Macroeconomics Relationships

Definition of National Output

Demand for National output by 3 groups

1) Household

2) Business

3) Government

Aggregate Demand	=	Consumer Demand	+	Firm (Business) Demand	+	Government Demand
Gross Domestic Expenditure (GDE)	=	Consumption Expenditure (C)	+	Investment Expenditure (I)	+	Government Expenditure (G)

National Income and Expenditure Equality

Expenditure	=	Value of Output	=	Income
GDE	=	GNP	=	Y	=	C	+	I	+	G

Open Economy

-– Economy with international trade

Foreigners buy goods and services or exports (X)

Domestic Households, Business, Government by foreign produced goods and services (Z)

When domestic expenditure > Output Imports (Z) > Output(X)

When domestic expenditure < Output Imports (Z) < Output (X)

GNP

=

Y

=

C

+

I

+

G

+

X

-

Z

GDE

=

C

+

I

+

G

GNP – GDE

=

X

-

Z

National Income Identity

Everything that is produced, earned or spent in a country GDP / GNP

Y

=

C

+

I

+

G

+

X

-

Z

Current and Constant Prices

Changes in GNP reflect changes in real output not changes in price level

Real versus Nominal output

	Year 1 Nominal GNP			Year 2 Nominal GNP			Year 2 Real output GNP at year 1 price
Product	Price $	Quantity	Value $	Price $	Quantity	Value $	Price $	Quantity	Value $
Guns	100	50	5000	100	25	2500	100	25	2500
Butter	1	5000	5000	2	5000	10000	1	5000	5000
	Nominal GNP		10000	Nominal GNP		12500	GNP at Year 1 price		7500

Nominal GNP	=	Current Prices
Real GNP	=	Constant Prices

Multiplier

One Persons Expenditure is another Persons Income

EXPENDITURE	creates	INCOME
INCOME	creates	EXPENDITURE

The process will continue as long as additional expenditure and additional income are generated. It is always a multiple of the increase.

The eventual increase in aggregate demand will be some multiple of the initial increase in demand.

Conditions for expenditure Multiplier to exist

1) Sufficient unemployment to allow the process to operation

2) Additional demand can be met by domestically produced goods and services

3) Rate of Interest does not change enough to cause reduction in investment and consumption expenditure

Common Misconceptions about Multiplier

Attempt to increase Y one using fiscal policies implies increasing Government Expenditure (G) and /or Decreasing Tax Rate (T) and FST Rate.

Attempt to increase Y by monetary policy implies increasing M

This would be the case the year policy change made, However whether it would result in an actual increase in Actual output (Y) over previous year depends on absence of offsetting factors for example

Decrease in exports due to an appreciation of the currency

Therefore possible for an expansionist policy to be accompanied by a reduction in Actual Output (Y) form one year to the next.

Potential Output

Output that would be produced in the economy operating at natural rate of unemployment i.e. U = 6% and 94% = employed workers.

Determined by

• quality, quantity and work effort of the labour force
• quality and quantity of the capital stock
• state of technology

Typically increase each year because of:

• Increase in labour force
• Increase in capital stock
• Technology changes

Potential output fall because of

War or Natural disaster killing people and destroying capital stock

Labour Force

Tends to increase only slowly over time in the absence of

Change in immigration policies affecting entry

Retirement from the labour force

Improved educational standards

Major determinant is past birth rates, participation rates, and existing retirement practices.

Major impact is Tax Rate

– assumed that lower the Tax Rate will increase work effort and consequently growth rate of Q

Capital Stock

Any year investment expenditure is very small relative to existing capital stock., variation in Investment (I) on Potential Output (Q) are marginal

Depreciation occurs at constant proportion

If investment expenditure < depreciation result in capitol stock will decrease

Technology Change

Implementation of more efficient way of procuring out form given resources

Major source of growth in Potential Output (Q )

Government policy incapable of affecting rate of technological progress in short run

Managing the Components of Gross National Product (GNP)

Components of Gross National Product

1) Government Expenditure (G)

2) Consumption Expenditure (C)

3) Investment Expenditure (I)

4) Exports (X)

5) Imports (Z)

Managing Gross National Income (Y)

Yⁱ = Cⁱ +Iⁱ G^c+ Xⁱ-Zⁱ

C = Consumption	c = Direct control
I = Investment Expenditure	i = Indirect control
G = Government Expenditure
X = Exports
Z = Imports

Consumption Expenditure

Depends on disposable income (Y_d) and Interest rate (R) in current year

Disposable Income

=

National Income

-

Taxes

+

Transfers (unemployment & welfare benefits)

