CHAPTER 11

Growth Theory

The heroic entrepreneurs of Schumpeter are resurrected, only slightly less heroically, in The General Theory (1936) of J.M. Keynes. Investment, in the Keynesian system, is an independent affair contingent upon finance and the "animal spirits" of entrepreneurs.

The issue is that Keynes did not extend his theory of demand- determined equilibrium into a theory of growth. This was left for the Cambridge Keynesians to explore. The first to come up with an extension was Sir Roy F. Harrod who (concurrently with Evsey Domar) introduced the "Harrod-Domar" Model of growth (Harrod in 1939, Domar in 1946).

Recall, from Keynes, that investment is one of the determinants of aggregate demand and that aggregate demand is linked to output (or aggregate supply) via the multiplier. Abstracting from all other components, we can write that, in goods market equilibrium:

Y = (1/s)I

Where Y is income, I investment, s the marginal propensity to save (and thus the multiplier is 1/s). But investment, note Harrod and Domar, increases the productive capacity of an economy and that itself should change goods market equilibrium.

For "steady state" growth, in the language of Harrod-Domar, aggregate demand must grow at the same rate as the economy's output capacity grows. Now, the investment-output ratio, I/Y, can be expressed as (I/K)(K/Y). Now, I/K is the rate of capital accumulation and K/Y is the capital-output ratio (call it "v"). Thus, the rate of capital accumulation, I/K, is the rate of capacity growth (call that "g"). Thus, for steady state it must be that I/K = (dY/dt)/Y = g (i.e. the rate of capital accumulation/capacity growth, I/K, and the real rate of output growth (dY/dt)/Y, must be at the same rate, g). Thus, plugging in our terms:

I/Y = (I/K)(K/Y) = gv

          But recall our goods market equilibrium term from the multiplier, i.e. Y = (1/s)I which can be rewritten I/Y = s. Thus, the condition for full employment steady-state growth is gv = s, or simply:

g = s/v

Thus, s/v is the "warranted growth rate" of output. However, Harrod and Domar originally held s and v as constants - determined by institutional structures. This gives rise to the famous Harrodian "knife-edge"if actual growth is slower than the warranted rate, then effectively we are claiming that excess capacity is being generated, i.e. the growth of an economy's productive capacity it outstripping aggregate demand growth. This excess capacity will itself induce firms to invest less - but, then, that decline in investment will itself reduce demand growth further and thus, in the next period, even greater excess capacity is generated.

Similarly, if actual growth is faster than the warranted growth rate, then demand growth is outstripping the economy's productive capacity. Insufficient capacity implies that entrepreneurs will try to increase capacity through investment - but that that itself is a demand increase, making the shortage even more acute. With demand always one step ahead of supply, the Harrod-Domar model guarantees that unless we have demand growth and output growth at exactly the same rate, i.e. demand is growing at the warranted rate, then the economy will either grow or collapse indefinitely.

The "knife-edge", thus, means that the steady-state growth path is unstable: the only stable growth path, the "knife-edge", is where the real growth rate is equal to s/v permanently. Any slight shock that will lead real growth to deviate from this path ensures that we will not gravitate back towards that path but will rather move further away from it.

It was up to Nicholas Kaldor (1955, 1957) to rescue this by proposing that savings are variable and would "jump" to the value necessary to bring the actual growth rate back into its warranted path. To justify this, Kaldor had to employ Classical considerations of income distribution with two classes: capitalists (who save a portion of their profits) and workers (who save from wages). Thus, letting s be the capitalists' propensity to save and s' be the workers', then total savings are:

S = sP + s'W

Where P are profits and W are wages. Naturally, W + P = Y, total income is made up of profits and wages, so W = Y - P. As capitalists are assumed to save more than workers, s > s', then obviously savings are positively related to the share of profits in income, P/Y.

For goods market equilibrium, it must be that investment is equal to savings, I = S. Following the Keynesian axiom that investment is independent, then investment determines savings (or, to word it differently, aggregate demand determines aggregate supply). However, as noted profits are positively related to savings. Hence, by substitution:

I = sP + s'(Y - P)

Which rearranging yields:

P/Y = [1/(s-s')](I/Y) - s'/s-s'

In other words, given the marginal propensities to save of each class, the relative size of profits in income is dependent only on the investment decision, I/Y. Naturally, the more investment, the greater the necessary slice profit takes out of income.

If we assume workers save nothing, so that s' = 0, then we quickly reach the conclusion that:

P/Y = (1/s)I/Y

Where P/Y depends on I/Y. Note that this is reminiscent of  Keynes' famous "widow's cruse" remark:

"However much of profits entrepreneurs spend on consumption, the increment of wealth belonging to the entrepreneurs remains the same as before. Thus, profits, as a source of capital increment for entrepreneurs, are a widow's cruse which remains undepleted, however much be devoted to riotous living"(J.M.Keynes, Treatise on Money, 1930: p.139)

Or any attempt by capitalists to increase their consumption (and thus reduce savings), will merely result in increased profits - thereby generating the savings to make up for their initial decline. Or, as Kaldor (1955) reminds us, this is merely Kalecki's adage that "capitalists earn what they spend and workers spend what they earn".

What if we are not in goods market equilibrium? Suppose we have excess demand for goods so that I > S, then investment has generated a level of profits are too low for equilibrium, i.e. capitalists have not saved enough. Consequently, as pressure is placed on the goods market, prices will rise and, assuming wages are constant, real wages will fall, increasing the share of profits in income. Thus, P/Y rises, which in turn increases savings, and so on until equilibrium is re-established.

  What about growth? Recall that I/Y = (I/K)(K/Y), where I/K is the rate of capital accumulation (equal to the rate of growth of productive capacity, g) and K/Y is the capital-output ratio (v). Thus, we can write I/Y = gv.

Now recall Kaldor's relationship, P/Y = (1/s)I/Y. Thus:

P/Y = gv/s

so that g = (s/v)P/Y. Recalling that v = K/Y, then this can be rewritten:

g = s(P/K)

But we should note that the ratio P/K is merely the rate of profit, r. Calling it thus, we can rewrite:

r = g/s

The rate of profit is equal to the growth rate divided by the savings rate of capitalists which is also known as the "Cambridge rule" for growth. In a von Neumann model, recall, workers consumer everything (as here), but he also has it that capitalists save everything (so s = 1). But note that in this case, we have r = g, or "Golden Rule" growth. Thus, we immediately see the affinity between Cambridge growth models and von Neumann growth models. Morishima's (1960, 1964) extension of von Neumann models which allowed for capitalist consumption produces precisely this "Cambridge rule" for von Neumann.

Joan Robinson (1962) recommended a modification so as to understand the properties of this model better. We have not really discussed what determines investment: we simply posited a full employment relationship, i.e. I/Y = gv, so as to obtain Kaldor's steady-state. But surely, in a Keynesian world, an independent investment function should remain independent! Robinson (1962) posited a relationship I/Y = f(P/Y) or g = f(r), where investment decisions by firms were functions of (expected) profit. She argued that this was a concave function, based on Kalecki's (1937) principle of increasing risk: investment is positively related to expected profit, but at a decreasing rate - as every extra unit of investment means greater debt and thus greater risk to the firm.

However, we know from the Kaldor relationship, P/Y = (1/s)I/Y or r = g/s, that profits are themselves generated by investment. Thus, Robinson's question can be asked: when is it true that the profits generated by the investment in the Kaldor relationship will themselves generate investment decisions that, in turn, generate the original profits? Alternatively, what is there that guarantees that the profits generated by the Kaldor relationship will themselves generate the amount of investment needed to sustain them? This is a question of stability.

  Robinson's (1962: p.48) diagram above of the concave Kalecki function and the linear increasing risk function is reproduced below. Assuming all is well, then we should have two equilibria where rs = g = f(r). Consider the rightmost equilibrium first. To the right of that equilibrium, Robinson posited that the economy was generating less profits than planned and thus investment plans will be shelved, inducing deaccumulation of capital and hence reducing growth. To the immediate left of it, the economy is generating more profits than planned, and thus firms will revise their expectations upwards and invest more, thereby increasing accumulation and growth. Hence, the right equilibrium is stable. A similar exercise will show that the left equilibrium is, for the same reasons, unstable.

Robinson (1962) went on to enrich her analysis by introducing labor growth and to consider the implications of including unemployment and inflation and the method of adjustment explicitly in the model. She discusses the various types of growth situations that could be encountered - Golden Rule and otherwise.

