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Chapter 20

Introduction to macroeconomics

and national income accounting

David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,

6th Edition, McGraw-Hill, 2000

Power Point presentation by Peter Smith

20.1

Macroeconomics is

about economic issues as in

–a measure of the number of people looking for

work, but who are without jobs

Output

–real gross national product (GNP) measures

total income of an economy

it is closely related to the economy's total output

More key issues in macroeconomics

–increases in real GNP, an indication of

the expansion of the economy’s total

output

–a variety of policy measures used by

the government to affect the overall

performance of the economy

The circular flow of income,

expenditure and output

Y

C + I I

C

S

B - T d

Y + B - T d

20.13

Adding the foreign sector

To incorporate the foreign sector into

the circular flow

country will buy imports from abroad

and that domestic firms will sell

(export) goods and services abroad.

20.14

GDP and GNP

–measures the output produced by

factors of production located in the

domestic economy

–measures the total income earned by

domestic citizens

GNP = GDP + net income from abroad

–the sum of output (value added)

produced in the economy

Deprec'n

National income

Indirect taxes

Wages and salaries

employment

Self-Profits, rents

20.17

What GNP does and does not measure

–to distinguish between real and nominal

measurements

–to take account of population changes

–to remember that GNP is not a

comprehensive measure of everything

that contributes to economic welfare

Chapter 21

The determination of national income

David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,

–the output the economy would produce

if all factors of production were fully

employed

–what is actually produced in a period

–which may diverge from the potential

level

21.2

Some simplifying assumptions

The actual quantity of total output is

demand-determined

–this will be a “Keynesian” model

–no government

–no foreign trade

Later chapters relax these assumptions

Aggregate demand

international trade, aggregate

demand has two components:

–Investment

firms’ desired or planned additions to

physical capital & inventories

for now, assume this is autonomous

between CONSUMPTION and

SAVING

–income that households have for

spending or saving

–income from their supply of factor

services (plus transfers less taxes)

The consumption function

Income

C = 8 + 0.7 Y

The consumption function shows desired aggregate

consumption at each level of aggregate income

0

With zero income, desired consumption

is 8 (“autonomous consumption”).

for each additional £1 of income, 70p is consumed.

Since all income is either saved or spent on consumption, the saving function can be derived from the consumption function or

function or vice versa vice versa.

to spend on consumption and what firms plan to spend on investment.

AD = C + I

II

The AD function is the vertical addition

of C and I.

(For now I is assumed autonomous.)

Equilibrium output

Output, Income

45oline The 45 o line shows the

points at which desired spending equals output

or income.

AD

Given the AD schedule,

This the point at which planned spending equals actual output and income.

Notice that the change in equilibrium output is

larger than the original change in AD.

The multiplier

The multiplier is the ratio of the

change in equilibrium output to the

change in autonomous spending that

causes the change in output.

consume, the larger is the multiplier.

–The higher is the marginal propensity to

save, the more of each extra unit of

income “leaks” out of the circular flow.

Chapter 22

Aggregate demand, fiscal policy,

and foreign trade

David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,

–government actions to try to keep output close

to its potential level

position of the AD schedule

Fiscal policy?

Income, output

AD 1

This seems to suggest that the government could influence aggregate output in the economy

but in surplus at high levels

then the budget will be in

deficit at low levels of

income

The government budget

The budget deficit equals total government spending

minus total tax revenue.

The balanced budget multiplier states that an increase in

government spending plus an equal increase in taxes leads

to higher equilibrium output.

Balanced budget

22.5

Deficits and the fiscal stance

The size of the budget deficit is not a good

measure of the government’s fiscal

stance.

The structural budget shows what the

budget would have been if output had

been at the full-employment level.

The inflation-adjusted budget uses real

not nominal interest rates to calculate

government spending on debt interest.

Automatic stabilizers

reduce the response of GNP to

shocks

–for example, in a recession:

–payments of unemployment benefits

rise

–and receipts from VAT and income tax

fall

22.7

Limits on active fiscal policy

Time lags: it takes time

– to diagnose the problem

– to take action

– for the multiplier process to operate

Uncertainty

– the size of the multiplier is not known

– aggregate demand is always changing

Induced effects on autonomous demand

– changes in fiscal policy may induce offsetting effects in

other components of aggregate demand

Why can’t shocks to aggregate demand

immediately be offset by fiscal policy?

22.8

Limits on active fiscal policy (2)

The budget deficit

– concern about inflation if the budget deficit

grows

Maybe we’re at full employment!

