EC 102: Introductory Macroeconomic Analysis

What is investment?

Midterm 2 Study Guide

Fundamental Macroeconomic Equation:

Y = C + I + G + NX

Y = GDP = aggregate expenditure

C = consumption

I = investment

G = government purchases

NX = net exports

*aggregate expenditure = GDP

Determinants of consumption: 

- Current disposable income = total current income (GDP) after taxes are taken out and after transfer payments are added

- YD = Y - T + TR , where T = total taxes and TR = transfer payments - NOTE: consumption depends on current disposable income, not current income - Expected Future Disposable Income (Y-T+TR)e 

- r = Real Interest Rate

Why productivity is so important?

- When r increases, consumption (C) decreases because it costs more to borrow to finance consumption there is more incentive to save

- When r decreases, consumption (C) increases because it costs less to borrow to finance consumption there is more incentive to save We also discuss several other topics like Define nucleophile.

- Household Wealth - wealth increases, C increases ; wealth decreases, C decreases - Household assets - value of home, car, financial investments (checking and savings accounts, stocks, bonds)

- Household liabilities - credit card debt, balance due on mortgage, balance due on auto loan

- Price level (P) - P increases, wealth decreases, C decreases ; P decreases, wealth increases, C increases

** Note: consumption is an upward trend

Marginal Propensity to Consume (MPC)

- Slope of consumption function: amount by which consumption spending changes when disposable income changes

Why is investment so important?

- MPC = change in consumption / change in disposable income

Marginal Propensity to Save (MPS)

- Change in saving divided by change in disposable income

- MPS = 1 - MPC

** MPC + MPS = 1

Investment: (NOTE: not a smooth trend)

What economists mean by investment: If you want to learn more check out What is a “standard candle” in astronomy?

- Not what we mean in ordinary language

- Doesn’t include

- Buying stock

- Opening savings account

- Buying share in small business

- Buying rare coins

- None of these activities add to GDP We also discuss several other topics like What makes good traits for candidates?

- Note involved in production of goods + services

What is Investment?

- Plant and equipment and software (about 78% of all investment in 2017) - Housing “Residential Investment” (20%)

- Change in Inventories (2%)

- What are inventories?

- Finished goods that haven’t been sold yet

- Raw materials that haven’t been used yet

- Goods that aren’t finished yet, and are still in the middle of the production process

*inventories don’t count towards investment part of GDP, change in inventories do - What do we mean by “change in inventories”?

- If firm adds $100B to inventories

- Firms sell, use, or finish $500B worth of stuff

- Net changes in inventories = $100B - $500B = - $400B counts as

investment

Why is investment so important?

- Most volatile component of aggregate expenditure

- Vital to economize growth

Why productivity is so important?

- When a nation’s workers are very productive, real GDP is large and incomes are high - When productivity grows rapidly, so do living standards

- What, then, determines productivity and its growth rate?

- Technological change If you want to learn more check out What is the function of cytotoxic t-cells?

- Capital

- Investment = change in capital

Determinants of Investment

- Expectations of future profitability (+) (positive correlation)

- Optimism or pessimism

- Taxes (-) (negative correlation)

- Corporate income tax

- Investment tax credits

- Cash flow (+)

r and investment (-)

r increases, I decreases - as r goes up, more expensive for firms to borrow to buy equipment and build factories and office buildings

r decreases, I increases - as r goes up, it is more expensive for families to borrow to buy houses and condos

Financing alternatives:

External Funds

Internal Funds

- Borrow the money

- Bank loans 15%

- Bonds 7.5%

- Sell Ownership Shares in a Company - Stocks 2.5%

- Using their own savings

- Retained Earrings 75%

Net Exports (NX): 

Exchange Rates:

- Nominal Exchange Rates: price of one currency in terms of another currency = number of units of foreign currency per unit of domestic currency

Ex. # of yen/dollar

= E If you want to learn more check out What is a mass fatality incident?

