Elements of Macroeconomics

Econ 10

Holmes

Micro: Trees

Pizza

Optimal prices, quantityEq. Price, quantityCostsetc.

Macro: Forest

How does our economy as a whole perform?

Some major issuesUnemployment: people who want to work but can’tInflation: increase in overall price levelRecession: decrease in value of produced goodsGross Domestic Product: how much do we-as an economy-make?Savings Rate: How well do we save our incomeInterest rate: how to stabilize economyTrade deficit: how much are we sending overseas?Stocks, bonds, investment….

Micro focussed on individual agents (or markets).Macro focuses on the performance of the economy in aggregate.

A Caution

Throughout macro lessons, we will often use micro as a motivation/analogy for macro issues. Recall, however, that we are dealing with society-wide analysis.

GDPGross Domestic Product: the total value of all final goods and services produced in a given year

We get by adding up everything that was produced in the US

Some issues:1. Market activity only (no home production)2. No leisure3. Bads and goods4. No ecological costs

Suppose my neighbor and I mow our own lawns. In GDP?Suppose we pay each other to mow our lawns. In GDP?

No double counting

Good Price Value addedTree $20 $20

Wood $35 $152 x 4's $50 $15Deck $150 $100

$150

Note that we eithera. count the value of final goods and services orb. add up the value added at each stage

GDP for this good is $150, not $20+$35+$50+$150

Big IdeaGDP is botha. the value of final goods and services produced in a yearb. the income of society (wages+salaries+profits+rents+dividends…)

Why? Think back to our deck example.

Good Price Value addedTree $20 $20 owner of tree

Wood $35 $15 to stockholders of weyerhauser2 x 4's $50 $15 to guy who rented us the sawDeck $150 $100 labor for installation

$150

Simple Model

What’s a government?Closed economy (no foreign trade)No banking system

Circular view of economy(A variant of Figure 24-1, page 567)

FirmsConsumers

C

I

Y (income) Y (production)

S D

Definitions

FirmsConsumers

C

I

Y (income) Y (production)

S D

Y= GDP or incomeC=Consumption (purchases by consumers on goods and services)S=Savings (any income not consumed)I=Investment (purchases by firms of capital)D=Expenditures (demand for goods and services)

Note S includes•savings•stocks•bonds•gold*•real estate*•anything to store value.

Examples

FirmsConsumers

C

I

Y (income) Y

S D

I buy a hamburger. (C)I buy a painting to look at (C).I buy a Van Gogh b/c it will be worth more (S).I buy IBM stock (S).

Pizza Hut buys a pizza oven (I).I buy a computer to surf the web (C).I buy a computer for my consulting company (I).Not as easy as you might think….

Check/PP

Define inflation, unemployment, recession.Define Y, C, I, S, D.What account (C,I,S) is it if I buy a CD and ……I listen to the compact disc at home…I use the data on the compact disc at work…I earn 5% on my Certificate of Deposit.Which of the following are in GDP?I clean my house. I pay someone to clean my house.I pay someone to clean my rugs after a hurricane. I clean my house faster so I can watch TV.

EquilibriumSuppose DY. Is the economy in eq?Answer: No. Compare value of goods demanded and value of goods produced.How to equilibrate?

FirmsConsumers

C

I

Y (income) Y

DS

How to equilibrate?

Best BuyThat’s a great idea!

Where does Y come in?

Y

Where does D come out?

D

Best BuyThat’s a great idea!

Y=$100

D=$150

D>YIf more are bought in a day than come in, where does BB get the TV’s?

Answer: inventories. Inventories fall by $50.

Best BuyThat’s a great idea!

Y=$200

D=$125

D<YIf less are bought in a day than come in, where does BB put the TV’s?

Inventories rise by $75.

Some equations

Y

IIYII

Y

CCYCC

ICD

SCY

DY

A

A

0),(

10),(

m)equilibriu(in

What do these mean?

Y

IIYII

Y

CCYCC

ICD

SCY

DY

A

A

0),(

10),(

m)equilibriu(in

Income= consumption + savings(you do one or the other with your check)Expenditure=consumption + investment(that’s who buys stuff)

Consumption is determined by two things:1. How much income society has2. Stuff other than incomeFurthermore, as income goes up by $1, C increases between $0 and $1.

What do these mean?Part II

Y

IIYII

Y

CCYCC

ICD

SCY

DY

A

A

0),(

10),(

m)equilibriu(in

C/ Y is marginal propensity to consume.S/ Y is marginal propensity to save.I/ Y is marginal propensity to invest.

What kinds of things are in CA?•Christmas•Summer vacations•Overall confidence•Tastes, etc.

Micro/Macro analogies

• As you get more wage income, you spend some of it and save some of it

• As your business gets more income, you probably expand

• As society earns more, it will consume some and save some

• As firms produce more, they must invest more

Note that...

