Long-run aggregate supply, however, can shift if the potential national income shifts. When potential national income increases, this brings the equilibrium price level down, and the equilibrium level of GDP up in the long run. Neoclassical economists believe that policies which intend to bring real economic growth and betterment should focus on shifting potential national income to the right (increasing it): they believe that policies which only focus on increasing aggregate demand merely cause price-inflation in the long run.
So, for a classical economist, instead of using short term fiscal policy "gap-busting" to correct short term deviations from potential national income (boosting or reducing government expenditures to correct recessionary and inflationary gaps), policies should focus on brining potential national income forward, and closing the gap through increased potential economic growth! We call this SUPPLY-SIDE ECONOMICS
SO... let's say that an economy is in an inflationary state... there are a few things which policy-makers can do to fix this
1: They can do nothing. The chain and anchor system of long term economic adjustment will make wages higher, which shifts AS to the left and brings the economy back to Y*, but with a higher price level
2: The government could engage in some "gap-busting" policies (ie: they could raise taxes and decrease expenditures to kick aggregate demand back to the left, which would bring equilibrium GDP back to its potential levels)
3: The government could focus on increasing long run aggregate supply. This is also called Reaganomics: some policies in with vein include cutting personal income taxes (which increases incentives to work), cutting corporate income taxes (which increases production and investment). This shifts LRAS to the right to close the gap, and arguably, there is no negative effect on overall tax revenues, despite these cuts (because the increased long run equilibrium national income creates a larger tax base, so the government is still able to generate the same amount of revenue, despite taxing at lower rates).
CRITICISMS of SUPPLY SIDE ECONOMICS
Although these sorts of policies may increase LRAS, critics note that decreases in personal income tax also increase disposable income, which drives consumption upward. Also, decreases in corporate income tax are likely to cause corporations to increase their levels of investment. Thus, while LRAS will shift to the right, aggregate demand will also shift to the right, and the inflationary gap will persist, even if the economy's productive potential grows. This means that economies where supply side economic policies are instated will experience EVEN LARGER price inflation.
FISCAL POLICY
There are two different models we use for the economy: the short run model and the long run model. These two models are very different.
Fiscal policies which are based on the long run model is focused on increasing economic growth by increasing either labour, capital, or technology. These are factors which cause the potential national income to shift, and thus, they create long-run changes in economic potential.
The short run model, on the other hand, deals with temporary fluctuations in the economy which causes GDP to fall above or below potential: this is the economy model which is centered around the business cycle. Most policies in this vein are based around gap-busting, or eliminating recessionary and inflationary gaps.
It is not particularly difficult to determine the direction of the shift which must be kickstarted by fiscal policies: rather, it is the mixture and the magnitude which is hard to determine (for an example, if lowering taxes is likely to eliminate a recessionary gap, the question which the government must ask is how much of a tax cut should be given, how long should these cuts persist for, and which taxes should be affected by the cut).
STABILIZATION POLICY
-This is meant to damped the fluctuations caused by the business cycle
-This reduces the amplitude of the fluctuations (so recessionary and inflationary gaps are less extreme)
-This is GAPBUSTING!
While the automatic economic adjustment which occurs thanks to natural wages shifts WILL bring economies back to potential GDP, one problem is that the natural adjustment process can take a very long time, and while the economy is adjusting to reduce a recessionary gap, unemployment will be high, and the economy will remain unproductive for a long while. Government stabilization policies can fix recessionary gaps a lot more quickly by increasing government expenditures and decreasing taxation. This boosts aggregate demand, and shifts equilibrium GDP back to Y* a lot more quickly than the natural AS shift to the right would have.
Contractionary fiscal policy works in a very similar way: if there is an inflationary gap, the government increases taxation and decreases government expenditure to shift aggregate demand to the right, thus bringing equilibrium GDP back to Y* much faster than the natural AS shift to the left would have.
THE PARADOX OF THRIFT!
In a recession, the natural tendency is for individuals to increase savings: while such prudent actions may benefit individuals, on a larger aggregate level, frugality decreases consumption, and therefore, it also reduces aggregate expenditures, aggregate demand, and GDP as a whole. As a result, this psychological tendency towards thriftiness in a recession can exacerbate recessionary gaps. A historical example of this occurred in the great depression when governments actually RASIED taxes as a response to the hard economic times.
Note* this negative economic result of savings only really applies to the short run: in the short run, increased savings means decreased consumption, and therefore decreased aggregate demand. In the long run, however (as we will learn in the next chapter), an increase in savings facilitates an increase in investment, which leads to a higher aggregate demand.
AUTOMATIC FISCAL STABILIZATION: This refers to built-in tax and expenditure rates which automatically stabilize the business cycle without the government having to specifically set up any policies
-Basically, tax 'n spend systems decrease the simple multiplier, so injections and withdrawals from the economy create smaller shifts in GDP.
-Automatic stabilization can be represented by the slope of the budget function (as GDP increases, there are more withdrawals from the economy)
-Discretionary stabilization (ie: expansionary and contractionary policies) can be represented by a shift in the budget function (so governments are taxing and spending at different rates for the same national income rate)
-Taxes aren't the only automatic stabilizer: other ones include employment insurance and welfare payments (which are forms of withdrawals or expenditures)
ONE FINAL IMPORTANT THOUGHT: WHY ARE ECONOMISTS SO LEERY ABOUT FISCAL STABILIZATION POLICY???
Why not just increase expenditures and lower taxes to fight unemployment???
Wellll....
There can be policy lags- so by the time a budgetary policy gets through the political process and takes effect, it may already be obsolete, or even counter-productive (remember, stabilization policy is extremely time-sensitive)
Also, economists recognize that many households are not "fooled" by short term changes in tax structures. Many households base their spending on what they believe their long term incomes are going to be (as Milton Friedman predicted), so short term changes in taxation which temporarily boosts income may not cause changes in spending habits.
Finally, most economists believe that fiscal policy creates too broad and general a change in the economic environment to fine tune an economy for optimal performance. While stabilization policy may be useful when large, sweeping economic changes are required, many economists believe that it is unnecessary overkill for small economic imbalances which will correct themselves.
THE LONG TERM EFFECTS OF FISCAL POLICY
While increased government purchases lead to increased AE, AD, and GDP in the short run, in the long run, they may "crowd out" private-sector consumption and investment
Similarly, while decreased taxes may increase AE, AD, and GDP in the short run, the long run effect is less clear. On the one hand, some economists believe that decreased taxes may increase investment and incentive to work in the long run, thus drumming up GDP. On the other hand, some economists believe that decreased taxes may crowd out public spending on public goods (case and point, check out Alberta's decaying public infrastructure)
Wednesday, February 17, 2010
Friday, February 12, 2010
Supply Shocks and Other Important Things!
SUPPLY SHOCKS: These also correct themselves in the long-run, but unlike demand shocks, these do not cause any net changes in the price level.
NEGATIVE SUPPLY SHOCK
-Let's say that the cost of oil rises: this shifts AS to the left, which decreases overall economic output and increases the price level.
