Lecture 9: Macro Mod 5

Lecture 9: Macro Mod 5 C.L. Mattoli (C) Red Hill Capital Corp., Delaware, USA 2008

This week • Chapter 14: A Simple Model of the Macro Economy (C) Red Hill Capital Corp., Delaware, USA 2008

Notice • Since most people from tutorial 1, Monday 2:00 had already transferred themselves to other tutorials, that tutorial will no longer exist, beginning today. (C) Red Hill Capital Corp., Delaware, USA 2008

Prelude • We looked at macroeconomic concepts and variables, such as GDP and its make-up, inflation, unemployment, and short- and long-term growth of the economy. • In this lecture we shall look more deeply into some of the concepts that we have talked about, and we shall discuss supply and demand on the aggregate level. (C) Red Hill Capital Corp., Delaware, USA 2008

Prelude • We have looked into some simple concepts and models of economic growth, which, after all, is one of the main concerns of people and, therefore, their governments. • Way back in the beginning of the course when we talked about the PPF, we said that there were two ways that an economy could get to a new PPF. (C) Red Hill Capital Corp., Delaware, USA 2008

Prelude • The first was changing its mix of output to more capital goods. Even then, we pointed out that the economy would have to produce less consumer goods. • The implicit result was that the people would have to give up consumption. • In the preceding lecture, we elaborated on that idea by pointing out that consuming less means saving more, and savings is required to fund investment. (C) Red Hill Capital Corp., Delaware, USA 2008

Prelude • Then, we went on to think about how since capital goods wear out and need to be replaced, there will need to be investment (requiring savings) just to replace the worn out capital. • To increase the capital stock, resulting in an increase of production factors/person, resulting in more potential output per person, resulting in higher gross output for the economy, will require more savings. (C) Red Hill Capital Corp., Delaware, USA 2008

Prelude • In the end, we talked about a Golden Rule level of savings. • The Golden rule is simply a conceptual argument based on some of the concepts that we covered in looking at production on the micro level in module 3. • To get to a higher level of output, we need more capital. • The more capital stock we accrue, the more that will wear out. (C) Red Hill Capital Corp., Delaware, USA 2008

Prelude • Also, since there is the law of diminishing returns, there will be an optimal level of capital goods/ person beyond which we should not go because it will just be a waste of money for the extra capital beyond that. • That means that the extra savings is wasted and that the only result will be that consumption will be less than it could have been. (C) Red Hill Capital Corp., Delaware, USA 2008

Prelude • The simple result of the Golden Rule is that it brings to economy to the perfect level of capital stock and capital stock/person, and after that level is reached, the savings supports exactly enough investment, each year, to replace the part of the capital stock that is wearing out. • The Economy will be at a maximal PPF and at one exact point on that PPF. (C) Red Hill Capital Corp., Delaware, USA 2008

Prelude • What makes it possible for economies to grow (and expand their PPF’s beyond the one that would come from the Golden Rule) is changing technology. • Then, as new technology is invented and used to replace the old technology, output/person can continue to increase, so total output can increase. (C) Red Hill Capital Corp., Delaware, USA 2008

Prelude • Although we have not filled in the extra result, all through our discussion, the other end result is that since output increases, income/person increase, and that means everyone’s standard of living has increased, which is the major goal of it all. • As a result, the economy can again continue to grow beyond the point where it got to from the Golden Rule. • We shall examine some models of the macro economy. (C) Red Hill Capital Corp., Delaware, USA 2008

Learning objectives On successful completion of this module, you should be able to: • Articulate Keynes’ rejection of the classical school’s explanation of the Great Depression of the 1930s • Explain the economic determinants of the components of aggregate expenditure (consumption, investment, government expenditure, and net exports) • Construct and use the ‘aggregate demand-output’ model for macroeconomic analysis (C) Red Hill Capital Corp., Delaware, USA 2008

