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!

Adding Government and Net Exports to the expenditure function

IMPORTANT: We spent a lot of time determining equilibrium values in this course, but it's important to remember that equilibrium is NOT NECESSARILY A GOOD THING: You could have an equilibrium level of national income which is abysmal and leads to unprecedented unemployment. The only thing we can state about the equilibrium level is that it does not change over time! Ye = the National Income at equilibrium

THE GOVERNMENT

Government purchases are added as a separate category to aggregate expenditure, but transfer payments are not (don't worry, they get factored in later)
-Remember, we are still assuming a constant price level
-Fiscal policy directs government purchases (which increase aggregate expenditure) and taxation (which decreases aggregate expenditure) to effect the equilibrium level of national income
-Government purchases affect aggregate expenditure DIRECTLY
-Taxes affect aggregate expenditure INDIRECTLY (they affect disposable income and consumption)
-Government SPENDING includes transfer payments AND government purchases. We don't include transfer payments in government purchases, however.

Government purchases are usually a function of election promises, not national income!

THEREFORE: Government purchases are a constant in the functional relationship with national income (not unlike investments, government spending as a function of national income is a flat line)


NET TAXES:
-Taxes DECREASE disposable income, while transfer payments increase disposable income
-Disposable income = Income minus net taxes
-Net taxes = Taxes minus transfer payments
-Usually, taxes are a function of income, and change with income: T = f(Y)
-We could say that T = tY, where t = the net tax rate (also called the marginal propensity to tax, or the marginal rate of taxation)
-If t is constant, then that is a flat tax rate
-Taxes include income tax, corporate tax, sales taxes, excise taxes, property taxes, and others!


THE BUDGET FUNCTION!

The government's budget is net taxation minus government purchases (money in minus money out): It's important to remember that this is withdrawals and injections for the GOVERNMENT, not for the circular flow economy (in terms of the economy, it's the opposite: taxes are withdrawals and government purchases are injections)

There are 3 types of budgets which a government can ring up:
-A budget surplus, where net taxes are higher than purchases, and therefore government revenues outweigh government expenditures
-A budget defecit, where net taxes are lower than purchases, and therefore government expenditures outweigh government revenues
-A balanced budget, where net taxes are equal to government purchases, and therefore government expenditure is equal to government revenue

THE PUBLIC SAVINGS FUNCTION is the budget surplus function: This is derived by graphing both government purchases and net taxes as functions of national income. While taxes increase with income (and thus form an upward-sloping line), purchases are flat. The point where taxes and purchases intersect is a balanced budget. The area where government purchases are greater than the level of net taxation represents budget deficits, while the area where net taxes are higher than government purchases represents budget surpluses.

The public savings function combines these two into one function to represent budget savings!
It is equal to Net Taxes minus Government Purchases as a function of national income
(T - G) = f(Y)

This shows that the budget changes as GDP changes. REMEMEBER: This budget represents money inflows and outflows for the government: while a government budget deficit is bad for the government in that they are losing money, it is good for the economy, in that the economy receives a monetary injection.

THE FEDERAL GOVERNMENT taxes about equal to provincial and municipal taxes, but federal government purchases are less than provincial municipal purchases. As a result, the feds spend more on transfer payments to the provinces. We include spending and taxing on all levels in our national income and expenditure accounts.

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

NET EXPORTS AND THE NET EXPORT FUNCTION

Net exports = imports minus exports (another name for this is the balance of trade)

-A balance of trade surplus occurs when there is more foreign money spent on exports than domestic money spent on imports (money in is higher than money out)
-A balance of trade deficit occurs when there is more domestic money spent on imports than foreign money spent on exports (money out is higher than money in)
-A balance of trade occurs when there are equal exports and imports, and money in is equal to money out

Exports are autonomous, since they depend on foreign economies, so we see than as a constant (flat line graph) in a functional relationship with national income
Imports, however, increase with national income, so we could say that:
Imports = m(Y) (where m is the marginal propensity to import [the slope of the import function], and Y is national income, not disposable income)

We can graph both imports and exports as functions of national income, and then find the difference between the value of exports and the value of imports to determine net exports.