Managing Consumption

C = f(Y_dⁱ,Rⁱ,VAT Rate^c)

f = function of (depends on)	i = Indirect
C = Consumption Expenditure
Yd = Disposable Income
R = Interest Rate
Yc = F(Y^i,Tax Rate^c,TransU^i,TransW^i

TransU = Unemployment Payments	C = Direct
TransW = Welfare Payment	i = Indirect

Increase C	Reduce Tax Rate	Higher disposable income
Increase C leave C=(I=X-Z)+G unchanged	Reduce Tax Rate And Decrease Government Expenditure (G)	Raise C Lower C+(I+X-Z)
Affect Consumption (C)	Enact Fiscal Policy and / or Monetary Policy which change Rate of Interest (R)
Reduction in Interest Rate (R)	Reduces cost of borrowing when cost of borrowing falls people borrow and spend more on major item
Increase R	Borrowing increases fewer borrow and slows down Consumption (C)

Investment Expenditure

Depends upon

Interest Rate (R)

Actual Output (Y),

Replacement expenditure (depreciation or capital consumption)

Factors cannot be controlled directly by policy measures.

Gross Investment:	Total expenditure on investments by business firms
Net Investment:	Gross investment – Replacement investment
Net Investment	Is the addition to the capital stock in a year.

Firms make investment expenditures as long as the expected rate of return exceeds the cost of borrowing (interest Rate)

Cost of borrowing rises, marginal investments will no longer be profitable

Policy that increases interest rate will make investment expenditure lower and vice versa

Some firs gear investment to current output of economy, component of I is directly related to Actual output (Y). Component increases when Actual Output (Y) increases and decreases when Actual Output (Y) decreases

Investment Plans affected by what decision makers think will happen in the future no matter how low R, think long term no matter how good – unwilling to invest. High unemployment rates are closely associated will underutilization of existing plant and equipment.

Rising unemployment often associated with decreasing Interest (I).

Lowering Interest rate will not guarantee a higher level of investment expenditure as it may swamped by falling Y and reduced expectations. Decrease in interest rates will always make investment expenditure higher that it otherwise would have been.

Inventories

Change in the level of stocks or inventories (INV) comprise a substantial portion of total Investment (I).

Actual Output (Y)	<	Potential Output (Q)	Firms keep inventory at desired levels
Actual Output (Y)	>	Potential Output (Q)	Firms must sell inventory to meet demand economy as a whole living beyond its means

Investment in Welfare Function

Value of Investment (I) combined with balance of trade (X-Z)

X > Z	Country’s resources being used to supply consumer and/ or investment goods and services to foreigners and future claims against foreign resources accumulated
X < Z	Trade balance is negative, the country is utilizing foreign resources and accumulating foreign debt

Indirect effects of Policy changes

When deciding on policy changes, take into account effect on components of GNP

Example increase in Money policy (M) which increases Investment (I) contributes to an increase in Consumption (C)

Caused by Increase in Investment (I) cause an Increase in Actual Output (Y) which in turn leads to increased disposable income for consumer there fore to increased Consumption (C)

The Budget

Budget

=

Tax Take (T)

-

Government Expenditure (G)

-

Transfers

Government Expenditure (G)	+	Transfers	>	Tax Take (T)	Result is:	Budget Deficit
Government Expenditure (G)	+	Transfers	<	Tax Take (T)	Result is:	Budget Surplus

Control only Government Expenditure (G), Tax Rate, and VAT Rate directly; Tax Take (T) and Transfer depend on outcome of policies

Estimate Tax Take(T) for year ahead requires prediction of Actual Output (Y),Consumption (C)and Investment (I)

Transfer depend on number of persons eligible for welfare payment, level payment set

Transfer unemployment requires prediction of unemployment calculation of rate set, this rate grows at the same rate as Potential Output (Q)

Managing the Budget

Tax Take (T)	=	Tax Rate^c	x	Y^i	+	VAT Rate^c	x	(C^i + I^i)
Outlay	=	G^c	+	Transfer
Where
Transfers	=	TransW^i	+	TransU^i
c	=	Direct
i	=	Indirect

Policy maker exert indirect control over the budget

Estimate budget surplus or deficit necessary to predict National Income, Consumption and Investment expenditure to calculate total tax revenue, also predict transfer payment when added to government expenditure yields government outlays.