Another extension was provided by Luigi Pasinetti (1962). It is unlikely that workers do not save, as we have assumed. Originally, Kaldor (1955) proposed that workers did save out of wages, but less than capitalists - in which case, profits would be more sensitive to the investment decision than we have allowed. However, Pasinetti (1962) called this "a logical slip". If workers can save, we should conceive of two different "types" of capital falling under different ownership: "workers' capital" and "capitalists' capital". Let us call the former K' and the latter K. Thus total savings are S = sP + s'(P' + W), workers save out of both profits and wages.

It is necessary that workers be paid a rate of interest on their capital just in the same manner as capitalists receive a rate of profit on theirs. By competition and arbitrage, Pasinetti argued that the rate of profit/interest for both capitalist and workers on their capital is equalized. Or:

P/K = P'/K' = r

Where P' is workers' profits. For savings, let S be capitalist savings and S' worker savings out of profits. Therefore, for steady state growth:

S/K = S'/K' = g

In the long-run, for steady-state, it must be that the rate of accumulation must be equal for both capitalists and workers, i.e.

P/S = P'/S'

Otherwise, if the rate of wealth accumulation is faster for either of the classes, then there will be a change in distribution and, as a result, a change in the composition of aggregate demand. In long-run equilibrium, aggregate demand must be stable therefore this is a necessary assumption.

However, as a consequence of this assumption, we can note that:

P/sP = P'/s'(W + P')

Where s and s' are the marginal propensity to save of capitalists and workers. Note again that workers also save out of wages, W, as well as profits, P', whereas capitalists only receive and save out of profits. Cross-multiplying:

s'(W + P') = sP'

Now, if investment (I) is equal to total savings which means that:

I = s'(W + P') + sP

Then using our previous relationship:

I = sP' + sP = s(P + P')

Let us call total profits P* = P + P', then I = sP* or:

P* = (1/s)I

So it must be that:

r = (P*/K) = (1/s)I/K = g

i.e., for long run Golden Rule steady-state growth, only the capitalist's propensity to save needs to be considered - workers' saving propensities can be dropped by the wayside. Thus, even with worker savings, the "Cambridge rule" is iron-clad. Only capitalists' savings propensity matters. As Pasinetti notes:

"In the long run, workers' propensity to save, though influencing the distribution of income between capitalists and workers, does not influence the distribution of income between profits and wages. Nor does it have any influence on the rate of profit!" (L.Pasinetti, 1962)

But there were important assumptions in the model yet undiscussed. Pasinetti posits one of his conditions to guarantee existence to be:

s > I/Y > s'

So that profits cannot take "a null or negative share of wages" (Pasinetti, 1962). This, in essence, defines the mechanism for adjustment. If distribution can be somehow organized such that there will be a "correct" level of profits to give us the savings necessary to be in equilibrium: i.e. make I/K = s/v. The first question that must be asked here is not only whether you can calculate for a given investment level what the profit level will be but whether there will be pressures that might bring this into equilibrium. Within certain limits, Kaldor argues, variations can take place such that P/Y is a function of the change in the I/Y ratio. According to Kaldor, prices respond to relative money wage rates as a consequence of demand. Assume, for instance, that given an excess demand for goods, prices will increase but not wages. As a consequence there is a shift in distribution such that there will be an increase in the profit share. Since profits increase, this implies there will be a substantial growth in savings.

However, as J.E. Meade (1961) points out, if prices rise relative to wages, then the real wage decreases. By substitution between capital and labor, there will be a change in the capital-output ratio (v). Therefore, for Kaldorian adjustment to be applied there is an implicit dependence on a constant capital-output ratio. However, a constant v necessarily means that we cannot be in long-run equilibrium since technique would otherwise be entirely flexible. One can perhaps regard at it as a vintage model, but here prices would have to change faster than wages. The greatest difficulty in this model, nevertheless, remains the adjustment towards the steady-state path. How do profits adjust so that one will achieve the steady-state savings rate? According to Kaldor, prices respond to relative money wage rates as a consequence of demand. Assume, for instance, that given an excess demand for goods, prices will increase but not wages. As a consequence there is a shift in distribution such that there will be an increase in the profit share. Since profits increase, this implies there will be a substantial growth in savings.

However, as J.E. Meade (1961, 1963, 1966) points out, if prices rise relative to wages, then the real wage decreases. By substitution between capital and labor, there will be a change in the capital-output ratio (v). Therefore, for Kaldorian adjustment to be applied there is an implicit dependence on a constant capital-output ratio. However, a constant K/Y necessarily means that we cannot be in long-run equilibrium since technique would otherwise be entirely flexible.

But a more general criticism can be made. We can note that given a stock of capital, labor and output, if prices move faster than wages, then profits will increase whereas if wages move faster than prices, then profits will fall - without changing techniques. The variety of consequences of this has led several economists, such as Meade (1961) and, later, Nell (1982), to argue that at least for a long-run model, Kaldor's theory has a rather poor price-adjustment mechanism. "Mr. Kaldor's theory of distribution is more appropriate for the explanation of short-run inflation than of long-run growth." (Meade, 1961: x).

 

 

CHAPTER 10

The Labor Market, Unemployment and Inflation

The Labor Market: Basic Concepts

    The unemployment rate is the ratio of the number of people unemployed to the total number of people in the labor force.

    Cyclical unemployment is the increase in unemployment that occurs during recessions and depressions.

    Frictional unemployment is the portion of unemployment that is due to the normal working of the labor market; used to denote short-run job/skill matching problems.

    Structural unemployment is the portion of unemployment that is due to changes in the structure of the economy that result in a significant loss of jobs in certain industries.

 

The Classical View of the Labor Market

  According to classical economists, the quantities of labor demanded and supplied are brought into equilibrium by rising and falling wage rates. There should be no persistent unemployment above the frictional and structural amount.

•    labor supply curve 
•    labor demand curve 

 

 The Unemployment Rate and the Classical View

  The unemployment rate is not necessarily an accurate indicator of whether the labor market is working properly.

    The unemployment rate may sometimes seem high even though the labor market is working well.

 

Explaining the Existence of Unemployment

  The fact that people are willing to work at a wage higher than the current wage does not mean that the labor market is not working.

   The term sticky wages refers to the downward rigidity of wages as an explanation for the existence of unemployment.

    If wages “stick” at W0 rather than fall to the new equilibrium wage of W* following a shift of demand, the result will be unemployment equal to L0 – L1.

  One explanation for downwardly sticky wages is that firms enter into social, or implicit, contracts. These contracts are unspoken agreements between workers and firms that firms will not cut wages.

The relative-wage explanation of unemployment holds that workers are concerned about their wages relative to the wages of other workers in other firms and industries. 

  Explicit contracts are employment contracts that stipulate workers’ wages, usually for a period of one to three years. Wages set in this way do not fluctuate with economic conditions.

    Cost of living adjustments (COLAs) are contract provisions that tie wages to changes in the cost of living. The greater the inflation rate, the more wages are raised. 

The efficiency wage theory is an explanation for unemployment that holds that the productivity of workers increases with the wage rate. If this is so, firms may have an incentive to pay wages above the market clearing rate. If firms have imperfect information, they may simply set wages wrong—wages that do not clear the labor market.

  Minimum wage laws set a floor for wage rates, and explain at least a fraction of unemployment.

  The Short-Run Relationship between the Unemployment Rate and Inflation

  In the short run, the unemployment rate (U) and aggregate output (income) (Y) are negatively related.

As depicted by this short run AS curve, the relationship between Y and the price level (P) is positive.

 

The relationship between U and P is negative. As U declines in response to the economy moving closer and closer to capacity output, the overall price level rises more and more. 

 

 The Phillips Curve

  The inflation rate is the percentage change in the price level.

   The Phillips Curve shows the relationship between the inflation rate and the unemployment rate.

   There is a trade-off between inflation and unemployment. To lower the inflation rate, we must accept a higher unemployment rate.

The Role of Import Prices

   The AS curve shifts when input prices change, and input prices are affected by the price of imports.

There were no large shifts in the AS curve in the 1960s due to changes in the price of imports. 

  The price of imports increased considerably in the 1970s. This led to large shifts in the AS curve during the decade.

  

 Expectations and the Phillips Curve

  Expectations are self-fulfilling. This means that wage inflation is affected by expectations of future price inflation.

