Aggregate Statistics
Used to describe the economy as a whole
Aggregate Output
(GDP) Total output in an economy, across all sectors and regions
National Accounts
statistics published by national statistical offices that use information about individual behavior to construct a quantitative picture of the economy as a whole.
What are the three different ways to estimate GDP?
Spending
Income
Production
How do you estimate GDP through Spending?
The total spent by households, firms, government, and residents of other countries on the home economy's products.
How do you estimate GDP through Income?
The sum of all the incomes received, comprising wages, profits, the incomes of the self-employed, and taxes received by the government.
How do you measure GDP using Production?
The total produced by the industries to operate in the home economy. Production is measured by the value added.
Value Added
For a production process this is the value of output minus the value of all inputs (called intermediate goods -- this does not include capital goods used in production)
(ex. Profits)
circular flow
the pattern in which goods and services and resources flow in the marketplace
The relationship between spending, production, and incomes in the economy as a whole.
At what stage can the national accounts measurement of GDP be taken? Why do we have to be carefuL?
At the Spending stage
Production stage
or Income Stage
(if accurate measurement possible, the total of expenditure, output, and incomes in a year would be same so the point at which the measurement is taken would not matter. Because any spending is someon
What does the circular flow model look like?
(Can be adjusted to include the role of government -- households receive some goods and services that are supplied by the government, for which they don't pay at the point of consumption. I.e. government provided primary school education)
Imports (m)
Goods and services produced in other countries and purchased by domestic households, firms, and the government
(Not included in GDP because produced elsewhere.)
Exports (x)
Goods and services produced in a particular country and sold to households, firms, and governments in other countries.
(Included in GDP (called domestic PRODUCT) because they are part of domestic production)
How do we define GDP when including m and x?
GDP is thus defined as:
- The expenditure on domestic production, or
- The income due to domestic production, or
- The value added of domestic production
How does Government play role in Circular flow model?
Households to government: Households pay taxes.
Government to households: these taxes pay for the production of public services used by households
-- the government can be seen as another producer, like a firm -- with the difference that the taxes paid by
What assumption do we have to make about public services?
The value added of government production is equal to the amount it costs the government to produce.
Why is it helpful to have expenditure = output = incomes?
Because expenditure = output = incomes -- we can use any one of these perspectivse to help us understand the others.
Ex. We describe recessions as periods of negative output of growth but this means there must also be periods of negative expenditure growt
Which continents use components from expenditure + national side of GDP?
US, Eurozone, China
Consumption
� Expenditure on consumer goods including both short-lived goods and services and long-lived goods, which are called consumer durables.
-- includes goods and services purchased by households
-- largest component of GDP in Eurozone and US (Over 50%)
What are "goods?" Different types of goods?
Goods are normally tangible things.
Goods that last for three years or more are called durable goods.
Goods that last for shorter periods are non-durable goods.
(- services are intangible things)
Investment
Expenditure on newly produced capital goods (machinery and equipment) and buildings, including new housing -- the unsold output (inventory)
Investment in the unsold output that firms produce is the other part of investment that is recorded as a separate i
Inventory
Goods held by firm prior to sale or use, including raw materials, and partially-finished or finished goods intended for sale.
What does Government G+S spending look like? What does Government investment look like?
Spending -- represents consumption and investment purchases by the government (consisting of central and local government or 'general government'). Health and Education.
-- purchases of goods (office equip, software, and cars) and services (such as wages
How do US and Europe deal with spending on transfers like pensions and unemployment benefits as a component of aggregate demand?
When used as component of aggregate demand, this doesn't include spending on transfers like pensions and unemployment benefits.
-- Benefits and pension, like Medicare in the US, or social security benefits in Europe are not included in G because household
Government Transfers
Spending by the Government in the form of payments to households or individuals. Unemployment benefits and pensions are examples. Transfers are not included in government spending (G) in the national accounts.
Net Exports (Trade Balance)
Value of exports minus the value of imports
Deficit if value of exports minus imports in negative.
Trade surplus if positive.