The Interest Rate

The price of money,. Determined by the demand for and supply of money (M)

Demand for money depends on:

· real Actual Output (Y)

· last years inflation rate

· Interest Rate (R)

Managing the Interest Rate

Md = f(Yⁱ,INF^t-1, Rⁱ)

Where
MS	=	M^c
f	=	function of (depends on)	c	=	Direct
Y	=	National Income	i	=	Indirect
Md	=	Demand of money
Ms	=	Supply for money
INFt-1	=	Last year’s Inflation rate

Interest rate important for two reasons

FIRST REASON

1) affects consumption (C) and investment (I) expenditures, both of which are components of Actual Output (Y)

2) Connection between the interest rate (R) and Actual output (Y) is therefore indirect:

Higher	Interest Rate (R)	Lower	Consumption (C)	Consumption (C) affects Actual Output (Y)
Higher	Interest Rate (R)	Lower	Investment (I)	Investment (I) affects Actual Output (Y)
Reverse is for a reduction in Interest Rate (R)

Problem facing economic policy makers is two-fold:

Effect of given change in money supply on Interest Rate (R)

Effect given change in Interest Rate have on both Consumption (C) and Investment (I)

SECOND REASON

Interest Rate (R) affects capital flows, in turn affect the balance of payments (BP) and the exchange rate, in turn affects Actual Output (Y).

Connection between Interest Rate (R) and Actual Output (Y) is indirect.

Higher

Interest Rate (R)

Higher

Capital inflows

Lower

Capital outflow

Capital flows affect the Balance of Payments (BP)

Balance of payments (BP) affect Exchange Rate (ExgeRate)

Exchange rate (ExgeRate) affects Exports (X) and Imports (Z)

Exports (X) and Imports affect Actual Output (Y)

Reverse is for a reduction in Interest Rate (R)

Importance of Interest Rate (R) is that it can affect the major components of Actual Output (Y).

Likely impact of a change in Interest Rate (R) on the level of Actual Output (Y)

Indirect link between changes in the money supply and the final effect on Actual output (Y) via a change in the interest rate.

One reason so much dispute to effectiveness of monetary policy.

Import to distinguish between real and nominal Interest Rate (R)

Real is the rate businesses use for investment decisions

Nominal is rate observed in everyday life.

Real and Nominal Interest Rates can Differ

To arrive at the real Interest Rate (R)

Real Interest Rate (R)	=	Last years Rate of Inflation (INF)		-	This years nominal Interest Rate
Rate of Inflation (INF) (%) Last Year (=Expected Rate of Inflation (INF) this year)			Nominal Interest Rate (R) (%) This Year			Real Interest Rate (R) (%) This Year
5			10			5
-2			4			6

Money market operates day to day on nominal Interest Rate (R) .

Nominal Interest Rate (R) fall very low financial markets would cease to function – cause increase money supply by say 150%

Deflation – danger that nominal Interest Rate (R) drop the following year – falling price level increases real stock of money.

How increase nominal Interest Rate?

Cannot change INF_t-1 it is history

Increase demand for money and/or reduce the supply of money to force Interest Rate (R) , the price of money, up

DO NOT DRIVE THE INTEREST RATE TOO LOW

The Unemployment Rate

4 Types of Unemployment

Frictional	Job search
Structural	Industrial Change
Seasonal	Dependent on season
Demand Deficient	Y < Q

First three always exist, while the last can be eliminated if demand for output, and hence the demand for labour, is stimulated sufficiently

Necessary condition for maximizing output, some unemployment of resources.

Potential Output (Q) is defined as output that would be produced if the economy were making full use of its resources, accepting that some temporarily unemployed

Economy is said to be at full employment win unemployment rate of labour (U) is 6% this is the natural rate of unemployment

Unemployment forced below natural rate – economy is operating above capacity.

Unemployment greater that natural rate Potential Output (Q) > Actual Output (Y) – economy is operation below its capacity

Potential Output (Q)	>	Actual Output (Y) then Unemployment Rate (U)	>	6%	(unemployment)
Potential Output (Q)	=	Actual Output (Y) then Unemployment Rate (U)	=	6%	(full employment)
Potential Output (Q)	<	Actual Output (Y) then Unemployment Rate (U)	<	6%	(over -full employment)

Potential Output (Q) grows each year, necessary to estimate the Actual Output (Y) required to maintain the Unemployment Rate (U)

At desired level, devise appropriate policies to achieve Actual Output (Y)

Decisions have to be made regarding the Unemployment Rate (U) to remove unacceptable inflation or deflation you may not wish to run at natural unemployment rate.

Inflation Rate

Inflation is sustained increase in the average price level of the entire economy,

Measured as a percentage (%) increase.