  Price expectations that affect wage contracts eventually affect prices themselves.

Inflationary expectations shift the Phillips curve to the right.

  Inflationary expectations were stable in the 1950s and 1960s, but increased in the 1970s.

 

The Long-Run AS curve, Potential GDP, and the Natural Rate of Unemployment

  When output is pushed above potential GDP (Y0), there is upward pressure on costs. Rising costs push the short-run AS curve to the left. The quantity supplied will end up back at Y0.

  If the AS curve is vertical in the long run, so is the Phillips Curve.

  In the long run, the Phillips Curve corresponds to the natural rate of unemployment.

  The natural rate of unemployment (U*) is the unemployment rate that is consistent with the notion of a fixed long-run output at potential GDP. 

 

 

The NAIRU—The Nonaccelerating Inflation Rate of Unemployment

  Many economists believe the relationship between the change in the inflation rate and the unemployment rate is as depicted by the PP curve in this figure.

  Only when the unemployment rate is equal to the NAIRU is the price level changing at a constant rate (no change in the inflation rate).

 

CHAPTER 9

Aggregate demand & Supply

The Aggregate Demand Curve

The aggregate expenditure framework that we have been using focuses on the components of aggregate demand (C, I, G, and the foreign sector). Recall that when we are looking at the changes in aggregate output stemming from changes in AE, the price level was assumed to be constant. While the AE framework is useful for depicting the multiplier effects of changes in C, I, G, or the foreign sector, it has some limitations. First, as aggregate output changes, so does the price level. In addition, the AE model does not fully develop the supply side of the economy. In this lecture, we will develop a framework that incorporates both the supply side of the economy as well as changes in the price level. Let us get started!

How does the aggregate demand (AD) framework relate to the aggregate expenditure framework? Both have aggregate output (income, Y) on the horizontal axis, but while the AE model has planned aggregate expenditures on the vertical axis, the aggregate demand curve has the price level on the vertical axis. The AD model, then, relates changes in the price level with changes in aggregate output. Let us examine how price level changes generate changes in aggregate output.

Deriving the Aggregate Demand Curve

 

          We start our examination of the link between the price level and aggregate output with the money market. A change in the price level affects money demand. An increase in the price level will increase the demand for money and cause the money demand curve to shift to the right. This causes the interest rate to increase, which causes a reduction in planned investment. Aggregate output will decrease in response to the decline in investment by more than the initial decline in investment due to the multiplier effect. 

  This whole process works in reverse as well. A decrease in the price level will lower money demand and the interest rate. Planned investment will increase in response to the lower interest rate and cause aggregate output to increase by more than the increase in investment.

          What we have demonstrated, then, is an inverse relationship between the price level and aggregate output. This relationship is what is depicted by the aggregate demand curve. The AD curve plots varying price levels and their corresponding levels of aggregate demand. In other words, each price level and its corresponding level of aggregate output plots as a point on the AD curve, 

 

The Aggregate Demand Curve: A Warning  An important point to note is that the aggregate demand curve is markedly different from a market demand curve for a particular good or service. On a market demand curve, only the price of the product and its quantity are allowed to vary. Everything else is held constant (income, the price of other goods, and so on). The aggregate demand curve is not even the sum of all individual market demand curves for an economy. To see why the AD curve is different than a market demand curve, let us examine why market demand curves have a negative slope and contrast this with the reasons for the downward sloping AD curve. To make the picture a little more concrete, let us pick a particular good, say rye bread, to illustrate the properties of a market demand curve. There are two main reasons why a market demand curve has a negative slope. The first is known as the substitution effect. If the price of rye bread increases, for example, it becomes more expensive than before relative to other goods. (Because all other prices are held constant, an increase in the price of rye bread makes it relatively more expensive than before the price rise. People will substitute rye bread, to some degree, with other types of bread, rolls, crackers, or other substitutes. Thus, an increase in the price of rye bread will lead to a reduction in quantity demanded. The second reason market demand curves have a negative slope is known as the income effect. Recall that when drawing a market demand curve, income is held constant. With income held constant, an increase in a good’s price means that consumers will not be able to buy as much of it as before while maintaining their purchases of other products. Thus, an increase in the price of a good will reduce the quantity demanded of the good. The AD curve, on the other hand, has a negative slope for different reasons. There cannot be any substitution or income effects here. There cannot be a substitution effect because we include all goods on the horizontal axis and all prices on the vertical axis. With all goods accounted for, all substitutions between goods are accounted for. Similarly, there cannot be an income effect because income (aggregate output) is not held constant in the case of the AD curve. It is allowed to change by virtue of the fact that aggregate output (income, Y) is on the horizontal axis. So why does the AD curve have a negative slope? We described one reason earlier in this lecture. With an increase in the price level, money demand increases and interest rates rise, causing a decline in investment and aggregate output. The other reasons for the negative slope of the AD curve are examined next.

 

Other Reasons for a Downward-Sloping Aggregate Demand Curve   Just as with planned investment, consumption spending by households is inversely related to the interest rate. With the increase in interest rates stemming from higher prices and increased money demand, consumption spending will fall. As with planned investment, a decline in consumption will cause aggregate output to decline. The response by investment and consumption spending to changes in interest rates stemming from changes in the price level is known as the interest rate effect.

Another reason for the negatively sloping AD curve is known as the real wealth effect or the real balance effect. Recall that when we derived the AD curve, monetary policy was held constant. With a given amount of money in the economy, an increase in prices means that fewer goods and services can be bought than before the price rise. With fewer products purchased, fewer products will be made. Thus, aggregate output will decrease with an increase in the price level.

 

Shifts of the Aggregate Demand Curve

The aggregate demand curve we saw above is based on the assumption that the government policy variables G, T and Ms are fixed. If any of these variables change, the aggregate demand curve will shift.

          Monetary policy will cause changes in aggregate demand. An increase in the money supply, for example, will increase aggregate demand and cause the AD curve to shift rightward. 

  Expansionary fiscal policy, consisting of an increase in government spending (or a decrease in taxes) will cause aggregate demand to increase and the AD curve to shift rightward. 

  

The Aggregate Supply Curve

Aggregate supply is the supply of all goods and services. There is considerable disagreement among economists about the meaning and shape of the aggregate supply curve. Many economists believe that the AS curve has different features in the short run than in the long run. We will first develop the concepts of the AS curve within the context of the short run, and then look at some of the implications of the long run on the AS curve.

The Aggregate Supply Curve: A Warning

The AS curve shows the relationship between the total supply of goods and services in the economy and the price level. Just as the AD curve is not the summation of the market demand curves for the economy, the AS curve is not the summation of the market supply curves in the economy.

Recall that in deriving market supply curves, the input prices are held constant. An increase in output price causes firms to respond to the resulting higher profit per unit by increasing production. For the AS curve, however, this phenomenon is not possible because the vertical axis shows the prices of all goods and services. There must, therefore, be other reasons for the positive slope of the AS curve.

Aggregate Supply in the Short Rule

One reason for the upward-sloping AS curve is that wages and input prices often lag output prices. While an increase in the price level on the AS diagram means that overall prices in the economy are going up, not all prices go up uniformly. There is evidence that wages and input prices lag output prices. For example, one reason that wages rise more slowly than output prices is that workers often have longer-term contracts during which wages are specified for some time into the future. If prices rise unexpectedly, the wage increases specified in these contracts will increase by less than the rise in output prices. 

          Note that at low levels of aggregate output (between points A and B) the AS curve is relatively flat, while at high levels of aggregate output (between points C and D) it is nearly vertical. What is the reason for this?

To answer this question, let us think about what the short run means in economics. In microeconomics, you may recall that the short run is defined by the presence of at least one fixed factor of production. For example, in the short run, firms can adjust output by changing the number of workers and quantity of inputs used. These firms, though, are constrained by the size of the existing factory. In the longer run, if the firm wants to increase production, it can increase the size of its factory. In the short run, however, the fixed size of a firm's factory acts as a capacity constraint. If the firm is producing at low levels of output and has excess capacity (extra factory space), it can increase output relatively easily. If, however, all of its factory space is being utilized, it is much more difficult (and costly) to increase output.