-There is now a recessionary gap in the economy, and this will cause unemployment to rise
-As unemployment rises, firms can get away with paying their workers less, so wages fall
-Because wages are a cost, production costs fall, and this shifts aggregate supply to the right, back to equilibrium
-Ultimately, the economy is right back where it started at: there is NO NET CHANGE
POSITIVE SUPPLY SHOCK
-Let's say that a new technology emerges which lowers the price of electricity: this shifts AS to the right, which increases overall economic output and decreases the price level
-There is now an inflationary gap in the economy, and this will cause unemployment to fall below its natural level
-As unemployment falls wages rise (overtime and worker retention)
-Because wages are a cost, production costs rise, and this shifts aggregate supply to the left, back to equilibrium
-Ultimately, the economy is right back where it started at: there is NO NET CHANGE
BUT, just because the economy is the same, this doesn't mean that wealth doesn't shift. In the event of a negative supply shock wealth tends to shift from the workers to the capital owners (so workers are paid less, and company owners make more money)
------------------------------
SHOCKS AND THE BUSINESS CYCLE
Positive supply and demand shocks cause GDP to rise above it's potential level for a period of time, and then to fall back to potential (because inflationary gaps cause decreased unemployment, higher wages, and increased factor prices)
THESE SHOCKS ARE RANDOM...
SO:
The economy's adjustment system accounts for these random shocks, and basicaly incorporates them into business cycles (short term fluctuations of the economy)
--------------------------
LONG RUN AGGREGATE SUPPLY: This is the relationship between price and GDP after changes in input prices have been taken into account. LRAS is the result of automatic adjustments which bring GDP back to its potential level. LRAS is also called classical aggregate supply, because classical economists assumed that the economy has an automatic tendency to return to Y*
LRAS, graphically, is a vertical line at Y*, because the amount of goods produced at the normal utilization rate is Y*
The only thing which this can be used to demonstrate is price changes: as long as factor prices rise by the same proportion as output prices, then Y*remains constant
----------------------------
SHIFTING Y*
NEGATIVE SUPPLY SHOCK
-Let's say that the cost of oil rises: this shifts AS to the left, which decreases overall economic output and increases the price level.
-There is now a recessionary gap in the economy, and this will cause unemployment to rise
-As unemployment rises, firms can get away with paying their workers less, so wages fall
-Because wages are a cost, production costs fall, and this shifts aggregate supply to the right, back to equilibrium
-Ultimately, the economy is right back where it started at: there is NO NET CHANGE
POSITIVE SUPPLY SHOCK
-Let's say that a new technology emerges which lowers the price of electricity: this shifts AS to the right, which increases overall economic output and decreases the price level
-There is now an inflationary gap in the economy, and this will cause unemployment to fall below its natural level
-As unemployment falls wages rise (overtime and worker retention)
-Because wages are a cost, production costs rise, and this shifts aggregate supply to the left, back to equilibrium
-Ultimately, the economy is right back where it started at: there is NO NET CHANGE
BUT, just because the economy is the same, this doesn't mean that wealth doesn't shift. In the event of a negative supply shock wealth tends to shift from the workers to the capital owners (so workers are paid less, and company owners make more money)
------------------------------
SHOCKS AND THE BUSINESS CYCLE
Positive supply and demand shocks cause GDP to rise above it's potential level for a period of time, and then to fall back to potential (because inflationary gaps cause decreased unemployment, higher wages, and increased factor prices)
THESE SHOCKS ARE RANDOM...
SO:
The economy's adjustment system accounts for these random shocks, and basicaly incorporates them into business cycles (short term fluctuations of the economy)
--------------------------
LONG RUN AGGREGATE SUPPLY: This is the relationship between price and GDP after changes in input prices have been taken into account. LRAS is the result of automatic adjustments which bring GDP back to its potential level. LRAS is also called classical aggregate supply, because classical economists assumed that the economy has an automatic tendency to return to Y*
LRAS, graphically, is a vertical line at Y*, because the amount of goods produced at the normal utilization rate is Y*
The only thing which this can be used to demonstrate is price changes: as long as factor prices rise by the same proportion as output prices, then Y*remains constant
----------------------------
SHIFTING Y*
Saturday, January 30, 2010
MACROECONOMIC EQUILIBRIUM: Putting it all Together
So, we have the aggregate supply curve and we have the aggregate demand curve.
AD measures levels of production which won't change over time as a function of price
AS measures levels of production which suppliers will actually produce at as a function of price.
SO... what happens when you put both of them together?
Answer: You get a real level of output which doesn't change over time (at the intersection point). Here, GDP is at an equilibrium, which means that output is equal to expenditures. Also GDP is an actual achievable level of output, which firms are willing to produce at, given the price level, to maximize profits: The actual output is in equilibrium!
The general price level is the y-axis, and we can use it to determine inflation (increases in the general price level)
GDP is the x-axis, and we can use actual GDP in relation to potential GDP to determine unemployment
This is also a stable equilibrium! If the price level is too low, then aggregate demand will overwhelm what producers are actually willing to produce. As production increases to meet the needs of the consumers, however, the accompanying rise in the price level reduces consumer demand until the two meet in the middle. Whenever the economy is not at macroeconomic equilibrium, there are pressures which ultimately bring it back to a state of equilibrium
Aggregate Demand Shocks and Macroeconomic Equilibrium:
These are a bit more tricky. If a change in autonomous expenditure shifts the family of aggregate expenditure functions, then in turn the Aggregate Demand function will shift (to the left in expenditure is lower, and to the right if it is higher). However, in macroeconomic equilibrium, an increase in aggregate demand predicts an accompanying increase in prices, while lower aggregate demand predicts an accompanying drop in prices (remember, firms will only produce more if prices increase to stabilize profit margins). This change in the price level changes aggregate expenditure, causing it to shift up or down due to a new price!
As a general rule, both price and output move in the same direction as a demand shock (increased demand = more output at higher prices. Decreased = less output at lower prices)
You may have noticed, but the simple multiplier, due to the change in price, can no longer predict the change in output caused by changes in expenditure. Instead, we use the multiplier (not simple, just multiplier) to determine output changes which result from expenditure changes. The multiplier is smaller than the simple multiplier. It represents the change in GDP divided by the change in aggregate expenditure.
The severity of a demand shock depends on the state of the economy: in other words, where an economy lies on the Aggregate Supply Curve.
When the economy has excess capacity (constant costs of production), it is called Keynesian short run aggregate supply (this is the flat part of the AS curve). Increases in AE cause Y to rise and Price to remain the same.
When the economy has increasing costs (the middle of this graph where the AS curve is about diagonally sloped), this is intermediate short run aggregate supply. Here, increases in aggregate expenditure cause increases in both price and output.
When the economy has rapidly increasing costs, this is classical short run supply (the vertical part of the AS curve). Here, increases in aggregate expenditure lead to increases in price, and no change in output.
Basically, the steeper AS is, the more a demand shock will affect price, and the less it will affect output.
We can have supply shocks too! The new intersection point is the new stable macroeconomic equilibrium.
Be careful- in some cases, both AS and AD will shift in response to a single event! (for an example, let's say the price level in China rises. This increases domestic AD (because of increased net exports). However, if domestic producers buy a lot of intermediate products from China, then their costs of production just rose, so aggregate supply shifts to the left. The net effect could be either positive or negative: it depends how invest producers are in chinese intermediate goods, and how much of the domestic economy is trade-determined.
Okay- that's all you'll need for the test. Good luck!
AD measures levels of production which won't change over time as a function of price
AS measures levels of production which suppliers will actually produce at as a function of price.
SO... what happens when you put both of them together?
Answer: You get a real level of output which doesn't change over time (at the intersection point). Here, GDP is at an equilibrium, which means that output is equal to expenditures. Also GDP is an actual achievable level of output, which firms are willing to produce at, given the price level, to maximize profits: The actual output is in equilibrium!