GDP
(Y) To calculate GDP, which is the aggregate demand for what is produced in the country, we add the purchases by those in other countries (exports) and subtract the purchases by home residents of goods and services produced abroad (imports)
-- EXPORT - IM
Percentage Change in GDP
(% change in consumption)(Share of consumption in GDP) + (% change in investment)(share of investment in GDP) + (Percentage change in government spending x share of government spending in GDP) + (% change in net exports)(Share of net exports in GDP)
Aggregate Demand
(+ EQUATION)
the total of the components of spending in the economy, added to get GDP:
Y = C + I + G +X - M
Total amount of demand for (or expenditure on) goods and services produced in the economy.
Problems with GDP?
It's a conventional measure of the economy but doesn't take into account things like environmental degradation.
Need to distinguish aggregate GDP vs. GDP per Capita -- especially when dicussing growth.
GDP per capita is flawed measure of living standards
Inflation
An increase in the general price level in the economy. Usually measured over a year
-- ex. Shopping basket
General trend in inflation rates since 1970s?
Upward spikes in inflation have tended to occur in periods of economic crisis, but the general trend worldwide since the 1970s has been a decline in inflation rates.
-- Inflation tends to be higher in poor than in rich countries.
Deflation
A decrease in the general price level
GDP deflator
A measure of the level of prices for domestically produced output. This is ratio of nominal (or current price) GDP to real (or constant price) GDP
Consumer Price Index
(CPI) Measures the general level of prices that consumers have to pay for goods and services, including consumption taxes.
- Basket of goods and services chosen is meant to reflect the spending of a typical household in the economy.
CPI inflation is often
Differences between CPI and GDP Deflator
GDP deflator includes all domestically produced goods and services, whereas the CPI includes only goods bought by consumers. For example, only the GDP deflator includes the price of U.S.-made heavy machinery and truck engines
The CPI measures the price of
CPI Formula
CPI (2014) = Price of basket (2014) / Price of basket in base year
GDP Deflator Formula
GDP Deflator (2014) = Nominal GDP (2014) / Real GDP (2014)
Inflation Rate Formula
Inflation rate (from year 1 to year 2) = % change in CPI or % change in GDP Deflator (depending on which rate you want to calculate)
How can governments stabilize economy?
Governments can use changes in taxes or government spending to stabilize the economy, but bad policy can destabilize it.
Why might spending on investment projects tend to occur in clusters?
Firms may adopt a new technology at the same time
Firms may have similar beliefs about expected future demand.
Why might spending on investment projects tend to occur in clusters?
...
Multiplier
a statistic that provides a way of answering the question of how decisions of firms (and households) raise or reduce investment spending will affect the economy as a whole.
-EX. New Spending takes place in the economy as a result of new technology so outp
Multiplier Rules
If the total increase in GDP is equal to the initial increase in spending: We say that the multiplier is equal to 1.
If the total increase in GDP is greater or less than the initial increase in spending: We say that the multiplier is greater than 1 or les
Aggregate Consumption (formula)
Aggregate consumption = Autonomous (fixed) consumption + consumption that depends on income
C = c0 + c1Y
Marginal Propensity to Consume
Change in consumption when disposable income increases by 1 unit.
(c1 = slope of the consumption function)
What does c0 represent?
C0 in the aggregate consumption function captures all the other influences on consumption that are not related to current income.
- Consumption independent of income; fixed/autonomous consumption.
~ how much a person with no income would consume
Aggregate Demand (Simple)
income = aggregate demand
(Assume investment doesn't depend on income, and for now exclude the role of the government and imports/exports)
AD = C + I = c0 + c1Y + I
Multiplier formula?
Y = AD = c0 + c1Y + I
Y(1-c1) = c0 + I
Y = (1/1-c1) x (c0 + I)
MUltiplier times the change in autonomous demand -- we can calculate how much output will increase or decrease
Why do we care about inflation?
It affects purchasing power (nominal wages purchases relatively less)
Changes in the distribution of national income (from those that see assets appreciated to those that don't)
Shift of debut burden from debtors to creditors (loans are paid at face value
Why do we care about inflation?
- Incentive to invest (e.g. entrepreneurs know they can charge a higher price tomorrow for a good on which they invest today)
- (Hidden) Tax called seigniorage (money costs nothing to be produced by the Government, having it depreciated is an implicit tax
Hyperinflation
monetary inflation occurring at a very high rate.
Goals of using Multiplier model?