Learning objectives • Construct and use the ‘aggregate demand-aggregate supply’ model for macroeconomic analysis In the next lecture: • Use the concepts of money demand and money supply to explain the determination of interest rates in an economy • Explain the effect of monetary policy on interest rates, prices, output and employment • Describe the Australian financial system as an example of a typical financial system in the 21st century (C) Red Hill Capital Corp., Delaware, USA 2008

Classical Economics • In classical economics, as led by the famous Adam Smith who imagined markets having an invisible hand that would make everything right, it was believed that markets would always clear. • Classically, it was believed that the forces of supply and demand would lead to all goods and services offered being sold and would naturally lead to full employment. • That was taken as a corollary of the flexibility of all prices, including wages and interest rates. (C) Red Hill Capital Corp., Delaware, USA 2008

Say’s Law…isn’t! • Laws cannot be broken, or they aren’t laws. Such is the case for one of the laws of classical economics: Say’s Law. • Say’s Law states that production of G&S (supply) generates an equal amount of spending (demand). • First, since people have unlimited wants, while there is limited supply of anything, it might seem logical. (C) Red Hill Capital Corp., Delaware, USA 2008

Say’s Law…isn’t! • Second, suppose that we look at the simple circular flow model of GDP, consider a firm in the economy that produces 100,000 packets of noodles to sell at $1/pack. • The supply decision potentially creates $100,000 of income through the factor markets as wages, profits and payment for the wheat. So it creates just enough income to clear the market in demand, and everyone remains employed. (C) Red Hill Capital Corp., Delaware, USA 2008

Say’s Law…isn’t! • Indeed, if the market could not clear, the price of noodles would be bid down. • In turn, wages and payments would also fall, and, again, there would be just enough income taken in to keep everyone employed and clear the noodle market. • If that might not happen immediately, then, it would happen over a short period of adjustment as the price and resulting factor payments came to new equilibrium levels that again balance out. (C) Red Hill Capital Corp., Delaware, USA 2008

Say’s Law…isn’t! • A prolonged depression (long recession), like that in the early 1930’s after the great stock market crash of 1929, would be impossible according to this law. • However, people do not like change, especially change for the worse, and even when change would be to their benefit they are slow to do so, if at all. • That is the case with accepting decreases in wages or any other financial loss. (C) Red Hill Capital Corp., Delaware, USA 2008

Keynes Theory (C) Red Hill Capital Corp., Delaware, USA 2008

Keynesian economics • Keynes, in his General Theory of Employment, Interest and Money, turned Say’s Law around, and said that demand creates it’s own supply. • He argued that over long periods aggregate demand (expenditures), C+I+G+(X–M) from the modules about GDP (expenditure approach), can be too small to achieve full employment. • We shall examine each of these categories of expenditures, in greater detail in what follows. (C) Red Hill Capital Corp., Delaware, USA 2008

C is for Consumption (C) Red Hill Capital Corp., Delaware, USA 2008

HH consumption • The primary factor in determining what you and your family spend on food, clothing, shelter, education, and other things is how much money you have, which depends on how much you earn. • Disposable income, DI, which is personal income after taxes, is how much you earn. (C) Red Hill Capital Corp., Delaware, USA 2008

HH consumption • Psychologically, it is expected that the more a person earns, the more he or she will consume, although that does not mean she or he will spend all of it (they might save some, S). • The relationship between C and DI is called the consumption function, C = f(DI), consumption is a function, f, of disposable income. (C) Red Hill Capital Corp., Delaware, USA 2008

HH consumption • In modern developed countries, C accounts for almost two-thirds of aggregate expenditures (equals GDP +M) and is the largest component. • Of course, there are other factors that affect consumption, and we shall also discuss those, below. (C) Red Hill Capital Corp., Delaware, USA 2008

Marginal Propensities for C & S • If HH do not use DI for spending, C, what they do with it is to save, S: DI = C+S. • Since we are talking about how C will depend on DI, we introduce the concept of marginal propensity to consume, MPC, which is just the change in consumption per change in disposable income, or: MPC = ΔC/ΔDI. • For example, if a person’s MPC=0.75, then, for every extra (marginal) dollar of DI she gets, she will use 75% of it for consumption. (C) Red Hill Capital Corp., Delaware, USA 2008