An analogous idea can be applied to the economy as a whole. The Federal Reserve issues estimates of the nation's capacity utilization rate. During recessions, when the economy is at low levels of aggregate output, there is excess capacity in the economy. For example, during the recession of the early 1990s, the capacity utilization rate was just under 80 percent. This means about 20 percent of the nation's factory space was not being utilized then. In addition, during low levels of aggregate output, the unemployment rate increases due to the presence of cyclical unemployment. With excess factory capacity and idle workers, the economy can more easily (and more cheaply) expand output than when the productive capacity is fully utilized. Thus, aggregate output will increase substantially with only a modest increase in the price level. This is what is shown by the relatively flat portion of the AS curve.

In contrast, at high levels of aggregate output when capacity utilization is high, there are much fewer idle resources. Factory space is nearly fully utilized and the unemployment rate is low. In this situation, it is more difficult (and costly) to gain further increases in output. Even sharp increases in the price level only bring about very small increases in aggregate output. This is what is shown by the steep portion of the AS curve.

There must be some time lag between changes in input prices and changes in output prices for the aggregate supply curve to slope upward (if there were no lag, it would be vertical). Wage rates may increase at exactly the same rate as the overall price level if the price-level increase is fully anticipated. But most employees do not receive automatic pay raises, and sometimes increases in the overall price level are unanticipated.

 

 Shifts of the Short-Run Aggregate Supply Curve

Let us look quickly at some of the factors that can shift the AS curve. Then we will put aggregate supply together with aggregate demand to explain the price level in the economy. As we will see, shift in either aggregate demand or aggregate supply will cause inflationary or deflationary changes in the price level. The factors that can shift the AS curve are summarized in the figure below. We will briefly go into each factor.

  Changes in wages or input prices will cause the AS to shift. Increases in wages or input prices will cause a decrease in aggregate supply and a leftward shift of the AS curve. Declines in wages or input prices will cause aggregate demand to increase. For example, the dramatic decline of world oil prices during the first part of 1998 caused a rightward shift of the AS curves for many nations. The extent to which AS increased depends on the degree to which oil is used as an input in a nation's productive processes. In the United States, for example, oil is an important input for electrical generation and many manufacturing processes. An unexpected change in input costs that causes a shift in the AS curve is termed a cost shock or supply shock.

Shifts in the AS curve can also be caused by any factor that affects the productivity or productive capacity of the economy. Increases in the size of the labor force, factory space, stock of capital, or improvements in technology or productivity will shift the AS curve to the right.

On the other hand, decreases in productivity or productive capacity will cause leftward shifts in the AS curve. Decreases in research and development, lack of investment in physical capital, and decreased educational and training opportunities, can all lead to decreases in aggregate supply. Similarly, wars, natural disasters, and adverse weather will shift the AS curve to the left.

  As shown in the right panel of the figure above, changes in a nation's aggregate supply can also be the focus of deliberate public policy. The supply-side economic policies of the Reagan administration of the 1980s are an example of this. The promise of these policies was economic growth without inflation. To see how this might work, let us turn now to how aggregate supply and demand interact to determine the equilibrium price level. 

CHAPTER 8

Open Economy Macroeconomics:The Balance of payment and the exchange rate

Balance of Payments

The balance of payments provides us with important information about whether or not a country is “paying its way” in the international economy.

What is the Balance of Payments? 

The balance of payments (BOP) records all of the many financial transactions that are made between consumers, businesses and the government in the UK with people across the rest of the World. The BOP figures tell us about how much is being spent by British consumers and firms on imported goods and services, and how successful UK firms have been in exporting to other countries and markets. It is an important measure of the relative performance of the UK in the global economy. At AS level we focus only on one part of the balance of payments accounts. This section is known as the current account. We will go through the make-up of this account in a later section.

Why is the export sector of the economy vital for the UK?

• Aggregate demand and the multiplier: An increasing share of Britain’s national output isexported overseas as the nation becomes ever more integrated into the global economy.Export earnings are an injection of AD into the circular flow. If British companies can successfully sell more goods and services overseas, the rise in exports boosts national income and should have a positive multiplier effect on the national income, output and employment.
• Manufacturing industry: Export sales are particularly important for manufacturing industry where exports are a high % of total production. Thousands of jobs depend directly on the performance of the export sector and even more are affected in supply industries. Select this link for more articles on British manufacturing industry
• Regional economic health: The relative success of failure of export industries is important for certain regions of the UK. When export sales dip (for example as a result of a global downturn or the impact of the strong exchange rate), output, employment and living standards comeunder threat and threaten to widen the existing north-south divide.

 

Trade in goods includes items such as: Manufactured goods Semi-finished goods and components Energy products Raw Materials Consumer goods (i) Durable goods e.g. DVD recorder and new cars (ii) Non-durable goods e.g. foods and beverages Capital goods (e.g. new plant and equipment)

Trade in services includes: Banking, insurance and consultancy services Other financial services including foreign exchange and derivatives trading Tourism industry Transport and shipping Education and health services Services associated with research and development Cultural arts

Trade in goods

Trade in goods includes exports and imports of oil and other energy products, manufactured goods, foodstuffs, raw materials and components. Until recently this was known as visible trade – i.e. exporting and importing of tangible products. Since 1986 the net balance of trade in goods for the UK has been in deficit. And as the following chart shows, the trade deficit in goods has increased enormously in the last few years. In 2005 there was a record trade deficit of £66 billion, over three times the deficit seen in 1998.

Trade in services

Overseas trade in services includes the exporting and importing of intangible products – for example, Banking and Finance, Insurance, Shipping, Air Travel, Tourism and Consultancy. Britain has a strong trade base in services with over thirty per cent of total export earnings come from services.

The balance of trade in services has been positive for many years. In 1999 the UK became the second largest exporters of services in the world and in 2004 the UK achieved its highest ever annual trade surplus in services although there was a smaller surplus in 2005 partly because of higher insurance payouts arising from the effects of Hurricane Katrina in the United States. Strong surpluses are especially common in financial and business services and hi-tech knowledge services.

But the UK runs a deficit in international travel and transportation in part because of the growth of demand for overseas holidays as living standards have improved. Once again, rising incomes have caused a large rise in the demand for overseas leisure and business travel and the sustained strength of the exchange rate against most European currencies and the rapid expansion of low cost airlines offering short haul overseas breaks has also played its part.

Britain has a comparative advantage in selling financial services to the rest of the world. London is one of the three main financial centres in the world and has the largest share of trading in many international financial markets. Many overseas banks have established themselves in London’s money and capital markets. And numerous British financial businesses have world class status in their areas of expertise.  Our UK based commercial banks, fund managers, securities dealers, futures and options traders, insurance companies and money market brokerage businesses are part of a complex network of financial and business services that represent a huge asset for the UK balance of payments accounts.

Measuring the current account

The current account balance comprises the balance of trade in goods and services plus net investment incomes from overseas assets. Net investment income arises from interest payments, profits and dividends from external assets located outside the UK. We also add in the net balance of private transfers between countries and government transfers (e.g. UK government payments to help fund the various spending programmes of the European Union).

The net investment income flow for the UK is positive – a reflection of the heavy investment overseas in recent years by British businesses and individuals. The transfer balance is negative – one reason is that the British government is a net contributor to the EU budget.

The current account of the balance of payments

The current account balance is essentially a reflection of whether the British economy is paying its way with other countries. The annual balance is volatile from year to year, because each of the four component parts is subject to wide fluctuations.

	Balance of trade in goods	Balance of trade in services	Net Investment Income	Current transfers	Current account balance
	£ billion	£ billion	£ billion	£ billion	£ billion
1996	-13.7	11.2	0.6	-4.8	-6.7
1997	-12.3	14.1	3.3	-5.9	-0.8
1998	-21.8	14.7	12.3	-8.4	-3.2
1999	-29.1	13.6	1.3	-7.5	-21.7
2000	-33.0	13.6	4.5	-10.0	-24.8
2001	-41.2	14.4	11.7	-6.8	-21.9
2002	-47.7	16.8	23.4	-9.1	-16.5
2003	-48.6	19.2	24.6	-10.1	-14.9
2004	-60.9	25.9	26.6	-10.9	-19.3
2005	-67.3	17.9	29.9	-12.2	-26.6
Source: Office of National Statistics

What are the main questions that concern economists regarding these figures?

• Causation: Why does the UK now run such large trade deficits in goods?
• Consequences: Does it really matter if the British economy is running persistent current account deficits?
• Correction: Which demand and supply-side economic policies are likely to be most effective in improving our trade balances in the years ahead?