The general price level is the y-axis, and we can use it to determine inflation (increases in the general price level)
GDP is the x-axis, and we can use actual GDP in relation to potential GDP to determine unemployment
This is also a stable equilibrium! If the price level is too low, then aggregate demand will overwhelm what producers are actually willing to produce. As production increases to meet the needs of the consumers, however, the accompanying rise in the price level reduces consumer demand until the two meet in the middle. Whenever the economy is not at macroeconomic equilibrium, there are pressures which ultimately bring it back to a state of equilibrium
Aggregate Demand Shocks and Macroeconomic Equilibrium:
These are a bit more tricky. If a change in autonomous expenditure shifts the family of aggregate expenditure functions, then in turn the Aggregate Demand function will shift (to the left in expenditure is lower, and to the right if it is higher). However, in macroeconomic equilibrium, an increase in aggregate demand predicts an accompanying increase in prices, while lower aggregate demand predicts an accompanying drop in prices (remember, firms will only produce more if prices increase to stabilize profit margins). This change in the price level changes aggregate expenditure, causing it to shift up or down due to a new price!
As a general rule, both price and output move in the same direction as a demand shock (increased demand = more output at higher prices. Decreased = less output at lower prices)
You may have noticed, but the simple multiplier, due to the change in price, can no longer predict the change in output caused by changes in expenditure. Instead, we use the multiplier (not simple, just multiplier) to determine output changes which result from expenditure changes. The multiplier is smaller than the simple multiplier. It represents the change in GDP divided by the change in aggregate expenditure.
The severity of a demand shock depends on the state of the economy: in other words, where an economy lies on the Aggregate Supply Curve.
When the economy has excess capacity (constant costs of production), it is called Keynesian short run aggregate supply (this is the flat part of the AS curve). Increases in AE cause Y to rise and Price to remain the same.
When the economy has increasing costs (the middle of this graph where the AS curve is about diagonally sloped), this is intermediate short run aggregate supply. Here, increases in aggregate expenditure cause increases in both price and output.
When the economy has rapidly increasing costs, this is classical short run supply (the vertical part of the AS curve). Here, increases in aggregate expenditure lead to increases in price, and no change in output.
Basically, the steeper AS is, the more a demand shock will affect price, and the less it will affect output.
We can have supply shocks too! The new intersection point is the new stable macroeconomic equilibrium.
Be careful- in some cases, both AS and AD will shift in response to a single event! (for an example, let's say the price level in China rises. This increases domestic AD (because of increased net exports). However, if domestic producers buy a lot of intermediate products from China, then their costs of production just rose, so aggregate supply shifts to the left. The net effect could be either positive or negative: it depends how invest producers are in chinese intermediate goods, and how much of the domestic economy is trade-determined.
Okay- that's all you'll need for the test. Good luck!
Aggregate Supply
In the short run, we're going to assume that factor prices remain constant (but later on, this can change, as we look at the long run)
The short run aggregate supply curve shows the amount which firms are willing to produce at any given price level.
Aggregate Supply is positively sloped!
Why?
Well, as firms increase output and input prices are constant, the law of diminishing marginal returns causes marginal output per factor to fall, and the short run average cost to rise. THUS, in order to retain expected profit margins, the only way for producers to feasibly increase production is to increase the price of goods: as such, as price rises, the actual GDP/output which firms will produce increases- there is a positive relationship here.
What about the slope? Why is it increasing?
Well... at low levels of output, firms have excess capacity, so they are capable of increasing output without making a huge investment, and the law of diminishing marginal returns hasn't really kicked in yet. Production can be increased at a relatively low cost (this corresponds to the flatter part of the curve)
At higher levels of output, however, there is no excess capacity, and great costs must be incurred to increase production.
Aggregate supply can shift (we call this an aggregate supply shock!). Basically, anything which would cause the cost of inputs (wages, intermediate goods, machinery, etc.) to rise OR anything which lowers the productivity of those factor inputs (like a rainy day on a farm) will shift the aggregate supply curve to the left (and consequently, lower input costs shifts AS to the right)
The short run aggregate supply curve shows the amount which firms are willing to produce at any given price level.
Aggregate Supply is positively sloped!
Why?
Well, as firms increase output and input prices are constant, the law of diminishing marginal returns causes marginal output per factor to fall, and the short run average cost to rise. THUS, in order to retain expected profit margins, the only way for producers to feasibly increase production is to increase the price of goods: as such, as price rises, the actual GDP/output which firms will produce increases- there is a positive relationship here.
What about the slope? Why is it increasing?
Well... at low levels of output, firms have excess capacity, so they are capable of increasing output without making a huge investment, and the law of diminishing marginal returns hasn't really kicked in yet. Production can be increased at a relatively low cost (this corresponds to the flatter part of the curve)
At higher levels of output, however, there is no excess capacity, and great costs must be incurred to increase production.
Aggregate supply can shift (we call this an aggregate supply shock!). Basically, anything which would cause the cost of inputs (wages, intermediate goods, machinery, etc.) to rise OR anything which lowers the productivity of those factor inputs (like a rainy day on a farm) will shift the aggregate supply curve to the left (and consequently, lower input costs shifts AS to the right)
Friday, January 15, 2010
Adding Investment to the Consumption Function, and then Finding Equilibrium
Before we move on to investment, it's important to understand the difference between shifts in consumption and movement along the consumption function.
Movement along the consumption function occurs whenever the national income changes- if it increases, then we move up and to the right along the consumption function. If the national income decreases, we move left and downwards along the consumption function. The graph itself, however, doesn't move in response to changes in national income.
Changes in the ceteris paribus variables (wealth, expectations, and interest rates), however CAN shift the consumption function up and down. This constitutes a SHIFT in consumption!
When consumption increases, the graph shifts up. When consumption decreases, the graft shifts down.
WEALTH causes direct shifts: an increase in wealth causes an upward shift of consumption
EXPECTATIONS cause direct shifts: optimism causes upward consumption shifts, while pessimism causes downward consumption shifts
INTEREST RATES cause inverse shifts: as interest rates rise, consumption decreases and vice versa.
Most of these variables tend to remain stable in the short run, however, so economists suspect that changes in consumption are not the root cause of the fluctuations we witness in business cycles.
There are other theories about consumption other than the one we have just learned about!
Modigliani and Friedman both came up with similar theories that suggest that consumption is a function of someone's average lifelong income, rather than current disposable income. This accounts for consumption which continues to remain high after retirement- current disposable income is very low for retirees, but they are able to live off of some stockpiled income from their income throughout the rest of their lives.
Okay.. time to factor in INVESTMENT!
Remember, investment involves Plant and Equipment, Inventories, and Residential Construction. Of all of these subfactors of investment, inventories tend to fluctuate the most.
There at 3 BIG factors which affect investment, so you could think of all of these at the ceteris paribus variables for investment
-The Real Interest Rate
-Changes in Sales
-Business Confidence
(Technology improvements, a decline in the price of new capital goods, and higher relative output prices may also affect investment, but we don't have to worry about that right now)
Interest Rates have a reverse relation to investment: the higher the interest rates, the higher the opportunity cost of borrowing money for investment, so overall investment decreases as interest rates rise
Sales have a direct relationship with investment. As sales increase, businesses need to have a larger inventory to buffer possible stock depletion, and also sales requires greater production, which facilitates investment in more plant an equipment.
Business Confidence has a direct relationship with investment. If business are confident that their economic futures are promising, then they will invest in more plants, equipment, buildings, and inventories. If the prospects appear grim, however, and businesses are uncertain if they will make profits in the near future, they are far less likely to invest.
