Econ 202 Book notes.docx

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ECON 202
Barry Mc Clinchey

Econ 202 Book notes CHAPTER 1-Policy and Practice of Macroeconomics • Macroeconomics is the study of economic activity and prices in the overall economy of nation/region • Economic theory is a logical framework to explain a particular economic phenomenon. It involves developing an economic model • Economic model is a simplified representation of the economic phenomenon that takes a mathematical or graphical form. It involves five steps: 1. Identify an interesting economic question (why unemployment rate rises or falls over time) 2. Specify variables to be explained by the model as well as the variables that explain them. Variable you want to explain is the endogenous variable because it is inside the model. Factors are called exogenous variables which are taken as given such as the weather or government policies. 3. Make a set of equations or graphical analysis to connect movement of exogenous variables to the endogenous variables. (Eg. Create formula showing how a 10% increase in government spending would change the unemployment rate with everything else remaining the same) 4. Compare conclusion of the model with what actually happened 5. If data is well explained, use model to make further predictions such as where unemployment rate will head a year from now. Economic Model Example Demand and supply of coffee Assumption: competitive market (price-taker as opposed to price-setter because small market) Variables: Q =cquantity of coffee that buyers demand s Q =Cquantity of coffee that producers supply Pc= price of coffee Y = aggregate income P T price of tea (substitute good) D Demand question: Q C = D (PC, Y, PT) Supply equation: Q SC = S (P C weather) P c Pc Pc S S P1 P* D D QC Q C Q* Q C Exogenous variables: P T Y, weather Endogenous variables: Q , Q , P c C c • Macroeconomists focus on three economic data series: o Real GDP measures the output of actual goods and services produced in an economy over a fixed period (usually a year)  Business Cycles are when Real GDP fluctuates over time. These represent recurrent up and down movements in economic activity  Recession is when economic activity declines and real GDP per person falls  Depression is when the decline in real GDP is severe o Unemployment rate measures the percentage of workers looking for work but do not have jobs at a particular time o Inflation rate tell us how rapidly the overall level of prices is rising. If inflation rate is negative that means price is growing in a negative way. It can be negative or zero (disinflation and deflation are different don’t confuse them) Macroeconomic Policy • The goal of developing models is to determine what policies can produce better macroeconomic outcomes: o How can Poor countries get rich? o Is saving too low? o Do government budget deficits matter?  GBD are an excess of gov’t spending relative to revenue. To cut deficit, some propose tightening fiscal policy (policymakers’ decisions to raise taxes), cut spending, or both. o How costly is it to reduce inflation?  Keeping inflation in check is main mission of central bank who also conduct monetary policy, the management of the amount of money in the economy and interest rates o How can we make financial crises less likely? o How active should stabilization policy be?  Important goal is the stabilization policy which is to minimize business cycle fluctuations and stabilize economic activity o Should macroeconomic policy follow rules? o Are global trade imbalances a danger? CHAPTER 2-Measuring Macroeconomic Data • GDP (in terms of expenditure/income) is the total income of everyone in the economy, and is also the total amount of expenditure for goods and services in the economy • National income accounting is an accounting system to measure economic activity and its components show the relationship among the expenditure, income and production methods of measuring GDP. We express national income accounting in the fundamental identity of national income accounting: o Total Production = Total Expenditure = Total Income • GDP (in production approach): current market value of all final goods and services newly produced in the economy during a fixed period of time. o Market Value is the price it sells for.  Nonmarket goods and services are those that do not have a market price  Underground economy are goods and services hidden from gov’t either because it is illegal or they want to avoid paying taxes  Imputed Value is an estimate of what the price of the good or service would be if it were traded in a market. (Eg. Renting apartment would be based on market value of housing) o Final Goods and Services are classified into intermediate goods and services and final goods and services.  