can see now that the firm’s decision regarding its capital stock – that is whether to add to it or let it depreciate – depends on whether owning and renting out capital is profitable. 47


• The change in the capital stock, called net investment, depends on the difference between the marginal product of capital and the cost of capital.

• If the MPK exceeds the cost of capital, firms find it profitable to add to their capital stock.

• If the MPK falls shorts of the cost of capital, they let their capital stock shrink.

• For a firm that both uses and owns capital, the benefit of an extra unit of capital is the marginal product of capital, and the cost is the cost of capital. Like a firm that owns and rents out capital, this firm adds to its capital stock if the MPK exceeds the cost of capital. Thus we can write

∆K = In (MPK-(Pk/P)(r+∂))where In ( ) is the function showing how much net investment responds to the incentive to invest 48


• We can now derive he investment function. Total spending on business fixed investment is the sum of net investment and the replacement of depreciated capital. The investment function is

I = In (MPK-(Pk/P)(r+∂))+∂K

Business fixed investment depends on the MPK, the cost of capital, and the amount of depreciation. (show graph figure 18 – 3)

49

Taxes and investment• Three most important provisions of corporate taxation: The

corporate profit tax rate itself, depreciation allowance, and the investment tax credit.

• The effect of a corporate profit tax on investment depends on how the law defines “profit” for the purpose of taxation.

• The depreciation allowance is based on the price of the capital when it was originally purchased.

• The Investment tax credit is a tax provision that encourages the accumulation of capital.

50

Stock market and Tobin’s q• The Noble-Prize-winning economist James Tobin proposed that

firms base their investment decisions on the following ratio which is now called Tobin’s q: q = market value of installed capital/replacement cost of installed capital

The numerator is the value of the economy’s capital as determined by the stock market. The denominator is the price of the capital if it were purchased today

If q is > 1 then the stock market values installed capital at more than its replacement cost. Managers can raise the market value of their firms’ stock by buying more capital

If q is < 1 managers will not replace capital as it wears out51

Residential Investment• Residential investment includes the purchase of new

housing both by people who plan to live in it themselves and by landlords who plan to rent it to others.

• To make things simple, it is useful to imagine that all housing is owner – occupied.

• There are two parts to the model. First, the market for the existing stock of houses determines the equilibrium housing price. Second, the housing price determines the flow of residential investment. (ex. Graph)

52

Inventory Investment

• Inventory investment – the goods that business put aside in storage – is at the same time negligible and of great significance.

• In recessions, firms stop replenishing their inventory as good are sold, and inventory investment becomes negative. In a typical recession, more than half the fall in spending can come from a decline in inventory investment.

53

Inventory Investment 1. One use of inventories is to smooth the level of

production over time. When sales are low, the firm produces more than it sells and puts extra goods into inventory. When sales are high, the firm produces less than it sells and takes goods out of inventory. This motive for holding inventories is called production smoothing.

2. Second reason for holding inventories is that they may allow a firm to operate more efficiently. In some ways, we can view inventories as a factor of production: the larger the stock of inventories a firm holds, the more output it can produce.

54

Inventory Investment 1. Third reason to hold inventories is to avoid running

out of goods when sales are unexpectedly high. If demand exceeds production and there are no inventories, the good will be out of stock for a period, and the firm will lose sales and profit. Inventories can prevent this from happening. This motive is called stock-out avoidance

2. A fourth explanation of inventories is dictated by the production process. When a product is only partly completed, its components are counted as part of a firm’s inventory. Theses inventories are called work in process

55

The accelerator model• One simple model that explains the data well,

without endorsing a particular motive, is the accelerator model.

• The model assume that firms hold a stock of inventories that is proportional to the firms’ level of output.

• If N = economy’s stock of inventories and Y = output, then:

N=B*Y

where B is a parameter reflecting how much inventory firms wish to hold as proportion of output

56

The accelerator model• Inventory investment I is the change in the stock of

inventories ∆N, therefore:

I = ∆N = B* ∆Y

The model predicts that inventory investment is proportional to the change in output. When output rises, firms want to hold a larger stock of inventories, so inventory investment is high. When output falls, firms want tot hold a smaller stock of inventories, so they allow their inventory to run down, and inventories investment is negative.