SOOO: Investment is related and affected by these three factors... BUUUUUUUUUTTTTTTTTTTTTT
INVESTMENT IS NOT RELATED TO NATIONAL INCOME! IT IS AUTONOMOUS
In other words, if we were to graph investment as a function of national income, it would be a constant, flat-line graph!
Investment stays the same even as national income change, as long as the ceteris paribus variables remain constant.
Changes in the ceteris paribus variables can shift investment up or down, however!
OKAY: That's all we need to know about investment. Now, we just have to put the two together: This is called aggregate expenditure, and we graph it as a function of national income, so AE = f(Y)
In a frugal economy (with only a bank added to the economic flow system), desired Aggregate Expenditure = Consumption + Investment
SO, AE = C + I = f(Y)
AE = autonomous consumption + mpc(national income) + Investment
AE = a +b(Y) + I
This is the aggregate expenditure function! The slope of the aggregate expenditure function is called the Marginal Propensity to Spend (The change in expenditure divided by the change in national income)
***Important: You do not want to consume MPSpend with MPS, as MPS is the marginal propensity to save (which is how much money is saved per dollar of income, or the slope of the savings function)
So, now we know what the aggregated expenditure function looks like. Now, the only thing left to do is to figure out where equilibrium is.
SO, where is equilibrium?
It's any point where Income stays constant over time!
Well, there are two ways of thinking about equilibrium in macroeconomics:
-The Garden Hose Theory suggests that equilibrium is when Income is equal to expenditures. If you think about this in terms of the circular flow diagram, this means that the incomes that household receive from firms are equal to the expenditures that firms receive from households. Here, the condition for equilibrium is that the national income must equal expenditures!
-The Bathtub theory suggests that equilibrium is when the amount of monetary injections into an economy are equal to the amount of monetary withdrawal from an economy. Think of it like a bathtub with the tap adding water to the tub, while the drain removes water from the tub. If the tap adds water to the tub at the same rate that the drain removes water from the tub, then the water level in the tub remains the same, so we could say that the tub is in equilibrium! Using our current frugal economic model, equilibrium is when savings (withdrawals) are equal to investment (injections).
You will find that the point where Y = AE and where J (Injections) = W (Withdrawals) is the same!
This is also a stable equilibrium! There are pressures which return both expenditure and investments to equilibrium levels in the event of disequilibrium!
Let's say that desired expenditure is lower than GDP: This means that people want to consume more than an economy is effectively producing. In response to this increase in demand, producers will increase their level of production to make more products to satisfy that demand. That increase in production causes gross domestic product to raise, and eventually align with expenditure!
On the other hand, if GDP is greater than expenditure, this means that more products are being produced by an economy than are being consumed by households. Businesses will notice the drop in sales, and respond by producing fewer products. This reduction in output causes the GDP to fall until it aligns with expenditure.
The savings function works similarly, BECAUSE IT IS DERIVED FROM THE CONSUMPTION FUNCTION!
We can then shift around all of these different graphs by changing ceteris paribus variables, and then try and predict where new equilibriums will be! Expect this sort of thing on your typical, Gateman-style examination! Practice this sort of activity in your precious spare time, and you'll be a macroeconomic whiz-kid!
I bet you're EXCITED!
Movement along the consumption function occurs whenever the national income changes- if it increases, then we move up and to the right along the consumption function. If the national income decreases, we move left and downwards along the consumption function. The graph itself, however, doesn't move in response to changes in national income.
Changes in the ceteris paribus variables (wealth, expectations, and interest rates), however CAN shift the consumption function up and down. This constitutes a SHIFT in consumption!
When consumption increases, the graph shifts up. When consumption decreases, the graft shifts down.
WEALTH causes direct shifts: an increase in wealth causes an upward shift of consumption
EXPECTATIONS cause direct shifts: optimism causes upward consumption shifts, while pessimism causes downward consumption shifts
INTEREST RATES cause inverse shifts: as interest rates rise, consumption decreases and vice versa.
Most of these variables tend to remain stable in the short run, however, so economists suspect that changes in consumption are not the root cause of the fluctuations we witness in business cycles.
There are other theories about consumption other than the one we have just learned about!
Modigliani and Friedman both came up with similar theories that suggest that consumption is a function of someone's average lifelong income, rather than current disposable income. This accounts for consumption which continues to remain high after retirement- current disposable income is very low for retirees, but they are able to live off of some stockpiled income from their income throughout the rest of their lives.
Okay.. time to factor in INVESTMENT!
Remember, investment involves Plant and Equipment, Inventories, and Residential Construction. Of all of these subfactors of investment, inventories tend to fluctuate the most.
There at 3 BIG factors which affect investment, so you could think of all of these at the ceteris paribus variables for investment
-The Real Interest Rate
-Changes in Sales
-Business Confidence
(Technology improvements, a decline in the price of new capital goods, and higher relative output prices may also affect investment, but we don't have to worry about that right now)
Interest Rates have a reverse relation to investment: the higher the interest rates, the higher the opportunity cost of borrowing money for investment, so overall investment decreases as interest rates rise
Sales have a direct relationship with investment. As sales increase, businesses need to have a larger inventory to buffer possible stock depletion, and also sales requires greater production, which facilitates investment in more plant an equipment.
Business Confidence has a direct relationship with investment. If business are confident that their economic futures are promising, then they will invest in more plants, equipment, buildings, and inventories. If the prospects appear grim, however, and businesses are uncertain if they will make profits in the near future, they are far less likely to invest.
SOOO: Investment is related and affected by these three factors... BUUUUUUUUUTTTTTTTTTTTTT
INVESTMENT IS NOT RELATED TO NATIONAL INCOME! IT IS AUTONOMOUS
In other words, if we were to graph investment as a function of national income, it would be a constant, flat-line graph!
Investment stays the same even as national income change, as long as the ceteris paribus variables remain constant.
Changes in the ceteris paribus variables can shift investment up or down, however!
OKAY: That's all we need to know about investment. Now, we just have to put the two together: This is called aggregate expenditure, and we graph it as a function of national income, so AE = f(Y)
In a frugal economy (with only a bank added to the economic flow system), desired Aggregate Expenditure = Consumption + Investment
SO, AE = C + I = f(Y)
AE = autonomous consumption + mpc(national income) + Investment
AE = a +b(Y) + I
This is the aggregate expenditure function! The slope of the aggregate expenditure function is called the Marginal Propensity to Spend (The change in expenditure divided by the change in national income)
***Important: You do not want to consume MPSpend with MPS, as MPS is the marginal propensity to save (which is how much money is saved per dollar of income, or the slope of the savings function)
So, now we know what the aggregated expenditure function looks like. Now, the only thing left to do is to figure out where equilibrium is.
SO, where is equilibrium?
It's any point where Income stays constant over time!
Well, there are two ways of thinking about equilibrium in macroeconomics:
-The Garden Hose Theory suggests that equilibrium is when Income is equal to expenditures. If you think about this in terms of the circular flow diagram, this means that the incomes that household receive from firms are equal to the expenditures that firms receive from households. Here, the condition for equilibrium is that the national income must equal expenditures!
-The Bathtub theory suggests that equilibrium is when the amount of monetary injections into an economy are equal to the amount of monetary withdrawal from an economy. Think of it like a bathtub with the tap adding water to the tub, while the drain removes water from the tub. If the tap adds water to the tub at the same rate that the drain removes water from the tub, then the water level in the tub remains the same, so we could say that the tub is in equilibrium! Using our current frugal economic model, equilibrium is when savings (withdrawals) are equal to investment (injections).
You will find that the point where Y = AE and where J (Injections) = W (Withdrawals) is the same!