Value Added is the value of a firm’s output minus the cost of intermediate goods purchased by the firm. By adding value added for each firm, you get the final value of the goods and services produced  Capital Good is a good that is produced in the current period to be used in the production of other goods that is not used up in the stages of production. New capital good is classified as final goods and this include them in GDP because they are not included in spending on other final goods and yet their production is certainly part of economic activity  Inventories are firms’ holdings of raw materials, unfinished goods, and unsold finished goods- are another type of good that are not used up in the current period. Inventory Investment is the change in inventories over a given period of time (ex. A year)  it is included in GDP because an increase in the level of inventories is an increase in economic activity o Newly Produced Good and Services should be included in the GDP because they are produced in the current period. o Fixed Period of Time is the period of time where the GDP is calculated. GDP is a flow, an amount per a given unit of time, in contrast to a stock, a quantity at a given point in time. • GDP, with the expenditure approach, is the total spending on currently produced final goods and services in the economy. • The national income account add up these four categories(below) of spending to determine GDP in the national income identity o Y = C + I + G + NX • The national income account divides spending into four basic categories: o Consumption: is the total spending for currently produced consumer goods and services.  Consumer durables are goods purchased by consumers that last long time.  Nondurable goods are short-lived consumer goods such as food and housing services (no purchase of house though which are part of investment), gasoline, and clothing.  Services are purchased by customers such as haircuts, education, medical care, air travel etc. o Investment is spending on currently produced capital goods that are used to produce goods and services over an extended period of time.  Fixed Investment is spending by business on equipment (machines, computers, furniture and trucks) and structures (factories, stores and warehouses)  Inventory Investment is the change in inventories held by firms. If inventories are increasing, inventory investment is positive, but if they are decreasing then inventory investment is negative.  Residual Investment is household purchases of new houses and apartments. (does not include houses from previous periods) o Government Purchases is spending by the government-whether federal, state or local-on currently produced goods and services.  Government consumption refer to gov’t purchases for a short lived goods and services like health care and police  Government Investment spending for capital goods like buildings and computers  Government transfers such as social security, Medicare, and unemployment insurance benefits are not included in ‘G’ because they are not payments in exchange for currently produced goods/services. Interest payments on gov’t debts are also no included. o Net Exports are exports minus imports. Reason imports is subtracted is because it is included in consumption, expenditure, investment and gov’t purchases, but imports are not produced in the United States. • Third way of measuring GDP is in the income approach which involves adding up all the incomes received by households and firms in the economy, including profits and tax revenue to the government Categories of Us Income in 2009 and how they changed over time: 1. Compensation of employees includes both wages and salaries of employees (excluding self-employed) and employee benefits 2. Other income includes income of the self-employed, income that individuals receive from renting their properties (including royalty income on books and music) and the net interest earned by individuals from businesses and foreign sources (interest income minus the interest that they pay. Also includes indirect business taxes like sales tax 3. Corporate profits is made up of the profits after (income) taxes of corporations 4. Net factor income equals wages, profits and rent (called factor income) paid to US residents by foreigners minus factor income paid by US residents to foreigners. 5. Depreciation is the loss of capital from wear and tear or because capital has been scrapped because it is out-dated. To obtain net income of businesses, depreciation was subtracted out, so in order to compute gross income, we have to add it back into GDP. If we do not add depreciation back in GDP, then we call the measure net domestic product. Income Measures • We add first three items (compensation of employees, other income, and corporate profits) to obtain national income. We then add (depreciation) to obtain gross national product (GNP) which measures total income earned by US residents. Then we add (net factor income), which is negative, to obtain GDP • Private disposable income is the amount of income the private sector has available to spend. It equals the income received by the private sector, plus payments made to the private sector by the government, minus taxes paid to the government. o Private disposable income = GDP + net factor income + transfer payments received from government + interest payments on government debt - taxes • Net government income is the disposable income that government has available to spend o Net government income = taxes - transfers - interest payments on government debt • Adding the above two equations together we can see that private disposable income plus net government income equals GDP plus net factor payments from foreigners, which is GNP Real versus Nominal GDP • Nominal variable is income, expenditure and production measured at the current market price. Disadvantage is that they don’t tell us what is happening to economic activity over time if prices are changing. (ex. When price of wheat doubles then nominal GDP doubles as well but quantity remains unchanged so we don’t know if quantity being purchased is rising, falling or staying the same) • Real variable is measure of economic variable in terms of quantities of an actual good or service. It uses constant prices rather than current prices. Real GDP is the GDP measure that is adjusted for changes