Net exports = (imports minus exports) as a function in national income
fY = X-M

This appears as a downward sloping line. When the national income is very low, there will not be a lot of imports, but there will be a constant amount of exports, so the value of the exports will outweigh the value of the imports, leading to a positive value for net exports. When national income is high, however, imports outweigh exports, leading to a negative value for net exports.

SHIFTS IN THE NET EXPORT FUNCTION
-Two things affect net exports as ceteris paribus variables
1) Foreign income (which affects domestic export levels)
2) Relative prices of goods (aka: the exchange rate)
-Domestic prices rise if domestic inflation rises or if the external value of domestic currencies rise
-Foreign prices rise if foreign inflation rates rise, or if the exchange rate of foreign currencies rise.
-Foreigners like to buy things that are CHEAPER, so the higher the exchange rate of their currencies, and the lower the external value of domestic currencies, the more they will want to import!

Generally, an increase in exports causes the net export function to shift up (and a decrease would cause it to shift down)
Meanwhile. an increase in the marginal propensity to import (the slope of the import function) causes net exports to rotate down (so net exports fall more steeply as a function of national income if MPM is higher)

Examples:
If a foreign country's national income decreases, then exports will decrease, and the net export function will shift downward
If relative canadian prices increase, this will lead to a reduction in exports, so the net export function will shift downward. However, this will ALSO lead to an increase in domestic consumers importing products (an increase in the marginal propensity to import), so the net export function will also rotate downward.
-An increase in external value (appreciation of domestic currencies) causes the same affect as an increase in the general domestic price level (fewer exports, and an increase in the MPS)

That's all for today

The Importance of Consumption! The consumption function, and other wonderful things!

Quick review:
We have 5 basic macro-economic variables: Y,U,P,i, and e
Y is the bull's eye, which we try to control using fiscal and monetary policy
There are 4 stages to developing our economic model
1) Spendthrift (where there is just the firm and the household)
2) Frugal (which allows for spending and investment through banks)
3) Governed (which factors in taxation and government expenditure)
4) Open (which factors in imports and exports)

Our end-goal is to find the relationship between the general price level and the national income!

Here are some basic assumptions we have to make in building our macroeconomic model right now:
-Demand determines output
-The price level is constant (we pretend there is no inflation)
-In a basic economy, the interest and exchange rates remain constant
-We assume that potential national income is constant

Autonomous versus Induced Variables:
-Autonomous variables do not depend on national income, and thus are external to our model: this includes things like exports, which are determined by foreign economies, not domestic economies

Induced Variables DO depend on national income, and are thus found within our model: imports for an example tend to increase as Canada's national income grows, thus this an induced variable.

Today, we are going to learn about consumption, which is a very important part of national expenditure (the other parts being investment, government expenditure and net exports).

First: DESIRED versus ACTUAL EXPENDITURE:
-This is similar to microeconomics where we talked about willingness to buy (quantity demanded) at a given price. In Macro, we talk about the willingness to expend at a given income- it's a similar concept
-Actual aggregated expenditure is measured by NIEA (national income and expenditure accounts), which is denoted by an "a" subscript
-Desired expenditure is planned or intended expenditure
-It is a combination of consumption, investment, government expenditure, and net exports
-It is a function of national income (so national income effects expenditure)

THE CONSUMPTION FUNCTION: As a general rule, if people have more money, they spend more. Who'd have thunk...
-Consumption is a function of disposable national income! (Yd = current disposable income, which is national income minus taxes). However, in a spendthrift economy, we don't have to worry about taxation! =D

The ceteris paribus variable for the consumption function are
-Wealth (accumulated income: higher wealth generally leads to more consumption)
-Expectations (if prices are expected to rise in the future, this increases current consumption; if prices are expected to fall in the future, this decreases current consumption)
-Interest Rates (higher interest rates decreases consumption)

DESIRED CONSUMPTION IS A FUNCTION OF NATIONAL INCOME! John Meynard Keynes figured this out!

Here are some basic assumptions of the consumption function:
1) There is a break-even level of consumption (where consumption is exactly equal to disposable income)
2) as disposable income increases, consumption increases, but by less and less (in other words, the higher disposable income, the larger the portion of that income which will go into savings)
3) DESIRED CONSUMPTION IS A FUNCTION OF CURRENT DISPOSABLE INCOME!