This is also a stable equilibrium! There are pressures which return both expenditure and investments to equilibrium levels in the event of disequilibrium!
Let's say that desired expenditure is lower than GDP: This means that people want to consume more than an economy is effectively producing. In response to this increase in demand, producers will increase their level of production to make more products to satisfy that demand. That increase in production causes gross domestic product to raise, and eventually align with expenditure!
On the other hand, if GDP is greater than expenditure, this means that more products are being produced by an economy than are being consumed by households. Businesses will notice the drop in sales, and respond by producing fewer products. This reduction in output causes the GDP to fall until it aligns with expenditure.
The savings function works similarly, BECAUSE IT IS DERIVED FROM THE CONSUMPTION FUNCTION!
We can then shift around all of these different graphs by changing ceteris paribus variables, and then try and predict where new equilibriums will be! Expect this sort of thing on your typical, Gateman-style examination! Practice this sort of activity in your precious spare time, and you'll be a macroeconomic whiz-kid!
I bet you're EXCITED!
Wednesday, January 13, 2010
The Importance of Consumption! The consumption function, and other wonderful things!
Quick review:
We have 5 basic macro-economic variables: Y,U,P,i, and e
Y is the bull's eye, which we try to control using fiscal and monetary policy
There are 4 stages to developing our economic model
1) Spendthrift (where there is just the firm and the household)
2) Frugal (which allows for spending and investment through banks)
3) Governed (which factors in taxation and government expenditure)
4) Open (which factors in imports and exports)
Our end-goal is to find the relationship between the general price level and the national income!
Here are some basic assumptions we have to make in building our macroeconomic model right now:
-Demand determines output
-The price level is constant (we pretend there is no inflation)
-In a basic economy, the interest and exchange rates remain constant
-We assume that potential national income is constant
Autonomous versus Induced Variables:
-Autonomous variables do not depend on national income, and thus are external to our model: this includes things like exports, which are determined by foreign economies, not domestic economies
Induced Variables DO depend on national income, and are thus found within our model: imports for an example tend to increase as Canada's national income grows, thus this an induced variable.
Today, we are going to learn about consumption, which is a very important part of national expenditure (the other parts being investment, government expenditure and net exports).
First: DESIRED versus ACTUAL EXPENDITURE:
-This is similar to microeconomics where we talked about willingness to buy (quantity demanded) at a given price. In Macro, we talk about the willingness to expend at a given income- it's a similar concept
-Actual aggregated expenditure is measured by NIEA (national income and expenditure accounts), which is denoted by an "a" subscript
-Desired expenditure is planned or intended expenditure
-It is a combination of consumption, investment, government expenditure, and net exports
-It is a function of national income (so national income effects expenditure)
THE CONSUMPTION FUNCTION: As a general rule, if people have more money, they spend more. Who'd have thunk...
-Consumption is a function of disposable national income! (Yd = current disposable income, which is national income minus taxes). However, in a spendthrift economy, we don't have to worry about taxation! =D
The ceteris paribus variable for the consumption function are
-Wealth (accumulated income: higher wealth generally leads to more consumption)
-Expectations (if prices are expected to rise in the future, this increases current consumption; if prices are expected to fall in the future, this decreases current consumption)
-Interest Rates (higher interest rates decreases consumption)
DESIRED CONSUMPTION IS A FUNCTION OF NATIONAL INCOME! John Meynard Keynes figured this out!
Here are some basic assumptions of the consumption function:
1) There is a break-even level of consumption (where consumption is exactly equal to disposable income)
2) as disposable income increases, consumption increases, but by less and less (in other words, the higher disposable income, the larger the portion of that income which will go into savings)
3) DESIRED CONSUMPTION IS A FUNCTION OF CURRENT DISPOSABLE INCOME!
*On a graph you can see this visually: consumption has risen with national income over the years in Canada.
Okay, so let's see one of these consumption functions!
-First off, this is a simplified version of the consumption function: most real ones would look more like curves, but we don't like to solve quadratics in this class
-The 45 degree line is where consumption is equal to disposable income- any point on this line is the break even point!
-As Y increases, so does C
-Here, Y = Yd (because this is a frugal economy)
-The slope of the consumption like is denoted by the variable 'b', and the actual term for it is the Marginal Propensity to Consume (MPC)
-The Y intercept is autonomous/exogenous expenditure which occurs even when there is no income: this is denoted by the variable 'a'
-Desired Consumption is 'C'
-Any point where consumption is higher than income has dissavings, or borrowed money, while any point where income is higher than consumption has savings
C = a + b(Yd)
for example: Consumption = 100 + 9/10(Disposable Income)
Basically
-Income is either spend (so it goes into consumption) or not spent (so it goes into savings)
-Savings are non-consumption
-Disposable income is then equal to consumption + savings
-Negative savings are dissavings, or loans
-Savings are Disposable income minus consumption
-At the break even point, income is equal to consumption, and savings is equal to zero
It is possible to build a savings function from the consumption function!
The savings function is derived from C = a + b(Yd)
S = Yd - C
if C is a straight linear function, then...
S = -a + (1-b)Yd
S = the vertical distance between C and the break even line (45 degrees)
SOME OTHER TERMS WHICH ARE IMPORTANT TO REMEMBER:
Average Propensity to Consume (APC): This is consumption divided by disposable income- this is the slope of the ray from the origin to the point being considered
Marginal Propensity to Consume (MPC): This is a change in consumption divided by a change in disposable income- this is the slope of the tangent to the curve being considered (so, for this very simplified, linear graph, it is equal to the slope of the consumption function)
Average Propensity to Save (APS): This is savings divided by disposable income- this is the slope of the ray from the origin to the point being considered on the savings function
Marginal Propensity to Save (MPS): This is a change in savings divided by a change in disposable income- this is the slope of the tangent to the curve being considered on the savings function (so for this linear savings curve, it's just equal to the slope of the savings function)
SOME MATHEMATICAL RELATIONSHIPS WHICH WILL MAKE PERFECT SENSE
Income = Consumption + Savings
Income/Income = Consumption/Income + Savings/Income, so 1 = APC + APS
/\Income//\Income = /\Consumption//\Income + /\Savings//\Income, so 1 = MPC + MPS
MPC is a value between 0 and 1
C = a + b(Yd) where a = the vertical intercept and b = MPC
THAT'S ALL FOR TODAY
We have 5 basic macro-economic variables: Y,U,P,i, and e
Y is the bull's eye, which we try to control using fiscal and monetary policy
There are 4 stages to developing our economic model
1) Spendthrift (where there is just the firm and the household)
2) Frugal (which allows for spending and investment through banks)
3) Governed (which factors in taxation and government expenditure)
4) Open (which factors in imports and exports)
Our end-goal is to find the relationship between the general price level and the national income!
Here are some basic assumptions we have to make in building our macroeconomic model right now:
-Demand determines output
-The price level is constant (we pretend there is no inflation)
-In a basic economy, the interest and exchange rates remain constant
-We assume that potential national income is constant
Autonomous versus Induced Variables:
-Autonomous variables do not depend on national income, and thus are external to our model: this includes things like exports, which are determined by foreign economies, not domestic economies
Induced Variables DO depend on national income, and are thus found within our model: imports for an example tend to increase as Canada's national income grows, thus this an induced variable.
Today, we are going to learn about consumption, which is a very important part of national expenditure (the other parts being investment, government expenditure and net exports).
