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*
Friday, January 29, 2010
Saturday, January 9, 2010
Introduction to Macroeconomics
Here we go!
MACROECONOMIC MODELING: There are two different ways to model the economy.
-Bottom up modeling uses all of the principles of microeconomics (such as profit and utility maximization) and analyzes the choices made by workers, firms, consumers, and others to create a model of the economy. A bottom-up model assumes that the economy works, and thus wages and prices are flexible within a bottom-up model.
-Top down modeling is a macroeconomic aggregation (summation) which analyzes the collective behavior of larger groups (as opposed to individual actors). Thus, top down modeling focuses on total demand and supply within an economy, and also assumes wage and price rigidity.
OUR course follows the Top Down approach to macroeconomic modeling. We do not explicitly rely on microeconomic foundations here, and we are initially assuming wage and price rigidity.
REMEMEBER:
-Macroeconomics is concerned with the 'big picture'
-Macroeconomics studies aggregates and how government policy affects them (ie: the government can manipulate the economy)
-The concepts of price and quantity which we learned in Microeconomics now become the general price level (P) and the national income or production or Gross Domestic Product (Y)
-Two issues of major importance are BUSINESS CYCLES and GROWTH of Y
BUSINESS CYCLES: The cycles of the national income in the medium term
GROWTH of Y: The long term trend of national income
Macroeconomics studies FISCAL and MONETARY policy
FISCAL POLICY: Government policies regarding taxation and spending
MONETARY POLICY: Government policies regarding interest rates and the money supply
There are 5 different variables which we have to learn for macroeconomics. Y, U, P, i, & e (we call these the YUPie varaibles in Gateman's class). For each of these different variables, we will be learning what exactly the variable refers to, what historical trends have we observed regarding the variable, and why the variable is important.
-----------------------------------------------
Y: OUTPUT AND INCOME
****REMEMBER: Output generates income!
DEFINITION OF Y: Final market value of all goods and services produced in the economy during a defined period of time (usually a fiscal year).
Final- refers to the fact that intermediate goods do not count towards GPD (so you cannot count both a car and the steel needed to produce that car both as contributors to national income)
Market Value- This refers to the value of products as determined by supply and demand
Good and Services- Both concrete goods (like tomatoes) and immaterial goods (like economics classes) contribute to GDP
Produced in the economy- this refers to the fact that 'flipping' products does not add to the GDP, so a stock broker who makes a small fortune from buying and selling stocks is not technically contributing to the GDP. On the other hand, if this broker were were to create a financial brokerage service for others, this WOULD contribute to the GDP (because the broker could be seen as offering a service to others for money)
A fiscal year in Canada is usually from April of one year until April of the next year, because that is when the government unveils the budget (their plan regarding spending and taxation)
Nation Income (Y) is the 'target' at which we aim the economy- in other words, it is the variable which we seek to manipulate directly in order to make changes to the economy. The government uses fiscal and monetary policy to accomplish this task. Unemployment (U) is inversely related to growth in Y, so as national income grows, unemployment shrinks. Conversely, as the national economy shrinks, unemployment rises. Inflaction (P) is directly related to growth in Y, so as the national income grows, the general price index (aka inflation, aka P) will increase.
Just REMEMEBER THIS:
National income (Y) is the primary target of attempts to manipulate the economy
Unemployment (U) and Inflation (P) are secondary
Interest Rates (i) and Exchange Rates (e) are tertiary
So, in other words, every macroeconomic variable we deal with in this course is affected by national income.
-------------------------------
THE CIRCULAR FLOW DIAGRAM
The red arrow flowing from households to producers represents flow of factors (workers provide factors to producers so that consumers may produce products)
The black arrow flowing from producers to households represents flow of income (producers give workers wages in return for providing labour as a factor of production)
The red arrow flowing from producers to households represents flow of output or goods (households buy products from producers)
The black arrow flowing from households to producers represents flow of expenditures (households pay producers money in order to purchase goods)
The red arrows here show real flows (flows of real goods, services, and factors), while the black arrows should money flows. There are two systems represented here: the output-expenditure flow (also known as the products market) and the factor income flow (also known as the factor market)
IMPORTANT*** GDP(Y) = GDP(E) (income = expenditures)
Also, OUTPUT GENERATES INCOME (so the higher our output, the higher out income)
This basic circular flow structure is called a spendthrift economy.
If we add a bank to the system, we can call it a frugal economy. Here, actors can put money into the bank (this is called savings) and the bank can lend money out to different actors (this is called investment). If the level of savings is equal to the level of investment, then the flow of money doesn't change, and the national income remains at equilibrium (so it is constant over time)
If we add government to the system in addition to a bank, we can call it a governed economy. There difference between a government and a bank is that with a bank, withdrawal and injections of money are voluntary, where as with the government, they are imposed. Taxation is like an imposed version of savings- it takes money out of the economy, while government spending is equivalent to investment, it injects money back into the economy.
If we also add the rest of the world to our economic system, we have an open economy. Here, we can have imports, where domestic consumers purchase foreign goods, and effectively move money out of the economy, and exports where foreign consumers purchase domestic goods and effectively inject money into the economy.
JUST REMEMEBER: for any of these added institutions, as long as all money withdrawals are equal to money injections the GDP is in equilibrium!
----------------------------
GDP - Income
W, R, i, & P all refer to different flows of income- they are the returns for factors of production
W = wages- a return on labour (N)
R = economic rent - a return on land (L)
i = interest - a return on capital (K)
P = economic profits - a return on technology and entrepreneurship (T & E)
GDP - Expenditures
C, I, G, & netX all refer to different flows of expenditure- they are returns for output products (ie: payments for goods and services)
There are four plays in an economy, all of whom must accumulate expenditures
C = Consumption, or expenditures by households
I = Investment, or expenditures by firms
G = Government Expenditure, which is obviously expenditure accumulated by the government
netX = Net exports: in other words, the total number of exports minus the total number of inputs. This is foreign expenditure on domestic goods minus domestic expenditure on foreign goods (X-M).
Y has many many different synonyms. It can refer to:
-national income
-national expenditure
-output
-production
-GDP
-the real thing
-it is a measure of material wealth (the standard of living is the per-capita GDP): this is basically a measure of the material wealth of a nation)
It is NOT, however, a measure of quality of life (money can't necessarily buy happiness).
------------------------
REAL VS. NOMINAL VALUES
Nominal: Actual, current, money, refers to changeable prices and quantities
Real: Constant dollar- here, there are only changes in quantity, while holding the price constant to base year values.
REAL = NOMINAL/PRICE (so real could be the number of cars produced, nominal would be the value of cars produced in 2009, and price would be the price of each car in 2009)
***IN OUR COURSE, WE WILL ALWAYS ASSUME THAT Y IS REAL UNLESS OTHERWISE STATED.
------------------------
OUTPUT GAPS
Potential National Income (Y*) is the maximum achievable output level if all inputs are used at their NORMAL UTILIZATION RATE
Output gap = Y - Y* (actual output level minus potential output level)
If the output gap is negative, then it is a recessionary gap, and the economy is producing at less than its potential
If the output gap is positive, the it is an inflationary gap, and the economy is producing at more than its potential.