Model in which aggregate demand line comprises only consumption and investment
GOALS:
- To find (aggregate goods market) equilibrium income for a given consumption function and investment
- determine how a change in investment (I) or one of the consumptio
Aggregate goods market equilibrium income
The level of income at which aggregate demand equals income.
AD is an upward sloping straight line whose slope equals the marginal propensity to consume
AD Slope =
AD is an upward sloping straight line whose slope equals the marginal propensity to consume
Equilibium income (equation)_
Set AD = y
Y = (1/1-c1) (c0 + I)
How do we characterize the effects of fall in demand/investment
The Multiplier is the sum of all these successive decreases in production: Eventually, output has fallen by a larger amount than the initial shift in demand
Why do we care why consumption changes?
Consumption is the largest component of GDP in most economies
- So important part of understanding changes in output is understanding why consumption changes.
- Shock to investment shifts the aggregate demand curve and is transmitted through the economy a
Effects of shift in autonomous consumption?
A change in c0 will in turn produce a multiplier response of output and employment through the circular flow of expenditure, output, and income
(In same way as fall in investment was multiplied)
Target Wealth
Level of wealth that a household aims to hold, based on its economic goals (or preferences) and expectations
We assume that households try to maintain this level of wealth in the face of changes in their economic situation, as long as it is possible to do
Precautionary saving
An increase in saving to restore its target wealth
(� Think about a family with a mortgage. If the price of houses falls, the family will be concerned that its wealth, too, has fallen. A likely reaction to this is for the household to save more.)
Great Depression
The period of a sharp fall in output and employment in many countries in the 1930s.
The fall in output and employment during the Great Depression highlights two ways in which aggregate consumption might fall�credit constraints in the multiplier process, a
How do firms make investment spending decisions?
Four choices:
Dividends: Allocate the funds to managerial or employee salaries, or to dividends for owners
Saving: Buy an interest-bearing financial asset such as a bond, or retire (pay off) existing debt
Investment abroad: Build new productive capacity i
How do firms pick projects to invest in?
If we rank investment projects by their expected post-tax rate of profit, then a lower interest rate raises the number of projects for which the expected rate of profit is greater than the interest rate
For example, if the interest rate is 4%, you'll gree
how does interest rate effect investment?
Thus a higher interest rate reduces investment, and a lower interest rate increases it.
Aggregate Investment Function
Downward-sloping line that represents the potential investment projects.
y-axis -- interest rate, profit rate
x-axis -- investment
How is interest rate determined?
by the central bank's monetary policy
The interest rate is the opportunity cost of purchases of machinery, equipment, and structures that increase the capital stock�if you have money available, you could save it with a return of r instead of investing it
What shifts aggregate investment function?
Increase in profit expectations shifts the aggregate investment function to the right.
consumption function with tax rate
C = c0 + c1(1-t)Y
Household consumption spending depends on post-tax income. The government charges a tax t, which we assume is proportional to income. The income left after the payment of tax, (1 ? t)Y, is called disposable income. The marginal propensit
Investment with Taxes
I( r)
We have just seen that investment spending will be influenced by the interest rate and the expected post-tax rate of profit.
Net exports (NX)
We assume that the marginal propensity to import is m, and that exports are exogenous (we ignore the effects of exchange rates)
NX = X - M = X - mY
FULL AD
AD = c0 + c1(1-t)Y + I( r) + G + X - mY
Y = (1/(1-c1(1-t)+m))(c0 + I( r) + G + X)
Multiplier: (1/(1-c1(1-t)+m))
How does government dampen fluctuations in the economy?
using
automatic stabilizers
fiscal policy
- Size of Government: pending on health and education, which are the two largest government budget items in most countries, does not fluctuate with capacity utilization or with business confidence. These kinds of
Why does government provide unemployment benefits?
- Correlated risk: In a recession, job loss will be widespread. This means that there will be a surge in insurance claims across the economy and a private provider may be unable to pay out on the scale required.
- Hidden actions -- insurance can't really
Automatic Stabilizer
Characteristics of the tax and transfer system in an economy that have the effect of offsetting an expansion or contraction of the economy
ex. unemployment benefits
Fiscal policy
Changes in taxes or government spending in order to stabilize the economy
Fiscal stimulus
The use by the government of fiscal policy (via a combination of tax cuts and spending increases) with the intention of increasing aggregate demand
What is the aim of Fiscal Stimulus?