First: DESIRED versus ACTUAL EXPENDITURE:
-This is similar to microeconomics where we talked about willingness to buy (quantity demanded) at a given price. In Macro, we talk about the willingness to expend at a given income- it's a similar concept
-Actual aggregated expenditure is measured by NIEA (national income and expenditure accounts), which is denoted by an "a" subscript
-Desired expenditure is planned or intended expenditure
-It is a combination of consumption, investment, government expenditure, and net exports
-It is a function of national income (so national income effects expenditure)
THE CONSUMPTION FUNCTION: As a general rule, if people have more money, they spend more. Who'd have thunk...
-Consumption is a function of disposable national income! (Yd = current disposable income, which is national income minus taxes). However, in a spendthrift economy, we don't have to worry about taxation! =D
The ceteris paribus variable for the consumption function are
-Wealth (accumulated income: higher wealth generally leads to more consumption)
-Expectations (if prices are expected to rise in the future, this increases current consumption; if prices are expected to fall in the future, this decreases current consumption)
-Interest Rates (higher interest rates decreases consumption)
DESIRED CONSUMPTION IS A FUNCTION OF NATIONAL INCOME! John Meynard Keynes figured this out!
Here are some basic assumptions of the consumption function:
1) There is a break-even level of consumption (where consumption is exactly equal to disposable income)
2) as disposable income increases, consumption increases, but by less and less (in other words, the higher disposable income, the larger the portion of that income which will go into savings)
3) DESIRED CONSUMPTION IS A FUNCTION OF CURRENT DISPOSABLE INCOME!
*On a graph you can see this visually: consumption has risen with national income over the years in Canada.
Okay, so let's see one of these consumption functions!
-First off, this is a simplified version of the consumption function: most real ones would look more like curves, but we don't like to solve quadratics in this class
-The 45 degree line is where consumption is equal to disposable income- any point on this line is the break even point!
-As Y increases, so does C
-Here, Y = Yd (because this is a frugal economy)
-The slope of the consumption like is denoted by the variable 'b', and the actual term for it is the Marginal Propensity to Consume (MPC)
-The Y intercept is autonomous/exogenous expenditure which occurs even when there is no income: this is denoted by the variable 'a'
-Desired Consumption is 'C'
-Any point where consumption is higher than income has dissavings, or borrowed money, while any point where income is higher than consumption has savings
C = a + b(Yd)
for example: Consumption = 100 + 9/10(Disposable Income)
Basically
-Income is either spend (so it goes into consumption) or not spent (so it goes into savings)
-Savings are non-consumption
-Disposable income is then equal to consumption + savings
-Negative savings are dissavings, or loans
-Savings are Disposable income minus consumption
-At the break even point, income is equal to consumption, and savings is equal to zero
It is possible to build a savings function from the consumption function!
The savings function is derived from C = a + b(Yd)
S = Yd - C
if C is a straight linear function, then...
S = -a + (1-b)Yd
S = the vertical distance between C and the break even line (45 degrees)
SOME OTHER TERMS WHICH ARE IMPORTANT TO REMEMBER:
Average Propensity to Consume (APC): This is consumption divided by disposable income- this is the slope of the ray from the origin to the point being considered
Marginal Propensity to Consume (MPC): This is a change in consumption divided by a change in disposable income- this is the slope of the tangent to the curve being considered (so, for this very simplified, linear graph, it is equal to the slope of the consumption function)
Average Propensity to Save (APS): This is savings divided by disposable income- this is the slope of the ray from the origin to the point being considered on the savings function
Marginal Propensity to Save (MPS): This is a change in savings divided by a change in disposable income- this is the slope of the tangent to the curve being considered on the savings function (so for this linear savings curve, it's just equal to the slope of the savings function)
SOME MATHEMATICAL RELATIONSHIPS WHICH WILL MAKE PERFECT SENSE
Income = Consumption + Savings
Income/Income = Consumption/Income + Savings/Income, so 1 = APC + APS
/\Income//\Income = /\Consumption//\Income + /\Savings//\Income, so 1 = MPC + MPS
MPC is a value between 0 and 1
C = a + b(Yd) where a = the vertical intercept and b = MPC
THAT'S ALL FOR TODAY
Monday, January 11, 2010
Calculating National Income
There are three different approaches which we can use to determine the national income. We're going to review all of them in a big, boring, and utterly painful lecture.
1) GDP from Value Added Approach- a measure of the value of all goods and services produced in a fiscal year
2) GDP from Expenditures Side- a measurement of the flow of expenditure
3) GDP from Income Side- a measurement of the flow of income
THE VALUE ADDED APPROACH
Problem: Why not just add the value of each producer's individual output?
Answer: Because production occurs in stages, so in order to avoid counting inputs twice (ie: counting the steel used to build a car, and then the car as well), we must either include only final products in our math, OR only count the value added to products at each stage of production.
Definitions:
Double Counting: Adding the value added more than once to the final value of a good or service
Intermediate Good: output which is used as an input for another good (ie: steel used to build a car)
Final Good: Output NOT used again as an input- output used for final consumption in the time period being considered
Value Added: The value which is added to a product at each stage of production. Revenue minus the cost of intermediate goods from other firms (ie: if a car sells for $2000, and the parts used to make it cost $1000, the added value is $1000). Value added is equal to factor income (WRiP) for any stage of production.
Revenue: Factor Income (WRiP) + The cost of intermediate goods from other firms.
NOTE: Value added does not factor in the costs of factors of production from other firms (so it does not matter how much it costs a steel manufacturer to produce car-steel: this is not factored into the final value of the car)
SO...
GDP (A measure of national income) is the FINAL (not intermediate) MARKET VALUE (determined by the price system of supply and demand) of all GOODS AND SERVICES (goods are tangible, like watermelons. Services are intangible, like haircuts) PRODUCED (so only actual output is measured- flipped assets like stocks or resold real estate does not factor into GDP) in a GIVEN PERIOD (A fiscal year is April to April)
THE EXPENDITURE SIDE APPROACH:
GDP is also equal to the total amount of expenditure required to produce all of the outputs which GDP encompasses.
There are 4 different players in the economy, and thus there are 4 different types of expenditure
CONSUMPTION- Expenditure by the household. This is the 'using up' of a product by a final user. Expenditure can be on durable and non durable goods, as well as services
INVESTMENT- Expenditure by the firm. Investment refers to a change in Capital (Plant, Equipment, Inventory, or Residential Construct). Most of the time, investiture is on goods which are NOT intended for present or immediate consumption. Also, investment is for goods which are used to produce other goods (ie: sewing machines)
Plant and Equipment are "business fixed investment"
Equipment includes machinery and equipment
Inventories are used to buffer fluctuations in production and sales.
Inventories may be outputs or inputs, and they are valued at fair market value
Inventories can be considered investment because they are expenditure on goods not for current consumption, and because we assume that the firm has paid for these goods themselves
Divestment is decumulation, or the reduction of inventory- in other words, a decrease in the stock of fixed goods available to be sold
Residential Construction is investment because a house or building is consumption over a long period of time, and thus not for present consumption
-This only applies to newly built houses or buildings- not purchases from a builder or used homes
GROSS INVESTMENT = NET INVESTMENT + DEPRECIATION! REMEMBER THIS!
Depreciation is the wearing out of capital, and also the cost of replacement capital: it is forced investiture which is not earned by any factor of production
Captial Cost Allowance (CCA) is an income tax act approximation for depreciation
we use GROSS INVESTMENT to calculate GDP (gross investment for gross domestic product- it makes sense). Why? Because all investment, even on broken equipment, creates an income flow and therefore contributes to GDP.