-------------------------
THE BUSINESS CYCLE: Changes in Y over real time
4 Stages:
1- Trough (recession/depression)
2- Expansion (boom/recovery)
3- Peak
4- Contraction (slump)
Recessions are downturns in economic growth: two quarters (6 months) of negative growth
Depressions are periods of persistent low growth, high unemployment, and excess capacity
HISTORICALLY, potential output has tripled since 1970, and the output gap is very cyclical (hence business cycles)
Growth varies, but average growth over the last 40 years had been 3.5% per year. Sometimes growth is negative (hence a recession)
WHY DOES NATIONAL INCOME MATTER?
Output gaps concern politicians, because inflation causes high prices which voters do not like, and unemployment also makes voters unhappy. As a result, politicians try to focus on eliminating output gaps.
Economists are more concerned by the potential output. Economic growth is a long term trend we are witnessing: per capita GDP or the standard of living is increasing over time (although this may be deceptive, as standard of living applies only to the average person. In reality, the standard of living may seen reasonable for a country when in reality, there is an enormous wealth gap between the poor and the wealthy).
That's all for today
MACROECONOMIC MODELING: There are two different ways to model the economy.
-Bottom up modeling uses all of the principles of microeconomics (such as profit and utility maximization) and analyzes the choices made by workers, firms, consumers, and others to create a model of the economy. A bottom-up model assumes that the economy works, and thus wages and prices are flexible within a bottom-up model.
-Top down modeling is a macroeconomic aggregation (summation) which analyzes the collective behavior of larger groups (as opposed to individual actors). Thus, top down modeling focuses on total demand and supply within an economy, and also assumes wage and price rigidity.
OUR course follows the Top Down approach to macroeconomic modeling. We do not explicitly rely on microeconomic foundations here, and we are initially assuming wage and price rigidity.
REMEMEBER:
-Macroeconomics is concerned with the 'big picture'
-Macroeconomics studies aggregates and how government policy affects them (ie: the government can manipulate the economy)
-The concepts of price and quantity which we learned in Microeconomics now become the general price level (P) and the national income or production or Gross Domestic Product (Y)
-Two issues of major importance are BUSINESS CYCLES and GROWTH of Y
BUSINESS CYCLES: The cycles of the national income in the medium term
GROWTH of Y: The long term trend of national income
Macroeconomics studies FISCAL and MONETARY policy
FISCAL POLICY: Government policies regarding taxation and spending
MONETARY POLICY: Government policies regarding interest rates and the money supply
There are 5 different variables which we have to learn for macroeconomics. Y, U, P, i, & e (we call these the YUPie varaibles in Gateman's class). For each of these different variables, we will be learning what exactly the variable refers to, what historical trends have we observed regarding the variable, and why the variable is important.
-----------------------------------------------
Y: OUTPUT AND INCOME
****REMEMBER: Output generates income!
DEFINITION OF Y: Final market value of all goods and services produced in the economy during a defined period of time (usually a fiscal year).
Final- refers to the fact that intermediate goods do not count towards GPD (so you cannot count both a car and the steel needed to produce that car both as contributors to national income)
Market Value- This refers to the value of products as determined by supply and demand
Good and Services- Both concrete goods (like tomatoes) and immaterial goods (like economics classes) contribute to GDP
Produced in the economy- this refers to the fact that 'flipping' products does not add to the GDP, so a stock broker who makes a small fortune from buying and selling stocks is not technically contributing to the GDP. On the other hand, if this broker were were to create a financial brokerage service for others, this WOULD contribute to the GDP (because the broker could be seen as offering a service to others for money)
A fiscal year in Canada is usually from April of one year until April of the next year, because that is when the government unveils the budget (their plan regarding spending and taxation)
Nation Income (Y) is the 'target' at which we aim the economy- in other words, it is the variable which we seek to manipulate directly in order to make changes to the economy. The government uses fiscal and monetary policy to accomplish this task. Unemployment (U) is inversely related to growth in Y, so as national income grows, unemployment shrinks. Conversely, as the national economy shrinks, unemployment rises. Inflaction (P) is directly related to growth in Y, so as the national income grows, the general price index (aka inflation, aka P) will increase.
Just REMEMEBER THIS:
National income (Y) is the primary target of attempts to manipulate the economy
Unemployment (U) and Inflation (P) are secondary
Interest Rates (i) and Exchange Rates (e) are tertiary
So, in other words, every macroeconomic variable we deal with in this course is affected by national income.
-------------------------------
THE CIRCULAR FLOW DIAGRAM
The red arrow flowing from households to producers represents flow of factors (workers provide factors to producers so that consumers may produce products)
The black arrow flowing from producers to households represents flow of income (producers give workers wages in return for providing labour as a factor of production)
The red arrow flowing from producers to households represents flow of output or goods (households buy products from producers)
The black arrow flowing from households to producers represents flow of expenditures (households pay producers money in order to purchase goods)
The red arrows here show real flows (flows of real goods, services, and factors), while the black arrows should money flows. There are two systems represented here: the output-expenditure flow (also known as the products market) and the factor income flow (also known as the factor market)
IMPORTANT*** GDP(Y) = GDP(E) (income = expenditures)
Also, OUTPUT GENERATES INCOME (so the higher our output, the higher out income)
This basic circular flow structure is called a spendthrift economy.
If we add a bank to the system, we can call it a frugal economy. Here, actors can put money into the bank (this is called savings) and the bank can lend money out to different actors (this is called investment). If the level of savings is equal to the level of investment, then the flow of money doesn't change, and the national income remains at equilibrium (so it is constant over time)
If we add government to the system in addition to a bank, we can call it a governed economy. There difference between a government and a bank is that with a bank, withdrawal and injections of money are voluntary, where as with the government, they are imposed. Taxation is like an imposed version of savings- it takes money out of the economy, while government spending is equivalent to investment, it injects money back into the economy.
If we also add the rest of the world to our economic system, we have an open economy. Here, we can have imports, where domestic consumers purchase foreign goods, and effectively move money out of the economy, and exports where foreign consumers purchase domestic goods and effectively inject money into the economy.
JUST REMEMEBER: for any of these added institutions, as long as all money withdrawals are equal to money injections the GDP is in equilibrium!
----------------------------
GDP - Income
W, R, i, & P all refer to different flows of income- they are the returns for factors of production
W = wages- a return on labour (N)
R = economic rent - a return on land (L)
i = interest - a return on capital (K)
P = economic profits - a return on technology and entrepreneurship (T & E)
GDP - Expenditures
C, I, G, & netX all refer to different flows of expenditure- they are returns for output products (ie: payments for goods and services)
There are four plays in an economy, all of whom must accumulate expenditures
C = Consumption, or expenditures by households
I = Investment, or expenditures by firms
G = Government Expenditure, which is obviously expenditure accumulated by the government
netX = Net exports: in other words, the total number of exports minus the total number of inputs. This is foreign expenditure on domestic goods minus domestic expenditure on foreign goods (X-M).