Ex. current yen / dollar exchange rate is about 112

The price of $1 is 112 yen

So E = the # of yen per dollar = 112

Earlier in the month, E = 114

It took 114 yen to buy $1

So the dollar depreciated

The price of $1 was 114 yen but now it is 112 yen

Ex. takes 1.31 canadian dollars to buy $1 so 1/1.31 = 0.763 US dollars for 1 canadian dollar If you want to learn more check out What is developmental contextualism?

Equilibrium in the Foreign Exchange Market

- Market exchange rates are determined by supply and demand just like any price (example in graph below)

- Surplus would be if the price is above the point of eq. - $ will depreciate

- Shortage would be if the price is below the point of eq. - $ will appreciate The demand for US dollars comes from:

1. Foreign firms and households wanting to

buy US goods and services

2. Foreign firms and households wanting to

invest in US physical or financial assets

3. Currency traders believing the value of the US dollar will rise

Changes in the Demand for and Supply of Foreign Exchange

Anything (apart from the exchange rate itself) affecting the demand for foreign exchange will shift the demand curve - to the right for an increase in demand, to the left for a decrease This might be caused by:

1. Changes in demand for US produced goods and services relative to foreign produced goods and services

2. Changes in desire to invest in the US relative to foreign countries

3. Changes in expectations of currency traders about the likely future value of $US relative to foreign currencies

The supply of $US for yen is the same as the demand for yen with $US, so the same factors change that demand also change supply.

What causes E to fluctuate?

Real interest rate (r) is one of the most important determinants 

r in the US (relative to r in the rest of the world) increases => demand for $ denominated assets increases => demand for $ increases => price of dollar increases => E increases

Real Exchange Rate (e) : the # of units of foreign goods per unit of domestic good = (P domestic x E) / P foreign

Ex. price of a watch in US: $100

Identical watch in switzerland: SF 300

Nominal exchange rate = SF 1.5 = $1 so the watch in the US costs SF 150 Real exchange rate = ($100 x 1.5) / SF 300 = ½

1 swiss watch is worth or will buy 2 american watches

e will change if:

1. E changes

2. P foreign changes

3. P domestic changes

Purchasing Power Parity (PPP) :

Theory that, adjusted for the nominal exchange rate, the same goods should cost the same wherever in the world they are sold

If PPP is true (and only if it is true) it must be that e=1

One unit of domestic good should sell for the same as one unit of a foreign good E = P foreign / P domestic

PPP and the Big Mac Index

Big Mac cost:

Ex. 15.4 yuan in Beijing

$4.20 in US

If PPP held and e = 1, then E would have to = 15.4 / 4.20 = 3.67

Instead E = 6.32 yuan to the dollar so yuan is undervalued

Ex. SF 6.5 in Switzerland

$4.20 in US

If PPP held true, e=1 and E would have to = 6.5 / 4.20 = 1.55

Instead, E = SF 0.96 to the dollar, so Swiss franc is overvalued

Limitations to PPP theory:

Two reasons why exchange rates do not always adjust to equalize prices across countries:

- Many goods cannot easily be traded

- Ex. haircuts, going to the movies

- Price differences on such goods cannot be arbitrated away

- Foreign, domestic goods not perfect substitutes

Nonetheless, PPP works well in many cases, especially as an explanation of long-run trends Ex. PPP implies the greater a country’s inflation rate, the faster its currency should depreciate (relative to low-inflation country like the US)

PPP and its implications:

Implies that nominal exchange rate between two countries should equal the ratio of price levels If two countries have different inflation rates, then E will change over time: If inflation is higher in Mexico than in the US, then P foreign rises faster than P domestic, so E rises - the dollar appreciates against the peso

If inflation is higher in the US that in Japan, then P domestic rises faster than P foreign, so E falls - the dollar depreciates against the yen

Trade Surpluses and Deficits

NX measures the imbalance in a country’s trade in goods and services

- Trade deficit = an excess of imports over exports

- Trade surplus = an excess of exports over imports

- Balanced trade = when exports = imports

NX = Exports - Imports = X - IM

Determinants of Exports

- Real exchange rate (e)