– unemployment may be (at least partly)

voluntary

Why doesn’t the government expand fiscal

policy when unemployment is persistently high?

Foreign trade

and income determination

Introducing exports (X) & imports (Z)

–when exports exceed imports

–Y = C + I + G + X - Z

22.10

At higher income levels, there is a trade deficit.

At relatively low income,

exports exceed imports – there is a trade surplus.

Exports, imports and the trade balance

Income

but that imports increase

with income

Imports Assume that exports

are independent of

income,

Exports

There is trade balance at income Y*, but there is no

guarantee that this corresponds to full employment.

Y*

22.11

Foreign trade and the multiplier

– is the fraction of additional income that

domestic residents wish to spend on

additional imports.

The effect of foreign trade is to

reduce the size of the multiplier

–the higher the value of the marginal

propensity to import, the lower the

value of the multiplier.

Chapter 23

Money and modern banking

David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,

6th Edition, McGraw-Hill, 2000

Power Point presentation by Peter Smith

23.1

Some key questions

influence money supply?

with the “real” economy?

money and interest rates?

23.2

Money

payment for delivery of goods or the

Money and its functions

Medium of exchange

–money provides a medium for the exchange of goods

and services which is more efficient than barter

Unit of account

–a unit in which prices are quoted and accounts are kept

Store of value

–money can be used to make purchases in the future

Standard of deferred payment

–a unit of account over time: this enables borrowing and

lending

23.4

Modern banking

A financial intermediary

–an institution that specializes in bringing

lenders and borrowers together

e.g a commercial bank, which has a government

licence to make loans and issue deposits

including deposits against which cheques can be

written

Clearing system

–a set of arrangements in which debts between

banks are settled

23.5

A beginner’s guide to the financial markets

Financial asset

–a piece of paper entitling the owner to a

specified stream of interest payments over a

specified period

–Notes and coin, paying no interest

–the most liquid of all assets.

Bills

–financial assets with less than one year until

the known date at which they will be

repurchased by the original owner

–highly liquid

A beginner’s guide to the financial markets

(continued)

Bonds

–longer term financial assets – less liquid because there

is more uncertainty about the future income stream

Perpetuities

–an extreme form of bond, never repurchased by the

original issuer, who pays interest forever

e.g Consols

Gilt-edged securities

–government bonds in the UK

Industrial shares (equities)

–entitlements to receive corporate dividends

– not very liquid

23.7

Credit creation by banks

a proportion of assets as cash

%

Public cash holding

Money supply

–the quantity of notes and coin in private

circulation plus the quantity held by the

banking system

–the change in the money stock for a £1

change in the quantity of the monetary

base

23.10

The money multiplier

Suppose the banks wish to hold cash reserves R as

as fraction (c b ) of deposits (D), and the private sector

wish to hold cash (C) as a fraction (c p ) of bank

The central bank

acts as banker to the commercial

Two key tasks:

and the government.

The Bank and the money supply

influence money supply:

– Reserve requirements

central bank sets a minimum ratio of cash reserves

to deposits that commercial banks must meet

– Discount rate

the interest rate that the central bank charges when

the commercial banks want to borrow

setting this at a penalty rate may encourage

commercial banks to hold more excess reserves

– Open market operations

actions to alter the monetary base by buying or

selling financial securities in the open market

The repo market

agreement

– e.g a bank sells you a gilt with a simultaneous

agreement to buy it back at a specified price at

a specified future date.

– this uses the outstanding stock of long-term

assets (gilts) as backing for new short-term

loans

out open market operations

24.4

Other functions of the Bank of England

– the Bank stands ready to lend to banks and

other financial institutions when financial

panic threatens

– the Bank ensures that the government can

meet its payments when running a budget

The demand for money

The opportunity cost of holding

money is the interest given up by

holding money rather than bonds.

People will only hold money if there

is a benefit to offset that opportunity

cost.

– payments and receipts are not perfectly

synchronized:

so money is held to finance known transactions

depends upon income and payment arrangements

– people dislike risk

– so may hold money as a low-risk component

of a mixed portfolio

depends upon opportunity cost (the nominal interest

rate)

– people may hold money rather than bonds

– if bond prices are expected to fall

– i.e the interest rate is expected to rise

depends upon the rate of interest and on

expectations about bond prices

The demand for money: summary

The demand for money is a demand

for real money balances

It depends upon:

cost of holding money)

Money market equilibrium

Real money holdings

LL

Other things being equal, the demand for real money balances will be lower when the opportunity cost (the rate

of interest) is relatively high.