The underlying causes of the UK trade deficit

It is useful to group the explanations for the record trade deficit in goods into short-term, medium-term and long-term factors. Some relate to the demand-side of the economy, others to supply-side economic influences

Short-term factors

• Strong consumer demand: Real household spending has grown more quickly than the supply-side of the economy can deliver, leading to a very high level of demand for imported goods and services
• High income elasticity of demand for imports: Evidence suggests that UK consumers have a high income elasticity of demand for overseas-produced goods – demand for imports grows quickly when consumer demand is robust.  Nicholas Fawcett and Michael Kitson in a recent article in the Guardian estimated that the income elasticity is around +2.3 suggesting that a 2% increase in real incomes boosts demand for imports by 4.6%. Because the overseas demand for UK exports rarely keeps pace with the surging demand for imported products, so the trade deficit widens when the economy enjoys a period of consumption-led growth.
• The strong exchange rate has helped to reduce the UK price of imports causing an expenditure-switching effect away from domestically produced output.
• The weakness of the global economy and in particular the slow growth in the Euro Zone has damaged UK export growth. Nearly 60% of UK manufactured goods exports and over 50% of our exports of services are to fellow members of the European Union.

Medium-term factors

• UK trade balances have been affected by shifts in comparative advantage in the international economy – for example the rapid growth of China as a source of exports of household goods and other countries in South-east Asia who have a cost advantage in exporting manufactured products
• The availability of imports from other countries at a relatively lower price inevitably causes a substitution effect from British consumers.

Longer-term factors

• Much of our trade deficit is due to structural rather than cyclical factors
• Our trade performance has been hindered by supply-side deficiencies which impact on the price and non-price competitiveness of British products in global markets - non-price competitiveness factors such as design and product quality are now more important for trade than merely price alone.
  • A relatively low rate of capital investment compared to other countries
  • The persistence of a productivity gap with our major competitors – measured by differences in GDP per person employed or per hour worked – this is linked to low investment and also to the existence of a skills-gap between UK workers and employees in many other countries
  • A relatively weak performance in terms of product innovation – linked to a low rate of business sector spending on research and development
• The UK manufacturing sector has been in long-term decline for more than twenty years. This is known as a process of deindustrialisation. Although we still have some world class manufacturing companies, the size of our manufacturing sector is not large enough both to meet consumer demand in the UK and also to export sufficient volumes of products to pay for a growing demand for imports

What does a current account deficit mean?

Running a sizeable deficit on the current account basically means that the UK economy is not paying its way in the global economy. There is a net outflow of demand and income from the circular flow of income and spending.  The current account does not have to balance because the balance of payments also includes the capital account. The capital account tracks capital flows in and out of the UK. This includes portfolio capital flows (e.g. share transactions and the buying and selling of Government debt) and direct capital flows arising from foreign investment.

The Effects of Changes in the Balance of Payments on the UK Economy

Consider the effects of a slowdown in exports and a faster growth in imports of goods and services caused by a rise in the value of sterling against other currencies that leads to a worsening of the balance of payments. This has further effects on the economy as a whole:

• Reductions in demand in the circular flow:  There will be a net fall in AD because more money is leaving the circular flow of income (through imports) than is coming in from exports. An inward shift of AD would lead to a contraction along the SRAS curve.
• Lost jobs: There will be a loss of employment if exporting industries require less labour and if UK businesses lose market share and output to cheaper imports from overseas.
• Dip in business confidence and investment: A fall in business confidence and a decline in capital investment spending by UK exporting firms whose order books are less full and whose profits take a hit from a fall in demand from overseas.
• Reductions in inflationary pressure: Lower inflation because imports coming into the UK are cheaper and a fall in AD takes the economy further away from full capacity. Reduced inflationary pressure might then persuade the Bank of England to reduce interest rates to provide a boost to macroeconomic activity.

The exchange rate and the balance of payments

Changes in the exchange rate can have a big effect on the balance of payments although these effects are subject to uncertain time lags. When sterling is strong then UK exporters found it harder to sell their products overseas and it is cheaper for UK consumers to buy imported goods and services because the pound buys more foreign currency than it did before.

The Balance of Payments and the Standard of Living

A common misconception is that balance of payments deficits are always bad for the economy. This is not necessarily true. In the short term if a country is importing a high volume of goods and services this is a boost to living standards because it allows consumers to buy more consumer durables. However, in the long term if the trade deficit is a symptom of a weak economy and a lack of competitiveness then living standards may decline.

 

CHAPTER 7

Money, the Interest Rate, and Output:  Analysis and Policy

The Links between the Goods Market and the Money Market

The goods and money markets do not operate independently.  There is a value of output (income) (Y) and a level of the interest rate (r) that are consistent with the existence of equilibrium in both markets.

This chapter examines how monetary and fiscal policies affect the level of output, interest rates, and investment spending.

Link 1:  Income and the Demand for Money

Income, which is determined in the goods market, has considerable influence on the demand for money in the money market.

 

An increase in aggregate output (income) shifts the money demand curve, which raises the equilibrium interest rate from 7 percent to 14 percent.

 

Link 2:  Planned Investment and the Interest Rate

• The interest rate, which is determined in the money market, has significant effects on planned investment in the goods market.

 

When the interest rate falls, planned investment rises,     and when the interest rate rises, planned investment falls (fewer projects are likely to be undertaken).

 

The Interest Rate and Planned Aggregate Expenditure

  An increase in the interest rate   from   3 percent to 6 percent lowers planned aggregate expenditure and thus reduces equilibrium income from Y₀ to Y₁.

 

Money Demand, Aggregate Output (Income), and the Money Market

The equilibrium interest rate is not determined exclusively in the money     market.  Changes in aggregate output (income), which take place in the goods market, shift the money demand curve and cause changes in the interest rate.

 Expansionary Policy Effects 

Expansionary fiscal policy is either an increase in government spending or a reduction in net taxes aimed at increasing aggregate output (income) (Y).

Expansionary monetary policy is an increase in the money supply aimed at increasing aggregate output (income) (Y).

  The Crowding-Out Effect  The tendency for increases in government spending to cause reductions in private investment spending is called the crowding-out effect.

  

 Expansionary Monetary Policy: An Increase in the Money Supply

   An increase in the money supply decreases the interest rate and increases investment and income.

However, the higher level of Y increases the demand for money, and this keeps the interest rate from falling as far as it otherwise would.

    

Effectiveness of Monetary Policy

The effectiveness of monetary policy depends on the shape (or responsiveness) of the investment function.

  The steeper the investment function, the less responsive investment is to changes in interest rates.  This lack of responsiveness may render monetary policy ineffective.

 

Fed Accommodation of an Expansionary Fiscal Policy

  An expansionary fiscal policy (higher government     spending or lower taxes) will increase aggregate output (income), shift the money demand curve to the right, and put upward pressure on the interest rate.

  If the money supply were unchanged, the interest rate would rise.  But if the Fed were to “accommodate” the fiscal expansion, the interest rate would not rise.

 

Contractionary Policy Effects

Contractionary fiscal policy refers to a decrease in government spending or an increase in net taxes aimed at decreasing aggregate output (income) (Y).

 

Contractionary Monetary Policy

Contractionary monetary policy refers to a decrease in the money supply aimed at decreasing aggregate output (income) (Y).

 

Other Determinants of Planned Investment

The determinants of planned investment are: 

• The interest rate
• Expectations of future sales
• Capital utilization rates
• Relative capital and labor costs

      Appendix:  The IS-LM Diagram

The IS-LM diagram is a way of depicting graphically the determination of aggregate output (income) and the interest rate in the goods and money markets.

• The IS curve shows a negative relationship between the equilibrium value of Y and r.
• Each point on the curve represents equilibrium in the goods market for a given value of the interest rate.

    

• The LM curve shows a positive  relationship between the equilibrium value of Y and r.
  • Each point on the curve represents equilibrium in the money market for a given value of aggregate output (income).

The LM curve is upward-sloping because higher income results in higher demand for money and a higher interest rat

   The point at which the IS and the LM curves        intersect  corresponds to the point at which the goods market and the money market are in equilibrium.

• An increase in the money supply shifts the LM curve to the right.
• This increases the value of Y and decreases the value of r.

• It is easy to use the IS/LM diagram to see how there can be a monetary and fiscal policy mix that leads to a particular outcome.
• For example, an increase in the money supply, accompanied by an increase in government spending leads to an increase in aggregate output, with no change in the interest rate.