- GDP of our trading partners (Y foreign)

- Tastes and preferences of people abroad for our goods and services

- Trade policies

Determinants of Imports:

- Real exchange rate (e)

- Domestic GDP

- Domestic tastes and preferences for foreign goods

- Trade policies

r and NX

r in US increases (relative to r in the rest of the world) => demand for $ denominated assets increases => demand for $ increases => E increases => e increases => X decreases, IM increases, NX decreases

Aggregate demand curve (AD) relates price level

Why does it slope down?

1. Wealth effect (all about C)

a. P increases => purchasing power of household wealth decreases => C decreases => Aggregate expenditure (= GDP) decreases

2. Interest rate effect

a. P increases => r increases => C, I NX decrease => AE decreases

3. International Trade Effect

a. P increases => e increases => NX decreases => AE decreases

*NOTE: whenever there is inflation it is an effect on the price and when the price changes you move along the same aggregate demand curve rather than shifting it. Therefore, if there is inflation, move along the same curve.

** an increase in aggregate expenditure causes a movement along same curve, increase in aggregate demand causes a rightward shift in the aggregate demand curve

What causes the AD curve to shift?

1. Government Policies

- Monetary policy : policies that affect r (done by the Federal Reserve)

- r increases => C, I, NX decrease => AD shifts left

- r decreases => C, I, NX increases => AD shifts right

- Fiscal policy : policies that affect gov’t purchases, transfer payments or taxes (done by Congress, the White House, or the Treasury Dept.)

- Government spending (G) increases => AD shifts right

- G decreases => AD shifts left

- T increases => C, I decrease => AD shifts left

- T decreases => C, I increases => AD shifts right

2. Changes in expectations of households or firms

- Expected disposable income increases => C increases => AD shifts right - Expected disposable income decreases => C decreases => AD shifts left - Expected GDP increases => I increases => AD shifts right

- Expected GDP decreases => I decreases => AD shifts left

3. Changes in foreign variables

- E decreases => e decreases => NX increases => AD shifts right

- E increases => e increases => NX decreases => AD shifts left

- Y domestic increases => IM increase => NX decrease => AD shifts left - Y dom decreases => IM decreases => NX increases => AD shifts right - Y foreign increases => X increases => NX increases => AD shifts right - Y for decreases => X decreases => NX decreases => AD shifts left

Aggregate Supply Curve: shows relationship between price level (measured for ex. By the GDP deflator or CPI) and the quantity of output that all firms in the economy are ready, willing, and able to supply

Long-run Aggregate Supply

Determinants of economy’s capacity to produce in the long run:

- Capital stock: factories, office buildings, machinery and equipment

- Labor: # of workers

- Technology

*NOTE: price level has no effect on long run aggregate supply

Short Run Aggregate Supply Curve (some sticky, some flexible)

Why does it curve up?

- Contracts make some wages and prices sticky

- Firms are often slow to adjust wages

- Menu costs make some prices sticky

*Short Run Aggregate Supply Curve with completely fixed (sticky) prices will be horizontal *Short Run Aggregate Supply Curve with completely flexible prices would be vertical like LRAS

*slope indicates degree of price stickiness in an economy

What causes the SRAS curve to shift?

- Increases in the labor force and capital stock

- Technological change

- Expected changes in the future price level

- Adjustments of workers and firms to errors in past expectations about the price level - Unexpected changes in the price of an important natural resource

Long Run Macro Equilibrium

** LRAS acts as a magnet to draw the economy back toward it

Negative Supply Shock is when the SRAS shifts to the left

Positive Supply Shock is when the SRAS shifts to the right

SRAS shifts right causes an increase in price level; SRAS shifts left, decrease in P

Inflationary Gap Recessionary Gap

Caused by rightward shift of AD curve Caused by a leftward shift in the AD curve