Y has many many different synonyms. It can refer to:
-national income
-national expenditure
-output
-production
-GDP
-the real thing
-it is a measure of material wealth (the standard of living is the per-capita GDP): this is basically a measure of the material wealth of a nation)
It is NOT, however, a measure of quality of life (money can't necessarily buy happiness).
------------------------
REAL VS. NOMINAL VALUES
Nominal: Actual, current, money, refers to changeable prices and quantities
Real: Constant dollar- here, there are only changes in quantity, while holding the price constant to base year values.
REAL = NOMINAL/PRICE (so real could be the number of cars produced, nominal would be the value of cars produced in 2009, and price would be the price of each car in 2009)
***IN OUR COURSE, WE WILL ALWAYS ASSUME THAT Y IS REAL UNLESS OTHERWISE STATED.
------------------------
OUTPUT GAPS
Potential National Income (Y*) is the maximum achievable output level if all inputs are used at their NORMAL UTILIZATION RATE
Output gap = Y - Y* (actual output level minus potential output level)
If the output gap is negative, then it is a recessionary gap, and the economy is producing at less than its potential
If the output gap is positive, the it is an inflationary gap, and the economy is producing at more than its potential.
-------------------------
THE BUSINESS CYCLE: Changes in Y over real time
4 Stages:
1- Trough (recession/depression)
2- Expansion (boom/recovery)
3- Peak
4- Contraction (slump)
Recessions are downturns in economic growth: two quarters (6 months) of negative growth
Depressions are periods of persistent low growth, high unemployment, and excess capacity
HISTORICALLY, potential output has tripled since 1970, and the output gap is very cyclical (hence business cycles)
Growth varies, but average growth over the last 40 years had been 3.5% per year. Sometimes growth is negative (hence a recession)
WHY DOES NATIONAL INCOME MATTER?
Output gaps concern politicians, because inflation causes high prices which voters do not like, and unemployment also makes voters unhappy. As a result, politicians try to focus on eliminating output gaps.
Economists are more concerned by the potential output. Economic growth is a long term trend we are witnessing: per capita GDP or the standard of living is increasing over time (although this may be deceptive, as standard of living applies only to the average person. In reality, the standard of living may seen reasonable for a country when in reality, there is an enormous wealth gap between the poor and the wealthy).
That's all for today
Aggregate Supply
In the short run, we're going to assume that factor prices remain constant (but later on, this can change, as we look at the long run)
The short run aggregate supply curve shows the amount which firms are willing to produce at any given price level.
Aggregate Supply is positively sloped!
Why?
Well, as firms increase output and input prices are constant, the law of diminishing marginal returns causes marginal output per factor to fall, and the short run average cost to rise. THUS, in order to retain expected profit margins, the only way for producers to feasibly increase production is to increase the price of goods: as such, as price rises, the actual GDP/output which firms will produce increases- there is a positive relationship here.
What about the slope? Why is it increasing?
Well... at low levels of output, firms have excess capacity, so they are capable of increasing output without making a huge investment, and the law of diminishing marginal returns hasn't really kicked in yet. Production can be increased at a relatively low cost (this corresponds to the flatter part of the curve)
At higher levels of output, however, there is no excess capacity, and great costs must be incurred to increase production.
Aggregate supply can shift (we call this an aggregate supply shock!). Basically, anything which would cause the cost of inputs (wages, intermediate goods, machinery, etc.) to rise OR anything which lowers the productivity of those factor inputs (like a rainy day on a farm) will shift the aggregate supply curve to the left (and consequently, lower input costs shifts AS to the right)
The short run aggregate supply curve shows the amount which firms are willing to produce at any given price level.
Aggregate Supply is positively sloped!
Why?
Well, as firms increase output and input prices are constant, the law of diminishing marginal returns causes marginal output per factor to fall, and the short run average cost to rise. THUS, in order to retain expected profit margins, the only way for producers to feasibly increase production is to increase the price of goods: as such, as price rises, the actual GDP/output which firms will produce increases- there is a positive relationship here.
What about the slope? Why is it increasing?
Well... at low levels of output, firms have excess capacity, so they are capable of increasing output without making a huge investment, and the law of diminishing marginal returns hasn't really kicked in yet. Production can be increased at a relatively low cost (this corresponds to the flatter part of the curve)
At higher levels of output, however, there is no excess capacity, and great costs must be incurred to increase production.
Aggregate supply can shift (we call this an aggregate supply shock!). Basically, anything which would cause the cost of inputs (wages, intermediate goods, machinery, etc.) to rise OR anything which lowers the productivity of those factor inputs (like a rainy day on a farm) will shift the aggregate supply curve to the left (and consequently, lower input costs shifts AS to the right)
MACROECONOMIC EQUILIBRIUM: Putting it all Together
So, we have the aggregate supply curve and we have the aggregate demand curve.
AD measures levels of production which won't change over time as a function of price
AS measures levels of production which suppliers will actually produce at as a function of price.
SO... what happens when you put both of them together?
Answer: You get a real level of output which doesn't change over time (at the intersection point). Here, GDP is at an equilibrium, which means that output is equal to expenditures. Also GDP is an actual achievable level of output, which firms are willing to produce at, given the price level, to maximize profits: The actual output is in equilibrium!
The general price level is the y-axis, and we can use it to determine inflation (increases in the general price level)
GDP is the x-axis, and we can use actual GDP in relation to potential GDP to determine unemployment
This is also a stable equilibrium! If the price level is too low, then aggregate demand will overwhelm what producers are actually willing to produce. As production increases to meet the needs of the consumers, however, the accompanying rise in the price level reduces consumer demand until the two meet in the middle. Whenever the economy is not at macroeconomic equilibrium, there are pressures which ultimately bring it back to a state of equilibrium
Aggregate Demand Shocks and Macroeconomic Equilibrium:
These are a bit more tricky. If a change in autonomous expenditure shifts the family of aggregate expenditure functions, then in turn the Aggregate Demand function will shift (to the left in expenditure is lower, and to the right if it is higher). However, in macroeconomic equilibrium, an increase in aggregate demand predicts an accompanying increase in prices, while lower aggregate demand predicts an accompanying drop in prices (remember, firms will only produce more if prices increase to stabilize profit margins). This change in the price level changes aggregate expenditure, causing it to shift up or down due to a new price!
As a general rule, both price and output move in the same direction as a demand shock (increased demand = more output at higher prices. Decreased = less output at lower prices)
You may have noticed, but the simple multiplier, due to the change in price, can no longer predict the change in output caused by changes in expenditure. Instead, we use the multiplier (not simple, just multiplier) to determine output changes which result from expenditure changes. The multiplier is smaller than the simple multiplier. It represents the change in GDP divided by the change in aggregate expenditure.