*On a graph you can see this visually: consumption has risen with national income over the years in Canada.

Okay, so let's see one of these consumption functions!

-First off, this is a simplified version of the consumption function: most real ones would look more like curves, but we don't like to solve quadratics in this class
-The 45 degree line is where consumption is equal to disposable income- any point on this line is the break even point!
-As Y increases, so does C
-Here, Y = Yd (because this is a frugal economy)

-The slope of the consumption like is denoted by the variable 'b', and the actual term for it is the Marginal Propensity to Consume (MPC)
-The Y intercept is autonomous/exogenous expenditure which occurs even when there is no income: this is denoted by the variable 'a'
-Desired Consumption is 'C'
-Any point where consumption is higher than income has dissavings, or borrowed money, while any point where income is higher than consumption has savings

C = a + b(Yd)

for example: Consumption = 100 + 9/10(Disposable Income)

Basically
-Income is either spend (so it goes into consumption) or not spent (so it goes into savings)
-Savings are non-consumption
-Disposable income is then equal to consumption + savings
-Negative savings are dissavings, or loans
-Savings are Disposable income minus consumption
-At the break even point, income is equal to consumption, and savings is equal to zero

It is possible to build a savings function from the consumption function!

The savings function is derived from C = a + b(Yd)
S = Yd - C
if C is a straight linear function, then...
S = -a + (1-b)Yd
S = the vertical distance between C and the break even line (45 degrees)

SOME OTHER TERMS WHICH ARE IMPORTANT TO REMEMBER:
Average Propensity to Consume (APC): This is consumption divided by disposable income- this is the slope of the ray from the origin to the point being considered
Marginal Propensity to Consume (MPC): This is a change in consumption divided by a change in disposable income- this is the slope of the tangent to the curve being considered (so, for this very simplified, linear graph, it is equal to the slope of the consumption function)
Average Propensity to Save (APS): This is savings divided by disposable income- this is the slope of the ray from the origin to the point being considered on the savings function
Marginal Propensity to Save (MPS): This is a change in savings divided by a change in disposable income- this is the slope of the tangent to the curve being considered on the savings function (so for this linear savings curve, it's just equal to the slope of the savings function)

SOME MATHEMATICAL RELATIONSHIPS WHICH WILL MAKE PERFECT SENSE
Income = Consumption + Savings
Income/Income = Consumption/Income + Savings/Income, so 1 = APC + APS
/\Income//\Income = /\Consumption//\Income + /\Savings//\Income, so 1 = MPC + MPS
MPC is a value between 0 and 1
C = a + b(Yd) where a = the vertical intercept and b = MPC

THAT'S ALL FOR TODAY

Basic Macroeconomic Concepts Continued

UNEMPLOYMENT (U):
-News publications will often toss around unemployment rates, but very few people actually know what the unemployment rate means, or what a 'good' rate for employment or unemployment is

Increases in output are either caused by
1) more works being utilized (aka an increase in employment) OR
2) each worker being more productive

In the SHORT RUN, changes in productivity usually don't happen (they take a longer time to come to be realized), so only changes in employment affect output

In the LONG RUN, changes in both productivity and employment can affect output (so the Canadian economy could raise it's GDP either by putting more people to work, or by implementing more efficient production processes [like switching to machine-centric production processes which allow each worker to produce more in a shorter amount of time])

Definitions and Terms Surrounding Employment and Unemployment:
LABOUR FORCE: The total number of people who wish to work at any given time (Unemployment + Employment) ***Note: The size of the labour force can grow and shrink depending on how motivated the general populace is to work. Often, higher wages motivate more people to work, so in times where wages are higher, the labour force is also larger
EMPLOYMENT: The total number of workers ages 15 and older who have any kind of job (including part time work, full time work, and self-employment)
UNEMPLOYMENT: The total number of workers ages 15 and older who are willing and able to work, but have NO job
UNEMPLOYMENT RATE (U): UNEMPLOYMENT/LABOUR FORCE
EMPLOYMENT RATE: EMPLOYMENT/POPULATION

NOTICE how unemployment rate and employment rates are calculated differently? Pretty tricky, huh?