57

Chapter 3: Aggregate Output

58

GDP: Supply and Demand• Short Term GDP

– Determined by how much output a country can supply as well as its internal demand for output

• Long-term GDP– Determined only by supply. GDP will always adjust to full

capacity.• But “What determines supply!?!1!” you may ask…

– Capital (K)• You need money and supplies

to produce anything obviously

– Labour (L)• You need workers to produce the output

– So Supply ( ) = F(K,L)59Y

GDP: Supply and Demand• Ok… so what determines demand?

– An equation that is the aggregate of all expenditure:–E = MPC(Y - T) + I(r) + G

• Break it down:– MPC (Y – T) = Consumption

• Consumption is spending so it needs to be added to the equation• Everyone has disposable income (Income – Taxes)• People either spend it or save it hence the marginal propensity to

consume– Think of it as the percentage of every dollar that you spend instead of

saving– So if you spend 75% of your income the equation would be 0.75(Y-T)

60

Savings

MPC = 0.75

GDP: Supply and Demand– I(r) = Investment

• Investment is spending on capital investments such as houses or cars

• Expensive so it requires borrowing, which has interest– real interest rate (r) = nominal interest rate (i) – inflation (π)– The higher the real interest rate, the higher the cost of borrowing– This is why it is represented by I(r). Investment spending is a function of r.

• Here is a fun graph:

– G = Government Spending• Determined by the fiscal policy of the government.

61

S,I

r

I = I(r)

Note that investment is inversely related with

the interest rate

GDP: Equilibrium• Equilibrium

– Achieved in an economy where supply is equal to demand– So where = C(Y-T) + I(r) + G– The interest rate is the exogenous variable that will adjust in

order to ensure equilibrium– In order to understand this we look at how r is determined

62

Y

GDP: Equilibrium and r• Interest rates will decrease or increase in

order to ensure: supply of loans = the demand for loans

• Demand for loans– We already saw this: The Investment line I(r) – Inversely related to the interest rate

• Supply of loans (S)– S = Public savings + Private Savings– S = (Disposable income - Taxes - Consumption) +

(Taxes - Government spending)– S = (Y-C-T) + (T-G) or, when simplified: – S= Y-C-G 63

GDP: Equilibrium and r• When S = I(r) we have financial equilibrium!

• When we have financial equilibrium, we also have output market equilibrium

• Why?– I(r) = S– I(r) = Y – C(Y-T) – G– Y = C(Y-T) + I(r) + G!

64

S,I

r I(r)

Equilibrium

r1

S = Y - C(Y-T) - G

GDP: Example 1

65

We start off with a financial market in equilibrium. This means that the output

market is also in equilibrium.

Suppose government spending decreases.

S,I

rI(r)

E1r1

S = Y - C(Y-T) - G

GDP: Example 1

66

Demand: A decrease in G has no effect on the investment demand curve.Supply: A decrease in G means there are more unspent tax revenues available for

investment. So the supply increases by the amount that G decreases.

S,I

r

S1

I(r)

E1r1

S2

GDP: Example 1

67

Supply of loans exceeds the demand. Interest rates fall so as to encourage more investment.

I increases with the falling interest rate.This continues until equilibrium where S2 = I(r).

S,I

r

S1

I(r)

E1r1

S2

r2 E2

GDP: Example 1• Looking now at total output:

– A decrease in G has no effect on output supply• Recall that it is a function of capital and labour

and is always at full capacity– It does not change total expenditure. It

does, however, change the composition of that expenditure:• G decreases but r adjusts which in turn

increases I(r)• The change in I(r) = the change in G• Thus total output is the same before and after

the decrease!68

GDP: Example 2

69

Back to square one!

Suppose, instead, taxes are decreased.