The severity of a demand shock depends on the state of the economy: in other words, where an economy lies on the Aggregate Supply Curve.
When the economy has excess capacity (constant costs of production), it is called Keynesian short run aggregate supply (this is the flat part of the AS curve). Increases in AE cause Y to rise and Price to remain the same.
When the economy has increasing costs (the middle of this graph where the AS curve is about diagonally sloped), this is intermediate short run aggregate supply. Here, increases in aggregate expenditure cause increases in both price and output.
When the economy has rapidly increasing costs, this is classical short run supply (the vertical part of the AS curve). Here, increases in aggregate expenditure lead to increases in price, and no change in output.
Basically, the steeper AS is, the more a demand shock will affect price, and the less it will affect output.
We can have supply shocks too! The new intersection point is the new stable macroeconomic equilibrium.
Be careful- in some cases, both AS and AD will shift in response to a single event! (for an example, let's say the price level in China rises. This increases domestic AD (because of increased net exports). However, if domestic producers buy a lot of intermediate products from China, then their costs of production just rose, so aggregate supply shifts to the left. The net effect could be either positive or negative: it depends how invest producers are in chinese intermediate goods, and how much of the domestic economy is trade-determined.
Okay- that's all you'll need for the test. Good luck!
AD measures levels of production which won't change over time as a function of price
AS measures levels of production which suppliers will actually produce at as a function of price.
SO... what happens when you put both of them together?
Answer: You get a real level of output which doesn't change over time (at the intersection point). Here, GDP is at an equilibrium, which means that output is equal to expenditures. Also GDP is an actual achievable level of output, which firms are willing to produce at, given the price level, to maximize profits: The actual output is in equilibrium!
The general price level is the y-axis, and we can use it to determine inflation (increases in the general price level)
GDP is the x-axis, and we can use actual GDP in relation to potential GDP to determine unemployment
This is also a stable equilibrium! If the price level is too low, then aggregate demand will overwhelm what producers are actually willing to produce. As production increases to meet the needs of the consumers, however, the accompanying rise in the price level reduces consumer demand until the two meet in the middle. Whenever the economy is not at macroeconomic equilibrium, there are pressures which ultimately bring it back to a state of equilibrium
Aggregate Demand Shocks and Macroeconomic Equilibrium:
These are a bit more tricky. If a change in autonomous expenditure shifts the family of aggregate expenditure functions, then in turn the Aggregate Demand function will shift (to the left in expenditure is lower, and to the right if it is higher). However, in macroeconomic equilibrium, an increase in aggregate demand predicts an accompanying increase in prices, while lower aggregate demand predicts an accompanying drop in prices (remember, firms will only produce more if prices increase to stabilize profit margins). This change in the price level changes aggregate expenditure, causing it to shift up or down due to a new price!
As a general rule, both price and output move in the same direction as a demand shock (increased demand = more output at higher prices. Decreased = less output at lower prices)
You may have noticed, but the simple multiplier, due to the change in price, can no longer predict the change in output caused by changes in expenditure. Instead, we use the multiplier (not simple, just multiplier) to determine output changes which result from expenditure changes. The multiplier is smaller than the simple multiplier. It represents the change in GDP divided by the change in aggregate expenditure.
The severity of a demand shock depends on the state of the economy: in other words, where an economy lies on the Aggregate Supply Curve.
When the economy has excess capacity (constant costs of production), it is called Keynesian short run aggregate supply (this is the flat part of the AS curve). Increases in AE cause Y to rise and Price to remain the same.
When the economy has increasing costs (the middle of this graph where the AS curve is about diagonally sloped), this is intermediate short run aggregate supply. Here, increases in aggregate expenditure cause increases in both price and output.
When the economy has rapidly increasing costs, this is classical short run supply (the vertical part of the AS curve). Here, increases in aggregate expenditure lead to increases in price, and no change in output.
Basically, the steeper AS is, the more a demand shock will affect price, and the less it will affect output.
We can have supply shocks too! The new intersection point is the new stable macroeconomic equilibrium.
Be careful- in some cases, both AS and AD will shift in response to a single event! (for an example, let's say the price level in China rises. This increases domestic AD (because of increased net exports). However, if domestic producers buy a lot of intermediate products from China, then their costs of production just rose, so aggregate supply shifts to the left. The net effect could be either positive or negative: it depends how invest producers are in chinese intermediate goods, and how much of the domestic economy is trade-determined.
Okay- that's all you'll need for the test. Good luck!
The Gap Effect, and the Expectation Effect
THE WONDERFUL WORLD OF INFLATION:
People talk about inflation a LOT, so its probably a good idea know what it is. If you've survived macroeconomics without knowing what inflation is up until this point, congratulations, you live a seriously charmed life.
For the rest of us, lets reiterate:
Inflation is any rise in the general price level (P)
Inflation can be temporary/transitory (the price level increases to a new equilibrium price level, where it stays put for a while) or it can be sustained/persistant (the price level rises continuously over time)
In classical economics, aggregate demand shocks and aggregate supply shocks cause TEMPORARY inflation (one-time jumps in the price level) as a side effect of gap inflation. In this chapter, we are more concerned with exploring the causes of sustained inflation (which, as we will learn, is affected by people's expectations). We're also going to look at what causes accelerating inflation.
On a very basic level, prices can rise for two different reasons
1) There is a decrease in supply (this is called cost-push inflation)
2) There is an increase in demand (this is called demand-pull inflation)
HERE IS A LIST OF TERRIBLY IMPORTANT DEFINITIONS WHICH WE SHOULD ALL PROBABLY LEARN IF WE WANT TO DO WELL IN MACROECONOMICS:
Inflation - A rise in the consumer price index
Inflation Rate - The percentage change in the consumer price index
Zero Inflation - A situation where there is no percentage change in the consumer price index
Stable Inflation - A situation where the inflation rate remains relatively constant over time (ie: inflation is 2% for seven years in a row)
Accelerating Inflation - The inflation rate increases over time (ie: inflation is 2% in 1991, 4% in 1992, 8% in 1993, and 13% in 1994)
Disinflation - The inflation rate decrease over time (ie: inflation is 16% in 1991, 9% in 1992, 5% in 1993, and 3% in 1994)
Deflation - A negative rate of inflation: the consumer price index goes down (so goods end up costing less)
Low inflation: 1-3%
Medium inflation: 3-6%
High inflation: Over 6%
Hyperinflation: Over 20%
Why are we concerned with inflation? Because too much inflation inflicts a bunch of costs on society. Here are some of them:
-It decreases the purchasing power of people who are on fixed incomes (both contractually and in terms of pensionary incomes)
-It can arbitrarily redistribute income
-It undermines the efficiency of the price system by distorting relative prices (so its harder for consumers to tell if they are getting a good deal or if they are getting ripped off if the general price level is continuously in flux)
---------------------------------------
One last important concept is NAIRU, which is the non-accelerating inflationary rate of unemployment. Basically, this is the rate of unemployment present in an economy when there are no inflationary or recessionary gaps (when Y is at Y*). This does not mean that there is no unemployment- only that there is no GAP unemployment (there can still be frictional and structural unemployment). NAIRU is also sometimes called "full employment," or U*.