TYPES OF UNEMPOYMENT:
Frictional- turnover unemployment (people who are unemployed because their still trying to find a job that works for them, like recent college graduates)
Structural- unemployment due to mismatching (like when there are 20 positions for teachers and 20 unemployed plumbers- there are enough jobs, but they are the wrong kind of jobs for those who are unemployed)
Cyclical- unemployment that results from recessionary gaps

NAIRU = Non-Accelerating-Inflationary-Rate of -Unemployment: The rate of unemployment that exists at full employment

THE HISTORY OF UNEMPLOYMENT:
-Employment tends to increase fairly constantly in line with growth in the labour force
-Unemployment rates peak during recessions. In Canada, they fluctuate from 12% to 4%, but usually average at around 7%

WHY DOES UNEMPLOYMENT MATTER? Unemployment causes stress and unhappiness on an individual level, and creates economic waste on a macro-level. Overall, it's a very bad sort of thing
---------------------------------
PRODUCTIVITY: Real output per unit of input (all five different kinds of inputs)
LABOUR PRODUCTIVITY: Real output per unit of labour input- this can be measured either per worker or per hour worked

HISTORY OF PRODUCTIVITY IN CANADA:
Real GDP per worker has increased at 1.3% per year
Real GDP per hour has increased at 1.1% per year
Per hour is probably the better measure because the number of hours worked per worker can contribute to per-worker productivity (in other words, we aren't necessarily becoming more productive in Canada as much as we are simply working more hours)

Why does productivity increase? Usually because of increases in human and physical capital.

The trend is that both per hour and per worker GDP have been rising gradually in Canada over time.
------------------------------------
INFLATION (P) OR GENERAL PRICE LEVEL: The average price of all goods in the economy (usually expressed at CPI)
Inflation is defined as an increase in P (an increase in the average cost of all products)

CPI is the consumer price index. This is weighted average of all goods and services in a representative basket of goods (where each good is weighted depending on what percentage of their income the average consumer would spend on it). This is used to measure the cost of living.

Problems with CPI:
-It doesn't adjust for quality changes (ie: situations where you would pay the same amount of money but for a much better product)
-It also doesn't adjust for changes in consumption patterns over time

4 steps to construct an index:
1) Determine the goods in the index
2) Find the base year quantity of goods times the base year price of goods
3) Find the current year quantity of goods times the current price of goods
4) The price index: the ratio of current year/base year

Purchasing power = the number of goods that can be purchased per dollar

HISTORICAL TREND: Inflation has caused the general price level to increase to over 6 times its 1960 level. The rate of inflation can fluctuate wildly

WHY INFLATION MATTERS: Inflation diminishes the purchasing power of money, it reduced the value of fixed assets. If inflation is unanticipated, it can have serious macro effects.
------------------------------
INTEREST RATES (i): The cost of borrowing money
-"The" interest rate is the mean of all of the different interest rates
-The prime rate is the rate which chartered banks charge to preferred customers
-The bank rate is the rate which the bank of Canada charges to chartered banks

The nominal interest rate is the current rate of borrowing (the real interest rate + inflation)
The real interest rate is the nominal interest rate corrected for changes in purchasing power (so if the current interest rate is 5% and inflation is currently 5%, then the real interest rate is 0% [nominal minus inflation])
----------------------------
EXCHANGE RATES (e): These are the same as they were in micro
Foreign Exchange = Actual Foreign currency
Foreign Exchange Market = The Market for Foreign Currency
External Value = The price of domestic currency
Exchange Rate = The price of foreign currency
Appreciation = rise in external value and fall in the exchange rate (when domestic currency becomes worth more relative to foreign currencies)
Depreciation = fall in external value and rise in exchange rate (when domestic currency becomes worth less relative to foreign currencies)

BALANCE OF PAYMENTS (BOP) = a measure of the money going in and out of any country
BALANCE OF TRADE = Exports minus Imports = net exports = NX

Historically, our imports and exports have both increased over time, but our net exports are positive (The US's net exports are negative right now).

Our exchange rate has fluctuated greatly over time. It's reached parity with the US a few times (like in 2008).

Growth and Fluctuations (Business cycles) are different!