The aim is to counteract the fall in aggregate demand from the private sector. A tax cut is intended to encourage the private sector to spend more, while an increase in G is a direct addition to aggregate demand
Government budget balance
The difference between government tax revenue and government spending (including government purchases of goods and services, investment spending, and spending on transfers such as pensions and unemployment benefits)
The government budget balance is the di
What is budget when G = T?
Budget is in balance
What is budget when G > T?
We have budget deficit
What happens to government transfers when economy is in recession?
If the economy is in recession, government transfers, like unemployment benefits, rise while tax revenues fall, so the government's budget balance deteriorates and may become negative
What happens to budget when G < T?
We have budget surplus
Austerity Policy
improving budgetary position by cutting spending or increasing taxes
Why would austerity happen?
High government debt can potentially lead to an increase in interest rates, and the government may have to default on its debt, leading to a debt crisis
On other hand, pursuing austerity during a recession can lead to devastating effects.
(A cut in spendi
Government Debt
The sum of all the bonds the government has sold over the years to finance its deficits, minus the ones that have matured
Governments raise revenue in the form of income taxes and taxes on spending, often called Value Added Tax (VAT) or sales tax. They al
Primary Budget Deficit
The government deficit (its revenue minus its expenditure) excluding interest payments on its debt
G-T, where T is tax revenue minus Transfers (tY)
What does budget deficit mean for government
means gov must borrow to cover gap between revenue and expenditure
-- Borrows by selling bonds -- sale of bonds adds to government's debt
Why are government bonds attractive to investors?
because they pay a fixed interest rate and because they are generally considered a safe investment: The default risk on government bonds is usually low.
Sovereign debt crisis
A situation in which government bonds come to be considered so risky that the government may not be able to continue to borrow
What might governments of countries experiencing sovereign debt crises have to do?
Governments of countries experiencing a sovereign debt crisis may have no alternative to austerity policies if they can no longer borrow, because in this case they cannot spend more than the tax revenue they receive
Unique features to Government debt?
A large stock of debt relative to GDP can be a problem because, like a household, the government has to pay interest on its debt and it has to raise revenue to pay the interest, which may require raising tax rates
Governments are not like households in th
Inflation can reduce the real value of debt. Why?
All else equal, inflation makes the amount borrow deteriorate in value, so that in real terms, less has to be repaid
Deflation will have the opposite effect. In real terms, more will have to be repaid
How do financial crises also raise government debt?
Governments borrow both to bail out failing banks and to support the economy in the lengthy recessions that follow financial crises. The UK's debt-to-GDP ratio rapidly doubled to more than 80% after the 2008 global financial crisis.
Zero Inflation
A constant price level from year to year means that inflation is zero
Rising Inflation
: If the rate of inflation is increasing, the price level is increasing at an increasing rate
Falling Inflation
Also disinflation. Note that inflation is still positive, and not negative. Prices are rising, but a lower pace. (Contrast with deflation, where the price level decreases)
Why do some voters dislike inflation?
Pension incomes, for example, are often fixed in nominal terms
If price levels increases, and your nominal income remains the same, your real income goes down
For example, if you were to receive a nominal income of $100,000 a year, but price levels go up,
Who benefits from Inflation?
Whether one loses or benefits from inflation also depends on which side of the credit market one is on
Let's say you're the creditor (lender). Then if prices rise before the loan is repaid, you can buy less with the repayment
If you're the debtor (borrow)
Interest Rate
Cost of borrowing funds
Nominal INterest Rate
Interest rate uncorrected for inflation
Real Interest Rate
Interest rate corrected for inflation.
FISHER EQUATION
Method of approximating Real interest rate:
Real interest rate (% per annum) = nominal interest rate (% per annum) minus inflation expected over the year ahead (% per annum)
Why is high inflation bad?
can hinder economic growth, etc.
makes it harder to tell what a change in price of particular product means. (Hard to differentiate between price increase due to demand and increase due to inflation)
distorts economic decisions by arbitrarily increasing/d
Would households and firms be better off with falling prices?
No - A sustained fall in the price level is undesirable for many of the same reasons that inflation is undesirable, and could have even more dramatic economic consequences!