S,I

r

S = Y - C - G

I(r)

E1r1

GDP: Example 2

70

Demand: Yet again, no effect on the investment demand curve.Supply: Less taxes means more cash to spend on savings or Bieber concerts.

Recall that C = MPC(Y-T)This means more C equal to MPC*(Change in taxes).

More spending means less savings. So we see a decrease in supply.

S,I

r

S1

I(r)

E1r1

S2

GDP: Example 2

71

If supply can’t keep up with demand the interest rate will increase. This will lower investor demand.

Investment decreases until I(r) = S once again.Equilibrium is achieved.

S,I

r

S1

I(r)

E1r1

S2

r2

E2

GDP: Example 2• Looking again at total output:

– A decrease in T has no effect on output supply

– It changes the composition of Output again:• T decreases which increases consumption by

MPC*∆T• r adjusts which causes I(r) to decrease• Thus total output is the same before and after

the decrease!

72

Chapter 5: The Open Market

73

GDP: The Open Economy• Two new flows:

1. Exports (EX) and Imports (IM) from trade• Half of your consumption is being spent on foreign products so it

can’t be counted• But you also must factor in local products that are being exported like

maple syrup and lumberjacks2. International borrowing and lending

• Effect on GDP equation (DON’T MEMORIZE):– Y = (C-Cforeign) + (I-Iforeign) + (G-Gforeign) + Exports– We group all of the foreign spending into one category: Imports– Y = C + I + G + (EX-IM)

• National Accounts Identity (MEMORIZE!):– Y = C + I + G + NX

• NX = (EX-IM)• So it’s the same identity! All you’re doing is adding in

NX.74

GDP: Open economy with S• Recall that S = Y-C-G

– In an open economy Y – C – G = I + NX– So S = I + NX or NX = S – I

• This makes sense because:– If S > I: Any savings that a country has

that isn’t spent on domestic investment will logically be spent overseas

– If S < I: Part of the investment spending must be funded by foreign investors, as the domestic savings is lacking

75

GDP: Open economy and r*– Main difference is in the real interest rate

• Recall that in a closed economy it is determined at the level that equates savings and investment

• In an open economy it is determined by the world interest rate (r*) r = r* + θ where θ is the risk premium

– For simplification purposes Canada’s risk premium is assumed as 0

– The interest rate is fixed, and does not adjust in order to match supply of investment and its demand

76

S,I

r

S = Y - C - G

I(r)

E1r1

S,I

r*

S = NX + I

I(r*)

E1r*1

Closed Economy Open Economy

Fixed!

77

GDP: Twin Deficits

77

S,I

r* I(r*)

E1r*world

Before

S

Suppose the economy begins in equilibrium where S = NX+I

Government spending (G) increases with no change in taxes.

This creates a budget deficit (T – G) < 0

This budget deficit causes the domestic supply of loans to decrease so the S curve shifts left.

This means demand for loans outstrips supply.

Foreign investors supply the difference so imports (IM) increases causing net exports (NX) to decrease.

This results NX < 0 which means there is a trade deficit as well as a budget deficit.S,I

r*I(r*)

r*world

After

NX = S – I

Chapter 4: Money and Inflation

78

The Price Level: Measurement

P = The average price of final goods and services purchased or produced within a period of timeTwo main price indexes:

• CPI overstates inflation (by ignoring substitution away from goods and services whose relative price has risen)

• \• GDP Deflator understates inflation (by ignoring loss in

welfare resulting from substitution away from goods and services whose relative price has risen

79

CPI2007 = ∑ P2007 * Q2002

∑ P2002 * Q2002

GDP Deflator2007 = ∑ P2007 * Q2007

∑ P2002 * Q2007

InflationInflation = Rate of change of a price indexNote: (can be rate of change of either GDP Deflator or CPI)