The position of this schedule depends upon real income and the price level.

When money supply is L 0 , money market equilibrium

occurs when the rate of interest is at r 0

L 0

r 0

24.10

Reaching money market equilibrium

Real money holdings

r 1 there is excess demand for money (the distance AB )

This implies an excess supply of bonds – which reduces the price

of bonds and thus raises the rate of interest until equilibrium

Given the money demand schedule:

The central bank can

EITHER set the interest rate at r 0 and allow money supply to adjust to L 0

OR set money supply at L 0 and allow the market rate

of interest adjust to r 0

BUT cannot set both money supply and interest rate independently.

the authorities know the shape and

position of money demand

problematic

– and the Bank of England has preferred to work

via interest rates

relationship between the interest rate and

the exchange rate

24.13

Targets and instruments of

monetary policy

– the variable over which the central bank

exercises day to day control

– e.g interest rate

– the key indicator used as an input to frequent

decisions about when to set interest rates

reliability of money supply as an indicator

– and central banks increasingly use inflation

forecasts as the intermediate target

Bringing together the real and financial sectors

Having seen equilibrium in the goods

and money markets separately,

it is now time to explore the links

and real sectors

– because interest rates can be seen to influence

consumption.

A modern theory of consumption

developed by Milton Friedman

planned consumption even if income

fluctuates

Consumption depends upon

permanent not transitory income.

The life-cycle hypothesis

A theory of consumption developed by Ando and Modigliani.

Permanent

income

Thus wealth and interest rates may influence consumption.

Income varies over an individual's lifetime.

Actual

income

Ricardian equivalence

Individuals will react to a shock such

as a tax change in different ways,

depending on whether changes are

seen to be temporary or permanent.

If the government cut taxes today,

but individuals realise this will have

to be balanced by higher taxes in the

future, then present consumption

may not adjust.

Trans Other mc/eq Dwellings Other build Intangible

Source: Economic Trends Annual Supplement, Monthly Digest of Statistics

25.8

The demand for fixed investment

Investment entails present sacrifice

for future gains

Expected returns must outweigh the

opportunity cost if a project is to be

undertaken

so at relatively high interest rates,

less investment projects are viable.

… shows how much investment firms wish to

undertake at each interest rate.

Investment demand

II

At relatively high interest rates, less investment projects are viable.

At r 0 , I 0 projects are viable.

r 0

I 0

but if the interest rate rises to r 1 , desired investment falls to I 1

r 1

I 1

25.10

Interest rates and aggregate demand

The position of the AD schedule is

now seen to depend upon interest

rates through the effects on

I 0

A fall in interest rates shifts the consumption function to CC 1 , and leads to higher investment at I 1

CC 1

I 1

Aggregate demand rises

to AD 1 , and the new

AD 1

Y 1

AD 1

Initially, equilibrium moves to Y 1

Y 1

But higher income raises money demand, so interest rates rise and consumption and investment fall, shifting AD back to AD 2 and equilibrium income to Y 2

AD 2

Y 2

25.13

Goods market equilibrium

The goods market is in equilibrium

when the aggregate demand and

actual income are equal

The IS schedule shows the different

combinations of income and interest

rates at which the goods market is in

at which the goods market

is in equilibrium.

AD 1

At a lower interest rate r 1

Consumption, investment and AD are higher.

r 1

The money market is in equilibrium

when the demand for real money

balances is equal to the supply.

The LM schedule shows the different

combinations of income and interest

rates at which the money market is in

At income Y 0 , money demand is at LL 0 and equilibrium

in the money market requires an interest rate of r 0

The LM schedule traces out the combinations of real income

and interest rate in which the money market is in equilibrium.

Shifting IS and LM schedules

The position of the IS schedule

depends upon:

shifts aggregate demand: e.g.

LM and the LM schedule (showing money market equilibrium).

Y*

r*

We can identify the unique combination of real income and interest rate (r*, Y*) which ensures overall equilibrium.

A bond-financed increase in government spending shifts the IS

by the increase in the rate of interest.

LM1 An increase in money supply shifts the LM schedule to the right.

Y 1

r 1

Equilibrium is now

at r 1 , Y 1

Income

r

Demand management is the use of monetary and fiscal policy

to stabilize the level of income around a high average level.

IS 1

LM1

policy (IS 1 ) with ‘tight’

monetary policy (LM 1 ).

This affects the private:

public balance of spending

in the economy.

25.22

But

The IS-LM model seems to offer

government a range of options for

influencing equilibrium income.

the price level and inflation

the supply-side of the economy

the exchange rate