GROWTH ACCOUNTING

It is generally believed that labour accounts for about 2/3 of all income generated, and that capital accounts for approximately 1/3 of national income

as such, percentage-growth in potential national income is = to the percentage change in the level of technology + 2/3 * the percentage change in labour + 1/3 * the percentage change in capital

MEASURING TECHNOLOGICAL CHANGE

-It is impossible to directly measure technological change. Solow tried, and got a Nobel Prize.

-The Solow growth model included only 3 independent varaibles: labour, capital, and "other"

-This "other" is the "Solow Residual" or "Total Factor Productivity" or "A" (in our model). It captures all growth in GDP which is not accounted for by changed in N (L and H) and K.

-BIG PROBLEM HERE: Solow's model included both the quantity and quality of labour and capital, and a great deal of technological change is EMBODIED with labour or capital (so technology factors into labour or capital, and cannot always be separated them from). For instance, if one of my shitty sweat-shop sewing machines breaks down and I decide to replace it with an uber-fast, ultra-modern sewing machine, the capital stock will remain the same for my sweatshop, but the technology level has increased.

-As such, the Solow residual underestimates true technical change (as it can only include disembodied technological changes)

--------------------------

The Cobb-Douglas Aggregate Production Function is an example of an aggregate production function with 2 characteristics
-The law of diminishing marginal utility
-Constant returns to scale

For this APF, Y = A * N(2/3) * K(1/3)

Here, equal growth rates in labour and capital cause total GDP to grow at the same rate (as it would in a steady state)

y = A * k(1/3)

This is the per-capita APF, where y is per-capita GDP, and k is the capital-labour ratio
Equal growth rates in both labour and capital (ie: a constant k) cause y (per capita GDP) to remain constant

SO: BIG QUESTION: HOW DO WE ALLOW FOR GROWTH?

1: Increase savings (let per capita savings become larger)- in order for growth to occur, the economy requires sufficient savings to increase the capital stock faster than the population growth.

If you are in the Robert Gateman club of not-breeding, choosing NOT to personally contribute to population growth can also help economies grow here...

2: Increase technology: This requires infrastructural developments (health, education, law, physiological needs such as food and water taken care of), and many such developments are difficult for developing nations to set up.

WHY IS TECHNOLOGICAL CHANGE IMPORTANT?

Technological improvements lead to increased productivity, which increases the potential per-capita GDP

Embodied Technical Change = technical change intrinsic to the particular human or unit of physical capital in use: it is a change in the quality of the input (so a higher education, or a computer upgrade would both be examples of embodied technical changes)

Disembodied Technical Change = technical change that is NOT intrinsic to human or physical capital in use. This is a change other than to the quality of the capital (so if my sweat-shop fore-woman comes up with a fantastic new sewing procedure which halves the time it takes her to sew a sneakers, and then she teaches all of her sweat-shop buddies how to sew like this, that new technique would be an example of a disembodied technical change)

Usually, disembodied changes eventually become embodied, so the distinction becomes less important over the long run.

CONVERGENCE HYPOTHESIS: This an interesting theory, and there are 2 different facets of it

1: Absolute Convergence: the tendency for GDP AND Growth Rates in GDP to be equal across nations: each nation will have the same steady state values for y* and k*
-This assumes that different countries have the same marginal propensity to save, the same rate of population growth, and the same rate of technological improvement
-This theory states that if two countries have the same growth model, then even if one starts farther to the left, they will both end up with the same standard of living

2: Conditional Convergence: the tendency for Growth Rates in GDP to be equal across nations: each nation will have the same steady state values.
-This theory assumes different marginal propensities to save for different nations, different population growth rates, and different technological growth rates
-This theory acknowledges that different countries will have different per-capita GDP, but states that they will have THE SAME GROWTH RATES!

-------------------------------------------------

NEW GROWTH MODELS

The Neoclassical Growth Model made growth dependent on exogenous variables such as population growth, the savings rate, and the rate of technological change.

Some new growth theories alter the 2 assumptions of the Neoclassical Model:
-Instead of technology as exogenous, they state that technological changes can be explained within the economic model
-Instead of having diminishing marginal returns, some new growth models suggest that the marginal product of capital is constant, or that there is even increasing marginal product of capital over time!