Example:2005 CPI = 112.42004 CPI = 110.12000 Base CPI = 100.0

80

Rate of Inflation= (112.4- 110.1) * 100 = 2.09% 110.1

Man trying to buy a loaf of bread in Zimbabwe

Money, Money, Money!Money is a stock of assets directly used in

transactions

Functions of money:1. Medium of exchange Use to buy stuff2. Unit of account Used for prices and debts3. Store of value Transfer your purchasing

power to the future!Types of money:4. Fiat No intrinsic value (just paper)5. Commodity Has intrinsic value (such as

gold since it is shiny)

Money is neutral (does not affect anything)The Money Supply determines the price level 81

Control and the Quantity Theory of Money

The Bank of Canada controls the money supply through open market operations

Bank of Canada buys government bonds

Bank of Canada sells government bonds

Quantity Theory of Money

• Quantity Equation: M * V = P * Y– Where:– Y = The volume of output per period– P = Price of a typical unity or GDP Deflator– M = The size of the money stock– V = Velocity of circulation of money (how many times the entire M is used

in a specific period)82

Money StockMoney Stock

QTM ContinuedQTM as a Theory of Nominal GDP• Assume that: M = M and V = V• Since Nominal GDP = M * V and Nominal GDP = P *

VTherefore: P * Y = M * V

QTM as a theory of Price Level• Assume that: M = M and V = V and Y = YTherefore: P = M * V YThis can be re-written as: %∆M + %∆V - %∆Y

83

Inflation and Nominal Interest Rates

i = nominal interest rater = real interest rateπ = actual inflation rate

Real Interest Rate =

Example: • Lend $1250 dollars for a year at an interest rate of

6%. After the year is done you realize that your real return was only 4.15%. How much did prices rise over that year?

Fisher Effect: Nominal interest rate = Real interest rate + Expected inflation rate

84

(1+r) = (1+i) (1+ π )

Welfare Costs of InflationThe following are welfare costs related to HIGH inflation:1. Shoeleather cost More frequent trips to the bank2. Menu cost Costs of frequently changing prices3. Non-indexed tax systems: (inflation lowers the after tax return

on savings)– r = i(1-t) – π – An indexed tax system would fix this where: r = (i–π)(1-t)

Other Inflation Related Dangers:• Unexpected inflation Creditors lose and debtors gain

(makes it difficult for pension funds / mortgages)• Variability of inflation Higher uncertainty and risk = Less

investment• Low Inflation Difficult to reduce real wages as most workers

resist nominal wage decreases (aka pay cuts)• Deflation Households may delay purchases

85

Chapter 5: Exchange Rates

86

Super Fun Definition Bonanza

– e : the nominal exchange rate• The cost in the nominal (monetary)

terms of the target country to buy one unit of your currency

• I.e. The cost in American dollars to buy one Canadian dollar = e

– Spot rate: Exchange rate at that time

– Forward rate: Rate if exchanged later

– Foreign Exchange Market: Electronic market that links all banks around the world through which currencies are exchanged 87

Defs: Flexible Rates

• Flexible exchange rate: Country allows for the international market to determine exchange rate– Pure: Central bank does absolutely nothing to

control the exchange rate– Dirty float (managed exchange rate): Only some

control. The principal is it is flexible.– Appreciation: An increase in the value of the

currency– Depreciation: A decrease in the value of the

currency88

• Let’s take a currency: Euro (€)• Very strong currency. • Many people are exchanging their currency for the Euro and its

reserves are decreasing. • Demand is increasing while supply remains the same.

• Naturally the exchange rate appreciates• In essence: The cost in a foreign currency (let’s say Indian

Rupees) to buy one Euro is more.

e

e1

€

D1 S

Example!

89

e

e1

€

D1 Se increases

e2

Defs: Fixed Rates• Fixed exchange rates: The exchange rate is

fixed in order to avoid the instability of flexible exchange rates– Revaluation: An increase in the value of currency– Devaluation: A decrease in the value of currency– Foreign Currency Reserve: A stock of assets held

by a bank in a foreign country’s currency

90

€

Example! Continued• Lets assume the European Union wants to keep

an attractive exchange rate with India. • They want to maintain the previous exchange

rate. So they want the € pegged at a fixed rate. The EU will simply increase the supply of € by printing more of them.