in the average level of prices in the economy, referred to as price level. o Real GDP = Nominal GDP Price Level o Nominal GDP = Price Level X Real GDP • Changes in real GDP can only occur if quantities of goods and services produced change. • Changes in real GDP provide information on whether economic well-being is improving, while nominal GDP frequently does not. • Economic statistics are seasonally adjusted; the process by which economists adjust the data to subtract out the usual seasonal fluctuations using advanced statistical techniques. • Chain-weighted measures of GDP in which it allows the base year to change continuously (ex. Price average from 2012-2013 is used to calculate real GDP over a year then for 2013-2014 the price average from 2013-2014 will be used to calculate real GDP over that year) Measuring Inflation • Measuring inflation involves different measures of the price level that we refer to as price indexes GDP Deflator • Price level = Nominal GDP Real GDP • Nominal GDP divided by Real GDP is known as GDP deflator or the implicit price deflator for GDP. The above equation measure deflates nominal GDP to obtain real GDP. • The GDP deflator is always calculated so that it equals 100 in the base year: o GDP Deflator for year y = 100 X Nominal GDP in year y Real GDP in year y • GDP deflator for 2013 is 100 X ($15 trillion/$12 trillion) = 125 which means that the price level as measured by the GDP deflator has risen by 25% from 2005 to 2013. PCE Deflator • Personal consumption expenditure (PCE) deflator which we calculate in the same way as the GDP deflator, but only for the personal consumption expenditure component of GDP o PCE deflator for year y = 100 X Nominal PCE in year y Real PCE in year y • Because PCE is based on the prices of consumer goods, it is closed to measuring what the consumer price index measures. Consumer Price Index • Consumer Price Index (CPI) measures the average prices of consumer goods and services. Think of it as a cost of living index. The Bureau of Labour Statistics calculates the CPI monthly, the GDP deflator is calculated quarterly and the PCE deflator is calculated monthly. • CPI for 2012 = 100 X (10 x Price of gas per gallon in 2012) + (2 x Price of apples in 2012) (10 x Price of gas gallon in 2005) + (2 x Price of apples in 2005) • CPI can overstate the cost of living, causing important policy implications. • CPI might overstate increases in cost of living on the order of one percent or a little high because: o When prices rise, consumers can find substitutes for the goods. o Second, price increases often reflect quality improvements in goods. o Third, introduction of new goods can improve consumer choice and reduce the cost of living without showing up in CPI Inflation Rate • Inflation rate is precisely the percentage rate of change of the price level over a particular period. o π =P - P = ∆ P t t t -1 t P P t -1 t -1 π t= inflation rate in period t P t price level at time t P t -1price level at time t-1 • If the price level rises from 100 to 102 over a year, then the inflation rate is 2% = (102- 100)/100 = 0.02). If it rises to 103 the next year, then the inflation rate for that year is 1% = (103-102)/102 = 0.01) Percentage Change Method and the Inflation Rate • The percentage change of a product of a number of variables is approximately equal to the sum of the percentage changes of each of these variables • In the case of the product of two variables, we write this fact as follows: o Percentage Change in (x X y) = (Percentage Change in x) + (Percentage Change in y) o Percentage Change in Nominal GDP = (Percentage Change in Price Level) + (Percentage Change in Real GDP) • The percentage change in the price level is the inflation rate, while the percentage changes in nominal and real GDP are the growth rate of these variables: o Growth Rate of Nominal GDP = (Inflation Rate) + (Growth Rate of Real GDP) o Inflation Rate = (Growth Rate of Nominal GDP) – (Growth Rate of Real GDP) Measuring Unemployment: • Unemployment rate (or civilian unemployment rate) is the percentage of people in the civilian population (which excludes those in the military or in prison) who want to work but who do not have jobs and thus are unemployed. • The survey classifies each adult (over age 16) in one of three categories: o Employed is if the person is working, either full time or part time, during the past week, or was temporarily away from his or her job because of illness, vacation, or the inability to get to work because of bad weather o Unemployed is if the person did not work during the past week, but had looked for a job over the previous four week, or was waiting to return to a job from which he or she had been laid off o Not in the labour force if the person did not work during the past week and had not looked for a job over the previous four weeks • Those not in the labour forces are of two types. Those who would like to work but have given up looking are discouraged workers. The other type is those who voluntarily have left the labour force—such as full-time students, retirees, or people who have chosen to stay at home, either raising children or taking care of the house. The labour force is as follows: o Labour force = Number of employed + Number of Unemployed o Unemployment Rate = Number of employed Labour Force • Labour Force Participation Rate is the percentage of the adult civilian population in the labour force o Labour-Force Participation Rate = Labour Force Adult Population • Employment Ratio is the percentage of the adult civilian population employed o