We're going to look at why NAIRU is called NAIRU in this chapter
--------------------------------------------------
INFLATION AND WAGE CHANGES:
Okay... why do people's wages change?
There are two factors which can explain why people's wages change
1) The gap effect
2) The expectation effect
THE GAP EFFECT
-Basically, this is demand-pull inflation caused by excess demand in the labour market.
-In an inflationary gap, we get GAP INFLATION. Y is larger than Y*, U is smaller than U*, and there is an excess demand for labour. As a result, firms are forced to raise wages in order to keep employees. The result of this rise in wages is that average costs rise (which, in turn, causes the short run aggregate supply to shift to the left, correcting the inflationary gap).
-In a recessionary gap, we get GAP DEFLATION. Y is smaller than Y*, U is greater than U*, and there is an excess supply of labour. As a result, firms can safely lower employee wages without the risk of losing employees (its better to have a low-paying job than no job at all). This, in turn, causes average costs to fall, which shifts short run aggregate supply to the right, correcting the inflationary gap.
-When there is no gap, there is NO INFLATION. Y equals Y*, U equal U*, demand and supply of labour are equal, wages remain constant, average costs remain constant, and the short run aggregate supply remains constant (as do prices).
The Phillips Curve shows the inverse relation between the unemployment rate and the rate of changes in nominal wages.
Basically, as unemployment gets higher, wage increases get smaller and smaller, and eventually, turn into wage decreases (salary cuts).
Classical economists ONLY considered the gap effect to be a source of inflation, and believed that gaps would only create a temporary period of inflation. They also believed that if there was no gap, that there would be no increase in wages...
They were entirely correct... there is also...
THE EXPECTATION EFFECT
-Here, expected inflation is taken into account when employees are negotiating wage demands with their employers
-Here, inflation is like a "self fulfilling prophecy". If employees believe that there will be inflation of a certain level over the next year, they will negotiate for higher wages to account for that inflation. This, in turn, increases firms' average costs, which shifts the SRAD curve to the left, effecting CAUSING an increase in prices in-step with what employees predicted. In other words, preemptively adjusting wages for expected inflation can MANUFACTURE real inflation!
Causes of expectation inflation:
-Expectation inflation can be caused by backward-looking, where people assume that past rates in inflation will continue into the future (people believe that history repeats itself)
-At the same time, if an economy has an extremely volatile inflation rate, it may take time for people to develop a psychological trend to respond to inflation- it takes a while to figure out how the pattern works and predict accurately for the future.
-Expectation inflation can also be forward-looking. Workers could look at governments' macroeconomic policies to predict what future changes may be in store (they can prognosticate).
-The main thing to remember is that in economics, we assume that people are RATIONAL BEINGS with their own best interests at heart. People try to use all available information to the best of their ability, and for the most part, they are correct. People can adjust rapidly to changes.
The TOTAL EFFECT: Changes in money wages are a combination of the gap effect and the expectation effect
-In this way, we can decompose an increase in the rate of wage changes into the gap effect (excess demand for labour) and the expectation effect (psychology)
-We can think of the expectation effect as the "cake" and the gap effect as the "icing", which causes increased wages changes on top of expected changes
-The total effect can be either positive or negative.
People talk about inflation a LOT, so its probably a good idea know what it is. If you've survived macroeconomics without knowing what inflation is up until this point, congratulations, you live a seriously charmed life.
For the rest of us, lets reiterate:
Inflation is any rise in the general price level (P)
Inflation can be temporary/transitory (the price level increases to a new equilibrium price level, where it stays put for a while) or it can be sustained/persistant (the price level rises continuously over time)
In classical economics, aggregate demand shocks and aggregate supply shocks cause TEMPORARY inflation (one-time jumps in the price level) as a side effect of gap inflation. In this chapter, we are more concerned with exploring the causes of sustained inflation (which, as we will learn, is affected by people's expectations). We're also going to look at what causes accelerating inflation.
On a very basic level, prices can rise for two different reasons
1) There is a decrease in supply (this is called cost-push inflation)
2) There is an increase in demand (this is called demand-pull inflation)
HERE IS A LIST OF TERRIBLY IMPORTANT DEFINITIONS WHICH WE SHOULD ALL PROBABLY LEARN IF WE WANT TO DO WELL IN MACROECONOMICS:
Inflation - A rise in the consumer price index
Inflation Rate - The percentage change in the consumer price index
Zero Inflation - A situation where there is no percentage change in the consumer price index
Stable Inflation - A situation where the inflation rate remains relatively constant over time (ie: inflation is 2% for seven years in a row)
Accelerating Inflation - The inflation rate increases over time (ie: inflation is 2% in 1991, 4% in 1992, 8% in 1993, and 13% in 1994)
Disinflation - The inflation rate decrease over time (ie: inflation is 16% in 1991, 9% in 1992, 5% in 1993, and 3% in 1994)
Deflation - A negative rate of inflation: the consumer price index goes down (so goods end up costing less)
Low inflation: 1-3%
Medium inflation: 3-6%
High inflation: Over 6%
Hyperinflation: Over 20%
Why are we concerned with inflation? Because too much inflation inflicts a bunch of costs on society. Here are some of them:
-It decreases the purchasing power of people who are on fixed incomes (both contractually and in terms of pensionary incomes)
-It can arbitrarily redistribute income
-It undermines the efficiency of the price system by distorting relative prices (so its harder for consumers to tell if they are getting a good deal or if they are getting ripped off if the general price level is continuously in flux)
---------------------------------------
One last important concept is NAIRU, which is the non-accelerating inflationary rate of unemployment. Basically, this is the rate of unemployment present in an economy when there are no inflationary or recessionary gaps (when Y is at Y*). This does not mean that there is no unemployment- only that there is no GAP unemployment (there can still be frictional and structural unemployment). NAIRU is also sometimes called "full employment," or U*.
We're going to look at why NAIRU is called NAIRU in this chapter
--------------------------------------------------
INFLATION AND WAGE CHANGES:
Okay... why do people's wages change?
There are two factors which can explain why people's wages change
1) The gap effect
2) The expectation effect
THE GAP EFFECT
-Basically, this is demand-pull inflation caused by excess demand in the labour market.
-In an inflationary gap, we get GAP INFLATION. Y is larger than Y*, U is smaller than U*, and there is an excess demand for labour. As a result, firms are forced to raise wages in order to keep employees. The result of this rise in wages is that average costs rise (which, in turn, causes the short run aggregate supply to shift to the left, correcting the inflationary gap).
-In a recessionary gap, we get GAP DEFLATION. Y is smaller than Y*, U is greater than U*, and there is an excess supply of labour. As a result, firms can safely lower employee wages without the risk of losing employees (its better to have a low-paying job than no job at all). This, in turn, causes average costs to fall, which shifts short run aggregate supply to the right, correcting the inflationary gap.