Marginal Propensities for C & S • Although there is reason to believe that MPC will be higher for lower income than for higher, in the models that we shall discuss, we assume that MPC is constant for all DI. • Hand-in-hand with MPC, we will have MPS, the marginal propensity to save. • Certainly, since DI = C + S, ΔDI/ΔDI = 1 = ΔC/ΔDI + ΔS/ΔDI = MPC + MPS, so that MPS = 1 – MPC. Thus, the person, above will have MPS = 1 – 0.75 = 0.25 (25%). (C) Red Hill Capital Corp., Delaware, USA 2008

Expectations and consumption demand • Consumer expectations (sentiment) about the futurecan also affect spending habits in the present. • They will tend to spend more when they are optimistic about the future and less when they are pessimistic. • Expectations will cover a number ofthings, like future inflation, future employment, future income, and future prices. (C) Red Hill Capital Corp., Delaware, USA 2008

Expectations and consumption demand • For example, if people expect inflation to move higher, they may buy, now, to avoid higher prices, later. • Then, prices will also be bid up. • If they expect a recession and the possibility of being unemployed, they might tighten their belts (means spend less money) and spend less, now. • Then, there might be a recession. (C) Red Hill Capital Corp., Delaware, USA 2008

Wealth • The wealth of HH’s includes things, like cars, TV sets, furniture, art, horses, and financial assets, as well (home purchases are part of I, not C). • The more wealth HH’s accumulate, the more they are expected to spend, ceteris paribus, and conversely. • The large losses of wealth in the stock market crashes of 1929 and 2001 were blamed for large dips in consumption spending, and the latter also resulted in a negative savings rate in the U.S. in the early 2000’s. (C) Red Hill Capital Corp., Delaware, USA 2008

Price levels • Changes in the general level of prices can affect consumption spending (demand) by increasing or decreasing the purchasing power of financial assets that have fixed nominal values. • For example, if you have a $100,000 bond, and prices increase by 10%. Then, the same financial asset will buy approximately 10% less in G&S when you sell it. • If the real value of wealth drops, HH’s will tend to spend less at any level of current DI. (C) Red Hill Capital Corp., Delaware, USA 2008

Interest rates • Interest rates, as we learned in the last module, also vary with the rate of inflation (nominal interest rate = real rate + inflation; NI = RI + INF). • Some HH purchases (big-ticket items), like cars, large appliances, boats and houses, are usually at least partly paid for with borrowed funds. (C) Red Hill Capital Corp., Delaware, USA 2008

Interest rates • Lower interest rates encourage borrowing, and higher rates discourage taking on debt. (Interest rate is % per year of borrowed money that you pay to use the money) • As a result, HH’s will be more disposed to using debt to finance consumption, when rates fall, and may be less inclined to make purchases on credit when rates are higher. (C) Red Hill Capital Corp., Delaware, USA 2008

I is for Investment (C) Red Hill Capital Corp., Delaware, USA 2008

I and C • It is widely believed that that changes in private-sector spending (as opposed to government, public sector), C+I, are the major cause of business cycles. • The more volatile of these two components is I. • The greater stability of C has to do with factors, other than income, acting to offset one another. (C) Red Hill Capital Corp., Delaware, USA 2008

I and C • Indeed, people might simply be reluctant to change personal spending habits and will dip into savings or borrow money to maintain their lifestyles. • Remember: I consists of spending on new residential and non-residential structures, P&E, and inventories. (C) Red Hill Capital Corp., Delaware, USA 2008

Major factors for I • The two most important variables in the investment decision are: the expected return from the investment and the interest rate for funds to finance the investment. • For example, suppose that I want to buy a truck for transporting beer between Qingyuan and Guangzhou. • The cost of the truck is $30,000, it will be scrap in a year, and I can earn $33,000 during the year. (C) Red Hill Capital Corp., Delaware, USA 2008