GOVERNMENT EXPENDITURE: This includes all government purchases of goods and services
-These are valued at cost to the government, not at their market value (because it is difficult to assign a market value to certain services which are provided at cost by the government, such as courts)
-Government expenditure also includes government investment!
-TRANSFER PAYMENTS are expenditures not in return for a service. Some examples include expenditure on the Canada Pension Plan, Employment Insurance, and Welfare payments (basically, situations where the government 'gives away' money in some form or another)
-This shows that "expenditure" is not always a "purchase"
-we EXCLUDE transfer payments from our calculation of the government''s expenditures when accounting for GDP
NET EXPORTS:
Exports = X = Goods leaving the country and money entering the country. This adds to our GDP
Imports = M = Goods entering the country and money leaving the country. This lowers our GDP
Net Exports = X - M (it can be positive or negative)
TOTAL EXPENDITURES = GDP
SO...
GDP = Consumption + Investment + Government Expenditure + Net Exports
Y = C+I+G+NetX
Wooooooooooo!
----------------------------
THE INCOME SIDE APPROACH TO GDP
Here, we use income claims from different factors and non-factors of production to calculate the national income. To put it simply we say that the national income is equal to factor payments plus non-factor payments
FACTOR PAYMENTS (WRiP): Another word for these is Net Domestic Product at Factor Costs
"Net" means that we do not take depreciation into account
"Domestic" means that these are domestic factors (ie: we can't add Saudi oil production incomes to Canada's GDP)
"Factor Cost" means the value of output which can be accredited to factors minus the net taxes paid by the firm
DIFFERENT TYPES OF FACTOR PAYMENTS
Wages & Salaries: A return to labour- it can include gross wages, cpp, other pensions, and extra benefits (like dental)
Economic Rent: A return to land- this can include stumpage fees, or oil royalties
Interest: A return to capital- This is the rate of return of capital
Profits: A return to Entrepreneurship and Technology- This includes dividends (distributed profits) and retained earnings (undistributed profits)
NON FACTOR PAYMENTS: Indirect Business Taxes minus Subsidies plus Depreciation
Non factor payments are money which is paid to firms which are not for income claims by factors
In other words, output by firms can generate income NOT accruing to those four factors. These are non-factor payments, and there are 2 types:
1) Indirect Business Taxes less Subsidies: Tax on production collected indirectly by third parties (like excise taxes, provincial sales taxes, and government sales taxes). This is a claim by the government on production which was NOT included in the net domestic product at factor costs. We add this to income to get the MARKET VALUE of goods.
Subsidies are benefits on production contributed indirectly by third parties (like the government subsidizing BC translink)- in other words, these are goods and services whose market value is artificially lowered due to government intervention. As a result, we subtract subsidies from income to get the market value of the good.
To make this easy, let's just say we want to calculate national income using what people ACTUALLY PAY for things: people actually pay indirect business taxes, so we add those, but people don't pay for subsidized portions of things, so we subtract those! Simple enough, right? =D
WriP + (IBT - Subsidies) = Net Domestic Product (NDP)
DEPRECIATION:
-This was not included in the NET domestic product at factor costs
-This is required reinvestment for simply maintaining capital stock
-It is not earned by any factor
NDP + Depreciation = GROSS DOMESTIC PRODUCT! YAY!
SOME EQUATIONS TO REMEMBER:
GDP = Factor Payments (WRiP) + Non Factor Payments ([IBT - Sub] + Dep)
NDP = GDP - Dep
NDPFC = NDP - (IBT - Sub)
WriP = NDPFC
NDPFC + (IBT - Sub) = NDP
NDP + Dep = GDP
---------------------
OTHER THINGS TO WORRY ABOUT
Gross Domestic Product versus Gross National Product
GDP: Income produced in Canada - domestic (it could be made in Canada by non-citizens and still count)
GNP: Income received by Canadians - nationals (it could be made by Canadians working outside of the country)
Calculating Gross National Product:
-GNP = GDP minus factor income produced in Canada but received by foreigners (non-Canadians) plus factor income received by Canadians from abroad
Generally, the value of Canadian based assets owned by foreigners is much greater than the value of foreign assets owned by Canadians (we do have a relatively small population in Canada), so the GDP is much higher than the GNP
Personal Income:
Personal Income is GDP minus any part NOT received by households (Depreciation, retained earnings, etc.)m plus transfer payments received by households: PI = GDP + Net Transfer Payments
Disposable Personal Income: Personal Income minus Personal Income Tax
Real Versus Nominal
Nominal values are related to money values, and change according to prices and current values. Nominal values reflect price changes and quantity changes
Real values stay constant over time. Real values only reflect quantity changes
REAL = Nominal/Price Index
For an example, real GDP = Nominal GDP/implicit GDP deflator (an implied raise in the price index, or inflation, in other words)
HOW TO DETERMINE THE IMPLICIT GDP DEFLATOR:
1: Set base year prices
2: Calculate current output at base year prices
3: Compare using ratios
GDP DEFLATOR = Current Q X Current P/Current Q X Base-year P
GDP DEFLATOR = GDP at current prices/GDP at base year prices
GDP DEFLATOR = Nominal GDP/Real GDP
Some things are omitted from GDP, for example...
-Illegal Activities (such as drug sales), because they are difficult to measure or ascertain
-Non-market Activities (such as housework, do it yourself repairs, and volunteer work), because these are not traded as services in a market
-Unreported Activities (such as bartered services or agreements), because they are difficult to measure or ascertain
-Economic "Bads" or negative externalities (such as pollution, stress, congestion, etc.)- these should be deducted from national income, but they are not traded in markets
Definitions for output
Production: Total output (GDP): This describes the size of the economy
Per Capita GDP: GDP divided by population- this is used to measure the standard of living
Productivity: GDP divided by employment, or GDP divided by # of hours worked- this is used to measure the rate of technological change and worker efficiency
Economics, however, is not involved in measuring happiness or quality of life. We leave that to other organizations!
That's all for now....
1) GDP from Value Added Approach- a measure of the value of all goods and services produced in a fiscal year
2) GDP from Expenditures Side- a measurement of the flow of expenditure
3) GDP from Income Side- a measurement of the flow of income
THE VALUE ADDED APPROACH
Problem: Why not just add the value of each producer's individual output?
Answer: Because production occurs in stages, so in order to avoid counting inputs twice (ie: counting the steel used to build a car, and then the car as well), we must either include only final products in our math, OR only count the value added to products at each stage of production.
Definitions:
Double Counting: Adding the value added more than once to the final value of a good or service
Intermediate Good: output which is used as an input for another good (ie: steel used to build a car)
Final Good: Output NOT used again as an input- output used for final consumption in the time period being considered
Value Added: The value which is added to a product at each stage of production. Revenue minus the cost of intermediate goods from other firms (ie: if a car sells for $2000, and the parts used to make it cost $1000, the added value is $1000). Value added is equal to factor income (WRiP) for any stage of production.
Revenue: Factor Income (WRiP) + The cost of intermediate goods from other firms.
NOTE: Value added does not factor in the costs of factors of production from other firms (so it does not matter how much it costs a steel manufacturer to produce car-steel: this is not factored into the final value of the car)
SO...
GDP (A measure of national income) is the FINAL (not intermediate) MARKET VALUE (determined by the price system of supply and demand) of all GOODS AND SERVICES (goods are tangible, like watermelons. Services are intangible, like haircuts) PRODUCED (so only actual output is measured- flipped assets like stocks or resold real estate does not factor into GDP) in a GIVEN PERIOD (A fiscal year is April to April)
THE EXPENDITURE SIDE APPROACH:
GDP is also equal to the total amount of expenditure required to produce all of the outputs which GDP encompasses.