-When there is no gap, there is NO INFLATION. Y equals Y*, U equal U*, demand and supply of labour are equal, wages remain constant, average costs remain constant, and the short run aggregate supply remains constant (as do prices).
The Phillips Curve shows the inverse relation between the unemployment rate and the rate of changes in nominal wages.
Basically, as unemployment gets higher, wage increases get smaller and smaller, and eventually, turn into wage decreases (salary cuts).
Classical economists ONLY considered the gap effect to be a source of inflation, and believed that gaps would only create a temporary period of inflation. They also believed that if there was no gap, that there would be no increase in wages...
They were entirely correct... there is also...
THE EXPECTATION EFFECT
-Here, expected inflation is taken into account when employees are negotiating wage demands with their employers
-Here, inflation is like a "self fulfilling prophecy". If employees believe that there will be inflation of a certain level over the next year, they will negotiate for higher wages to account for that inflation. This, in turn, increases firms' average costs, which shifts the SRAD curve to the left, effecting CAUSING an increase in prices in-step with what employees predicted. In other words, preemptively adjusting wages for expected inflation can MANUFACTURE real inflation!
Causes of expectation inflation:
-Expectation inflation can be caused by backward-looking, where people assume that past rates in inflation will continue into the future (people believe that history repeats itself)
-At the same time, if an economy has an extremely volatile inflation rate, it may take time for people to develop a psychological trend to respond to inflation- it takes a while to figure out how the pattern works and predict accurately for the future.
-Expectation inflation can also be forward-looking. Workers could look at governments' macroeconomic policies to predict what future changes may be in store (they can prognosticate).
-The main thing to remember is that in economics, we assume that people are RATIONAL BEINGS with their own best interests at heart. People try to use all available information to the best of their ability, and for the most part, they are correct. People can adjust rapidly to changes.
The TOTAL EFFECT: Changes in money wages are a combination of the gap effect and the expectation effect
-In this way, we can decompose an increase in the rate of wage changes into the gap effect (excess demand for labour) and the expectation effect (psychology)
-We can think of the expectation effect as the "cake" and the gap effect as the "icing", which causes increased wages changes on top of expected changes
-The total effect can be either positive or negative.
Sunday, January 3, 2010
Calculating National Income
There are three different approaches which we can use to determine the national income. We're going to review all of them in a big, boring, and utterly painful lecture.
1) GDP from Value Added Approach- a measure of the value of all goods and services produced in a fiscal year
2) GDP from Expenditures Side- a measurement of the flow of expenditure
3) GDP from Income Side- a measurement of the flow of income
THE VALUE ADDED APPROACH
Problem: Why not just add the value of each producer's individual output?
Answer: Because production occurs in stages, so in order to avoid counting inputs twice (ie: counting the steel used to build a car, and then the car as well), we must either include only final products in our math, OR only count the value added to products at each stage of production.
Definitions:
Double Counting: Adding the value added more than once to the final value of a good or service
Intermediate Good: output which is used as an input for another good (ie: steel used to build a car)
Final Good: Output NOT used again as an input- output used for final consumption in the time period being considered
Value Added: The value which is added to a product at each stage of production. Revenue minus the cost of intermediate goods from other firms (ie: if a car sells for $2000, and the parts used to make it cost $1000, the added value is $1000). Value added is equal to factor income (WRiP) for any stage of production.
Revenue: Factor Income (WRiP) + The cost of intermediate goods from other firms.
NOTE: Value added does not factor in the costs of factors of production from other firms (so it does not matter how much it costs a steel manufacturer to produce car-steel: this is not factored into the final value of the car)
SO...
GDP (A measure of national income) is the FINAL (not intermediate) MARKET VALUE (determined by the price system of supply and demand) of all GOODS AND SERVICES (goods are tangible, like watermelons. Services are intangible, like haircuts) PRODUCED (so only actual output is measured- flipped assets like stocks or resold real estate does not factor into GDP) in a GIVEN PERIOD (A fiscal year is April to April)
THE EXPENDITURE SIDE APPROACH:
GDP is also equal to the total amount of expenditure required to produce all of the outputs which GDP encompasses.
There are 4 different players in the economy, and thus there are 4 different types of expenditure
CONSUMPTION- Expenditure by the household. This is the 'using up' of a product by a final user. Expenditure can be on durable and non durable goods, as well as services
INVESTMENT- Expenditure by the firm. Investment refers to a change in Capital (Plant, Equipment, Inventory, or Residential Construct). Most of the time, investiture is on goods which are NOT intended for present or immediate consumption. Also, investment is for goods which are used to produce other goods (ie: sewing machines)
Plant and Equipment are "business fixed investment"
Equipment includes machinery and equipment
Inventories are used to buffer fluctuations in production and sales.
Inventories may be outputs or inputs, and they are valued at fair market value
Inventories can be considered investment because they are expenditure on goods not for current consumption, and because we assume that the firm has paid for these goods themselves
Divestment is decumulation, or the reduction of inventory- in other words, a decrease in the stock of fixed goods available to be sold
Residential Construction is investment because a house or building is consumption over a long period of time, and thus not for present consumption
-This only applies to newly built houses or buildings- not purchases from a builder or used homes
GROSS INVESTMENT = NET INVESTMENT + DEPRECIATION! REMEMBER THIS!
Depreciation is the wearing out of capital, and also the cost of replacement capital: it is forced investiture which is not earned by any factor of production
Captial Cost Allowance (CCA) is an income tax act approximation for depreciation
we use GROSS INVESTMENT to calculate GDP (gross investment for gross domestic product- it makes sense). Why? Because all investment, even on broken equipment, creates an income flow and therefore contributes to GDP.
GOVERNMENT EXPENDITURE: This includes all government purchases of goods and services
-These are valued at cost to the government, not at their market value (because it is difficult to assign a market value to certain services which are provided at cost by the government, such as courts)
-Government expenditure also includes government investment!
-TRANSFER PAYMENTS are expenditures not in return for a service. Some examples include expenditure on the Canada Pension Plan, Employment Insurance, and Welfare payments (basically, situations where the government 'gives away' money in some form or another)
-This shows that "expenditure" is not always a "purchase"
-we EXCLUDE transfer payments from our calculation of the government''s expenditures when accounting for GDP
NET EXPORTS:
Exports = X = Goods leaving the country and money entering the country. This adds to our GDP
Imports = M = Goods entering the country and money leaving the country. This lowers our GDP
Net Exports = X - M (it can be positive or negative)
TOTAL EXPENDITURES = GDP
SO...
GDP = Consumption + Investment + Government Expenditure + Net Exports
Y = C+I+G+NetX
Wooooooooooo!