• The exchange rate stays constant91

e

e

€

D2 S1D1

S2

e

e1

€

D1 S

Defs: Real Exchange Rate• Real exchange rate

– Denoted as ε• The relative price of goods in the two countries used

– Equation: ε = eP/P*• e = Nominal exchange rate in Canada (Cost in US$ to

buy one Canadian dollar• P= price level of a good in Canada in Canadian dollars• eP = Price level of a good in Canada in US dollars• P* = price level of a good in the US in US dollars

– The higher the real exchange rate the more expensive is a good in Canada as compared to the US

92

Purchasing Power Parity• Method of predicting

future exchange rates

• PPP Approach Fast Facts• Only long run predictions• Two-types Absolute and Relative• Basic idea behind PPP approach: Law of one

price– The Law of one Price argues that goods should cost

the same in every country

93

PPP: Law of One Price• Argues that eP = P*• Suppose eP > P*

– The cost of an item in Canada, translated to American dollars (eP) is more than the cost of the item in the United States (P*).

• That item is therefore exported to the US much less – They can get it much cheaper by buying it domestically.

• The result is an excess supply so logically the price in Canada (P) is lowered. – This in turn decreases eP

• At the same time, US purchases of the US-made product will increase, also leading to an increase in P*

• Over time, eP decreases while P* increases until eP=P*

• This process is called arbitrage

94

PPP: Absolute PPP• Basically argues that law of one price holds for the

aggregate of all products between two countries– So ε = 1 for the average price of all goods– In essence, the average price of goods in one country is

equal to the average price of goods in the other country after being adjusted to account for the exchange rate

• This can’t happen if:– The good is untradeable

• Services, advertising, housing etc.• Most goods are not tradable

– There are massive transportation costs– There are obstacles to trade (quotas, tariffs, regulations

etc.)• Because of these, ABS PPP often doesn’t hold

95

PPP: Relative PPP• This is used to compensate for the shortcomings of

ABS PPP• Basically argues that instead of ε equalling 1 for the

aggregate of all products, it is instead equal to a ratio

• Quick Example to illustrate:– P = $100 P* = $95 e = 0.9– ε = 0.9*100/95 = 0.947– The Canadian price inflates to $110 while US price inflates

to $100– What is the new exchange rate if relative PPP holds?– The price ratio of 0.947 must hold– So 0.947 = e110/100– e = 0.861 96

Alternate Formula

Interest Rate Parity Approach

• Interest Rate Parity explains exchange rates in the short term

• Basic Idea:– Investors will reallocate their assets across

countries until the expected rate of return is the same

– They will either buy a bond in Canada, or, if there are better interest rates elsewhere, they can exchange to that country’s currency and buy bonds there

97

Interest Rate Parity Approach

• Strict Formula:

– Left side: The amount that would be received in one year if a dollar was invested in local bonds

– Top right: The amount that would be received in one year if a dollar was exchanged to a foreign currency (e) and then invested in that country’s bonds (foreign interest rate = i*)

– Bottom right: The exchange rate between the two countries one year from now

• The interest rate parity approach states that these will always be equal to each other

• If one changes, then it will sort itself out by process of arbitrage 98

Interest Rate: Approximation

• Equation translation:– The percentage change of the domestic

currency exchange rate (right side) is equal to the foreign interest rate minus the domestic interest rate (left side)

• This makes sense because: if investors expect the Canadian dollar to appreciate relative to the US dollar by 1% they accept 1% lower interest return on Canadian bonds 99

Example 1• Use approximation formula

• Start with interest rate parity condition satisfied• Suppose Canadian interest rates (i) increase

– Left-hand side decreases– Investors are very happy with Canadian interest rates.– So they start exchanging to Canadian dollars and investing

like crazy– But, for parity to hold, right side must also decrease

• So the expected percentage change in the exchange rate must decrease

• Will happen if the expected exchange rate in one year (eE+1) decreases

or the current exchange rate (e) increases• No reason to suggest the future exchange rate (eE