-----------------------------------

ENDOGENOUS TECHNOLOGICAL CHANGE:
Endogenous growth is self-sustaining growth
In this theory, we assume constant marginal product of capital
For an example, if the price of an input rises, firms will develop a new technology rather than just switching to an existing alternative input (so market structures and competition can facilitate technological change)
-Some people believe that competition foster technological change: others believe, especially in the case of health technologies, that only monopolies can risk the large expenditure required to create new drugs

LEARNING BY DOING: In the 1940s, Shumpeter said that innovation was a one-way street- that research caused new developments, which led to new machines and new products. Today, things work different: it is more of a 2-way street. There is a feedback mechanism (ie: the Japanese method of building cars, where the mechanics and workers collaborate with the designer in order to streamline research and production in such a way that is productively efficient).

SHOCKS and INNOVATION:
-Different countries respond to economic shocks in different ways. Some will find different countries to produce goods in where costs are cheaper: others will change production methods and increase technology to make it more cost effective!

---------------------------------------

INCREASING MARGINAL RETURNS TO INVESTMENT: Here, each new addition to the capital stock is more productive than the last.

There are 2 sources of increasing marginal returns to investment:

Market-Development Fixed Costs (Paul Romer)
-The original investment into new knowledge or technology has a large fixed cost
-Adopting or adapting this new technology once it has already been established is cheaper
-Also, consumers, wait to use new technologies
-In this way, the costs decrease as more and more people adopt new technologies, so the returns to scale increase with increasing investment

Knowledge
-It is a public good, so it is not subject to the law of diminishing marginal returns
-New ideas are non-excludable and non-rivalrous (as much as copyright laws try to prevent people from accessing them)
-New ideas are pure public goods
-New ideas may not suffer diminishing marginal returns
-SOOOO, because ideas play such a big role in economics, and ideas are practically unlimited, economics doesn't have to the be DISMAL SCIENCE! Yay!

------------------------------------

LIMITS TO GROWTH

-1970s, the club of Rome published a book called "Limits to Growth"
-This book predicted that increased growth would eventually destroy the earth's resources...

Here is their usual anti-growth argument: growth will look like more of what we witness today: production of mostly useless, impractical consumer goods with a short lifespan, which end up in the landfills in a couple of years.

This could be countered with the argument that growth can still occur, but under that condition that instead of producer large quantities of shitty goods, we focus on producing higher-quality, cleaner, longer-lasting, more efficient products.
-Growth permits societies to protect the environment and help the poor (if you haven't noticed, environmental protection legislation is more a by-product of mature industrial economies, and less-so of developing nations)
-The thought is that market participants will react to supply shortages, and innovate around them (ie: by the time oil runs out, productive processes will have innovated away from it)

RESOURCE EXHAUSTION
-Limits to growth are based on fixed technology and resources
-BUT, technology leads to more efficient resource use
-AND technology leads to the discovery of new resources
-Problem: THERE ARE TOO MANY PEOPLE: More people on the earth means that we will require more resource expenditure

POLLUTION:
-Economic growth creates pollution. Nuff said

Although many economists believe that growth creates opportunities for humankind to combat resource depletion and pollution through increased technologies, a lot of these beliefs are based on blind faith.

Like... we are basically relying on our ability to innovate away from these problems...

but what if we simply can't do that? Then what..............?

The Neoclassical Growth Model and Steady States

THE NEOCLASSICAL GROWTH THEORY: This focuses on capital accumulation, and how it is affected by savings

One important function in the neoclassical growth theory is the AGGREGATE PRODUCTION FUNCTION. This function shows the relationship between total real output and total inputs (sort of like a "macro" version of the production function for individual firms we saw in microeconomics)

REMEMBER from the last leccture? There are three main determinants of economic growth: labour, capital, and technology. Well, with the aggregate production function, we say that output is technology times a function of labour and capital

Y = A x F(N,K) where A = total factor productivity (disembodied technology), N = Labour and Human Capital, and K = capital (both quantity and quality)

Now what happens if we divide through by N?