----------------------------
THE INCOME SIDE APPROACH TO GDP
Here, we use income claims from different factors and non-factors of production to calculate the national income. To put it simply we say that the national income is equal to factor payments plus non-factor payments
FACTOR PAYMENTS (WRiP): Another word for these is Net Domestic Product at Factor Costs
"Net" means that we do not take depreciation into account
"Domestic" means that these are domestic factors (ie: we can't add Saudi oil production incomes to Canada's GDP)
"Factor Cost" means the value of output which can be accredited to factors minus the net taxes paid by the firm
DIFFERENT TYPES OF FACTOR PAYMENTS
Wages & Salaries: A return to labour- it can include gross wages, cpp, other pensions, and extra benefits (like dental)
Economic Rent: A return to land- this can include stumpage fees, or oil royalties
Interest: A return to capital- This is the rate of return of capital
Profits: A return to Entrepreneurship and Technology- This includes dividends (distributed profits) and retained earnings (undistributed profits)
NON FACTOR PAYMENTS: Indirect Business Taxes minus Subsidies plus Depreciation
Non factor payments are money which is paid to firms which are not for income claims by factors
In other words, output by firms can generate income NOT accruing to those four factors. These are non-factor payments, and there are 2 types:
1) Indirect Business Taxes less Subsidies: Tax on production collected indirectly by third parties (like excise taxes, provincial sales taxes, and government sales taxes). This is a claim by the government on production which was NOT included in the net domestic product at factor costs. We add this to income to get the MARKET VALUE of goods.
Subsidies are benefits on production contributed indirectly by third parties (like the government subsidizing BC translink)- in other words, these are goods and services whose market value is artificially lowered due to government intervention. As a result, we subtract subsidies from income to get the market value of the good.
To make this easy, let's just say we want to calculate national income using what people ACTUALLY PAY for things: people actually pay indirect business taxes, so we add those, but people don't pay for subsidized portions of things, so we subtract those! Simple enough, right? =D
WriP + (IBT - Subsidies) = Net Domestic Product (NDP)
DEPRECIATION:
-This was not included in the NET domestic product at factor costs
-This is required reinvestment for simply maintaining capital stock
-It is not earned by any factor
NDP + Depreciation = GROSS DOMESTIC PRODUCT! YAY!
SOME EQUATIONS TO REMEMBER:
GDP = Factor Payments (WRiP) + Non Factor Payments ([IBT - Sub] + Dep)
NDP = GDP - Dep
NDPFC = NDP - (IBT - Sub)
WriP = NDPFC
NDPFC + (IBT - Sub) = NDP
NDP + Dep = GDP
---------------------
OTHER THINGS TO WORRY ABOUT
Gross Domestic Product versus Gross National Product
GDP: Income produced in Canada - domestic (it could be made in Canada by non-citizens and still count)
GNP: Income received by Canadians - nationals (it could be made by Canadians working outside of the country)
Calculating Gross National Product:
-GNP = GDP minus factor income produced in Canada but received by foreigners (non-Canadians) plus factor income received by Canadians from abroad
Generally, the value of Canadian based assets owned by foreigners is much greater than the value of foreign assets owned by Canadians (we do have a relatively small population in Canada), so the GDP is much higher than the GNP
Personal Income:
Personal Income is GDP minus any part NOT received by households (Depreciation, retained earnings, etc.)m plus transfer payments received by households: PI = GDP + Net Transfer Payments
Disposable Personal Income: Personal Income minus Personal Income Tax
Real Versus Nominal
Nominal values are related to money values, and change according to prices and current values. Nominal values reflect price changes and quantity changes
Real values stay constant over time. Real values only reflect quantity changes
REAL = Nominal/Price Index
For an example, real GDP = Nominal GDP/implicit GDP deflator (an implied raise in the price index, or inflation, in other words)
HOW TO DETERMINE THE IMPLICIT GDP DEFLATOR:
1: Set base year prices
2: Calculate current output at base year prices
3: Compare using ratios
GDP DEFLATOR = Current Q X Current P/Current Q X Base-year P
GDP DEFLATOR = GDP at current prices/GDP at base year prices
GDP DEFLATOR = Nominal GDP/Real GDP
Some things are omitted from GDP, for example...
-Illegal Activities (such as drug sales), because they are difficult to measure or ascertain
-Non-market Activities (such as housework, do it yourself repairs, and volunteer work), because these are not traded as services in a market
-Unreported Activities (such as bartered services or agreements), because they are difficult to measure or ascertain
-Economic "Bads" or negative externalities (such as pollution, stress, congestion, etc.)- these should be deducted from national income, but they are not traded in markets
Definitions for output
Production: Total output (GDP): This describes the size of the economy
Per Capita GDP: GDP divided by population- this is used to measure the standard of living
Productivity: GDP divided by employment, or GDP divided by # of hours worked- this is used to measure the rate of technological change and worker efficiency
Economics, however, is not involved in measuring happiness or quality of life. We leave that to other organizations!
That's all for now....
1) GDP from Value Added Approach- a measure of the value of all goods and services produced in a fiscal year
2) GDP from Expenditures Side- a measurement of the flow of expenditure
3) GDP from Income Side- a measurement of the flow of income
THE VALUE ADDED APPROACH
Problem: Why not just add the value of each producer's individual output?
Answer: Because production occurs in stages, so in order to avoid counting inputs twice (ie: counting the steel used to build a car, and then the car as well), we must either include only final products in our math, OR only count the value added to products at each stage of production.
Definitions:
Double Counting: Adding the value added more than once to the final value of a good or service
Intermediate Good: output which is used as an input for another good (ie: steel used to build a car)
Final Good: Output NOT used again as an input- output used for final consumption in the time period being considered
Value Added: The value which is added to a product at each stage of production. Revenue minus the cost of intermediate goods from other firms (ie: if a car sells for $2000, and the parts used to make it cost $1000, the added value is $1000). Value added is equal to factor income (WRiP) for any stage of production.
Revenue: Factor Income (WRiP) + The cost of intermediate goods from other firms.
NOTE: Value added does not factor in the costs of factors of production from other firms (so it does not matter how much it costs a steel manufacturer to produce car-steel: this is not factored into the final value of the car)
SO...
GDP (A measure of national income) is the FINAL (not intermediate) MARKET VALUE (determined by the price system of supply and demand) of all GOODS AND SERVICES (goods are tangible, like watermelons. Services are intangible, like haircuts) PRODUCED (so only actual output is measured- flipped assets like stocks or resold real estate does not factor into GDP) in a GIVEN PERIOD (A fiscal year is April to April)
THE EXPENDITURE SIDE APPROACH:
GDP is also equal to the total amount of expenditure required to produce all of the outputs which GDP encompasses.
There are 4 different players in the economy, and thus there are 4 different types of expenditure
CONSUMPTION- Expenditure by the household. This is the 'using up' of a product by a final user. Expenditure can be on durable and non durable goods, as well as services
INVESTMENT- Expenditure by the firm. Investment refers to a change in Capital (Plant, Equipment, Inventory, or Residential Construct). Most of the time, investiture is on goods which are NOT intended for present or immediate consumption. Also, investment is for goods which are used to produce other goods (ie: sewing machines)
Plant and Equipment are "business fixed investment"
Equipment includes machinery and equipment
Inventories are used to buffer fluctuations in production and sales.