Employment Ratio = Employed Adult Population • Unemployment rate is reported using household survey or alternatively using the establishment survey. Why do these two surveys give a different picture of conditions in the labour market? o The household survey counts workers not job while establishment survey does opposite so if a worker holds two jobs they get counted twice in establishment survey o Household survey counts the self-employed as working while establishment survey does not. o Establishment survey is more extensive than household survey: it covers more workers. Measuring Interest Rates • An interest rate is the cost of borrowing or the price paid for the rental of funds Types of Interest Rates • Many different types of debt securities with bonds, which make payments on a regular basis for a specified period of time, being the most prominent. Real versus Nominal Interest Rates • Interest rate read in newspapers is a nominal interest rate because it makes no allowance for inflation • Real interest rate is the amount of extra purchasing power a lender must be paid for the rental of his or her money. Hence, the real interest rate is the interest rate that is adjusted by subtracting expected changes in the price level (inflation) to accurately reflect the real cost of borrowing • Above definition refers to as the ex ante real interest rate because it is adjusted for expected changes in the price level and it is the most relevant to economic decisions and typically what economists refer to when they mean ‘real’ interest rate • Ex post real interest rate is the interest rate that is adjusted for actual changes in the price level. It describes how well a lender has done in real terms after the fact. Fisher Equation • Fisher equation defines the real interest rate in precise terms by stating that the nominal interest rate ‘i’ equals the real interest rate plus the expected rate of inflation π e. π e o i = r + π e o r = i - • example: You made one-year loan with a 4% interest rate (i = 4%) and you expect the π e price level to rise by 6% over the course of the year ( = 6%). As a result of making the loan, at the end of the year you will have 2% less in real terms—that is, in terms of real goods and services you can buy. o r = 4% - 6% = -2% o As a lender you are clearly less eager to make a loan in this case, because in terms of real goods and services you have actually earned negative interest rate of 2%. CHAPTER 3—Aggregate Production and Productivity • Real GDP is determined by 1) the amount of inputs, or factors of production, which go into the production process, and 2) the production function, which tells us how much is produced from given quantities of the factors of production. Factor of Production • Two most important factors of production: • Labour: sum of the number of hours people work, or person-hours, which we denote by L. Assume that hours each person works is constant so that we can use the number of workers as the unit for labour input • Capital is the quantity of structures and equipment—such as factories, trucks, and computers—that workers use to produce goods and services, which we denote by K. We will assume that the quantity of capital and labour available in the economy is fixed:  K = K  L = L Production Function • Aggregate Production Function, also known as the production function, is the description of how much output, Y, is produced for any given amounts of factor inputs, such as K and L:  Y = F(K,L)  F = the function that translates K and L into a quantity of real output Cobb-Douglas Production Function • Can build on the basic idea of a production function by making two observations: • First, an efficient, developed economy will generally produce more with the same quantity of capital and labour than an inefficient, primitive economy • Second, he shares of labour and capital income in the US economy have remained relatively constant over time at about 70% labour and 30% capital. • The Cobb-Douglas production functions incorporates both of these ideas: o Y = F(K,L) = AK L0.3 0.7 o The ‘A’ variable describes productivity or, more precisely, total factor productivity, telling us how productive capital and labour are. It tells us how much output an economy can produce given one unit of capital and one unit of labour. • If total factor productivity, A, goes up by 5%, then for the same amount of labour and capital, the total amount of goods and services produced in the economy increases by 5% under the Cobb-Douglas function. • Labour productivity is the amount of output produced per unit of labour. It is measured by dividing measured output by the amount of labour input • Unlike labour productivity, total factor productivity takes into account how productive labour and capital are together. • We can solve for ‘A’ when given the values Y,K, and L by dividing both sides of the above equation by K L :0.30.7  A = Y K L.3 0.7 Ex. A = 10 = 0.20 (Output of $10 trillion, capital of $10 trillion 0.3 0.7 10 100 and labour of 100 million workers) The production function then is: 0.3 0.7 Y = 0.20 X K L Review page 49-50 application on why some countries are rich and others poor Cobb Douglas Production Function Characteristics • The Cobb Douglas Production function has two particularly attractive characteristics that give it a prominent role in the study of macroeconomics: 1) it displays constant returns to scale and 2) it has diminishing marginal product o Constant returns to scale if you increase all the factor inputs by the same percentage, then output increases by exactly the same percentage. If a company can produce 1000 apples a week, it should be able to produce 2000 apples per week with two identical companies. We substitute 2K and 2L: 0.3 0.7  Y = F( 2K, 2L) = 0.20(2K) (2L) 0.3 0.7 0.30.7 (0.3+0.7)  = 0.2 X (2 2 ) X K L = (2 ) X F(K,L)  = (2 ) X F(K,L) = 2 X F(K,L) o Diminishing Marginal Product means that as the amount of one factor increases, holding other inputs constant, the increased amount of output from an extra unit of the input (its marginal product) declines. Let’s write the production function for 100 million workers (L):  Y = 0.20 x K (100) 0.7= 0.20 x K (25.1) = 5.0 x K 0.3  As capital increases, output goes up. Further as capital increases, the slope, ∆ Y/ ∆ K, falls.  