Well, we get

y = A x F(k) where y is the amount of GDP produced per worker, and k is the amount of physical capital available for each worker

Also, potential output is also representable here

Y* = A x F(Nfe, Kfc) where Nfe is full employment, and Kfc is full capacity. In other words, potential output is technology times a function of labour at its full employment level, and physical capital at its full- capacity level

Some important things to remember:
We assume in the long run that income is at its potential level (that there is no output gap)
L is labour quantity, H is labour quality, and N includes both the quality and quantity of labour.
K includes both the quality and quantity of physical capital
We omit land as a factor input for the sake of simplicity in this model
Technology includes entrepreneurship and savviness

PROPERTIES OF THE NEOCLASSICAL AGGREGATE PRODUCTION CURVE

1: In the short run, there are diminishing returns to scale: as more of a variable factor is added to a given amount of fixed factor, the additional output generated by the added factor (the "return") will get increasingly smaller and smaller: they will diminish... ceteris paribus (they will diminish if all other things are held constant) after a certain point (they will not begin to diminish immediately)
But, this is only true of the short run when one factor is increased, and all other factors are held constant!

2: In the long run, there are constant returns to scale: When all factors increase the same amount, output will also increase by that amount (so if I double the amount of workers and also the amount of sewing machines, my sweat shop should double its output of shitty sneakers!)

3: Technology is nuetral: A affects the productivity of K and N equally, so although technology is present, it will not disproportionately impact any one factor.

Image Plz! y = f(k)

4: Steady state equilibrium: Here, the per-capita capital (k) and the per capita output (y) remain constant over time, so /\y = /\k = 0

If the population is growing at n, then income and capital must also grow at the same rate in order to remain in a steady state equilibrium. In other words, in order to be in a stead state equilibrium, the percentage change in output must equal the percentage change in capital, which must = the percentage change in the workforce.

y* and k* are the steady state values (they don't change over time)

Investment required to provide capital for new workers and to replace machines that have worn out (depreciation) is just equal to the national savings in a steady state equilibrium, so New Capital + Replacement Capital = Investment = Savings

If savings is greater than investment, than capital per worker will increase, and thus output per worker will also increase

If savings is just equal to investment, then the capital per worker will be k* and thus output per worker will be y*

When savings is equal to required investment, the economy is in a steady state equilibrium, each worker will have access to k*, and will produce y*

MORE ON THE STEADY STATE

To maintain k at a constant rate, investment depends on both population growth and the depreciation rate. Some of investment will have to go to the new workers

WE ASSUME that the population growth rate is constant: thus, to keep capital per worker constant, you must grow capital by nk (the population growth rate times the amount of capital per worker)
WE ASSUME that the rate of depreciation is constant: thus to keep capital per worker constant, you must grow capital by dk as well (the depreciation rate times the amount of capital per worker)

The level of investment required to fund all of this capital growth to maintain a constant capital-worker ratio can be represented by
I = (n + d)k

THE SAVINGS FUNCTION
Here, we assume that we have a frugal economy (there is no government or international trade)
We also assume that the marginal propensity to save is constant
So:
S/N = sy = sf(k)
in other words, per capita savings are a function of per-capita output, which in turn, is a function of the labour-capital ratio

PUTTING IT ALL TOGETHER:
The net change in the capital-labour ratio is equal to the excess of actual savings over required investment
/\k = to per-capita savings - the capital-labour ratio multiplied by (the population growth rate + the rate of depreciation)

In a steady state, /\k = o, so per-capita savings must be equal to per-capita required investment
sy* = (n + d)k*

Image plz

If we graph the production function, the savings function, and the required investment function with money on the Y axis and the capital labour ratio on the X axis, the savings function and the required investment function will eventually intersect: this point is the steady state equilibrium, E
at E, actual investment is just equal to required investment
the capital-labour ratio k* and standard of living y* are constant
At capital labour ratios lower than k*, savings will be greater than required investment, so the capital labour ratio and the standard of living will both increase.

Supply and Demand-Side Economics

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)

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*

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!

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)

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!