+1) will decrease so the current exchange rate (e) must increase

– The exchange rate (e) increases in order to meet the condition

100

Chapter 6: Unemployment

101

Definitions and Ratio’s• Definitions:

– Employed: Paid full time or part time employment– Unemployed: Available to work and has actively looked for

work in the last 4 weeks– Not in the Labour Force: Not employed and under 15

years of age or has not looked for work in the past 4 weeks• Ratios

– Employment = [E]– Unemployment = [U]– Labour Force = [L] = ([E] + [U])– Unemployment Rate = [U] / [L]– Labour Force Participation Rate = [L] / population above 15

102

Trends and Natural U• Employment Trends

– Women entering the workforce– 1950’s-1990’s steady increase in employment– 2000-2005 unemployment back to lower levels

• Natural Unemployment: [u*] is the average level of unemployment over a given time (usually 20+ years)– s fraction of employed [E] people who become unemployed

in a given month– f fraction of unemployed [U] people who become employed

in a given month

• Formula: [u*] = s / (s+f) 103

Frictional Unemployment• Frictional Unemployment: Unemployment caused by

the time it takes workers to find a job– Comes from

• Sector shifts• Technology change• Business failures• Individual factors

– Fired / Quit– Geographic Mobility

– Why it lasts• Imperfect job information (job searching takes time)• Geographic immobility (most workers cannot just pack up and move)

– Policies that affect frictional unemployment• Employment Insurance raises the rate of frictional unemployment• Employment agencies can aid unemployed• Retraining programs encourage companies to retrain rather than lay off

104

“In between jobs”

Structural Unemployment• Structural Unemployment: Unemployment due to a

mismatch between demand and supply of labour• This is caused by real wage rigidity and job rationing

– Real wage rigidity: Failure of wages to adjust so that labour demand = labour supply

– If wages are too high compared to demand Job rationing

105Employment

Real WageLabour SupplyRigid

RealWage

StructuralUnemployment

Labour Demand

EquilibriumWage

Reasons for Wage Rigidity• Minimum wage laws

– Raise the real wage above the market equilibrium– Refundable tax credits: Better way to increase incomes for

the poor (as this does not affect labour costs)

• Unions– Raises wages above equilibrium through collective

bargaining– Raises wages at non-unionized firms

• Efficiency Wages– Higher wages = more productive workers

106

Employment

Real Wage Labour Supply

MinimumWage

Unemployment

Labour Demand

EquilibriumWage

Minimum wages raise the

real wage above

equilibrium and create

unemployment

Employment Explained• Incidence of unemployment: The chance that a

worker will become unemployed (increase in unemployment is 1/3 a result of an increase in incidence)

• Duration of unemployment: Average spell of unemployment (increase in unemployment is 2/3 a result of an increase in duration)

• Upward shift in unemployment from 1950’s-1990’s:– Changing Composition: More young workers / women– Faster Sectoral Shifts: Increased pace of technological

change– Skill Based Technical Change: Led to lower employment

rather than lower wages 107

Finished!

108

Question Period• Are there any questions?

109

Exam Study Tips• Memorize the equations but make sure you

understand them too!– Know what each variable represents, and know what affects

each variable.• Remember how to draw the graphs and what

changes will move what curves. This helps a HUGE amount especially if you’re a visual learner.– Any time you have a question that involves a graph (even

multiple choice), just draw a quick graph out and draw the movement of the curves and you’ll have your answer.

– If you do it in your head you will probably get it wrong.• Bring a ruler. Using a OneCard sucks.• Do lots of practice questions. They probably won’t be

too different from the exam questions. 110

Bibliography• Robertson, A., and J. Konieczny. Intermediate Macroeconomic Analysis

for Management. Wilfrid Laurier University: Course Pack, 2008. Print.

111

ec:250 intermediate macroeconomics!

Documents