 

 

 

CHAPTER 6

Money demand, The equilibrium interest rate and Monetary policy

 

What is “the Demand for Money?”

How much money would you like to have? A billion or two? Of course, that is not what we mean by your demand for money! What we do mean by your demand for money is this: how much of your wealth do you wish to keep in the form of money, that is, currency and bank deposits? For example, suppose that the Joneses have $50,000 in financial assets which they divide between investment in bonds and holding money. How are they going to decide how much of their $50,000 to invest in bonds and how much to hold in the form of money, including currency and the balance in their checking account? An investment in bonds pays interest, but currency pays none and the Joneses receive no interest from their bank on their checking account.

Clearly, the opportunity cost of holding money is the rate of interest. If the Joneses keep $1,000, on average, in currency and in their checking account during the year and bonds yield 10%, then it costs the Joneses $100 in foregone interest to hold that $1,000. Why, then, should the Joneses hold any money at all instead of putting all of their wealth into bonds and other assets that will earn a return? For that matter, why does anyone hold any money?

 

Economists have identified three primary motives for holding money:

• To settle transactions, since money is the medium of exchange.

• As a precautionary store of liquidity, in the event of unexpected need.

• To reduce the riskiness of a portfolio of assets by including some money in the portfolio, since the value of money is very stable compared with that of stocks, bonds, or real estate.

  These three motives for holding money are often referred to as the transactions motive, the precautionary motive, and the portfolio motive respectively. Together they provide good reasons for the Joneses to hold some money in their portfolio in spite of the opportunity cost of foregone interest.

Now suppose, hypothetically, that with the interest rate at 20% the Joneses choose to hold $1,000 of their $50,000 in the form of money. What will they do if the interest rate now drops to 5%? With the opportunity cost of holding money reduced, they will very likely choose to increase their money holdings by reducing their bond holdings. After all, it now costs the Jones only 5 cents per year to hold an extra dollar instead of 20 cents, while adding to their holdings of money will give them more of the services that holding money provides. The more currency in your wallet the less frequently you need to stand in line at a cash machine or teller's window. The larger your checking account balance the more readily you can meet unexpected payments, such as buying that suit that is on sale even though your credit card is up to its limit. The larger your cash position, the less worrisome is a fall in the stock market.

As a result of the interest rate falling from 20% to 5% the Joneses might well decide to increase their money holdings, say from $1,000 to $1,500. They would accomplish that increase in their money holdings by selling bonds worth $500 and keeping the money they would be paid. The amount of money demanded by the Joneses would change if their income increased. They would demand more money (at a given level of interest rates) primarily because their transactions and precautionary demands would increase at their new higher level of spending. An increase in their wealth would increase their portfolio demand for money. Even a change of jobs could affect their demand for money. Someone who travels a great deal in a sales position will have a greater precautionary demand for money than someone who stays in town.

We see, then, that a households' demand for money depends on the interest rate, their income, and wealth, among perhaps many other variables. Firms are also holders of money, in their cash registers and bank accounts, for essentially the same basic reasons as households. When we add up the demand for money by all households and firms we have the total demand for money in the economy and that demand will be most importantly a function of the interest rate, income, and wealth in the economy.

The demand for any good or service is usually pictured in economics as a function of its price, holding income and other factors constant. In the case of holding money, the "price" is the opportunity cost of holding one dollar for one year, the interest rate. When we plot the quantity of money demanded on the horizontal axis and the interest rate on the vertical axis, just as we would the quantity of oranges demanded and the price of oranges, we will have a demand curve like the one pictured in Figure 7.1.

Note that the quantity of money demanded is higher when the interest rate is lower, just as the quantity of oranges demanded is higher when the price of oranges is lower. As this hypothetical demand for money has been drawn, the demand for money is $600 billion when the interest rate is 5%, but only $150 billion when it is 20%. This inverse relationship between the interest rate and the demand for money just reflects the fact that when the opportunity cost of holding money is low, people will want to hold more of it, and when it is high people will want to hold less of it.

Notice, too, that at very low levels of the interest rate in Figure 7.1, the quantity of money demanded increases dramatically, meaning that people would then want to hold a very great amount of their wealth in the form of money. And why not hold money instead of bonds when the reward to holding bonds is very, very small? After all, money is more liquid than bonds, and bonds are subject to the risk of price fluctuation that we discussed in Chapter 3.

In contrast, even when the interest rate is very, very high, people will still want to hold some money. Even if it costs 30 cents per year to hold a dollar, we will still hold some dollars because it is even more costly to revert to barter in making transactions. How will the demand for money change when the income and wealth increases? Imagine that over the next decade the economy grows in real terms by 3% per year while inflation averages 4%, so nominal income roughly doubles (Remember how to compute doubling time?). Clearly the quantity of money demanded will rise. Sales at the supermarket will have doubled, reflecting both the greater quantity of goods and higher prices, so the transactions demand for money must roughly double.

          Further, it is likely that rising wealth will also contribute to higher demand for money holdings through the portfolio motive. Indeed, it seems likely that wealth would also roughly double in nominal terms over a decade in which nominal income had doubled. Overall, the quantity of money demanded at any given interest rate will be much higher a decade later under our assumptions, probably about twice its level a decade earlier. We depict this change in the demand for money by shifting the demand curve to the right. In Figure 7.2, the doubling of nominal incomes and wealth doubles the demand for money at any given interest rate. For example, at an interest rate of 5%, the quantity of money demanded is $1,200 billion at the end of the decade, while it was only $600 billion at the beginning of the decade ago when nominal income and wealth were half as great.

Overall, the quantity of money demanded at any given interest rate will be much higher a decade later under our assumptions, probably about twice its level a decade earlier. We depict this change in the demand for money by shifting the demand curve to the right. In Figure 7.2, the doubling of nominal incomes and wealth doubles the demand for money at any given interest rate. For example, at an interest rate of 5%, the quantity of money demanded is $1,200 billion at the end of the decade, while it was only $600 billion at the beginning of the decade ago when nominal income and wealth were half as great.

 

Demand for Money Wrap Up

The demand for money is not at all constant. There are quite a few factors which influence the demand for money.  

Factors Which Increase the Demand for Money

1. A reduction in the interest rate.
2. A rise in the demand for consumer spending.
3. A rise in uncertainty about the future and future opportunities.
4. A rise in transaction costs to buy and sell stocks and bonds.
5. A rise in inflation causes a rise in the nominal money demand but real money demand stays constant.
6. A rise in the demand for a country's goods abroad.
7. A rise in the demand for domestic investment by foreigners.
8. A rise in the belief of the future value of the currency.
9. A rise in the demand for a currency by central banks (both domestic and foreign).

Effects of Expansionary Monetary Policy on Interest Rates

  Expansionary monetary policy refers to any policy initiative by a country's central bank to raise, or expand, its money supply. This can be accomplished with open market purchases of government bonds, with a decrease in the reserve requirement or with an announced decrease in the discount rate. In most growing economies the money supply is expanded regularly to keep up with the expansion of GDP. In this dynamic context, expansionary monetary policy can mean an increase in the rate of growth of the money supply, rather than a mere increase in money. However, the money market model is a non-dynamic (or static) model, so we cannot easily incorporate money supply growth rates. Nonetheless, we can project the results from this static model to the dynamic world without much loss of relevance. (In contrast, any decrease in the money supply, or decrease in the growth rate of the money supply, is referred to as contractionary monetary policy.)

Suppose the money market is originally in equilibrium in the adjoining diagram at point A with real money supply M^S'/P_$ and interest rate i_$' when the money supply increases, ceteris paribus. The ceteris paribus assumption means that we assume all other exogenous variables in the model remain fixed at their original levels. In this exercise it means that real GDP (Y_$) and the price level (P_$) remain fixed. An increase in the money supply (M^S) causes an increase in the real money supply (M^S/P_$) since P_$ remains constant. In the diagram this is shown as a rightward shift from M^S'/P_$ to M^S"/P_$ . At the original interest rate, real money supply has risen to level 2 along the horizontal axis while real money demand remains at level 1. This means that money supply exceeds money demand and the actual interest rate is higher than the equilibrium rate. Adjustment to the lower interest rate will follow the "interest rate too high" equilibrium story.