The slope of production ∆ Y/ ∆ K, the marginal product of capital (MPK), indicates how much output increases for each additional unit of capital, holding other inputs constant.  As the capital stock increases, the marginal product of capital decreases.  Marginal product of labour (MPL) indicates how much output increases for each additional unit of labour, holding capital constant.  As the amount of labour input increases, the marginal product of labour declines. o Calculating the marginal product of capital and labour  MPK = 0.3Y/K (page 53)  MPK = 0.7Y/L Changes in the Production Function: Supply Shocks • Supply Shock change in the output an economy can produce from the same amount of capital and labour. In other words, it involves a change in A, total factor productivity o Positive (or favourable) supply shocks result in an increase in the quantity of output produced for given combinations of capital and labour o Negative (or adverse) supply shocks lead to a decline in the quantity of output produced from given quantities of capital and labour. (less common, but can occur if burdensome gov’t regulations make economy less productive) • Types of Supply Shocks: 1. Technology Shock: technological advances, such as the development of a faster computer chip, can raise the A parameter in the production function in equation (Y = F(K,L) = AK L ) so that total factor of productivity rises 2. Natural Environmental Shock: blizzards, droughts, floods, earthquakes, and hurricanes can slow construction activity to a grind, reducing output for a given level of capital and labour. An unusually warm winter may have opposite effect. 3. Energy Shocks: important factor of production separate from capital and labour. When energy supplies are disrupted—for example, when OPEC cuts backs production of oil to raise prices—firms use less energy causing the amount of output the company produces to fall for a given quantity of capital and labour. • Effect of a Supply Curve o A negative (positive) supply shock causes the aggregate production function to shift downward (upward) and also causes the marginal products of capital and labour to fall (rise) Determination of Factor Prices • Analysis is conducted under a classical framework, assuming the company has: o Perfect Competition: firms take market prices as given because they are not large or powerful enough to charge more than market price for their goods/service. o Is as its long-term equilibrium level Demand for Capital and Labour • The more capitals and labour employed by firms, the more they can produce and sell. But adding additional capital/labour adds costs, reducing profit. • Economic Profits are the revenue from selling goods and services, minus the costs of inputs. Key components of economic profit include the following: 1. Revenue from selling goods and services is the average level of goods/services, P, times the amount of goods and services sold, Y: using the production function, the revenue:  P x Y is P x F(K,L) 2. The cost of using capital is the price paid to rent capital, R, times the amount of capital, K, which is RK 3. The cost of labour is the price of labour, the wage rate, W, times the amount of labour, L, which is WL  Nominal economic profits is: P x F(K,L) – RK – WL  We divide the expression by the price level, P, to get real economic profits, II : II = F(K,L) – (R/P)K – (W/P)L  We define the real rental price (or cost) of capitalC r = (R/P), as the rental price of capital in terms of goods/services and real wage rate is wage in terms of goods/services, w = (W/P) : II = F(K,L) - r C – wL • Profit maximization implies first that firms will want an amount of capital that will make the marginal product of capital equal to the real rental price of capital: o MPK = (R/P) = r C • Maximizing profits also implies that firms will hire an amount of labour that will make the marginal product of labour capital equal to the real wage rate: o MPL = (W/P) = w • Firms demand additional quantities of each factor of production (labour and capital) until the marginal product of that factor falls to its real factor price Supply of Capital and Labour: • Assume that the quantity of capital and labour are given at fixed values o L = L, K = K Factor Market Equilibrium • Market of equilibrium is achieved when the quantity of the factor demanded equal the quantity of the factor supplied. Equilibrium in the market for labour means: L L  D = S o And in the capital markets it means:  D = S K L L K K o Excess Supply : D < S or D < S o Excess Demand: D > S or D > S K K Distribution of Real Income: • Income paid to labour in real terms, real labour income, is the real wage times the quantity of labour. Recall, real wage = marginal product of labour, w = MPL. Thus, o Real Labour Income = wL = MPL x L • Income paid to owners of capital in real terms, known as real capital income, is