Y

S

Y

CY

S

Y

C

Y

Y

SCY

SCY

1

SampleSuppose C/ Y=.6, I/ Y=.2

Y C S D I100 60 60200300

Y C S D I100 60 40 120 60200300

Y C S D I100 60 40 120 60200 120 80 200 80300 180 120 280 100

Y=C+S, so 100=60+? S=40. D=C+I==>D=120.Are we in equilibrium? No. D>Y. (inventories?)As Y increases by 100, what happens to C?C/ Y = .6, so C=100*.6 = 60. C increases by 60 to 120.S must be 80, then. I/ Y = .2, so I=100*.2 = 20. D = 80+120.Do again for Y=300.

Sample, cont.Y C S D I

100 60 40 120 60200 120 80 200 80300 180 120 280 100

So the final equilibrium must be Y=D=200.Note we could have figured S by using S/ Y=1- C/ Y=.4 What if we had an autonomous increase in S? say SA=20.

Y C S D I100 40 60 100 60200300

Autonomous effectY C S D I

100 60 40 120 60200 120 80 200 80300 180 120 280 100

Old one

Y C S D I100 40 60 100 60200 100 100 180 80300 160 140 260 100

New equilibrium at Y=D=100

Note

Y

I

Y

C

Y

D

ICD

ICD

ICD

AAA

Marginal Propensity to Spend (MPS) D/ Y

Y C S D I100 40 60 100 60200 100 100 180 80300 160 140 260 100

Here, DA= -20. D/ Y = .6 + .2 = .8(Can you do the table with D and Y only?)Note that D fell 20 and Y fell 100. Here, then Y/ DA= -100/ -20 = 5

The Multiplier

We call Y/ DA the multiplier.

Let’s analyze. Why does it multiply?(A Micro Analogy)Suppose you spend an additional $100. You buy a music lesson. The teacher takes that $100 and spends .8*100 or $80. She purchases a new guitar. The guitar owner spends .8*80 or $64 on a manicure. The manicurist spends .8*$64 on a….The initial DA gets multiplied throughout the economy.

Multiplier in Action

North Carolina gets hit with a hurricane. We spend $100 million on goods from South Carolina. They spend $80 million of that in Georgia, who spends $64 million in Florida…

Does it really work geographically? No. But the multiple waves are key.

Multiplier in ExcelWave dD dY total dY

0 $100.00 $100.00 $100.001 $80.00 $80.00 $180.002 $64.00 $64.00 $244.003 $51.20 $51.20 $295.204 $40.96 $40.96 $336.165 $32.77 $32.77 $368.936 $26.21 $26.21 $395.147 $20.97 $20.97 $416.118 $16.78 $16.78 $432.899 $13.42 $13.42 $446.31

10 $10.74 $10.74 $457.0511 $8.59 $8.59 $465.6412 $6.87 $6.87 $472.5113 $5.50 $5.50 $478.0114 $4.40 $4.40 $482.4115 $3.52 $3.52 $485.9316 $2.81 $2.81 $488.7417 $2.25 $2.25 $490.9918 $1.80 $1.80 $492.7919 $1.44 $1.44 $494.24… … … …

$500.00

With a MPS of .8, the total effect on Y is $500 for a autonomous increase in D of 100.

Multiplier-Graph

$0.00

$100.00

$200.00

$300.00

$400.00

$500.00

$600.00

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19

Wave

Incr

ea

se i

n Y

Multiplier-Algebra

Aw

Aw D

MPSDMPS

1

1

,0

Here, MPS=.8 ==>multiplier=1/(1-.8)=1/(.2)=5So DA=100, multiplier=5 ==> Y=500

Multiplier

So you have two ways to find the multiplier, given MPS

Y D1 D20 0

100 80 100

1. Pick two Y’s2. Make one an eq.3. Given MPS, compute D1 at high Y4. Compute DA that solves (here 20)5. Compute Y/ DA=100/20=5

Method 1

1. Compute 1-MPS2. Compute 1/(1-MPS)

Method 2

Note on the Algorithm

It doesn’t matter which numbers you choose for the Y’s

Y D1 D20 0

100 80 100

MPS 0.8dY 100dDa 20

Multiplier 5

Y D1 D21.7 1.735.6 29 36

MPS 0.8dY 34dDa 6.8

Multiplier 5

Y D1 D23.14159 3.141.41421 1.76 1.4

MPS 0.8dY -1.73dDa -0.35

Multiplier 5

Y D1 D21999 1999-40 367.8 -40

MPS 0.8dY -2039dDa -407.8

Multiplier 5

Y D1 D2-1 -10 -0 0

MPS 0.8dY 1dDa 0.2

Multiplier 5

…but 0,100 is easier than , 2

Which one do I choose?

The fraction is probably easier if you can remember the formula.The algorithm is easier if you think you may forget it on the exam.

IMPORTANT NOTICE: ON THE NEXT TEST, NO CALCULATORS WILL BE ALLOWED.

Algorithm movie is on the web.

Multiplier Questions

MPC=.5, MPI=.3MPC=.6, MPI=.3MPSave=.5. MPI=.1MPC=.7, MPI=.3MPC=0, MPI=0 Discuss and interpret

these last two.

We’re ready!

You now have the tools to begin solving problems.

See MACRO PROBLEMS on the web for some practice.