The final equilibrium will occur at point B on the diagram. The real money supply will have risen from level 1 to 2 while the equilibrium interest rate has fallen from i_$' to i_$". Thus, expansionary monetary policy (i.e., an increase in the money supply) will cause a decrease in average interest rates in an economy. In contrast, contractionary monetary policy (a decrease in the money supply) will cause an increase in average interest rates in an economy.

 

 

 

 

 

 

 

 

 

Chapter 5

The money supply and the central bank

 

The money supply and the central bank

 

          The Money Supply is the sum of all money in particular country. Before going into details we need to define what is money. For thousands of years the mankind has been using commodity money, most notably silver and gold. However most world countries use fiat currencies now, which don't have any intrinsic value, and are subject to the worst of all taxes – inflation. The fiat money supply includes paper bills, coins, and demand deposits. Money supply is measured in several different ways depending on what exactly is considered to be money. 

Money Aggregates

Central bank

          A Central Bank is a financial institution that controls country’s monetary policy, and usually has several mandates including, but not limited to issuing national currency, maintaining the value of the currency, ensuring financial system stability, controlling credit supply, serving as a last-resort lender to other banks and acting as government’s banker. The central bank might be or might not be independent the government. In theory independent central bank, will ensure there is no political influence over the central bank’s policy; however even with the so-called "independent central banks" that is not always the case. 

         Some of the well-known central banks are the US Federal Reserve, Bank of England, Bank of Canada, Reserve Bank of Australia, and the European Central Bank. Some central banks are responsible for single’s country monetary policy, for example the Bank of Canada, while others manage the monetary policy of group of countries like the European Central Bank. There is no single naming convention for central bank’s naming, but usually the name is in one or close to one of the following forms – Bank of [Country], Central Bank of [Country] or National Bank of [Country]. One notable exception here is the US Federal Reserve.                                                                                                     On the surface it appears that central banks have noble goals and work for the greater good, however many people consider the real role of a central banking system to be supporting the fractional-reserve banking system, which enriches the financial elite at the expense of the common people.

Short-term Inst Rates 

         One of the most powerfultere weapons in central banks’ arsenal is the short-term interest rate setting. The short-term interest rate is the overnight interbank lending rate. Lowering the short-term interest rate in effect lowers the cost of credit, thus stimulating people and businesses to borrow in hope to expand the economy. Increasing interest rates, makes borrowing more expensive, and is usually used to control overheating economies and inflation.

Open Market Operations 
         Open market operations are purchases and/or sales of government securities in the open market. Central banks use open market operations to effectively control the money supply – the total amount of money circulating in the country’s economy. Purchasing government securities expands the money supply, while selling them actually contracts the money supply.

 

 

CHAPTER 4

The government and fiscal policy and equilibrium output

Government in the Economy                                                                           

   - Fiscal policy is the government’s spending and taxing policies.                 

- Monetary policy is the behavior of the Bank of Canada regarding the nation’s money supply.                                                                                               

- Discretionary fiscal policy is the changes in taxes or spending that are the result of deliberate changes in government policy

Disposable Income                                                                                             

  - Net taxes are taxes paid by firms and households to the government minus transfer payments made to households by the government.                          

  - Disposable income or after-tax income (Yd) is total income minus net taxes:>Yd = Y - T                  

Aggregate Expenditures with Government                                                      

    Yd = Y - T 

          Yd = C + S

          Y - T = C + S

          Y = C + S + T

          AE = C + I + G

 

Government Budget Surplus/Deficit                                                                           

- Budget deficit is the difference between what a government spends and what it collects in net taxes in a given period: G – T

-Budget surplus is net taxes minus government purchases: T - G. Also called the budget balance.

 

Consumption with Government                                                                       

  Instead of C = a + bY

          we have C = a + bYd

                        or

              C = a + b (Y - T)

 

Finding Equilibrium Output                                                                             

Since equilibrium occurs where Y = AE and

                             AE = C + I + G

          the equilibrium condition is Y = C + I + G.

                   From the example:

                   C = 100 + 0.75Yd or C = 100 + 0.75(Y - T)

          We add to this the assumptions that government spending is 100 billion, net taxes are 100 billion and planned investment is 100 billion.

 

(1)	(2)	(3)	(4)	(5)	(6)	(7)	(8)	(9)	(10)
OUTPUT (INCOME)      Y	NET TAXES T	DISPOSABLE INCOME          Yd = Y - T	CONSUMPTION SPENDING (C = 100 + .75 Yd)	SAVING S (Yd – C)	PLANNED INVESTMENT SPENDING I	GOVERNMENT PURCHASES G	PLANNED AGGREGATE EXPENDITURE  C + I + G	UNPLANNED INVENTORY CHANGE Y - (C + I + G)	ADJUSTMENT TO DISEQUILI- BRIUM
300	100	200	250	-50	100	100	450	-150	Output ↑
500	100	400	400	0	100	100	600	-100	Output ↑
700	100	600	550	50	100	100	750	-50	Output ↑
900	100	800	700	100	100	100	900	0	Equilibrium
1,100	100	1,000	850	150	100	100	1,050	+50	Output ↓
1,300	100	1,200	1,000	200	100	100	1,200	+100	Output ↓
1,500	100	1,400	1,150	250	100	100	1,350	+150	Output ↓

 

Government Spending Multiplier                                                                      

- The government spending multiplier is the ratio of the change in the equilibrium level of output to a change in government spending.

        - If the government wishes to increase output by a certain level, for instance 200 billion, to reduce unemployment, it would not need to increase government spending by the same amount because of the multiplier.              

       - Government spending is a component of autonomous expenditure, similar to investment. Therefore the government spending multiplier is equal to 1 / MPS.

      - In C = 100 + 0.75Yd the MPS is equal to 0.25 (1 - MPC) and the multiplier equal to 4.

       - To increase equilibrium output by 200 billion the government would only have to increase spending by 200/4 = 50 billion.

 

The Tax Multiplier                                                                                            

 - The tax multiplier is the ratio of change in the equilibrium level of output to a change in taxes.

        - The multiplier for a change in taxes is not the same as the multiplier for a change in government spending.                                                   

 - Taxes do not directly impact spending like government spending does, rather they influence disposable income, which influences the household’s consumption (which is part of total spending).

                 AY = (Initial increase in aggregate expenditure) x 1/MPS

Since the initial change in AE caused by AT is equivalent to - AT x MPC

     AY = (- AT x MPC) x (1/MPS) = - AT x (MPC/MPS)

so the Tax Multiplier (AY/AT) = - (MPC/MPS)

 

Balanced-Budget Multiplier                                                                               

- The balanced -budget multiplier is the ratio of change in equilibrium level of output to a change in government spending where the change in government spending is balanced by a change in taxes so as not to change the

surplus or deficit.

-The balanced -budget multiplier is equal to 1: the change in Y resulting from the change in G and the equal change in T is exactly the same size as the initial change in G or T itself.

Adding the International Sector                                                                        

- The models presented so far have been in a closed economy without trade.

       -In an open economy net exports (exports - imports) are added to output.

                                                Y = C + I + G + (EX - IM)

          -If (EX - IM) is equal to zero then the expression can be omitted.

 

The Leakages/Injections Approach to Equilibrium

                             For equilibrium Y = AE

          Y = C + S + T and AE = C + I + G + EX - IM

                          C + S + T = C + I + G + EX - IM

                               S + T = I + G + EX - IM

                               S + T + IM = I + G + EX

                          LEAKAGES = INJECTIONS

 

Federal Budget

-The federal budget is the budget of the federal government, listing in great detail all the things the government plans to spend money on and all the sources of government revenues for the coming year.

 

 

 

 

CHAPTER 3

Aggregate Expenditure and Equilibrium Output

 

Aggregate Output and Aggregate Income (Y)

          One way of measuring the output of the economy, real GDP, is to add up all the spending by households, businesses, government, and foreigners on domestically produced goods and services. As a result, changes in spending by any of these groups can affect real GDP and, consequently, unemployment.

In this lecture, we will focus on spending by households and firms. We will develop a framework that illustrates how changes in spending affect the economy. In the next chapter, we will add government spending and spending by the rest of the world to this framework.

Aggregate Output and Aggregate Income (Y) 

Let us quickly review a few basic concepts before we move on. Recall that the aggregate output of an economy is all of the goods and services the economy produces. Real GDP is one measure of this output. Because it controls for changes in prices, an increase in real GDP means the amount of goods and services produced in an economy has increased. Fluctuations in real GDP define the oscillation of the economy between recessions and expansions. As such, we are interested in the real aggregate output of the economy: real GDP.