the real rental price of capital times the quantity of capitaC, r K = MPK. So, o Real Capital Income = r C = MPK x K o National Income = Real labour income + Capital Income • National income is thus divided between payment to labour and the payments to capital, with the size of these payments determined by the marginal products of labour and capital • Cobb-Douglas production function implies that the shares of labour income and capital income in national income do not change even as the total level of income rises and falls CHAPTER 4: SAVING AND INVESTMENT IN CLOSED/OPEN ECONOMIES Relationship between Saving and Wealth • Wealth: is a person’s holding assets (such as bonds, stocks, houses and fine arts) minus his or her liabilities, the amount they owe (such as mortgages, loans, and credit card balances). • National Wealth: a country’s holdings of assets minus its liabilities at a particular point in time Private Saving • Private saving: equals private disposable income minus consumption expenditure. We calculate private disposable income, D , as GDP, Y, minus net taxes, T (taxes minus government transfers minus interest payments on the debt): o Y D Y – T o Thus, we write private saving, P , as disposable income, Y – T, minus consumption expenditure, C: o S P Y – T – C • Private saving rate is the proportion of private disposable income that is savPd:DS /Y Government Saving • Government purchases consist of two components: o Government investment (I ) Ghich is spending on capital goods like highways and schools that add to the capital stock and promote economic growth o Government Consumption (C ) whiGh is government spending on current needs  G = C G I G • Government saving equals government income less government consumption  S G T - C G  Or, SG= T – G • Budget surplus occurs if T > G, budget deficit occurs if T < G National Saving • National saving: is calculated by summing private saving and government saving. (Adding two equations cancels ‘T’ out). So national saving, S, is: o S = Y – C – G • The national saving rate is the share of national income saved by the government and households, or S/Y. (‘S’ always refers to national saving) Policy and Practice • Government stimulate saving through four main methods: o Tax Consumption: higher tax on consumption encourages consumers to spend less, save more which increases wealth o Provide Tax Incentives for Saving: providing households a tax break if they put their money in a savings account to encourage saving which increases national saving o Increase Return on Saving: increasing returns on assets like common stocks which encourages households to save o Reduce budget Deficits: this increases national saving, but recently the opposite has occurred. Uses of Savings • Savings can be determined by substituting C + I + G + NX for ‘Y’ which equals: o S = (C + I + G + NX) – C – G = I + NX • The above equation is referred to as uses-of-saving identity. This tells us that saving either goes into investment—acquiring capital goods and boosting the capital shock—or into net exports—selling goods to foreigners in exchange for foreign currency assets. We can rewrite: o S – I = NX net capital outflow identity o Net capital outflow = Trade balance • Net capital outflow (S – I) is the difference between saving and investing. o Trade Surplus NX > 0 o Trade Deficit NX < 0 The Link between Saving and Wealth • Uses of saving and net capital outflow identifies show that: o Saving is linked to wealth o Saving can either finance investment or net exports o An increase in net foreign assets is clearly an increase in wealth Application • Up until the 1980’s, US was the largest net creditor in the world (owned more foreign assets than foreigners owned of US) • By 2008, net foreign debt was over $3.5 trillion, or 24% of GDP • How did the US go from being the largest net creditor in the world to the largest net debtor? • The net capital outflow is the answer Saving, Investment, and Goods Equilibrium in a Closed Economy • To further understand the link between saving and investment in the long run when all prices are flexible, we first assume: o The goods market is in equilibrium o Start with closed economy, an economy that has no international trade (NX = 0)  Y = C + I + G • When we subtract C and G from both sides (national market = S from Y – C – G equation), we can rewrite the condition for goods market equilibrium as: o S = Y – C – G = I o Saving = Investment • We will see that the real interest rate keeps the market for saving and investment in equilibrium • Amount consumers want to spend is a function of three factors: o Disposable income (Y – T) o Real interest rate (r) o Autonomous consumption (C) the amount of consumption expenditure that is unrelated to either disposable income or real interest rate • Relationship of consumption expenditure to disposable income and real interest rate is: o C = C + C(Y – T, r) + - o The plus sign under (Y-T) indicates that as disposable income increases, consumption expenditure rises o The minus sign under ‘r’ indicates that as real interest rate rises, consumption expenditure falls • Level of capital and labour is exogenous and fixed at K and L. Long-run aggregate output is therefore also exogenous variable, which we fix at Y. So: o Y = F(K,L) = Y • Recognizing that saving S = Y – C – G and substituting in equations above, we can describe the desired amount of saving as : o S = Y – C – C(Y – T, r) – G o G is gov’t fiscal policy meaning it’s determined by political consideration
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