Inventories may be outputs or inputs, and they are valued at fair market value
Inventories can be considered investment because they are expenditure on goods not for current consumption, and because we assume that the firm has paid for these goods themselves
Divestment is decumulation, or the reduction of inventory- in other words, a decrease in the stock of fixed goods available to be sold
Residential Construction is investment because a house or building is consumption over a long period of time, and thus not for present consumption
-This only applies to newly built houses or buildings- not purchases from a builder or used homes
GROSS INVESTMENT = NET INVESTMENT + DEPRECIATION! REMEMBER THIS!
Depreciation is the wearing out of capital, and also the cost of replacement capital: it is forced investiture which is not earned by any factor of production
Captial Cost Allowance (CCA) is an income tax act approximation for depreciation
we use GROSS INVESTMENT to calculate GDP (gross investment for gross domestic product- it makes sense). Why? Because all investment, even on broken equipment, creates an income flow and therefore contributes to GDP.
GOVERNMENT EXPENDITURE: This includes all government purchases of goods and services
-These are valued at cost to the government, not at their market value (because it is difficult to assign a market value to certain services which are provided at cost by the government, such as courts)
-Government expenditure also includes government investment!
-TRANSFER PAYMENTS are expenditures not in return for a service. Some examples include expenditure on the Canada Pension Plan, Employment Insurance, and Welfare payments (basically, situations where the government 'gives away' money in some form or another)
-This shows that "expenditure" is not always a "purchase"
-we EXCLUDE transfer payments from our calculation of the government''s expenditures when accounting for GDP
NET EXPORTS:
Exports = X = Goods leaving the country and money entering the country. This adds to our GDP
Imports = M = Goods entering the country and money leaving the country. This lowers our GDP
Net Exports = X - M (it can be positive or negative)
TOTAL EXPENDITURES = GDP
SO...
GDP = Consumption + Investment + Government Expenditure + Net Exports
Y = C+I+G+NetX
Wooooooooooo!
----------------------------
THE INCOME SIDE APPROACH TO GDP
Here, we use income claims from different factors and non-factors of production to calculate the national income. To put it simply we say that the national income is equal to factor payments plus non-factor payments
FACTOR PAYMENTS (WRiP): Another word for these is Net Domestic Product at Factor Costs
"Net" means that we do not take depreciation into account
"Domestic" means that these are domestic factors (ie: we can't add Saudi oil production incomes to Canada's GDP)
"Factor Cost" means the value of output which can be accredited to factors minus the net taxes paid by the firm
DIFFERENT TYPES OF FACTOR PAYMENTS
Wages & Salaries: A return to labour- it can include gross wages, cpp, other pensions, and extra benefits (like dental)
Economic Rent: A return to land- this can include stumpage fees, or oil royalties
Interest: A return to capital- This is the rate of return of capital
Profits: A return to Entrepreneurship and Technology- This includes dividends (distributed profits) and retained earnings (undistributed profits)
NON FACTOR PAYMENTS: Indirect Business Taxes minus Subsidies plus Depreciation
Non factor payments are money which is paid to firms which are not for income claims by factors
In other words, output by firms can generate income NOT accruing to those four factors. These are non-factor payments, and there are 2 types:
1) Indirect Business Taxes less Subsidies: Tax on production collected indirectly by third parties (like excise taxes, provincial sales taxes, and government sales taxes). This is a claim by the government on production which was NOT included in the net domestic product at factor costs. We add this to income to get the MARKET VALUE of goods.
Subsidies are benefits on production contributed indirectly by third parties (like the government subsidizing BC translink)- in other words, these are goods and services whose market value is artificially lowered due to government intervention. As a result, we subtract subsidies from income to get the market value of the good.
To make this easy, let's just say we want to calculate national income using what people ACTUALLY PAY for things: people actually pay indirect business taxes, so we add those, but people don't pay for subsidized portions of things, so we subtract those! Simple enough, right? =D
WriP + (IBT - Subsidies) = Net Domestic Product (NDP)
DEPRECIATION:
-This was not included in the NET domestic product at factor costs
-This is required reinvestment for simply maintaining capital stock
-It is not earned by any factor
NDP + Depreciation = GROSS DOMESTIC PRODUCT! YAY!
SOME EQUATIONS TO REMEMBER:
GDP = Factor Payments (WRiP) + Non Factor Payments ([IBT - Sub] + Dep)
NDP = GDP - Dep
NDPFC = NDP - (IBT - Sub)
WriP = NDPFC
NDPFC + (IBT - Sub) = NDP
NDP + Dep = GDP
---------------------
OTHER THINGS TO WORRY ABOUT
Gross Domestic Product versus Gross National Product
GDP: Income produced in Canada - domestic (it could be made in Canada by non-citizens and still count)
GNP: Income received by Canadians - nationals (it could be made by Canadians working outside of the country)
Calculating Gross National Product:
-GNP = GDP minus factor income produced in Canada but received by foreigners (non-Canadians) plus factor income received by Canadians from abroad
Generally, the value of Canadian based assets owned by foreigners is much greater than the value of foreign assets owned by Canadians (we do have a relatively small population in Canada), so the GDP is much higher than the GNP
Personal Income:
Personal Income is GDP minus any part NOT received by households (Depreciation, retained earnings, etc.)m plus transfer payments received by households: PI = GDP + Net Transfer Payments
Disposable Personal Income: Personal Income minus Personal Income Tax
Real Versus Nominal
Nominal values are related to money values, and change according to prices and current values. Nominal values reflect price changes and quantity changes
Real values stay constant over time. Real values only reflect quantity changes
REAL = Nominal/Price Index
For an example, real GDP = Nominal GDP/implicit GDP deflator (an implied raise in the price index, or inflation, in other words)
HOW TO DETERMINE THE IMPLICIT GDP DEFLATOR:
1: Set base year prices
2: Calculate current output at base year prices
3: Compare using ratios
GDP DEFLATOR = Current Q X Current P/Current Q X Base-year P
GDP DEFLATOR = GDP at current prices/GDP at base year prices
GDP DEFLATOR = Nominal GDP/Real GDP
Some things are omitted from GDP, for example...
-Illegal Activities (such as drug sales), because they are difficult to measure or ascertain
-Non-market Activities (such as housework, do it yourself repairs, and volunteer work), because these are not traded as services in a market
-Unreported Activities (such as bartered services or agreements), because they are difficult to measure or ascertain
-Economic "Bads" or negative externalities (such as pollution, stress, congestion, etc.)- these should be deducted from national income, but they are not traded in markets
Definitions for output
Production: Total output (GDP): This describes the size of the economy
Per Capita GDP: GDP divided by population- this is used to measure the standard of living
Productivity: GDP divided by employment, or GDP divided by # of hours worked- this is used to measure the rate of technological change and worker efficiency
Economics, however, is not involved in measuring happiness or quality of life. We leave that to other organizations!
That's all for now....
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