We also learned that the expenditures by one component of the economy means income for another component. Recall that real GDP can also be measured by adding up all the income for different groups in the economy. Real GDP, therefore, is a measure of both the aggregate output and aggregate income for an economy. We will refer to aggregate income with the symbol Y.

Income, Consumption, and Saving (Y, C, and S) 

Households receive income from wages, interest, rental payments made to them, and other sources. What do they do with this income? There are two basic choices: they can spend it or save it. The amount that households spend during some period of time is called consumption. The remaining income can be saved. The amount that households save during some time period is called saving.

Income that households do not consume (C) will be saved (S). The marginal propensity to save (MPS) is the fraction of additional income (Y) spent on savings (S) and can be written as:

S=Y-C

marginal propensity to save (MPS) = ∆S/∆Y

In our earlier example, the MPC equaled 0.75. With an additional $1 billion, $750 million will go to C and the remainder ($250 million) will go to S. In other words, when MPC = 0.75, then MPS = 0.25. This relationship between MPC and MPS can be written as:

  The relationship between saving and consumption can be illustrated with the aggregate consumption function figure we saw earlier. One feature will be added to it: a 45o line. With the numbers along each axis being the same, a 45o line has a very useful feature. At every point along the 45o line, the values on one axis are equal to the values along the other axis. 

  All along the 45o line, aggregate consumption (vertical axis) equals aggregate income (horizontal axis). Note that the aggregate consumption line crosses the 45o line at $400 billion. That means when aggregate income equals $400 billion, aggregate consumption also equals $400 billion.

Think again about saving. When aggregate income and aggregate consumption are both $400 billion, all income goes toward consumption and there is no saving. When aggregate income exceeds aggregate consumption, the extra income goes toward saving and saving is positive. Consider the point in the figure when aggregate income is $800 billion, aggregate consumption is $700 billion. At this level of income, there will be $100 billion in saving.

When income is less than consumption, there is dissaving and saving is negative. In the figure, such a point occurs at an aggregate income level of $200 billion.

Aggregate Output and Aggregate Income  Planned Investment (I) & Planned Aggregate Expenditure (AE)

The aggregate savings on the part of households in the economy provide the money for investment. Recall that investment is the building of new factories, the purchases of new equipment, as well as additions to inventories. While buying corporate stocks and bonds, money market funds, and other saving alternatives is not considered to be investment, the use of those funds by firms to buy new plants and equipment, or to build up inventories, is considered investment.

Unlike consumption spending by households, however, investment is not completely under the control of firms. The building up or drawing down of inventories can occur, unplanned, when consumers buy more or fewer products than firms anticipated.

REALITY CHECK: For example, if Microsoft plans on selling 50 million copies of Windows 2000 and produces that many, but consumers only purchase 40 million copies, inventories of Windows 2000 will be larger than planned.

The amount of new plants, equipment and inventory that is planned by firms is called desired or planned investment. The actual amount spent on plants, equipment and actual investment, including any unplanned additions or drawdown of inventories, is called actual investment. The amount of planned and actual investment in an economy depends on a host of factors. We will take these up in later lectures. For now, however, we will make the assumption that the amount of actual investment is fixed. This means that it does not vary with the level of income, changes in expectations, or any of a host of other factors. This will keep things simpler until we get used to this framework for analyzing the economy. In the figures we will use for the rest of this lecture, investment is assumed to be fixed at $25 billion. This is shown by the following figure:

 

Planned Aggregate Expenditure (AE) 

Planned aggregate expenditure (AE) is the total amount that the economy plans to spend in a given period. It is defined as being identical to consumption plus planned investment.

 

 

 

 

 

CHAPTER 2

Measuring National Output and National Income

 

Measures of national income and output

    A variety of measures of national income and output are used in economics to estimate total economic activity in a country or region, including gross domestic product (GDP), gross national product (GNP), and net national income (NNI). All are especially concerned with counting the total amount of goods and services produced within some "boundary". The boundary may be defined geographically, or by citizenship; and limits on the type of activity also form part of the conceptual boundary; for instance, these measures are for the most part limited to counting goods and services that are exchanged for money: production not for sale but for barter, for one's own personal use, or for one's family, is largely left out of these measures, although some attempts are made to include some of those kinds of production by imputing monetary values to them. Mr. Ian Davies defines development as 'Simply how happy and free the citizens of that country feel.

National accounts

    Arriving at a figure for the total production of goods and services in a large region like a country entails a large amount of data-collection and calculation. Although some attempts were made to estimate national incomes as long ago as the 17th century, the systematic keeping of national accounts, of which these figures are a part, only began in the 1930s, in the United States and some European countries. The impetus for thcs, which prescribed a greater role for the government in managing an economy, and made it necessary for governments to obtain accurate information so that their interventions into the economy could proceed as much as possible from a basis of fact.

Market value 

    In order to count a good or service it is necessary to assign some value to it. The value that the measures of national income and output assign to a good or service is its market value – the price it fetches when bought or sold. The actual

the economy on an industry-by-industry basis. The expenditure method is based on the idea that all products are bought by somebody or some organisation.

1. The income method works by summing the incomes of all producers within the boundary.

The output approach 

    The output approach focuses on finding the total output of a nation by directly finding the total value of all goods and services a nation produces.

Formulae:

    GDP (gross domestic product) at market price = value of output in an economy in a particular year - intermediate consumption

    NNP at factor cost = GDP at market price - depreciation + NFIA (net factor income from abroad) - net indirect taxes

The income approach

    The income approach equates the total output of a nation to the total factor income received by residents of the nation. The main types of factor income are:

• Employee compensation (= wages + cost of fringe benefits, including unemployment, health, and retirement benefits).
• Interest received net of interest paid.
• Rental income (mainly for the use of real estate) net of expenses of landlords.
• Royalties paid for the use of intellectual property and extractable natural resources.

Formulae:

    NDP at factor cost = Compensation of employees + Net interest + Rental & royalty income + Profit of incorporated and unincorporated firms + Income from self-employment.

    National income = NDP at factor cost + NFIA (net factor income from abroad) - Depreciation.

The expenditure approach

    The expenditure approach is basically an output accounting method. It focuses on finding the total output of a nation by finding the total amount of money spent. This is acceptable, because like income, the total value of all goods is equal to the total amount of money spent on goods. The basic formula for domestic output combines all the different areas in which money is spent within the region, and then combining them to find the total output.

GDP = C + I + G + (X - M)

    Where:
C = household consumption expenditures / personal consumption expenditures
I  = gross private domestic investment
G = government consumption and gross investment expenditures
X = gross exports of goods and services
M = gross imports of goods and services

Note: (X - M) is often written as X_N, which stands for "net exports"

 

 

GDP and GNP

    Gross domestic product (GDP) is defined as "the value of all final goods and services produced in a country in 1 year. Gross National Product (GNP) is defined as "the market value of all goods and services produced in one year by labor and property supplied by the residents of a country.

National income and welfare

    GDP per capita (per person) is often used as a measure of a person's welfare. Countries with higher GDP may be more likely to also score highly on other measures of welfare, such as life expectancy. However, there are serious limitations to the usefulness of GDP as a measure of welfare:

• Measures of GDP typically exclude unpaid economic activity, most importantly domestic work such as childcare. This leads to distortions; for example, a paid nanny's income contributes to GDP, but an unpaid parent's time spent caring for children will not, even though they are both carrying out the same economic activity.
• GDP takes no account of the inputs used to produce the output. For example, if everyone worked for twice the number of hours, then GDP might roughly double, but this does not necessarily mean that workers are better off as they would have less leisure time. Similarly, the impact of economic activity on the environment is not measured in calculating GDP.
• Comparison of GDP from one country to another may be distorted by movements in exchange rates. Measuring national income at purchasing power parity may overcome this problem at the risk of overvaluing basic goods and services, for example subsistence farming.
• GDP does not measure factors that affect quality of life, such as the quality of the environment (as distinct from the input value) and security from crime. This leads to distortions - for example, spending on cleaning up an oil spill is included in GDP, but the negative impact of the spill on well-being (e.g. loss of clean beaches) is not measured.
• GDP is the mean (average) wealth rather than median (middle-point) wealth. Countries with a skewed income distribution may have a relatively high per-capita GDP while the majority of its citizens have a relatively low level of income, due to concentration of wealth in the hands of a small fraction of the population.