Major factors for I • Then, my return on investment (ROI) is ($33,000 – $30,000)/$30,000 = 10%: my earnings minus cost divided by investment. • Next consider the cost of borrowing money to finance the truck (interest payments). • If the interest rate is below 10%, I can make a positive return by borrowing all of the money to finance the truck. (C) Red Hill Capital Corp., Delaware, USA 2008

Major factors for I • If the rate is above 10%, my net return would be negative, and I could not do it. • Ceteris paribus, this simplistic example suggests that as interest rates fall, aggregate investment spending will increase. As interest rates rise, people will take on fewer investment projects as required return is higher. (C) Red Hill Capital Corp., Delaware, USA 2008

The expectations factor in I • If you look closely at our 2 major factors in I, the word expected should pop out. • Expectations play a primary role in business decisions since all investment has a future-oriented nature. • We invest, now, to get money, then, and many things can affect expected returns. • As irrational human beings, business people are moody and can become optimistic or pessimistic about economic conditions. (C) Red Hill Capital Corp., Delaware, USA 2008

The expectations factor in I • Then, those expectations involve normative analysis in forecasting sales, costs, and ultimately profitability of investment projects. • Forecasting, in turn, involves consideration of a mass of ever-changing factors, such as consumer sentiment, population growth, trends in tastes, government spending, taxes, central bank monetary policy, conditions in securities markets, and national and world events. (C) Red Hill Capital Corp., Delaware, USA 2008

The expectations factor in I • Forecasting and confidence in forecasts is quite difficult, and there can be waves of pessimism and optimism in business because people talk to each other and watch each other, and attitudes spread. • All of this is against a background of a current rate of interest for investment funds. (C) Red Hill Capital Corp., Delaware, USA 2008

The expectations factor in I • The result can be broad-based reductions or increases in investment spending in the economy. • That was the case during the Great Depression of the 1930’s. It also played a part in the early part of this century. • Thus business confidence is a major cause of fluctuations in investment spending. (C) Red Hill Capital Corp., Delaware, USA 2008

Technological change • Technological progress includes the introduction of new products or new ways of doing things. • New technology results in a flurry of investment spending as firms buy the latest technology to improve production and to keep up with or ahead of the competition, so investment demand rises. • Indeed sometimes purchases of technology are necessary, like was the case in the 1990’s as everyone rushed to buy technological fixes as the world approached Y2K. (C) Red Hill Capital Corp., Delaware, USA 2008

Capacity utilization • The amount of capacity being used by businesses in the economy will also have a major affect on new investment decisions. • During recessions, many businesses are operating below their maximum potential productive capacities. Thus, there is little incentive for business to make new investment to add to their capital stock to increase productive capacity. • When cap utilization is high and the outlook for increased sales is good, there is pressure to invest to increase capacity. (C) Red Hill Capital Corp., Delaware, USA 2008

Business taxes • Since, after all, businesses, as anyone, focus on profits after tax, changes in taxes can also affect business decisions about investing. • If taxes increase, profitability of potential projects will decrease at any interest rate, and investment spending will decrease. (C) Red Hill Capital Corp., Delaware, USA 2008

Business taxes • On the other hand, government can encourage investment with, for example, investment tax credits of some sort for new investments. • For example, the government could offer a tax credit of 10% on new investment in addition to the usual depreciation expense available for investment. (C) Red Hill Capital Corp., Delaware, USA 2008

G is for Government Demand (C) Red Hill Capital Corp., Delaware, USA 2008

G equals government consumption & investment • Government spending is considered autonomous expenditure: they are not affected in any systematic way by changing interest rates or income. • The rationale for that assumption is that government spending results, primarily, from political decisions, not from economic impetus, like the level of output or interest rates. (C) Red Hill Capital Corp., Delaware, USA 2008

G equals government consumption & investment • This particular part of expenditures was crucial for Keynes, in that, even if private sector was fearful about the future and was reluctant to spend for consumption and investment, the government could be the vanguard of spending and could kick start the economy and stimulateprivate sector spending by improving sentiment about the future. (C) Red Hill Capital Corp., Delaware, USA 2008

Lecture 9: Macro Mod 5