There are 4 different players in the economy, and thus there are 4 different types of expenditure
CONSUMPTION- Expenditure by the household. This is the 'using up' of a product by a final user. Expenditure can be on durable and non durable goods, as well as services
INVESTMENT- Expenditure by the firm. Investment refers to a change in Capital (Plant, Equipment, Inventory, or Residential Construct). Most of the time, investiture is on goods which are NOT intended for present or immediate consumption. Also, investment is for goods which are used to produce other goods (ie: sewing machines)
Plant and Equipment are "business fixed investment"
Equipment includes machinery and equipment
Inventories are used to buffer fluctuations in production and sales.
Inventories may be outputs or inputs, and they are valued at fair market value
Inventories can be considered investment because they are expenditure on goods not for current consumption, and because we assume that the firm has paid for these goods themselves
Divestment is decumulation, or the reduction of inventory- in other words, a decrease in the stock of fixed goods available to be sold
Residential Construction is investment because a house or building is consumption over a long period of time, and thus not for present consumption
-This only applies to newly built houses or buildings- not purchases from a builder or used homes
GROSS INVESTMENT = NET INVESTMENT + DEPRECIATION! REMEMBER THIS!
Depreciation is the wearing out of capital, and also the cost of replacement capital: it is forced investiture which is not earned by any factor of production
Captial Cost Allowance (CCA) is an income tax act approximation for depreciation
we use GROSS INVESTMENT to calculate GDP (gross investment for gross domestic product- it makes sense). Why? Because all investment, even on broken equipment, creates an income flow and therefore contributes to GDP.
GOVERNMENT EXPENDITURE: This includes all government purchases of goods and services
-These are valued at cost to the government, not at their market value (because it is difficult to assign a market value to certain services which are provided at cost by the government, such as courts)
-Government expenditure also includes government investment!
-TRANSFER PAYMENTS are expenditures not in return for a service. Some examples include expenditure on the Canada Pension Plan, Employment Insurance, and Welfare payments (basically, situations where the government 'gives away' money in some form or another)
-This shows that "expenditure" is not always a "purchase"
-we EXCLUDE transfer payments from our calculation of the government''s expenditures when accounting for GDP
NET EXPORTS:
Exports = X = Goods leaving the country and money entering the country. This adds to our GDP
Imports = M = Goods entering the country and money leaving the country. This lowers our GDP
Net Exports = X - M (it can be positive or negative)
TOTAL EXPENDITURES = GDP
SO...
GDP = Consumption + Investment + Government Expenditure + Net Exports
Y = C+I+G+NetX
Wooooooooooo!
----------------------------
THE INCOME SIDE APPROACH TO GDP
Here, we use income claims from different factors and non-factors of production to calculate the national income. To put it simply we say that the national income is equal to factor payments plus non-factor payments
FACTOR PAYMENTS (WRiP): Another word for these is Net Domestic Product at Factor Costs
"Net" means that we do not take depreciation into account
"Domestic" means that these are domestic factors (ie: we can't add Saudi oil production incomes to Canada's GDP)
"Factor Cost" means the value of output which can be accredited to factors minus the net taxes paid by the firm
DIFFERENT TYPES OF FACTOR PAYMENTS
Wages & Salaries: A return to labour- it can include gross wages, cpp, other pensions, and extra benefits (like dental)
Economic Rent: A return to land- this can include stumpage fees, or oil royalties
Interest: A return to capital- This is the rate of return of capital
Profits: A return to Entrepreneurship and Technology- This includes dividends (distributed profits) and retained earnings (undistributed profits)
NON FACTOR PAYMENTS: Indirect Business Taxes minus Subsidies plus Depreciation
Non factor payments are money which is paid to firms which are not for income claims by factors
In other words, output by firms can generate income NOT accruing to those four factors. These are non-factor payments, and there are 2 types:
1) Indirect Business Taxes less Subsidies: Tax on production collected indirectly by third parties (like excise taxes, provincial sales taxes, and government sales taxes). This is a claim by the government on production which was NOT included in the net domestic product at factor costs. We add this to income to get the MARKET VALUE of goods.
Subsidies are benefits on production contributed indirectly by third parties (like the government subsidizing BC translink)- in other words, these are goods and services whose market value is artificially lowered due to government intervention. As a result, we subtract subsidies from income to get the market value of the good.
To make this easy, let's just say we want to calculate national income using what people ACTUALLY PAY for things: people actually pay indirect business taxes, so we add those, but people don't pay for subsidized portions of things, so we subtract those! Simple enough, right? =D
WriP + (IBT - Subsidies) = Net Domestic Product (NDP)
DEPRECIATION:
-This was not included in the NET domestic product at factor costs
-This is required reinvestment for simply maintaining capital stock
-It is not earned by any factor
NDP + Depreciation = GROSS DOMESTIC PRODUCT! YAY!
SOME EQUATIONS TO REMEMBER:
GDP = Factor Payments (WRiP) + Non Factor Payments ([IBT - Sub] + Dep)
NDP = GDP - Dep
NDPFC = NDP - (IBT - Sub)
WriP = NDPFC
NDPFC + (IBT - Sub) = NDP
NDP + Dep = GDP
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OTHER THINGS TO WORRY ABOUT
Gross Domestic Product versus Gross National Product
GDP: Income produced in Canada - domestic (it could be made in Canada by non-citizens and still count)
GNP: Income received by Canadians - nationals (it could be made by Canadians working outside of the country)
Calculating Gross National Product:
-GNP = GDP minus factor income produced in Canada but received by foreigners (non-Canadians) plus factor income received by Canadians from abroad
Generally, the value of Canadian based assets owned by foreigners is much greater than the value of foreign assets owned by Canadians (we do have a relatively small population in Canada), so the GDP is much higher than the GNP
Personal Income:
Personal Income is GDP minus any part NOT received by households (Depreciation, retained earnings, etc.)m plus transfer payments received by households: PI = GDP + Net Transfer Payments
Disposable Personal Income: Personal Income minus Personal Income Tax
Real Versus Nominal
Nominal values are related to money values, and change according to prices and current values. Nominal values reflect price changes and quantity changes
Real values stay constant over time. Real values only reflect quantity changes
REAL = Nominal/Price Index
For an example, real GDP = Nominal GDP/implicit GDP deflator (an implied raise in the price index, or inflation, in other words)
HOW TO DETERMINE THE IMPLICIT GDP DEFLATOR:
1: Set base year prices
2: Calculate current output at base year prices
3: Compare using ratios
GDP DEFLATOR = Current Q X Current P/Current Q X Base-year P
GDP DEFLATOR = GDP at current prices/GDP at base year prices
GDP DEFLATOR = Nominal GDP/Real GDP
Some things are omitted from GDP, for example...
-Illegal Activities (such as drug sales), because they are difficult to measure or ascertain
-Non-market Activities (such as housework, do it yourself repairs, and volunteer work), because these are not traded as services in a market
-Unreported Activities (such as bartered services or agreements), because they are difficult to measure or ascertain
-Economic "Bads" or negative externalities (such as pollution, stress, congestion, etc.)- these should be deducted from national income, but they are not traded in markets
Definitions for output
Production: Total output (GDP): This describes the size of the economy
Per Capita GDP: GDP divided by population- this is used to measure the standard of living
Productivity: GDP divided by employment, or GDP divided by # of hours worked- this is used to measure the rate of technological change and worker efficiency
Economics, however, is not involved in measuring happiness or quality of life. We leave that to other organizations!
That's all for now....
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