Effects of Deflation
-- when prices falling, households postpone consumption because they expect goods will be cheaper in future.
-- increases debt burden of borrowers. Therefore consumers borrow less.
-- weaker aggregate spending will tend to depress prices further and can t
Phillips curve
When unemployment is lower, inflation is higher and vice versa
This suggests that the Phillips curve is "feasible set" from which the policymaker can select the desired combination of unemployment and inflation
Curve that shows tradeoff between unemployme
What is Monetary Policy? UK
Monetary policy is action that a country's central bank or government can take to influence how much money is in the economy and how much it costs to borrow
What is Monetary Policy used for? UK
Monetary policy affects how much prices are rising - called the rate of inflation. We set monetary policy to achieve the Government's target of keeping inflation at 2%. Low and stable inflation is good for the UK's economy and it is our main monetary poli
What are goals of US monetary policy?
To promote "maximum" sustainable output and employment and to promote "Stable" prices.
What does "maximum" sustainable output and employment and to promote "Stable" prices mean?
Amt of goods and services the economy produces and the number of jobs it gene
Target Inflation rates?
Most people have no reason to object to a (slowly) rising price level �
In fact, many central banks around the world have policies to target an inflation rate of 2% �
They either set this objective for themselves, or the government sets the objective for
What happens when inflation higher or lower than 2%?
When inflation is forecast to be higher or lower than 2%, the central bank can take action to adjust the level of aggregate demand and employment so as to steer the economy toward a 2% target
What do central banks use to stabilize economy?
When they can, central banks use changes in the policy interest rate as their monetary policy instrument to stabilize the economy
Monetary policy relies on the central bank being able to control interest rates, and on changes in interest rates influencing
What is "Trasnmission of Monetary policy" BoC
the process by which chagnes in the Bank of Canada's policy interest rate work their way through the economy, ultimately to affect the rate of inflation.
policy interest rate
The interest rate set by the central bank, which applies to banks that borrow base money from each other, and from the central bank.
what are the four transmission channels of monetary policy?
market interest rate -- set by commercial banks so households and firms pay when they take out loans. (Typically above policy interest rate)
asset price -- include government bonds, shares issues by companies (ripples iwth change in interest rate)
expecta
How is policy rate set?
the central bank will work backwards, starting with its desired level of aggregate demand:
It will estimate a target for the total aggregate demand, Y, to stabilize the economy �
It will then estimate the real interest rate, r, which will produce this lev
exchange rate
The number of units of home currency that can be exchanged for one unit of foreign currency. For example, the number of Australian dollars (AUD) needed to buy one US dollar (USD) is defined as number of AUD per USD
depreciation
increase in exchange rate
appreciation
decrease in exchange rate
foreign exchange market
a market in which currencies of different countries are exchanged
exchange rate dollar
0
Why does interest rate affect the exchange rate?
Much of the demand for different countries' currencies comes from international investors who want to hold and trade financial assets from around the world
These investors prefer to earn a higher return, so they prefer assets with a high yield, or interes
Monetary vs. Fiscal Policy
Monetary policy can be used by the central bank to stabilize the economy in a recession. The government could also have played this role by cutting taxes, or by boosting spending
Fiscal policy is complicated to adjust and inflexible. Instead, to keep aggr
Negative interest rate
The government could also have played this If the policy interest rate were negative, people would simply hold cash rather than put it in the bank, because they would have to pay the bank for holding their money (that's what a negative interest rate means
zero lower bound
The fact that the nominal interest rate cannot be negative, thus setting a floor on the nominal interest rate that can be set by the central bank at zero
Lower bound on real interest rate is equal to minus the inflation rate
The ZLB on the nominal interes
Quantitative Easing
Central bank purchases of financial assets aimed at reducing interest rates on those assets when conventional monetary policy is ineffective because the policy interest rate is at the zero lower bound
The aim of QE is to increase aggregate demand by buyin
How is QE supposed to work?
Central bank buys bonds and other financial assets -- creates additional base money for this purpose.
increased supply of money leads to lower cost of borrowing money -- lower interest rates
Boosts spending
So, even when the interest rate the central bank
what if country doesn't control its own currency?
Then monetary policy may not be available to that country. For example, members of the Eurozone gave up their own monetary policy when they joined the currency union.