Price level can also decrease this is deflation

Real economies inflation is easy to acquire but difficult and painful to cure.

where t-1 is the previous year.

Demand for Final Goods and Services

Unemployment Rate (U) falls below full employment rate, i.e. when Actual Output (Y) > Potential Output (Q) and Unemployment (U) < 6%, aggregate demand exceeds amount of goods and services that can be produced. Causes prices to rise at a rate depending upon the excess of Actual Output (Y) > Potential Output (Q)

Labour Markets

When Unemployment Rate (U) < 7% wage rates increase eon average.

Unemployment Rate (U) 7% = excess supply of labour at going wage rate.

Real work labour contracts, psychological real cost of firing people and reducing wage rates tend to make wage rates ‘sticky’ downward.

Industries high Unemployment Rate (U) < 7%men rate labour cost may not fall

Industries tight Increase in wage rate result in rising unit labour cost

Net effect of is rising unit labour costs in one sector not cancelled out by falling wage rate in sectors with high unemployment rate.

Unemployment rate < 7% wage rate inflation (WGR) increases

Unemployment rate < 6%, excess demand for labour exist in labour markets result wage rate increases in all labour markets.

i.e. Wage Rate Inflation (WGR) rises faster than it does when Unemployment rate between &% and 6%.

Wage Rate Inflation (WGR) fees through Rate of Inflation(INF) the following year. Annual increase in labour productivity of about 2% per annum, first 2% Wage rate inflation (WGR) does not affect next year Rate of Inflation (INF), When Unemployment Rate (U) exceeds 7% deflationary forces are set in motion.

Wage Rate inflation Affects Inflation Rate

Time Lag Productivity Offset

Expectations

Sellers must agree on a price today for delivery in the future.

One method is making assumption that current Rate of Inflation (INF) will remain until delivery year and add on an increase for inflation for each year until delivery this fashion Rate of Inflation partly determined by people’s expectation of inflation rate.

INF_t = f(INF_t-1)

Indexing

This year wage rate partly determined by last year’s Rate of Inflation (INF)

WGR_t = f(INF_t-1)

Exchange Rate Movement

When pound depreciates foreign goods cost > UK consumers and firms, and UK goods cost < foreigners

When pound appreciates foreign goods cost < UK consumers and firms, and UK goods cost > foreigners

INF_t = f(Change in Exchange Rate_t-1)

Inflation Policies

Unemployment rate reduced – deflationary forces will be lessened

If unemployment rate reduced sufficiently – will be replaced by inflationary forces

Strength of Inflationary forces partly depend on the gap between potential and actual output

Interest rate will vary with increases in monetary demand (unless cancelled out by changes in the money supply) causing investment expenditure to fluctuate.

Unemployment rate exceeds 6% - demand causes of inflation

Several years of high unemployment to reduce the inflation rate.

Stimulate economy to much over succession of year – a high inflation rate can quickly emerge.

Curing high inflation rate is a costly experience.

Some inflation Policy Issues

How close to potential output should actual output be set?

How will last year’s inflation rate affect this year’s rate?

How will last year’s wage rate inflation affect this year’s inflation rate?

What happened to the exchange rate last year?

The Operation of the International Sector

Two separable sub-sectors

Trade Sector

Concerned with the annual flow of goods and services across international boundaries.

Balance of Trade = Exports – Imports

Exports	>	Imports	Trade Surplus
Exports	=	Imports	Trade Balance
Exports	<	Imports	Trade Deficit

Capitol Sector

Concerned with movement of capital (Currency and claims to foreign assets)

Net Capital Flows = Capital Inflows – Capitol Outflows

Inflows	>	Outflows	Capital Account Surplus
Inflows	=	Outflows	Capital Account Balance
Inflows	<	Outflows	Capital Account Deficit

Balance of Payments = Balance of Trade + Net Capital Flows

Balance of Trade

Exports	>	Imports	Trade Surplus
Exports	<	Imports	Trade Deficit

Balance of trade enters directly into the welfare function because Export (X) – Import(Z) included as a component of Investment (I )

Variations in Export (X) and Import(Z) can significantly affect Actual Output (Y) and other variables which enter the welfare equation.

Factors Affecting Exports

Important to recognize which factors are likely to cause exports to increase or decrease.

Managing Exports

X = f(ForY^e,INFⁱ_t-1,ForINF^e_t-1,+ExgeRateⁱ)

Where
f	=	function of (depends on)	i	=	Indirect
X	=	Exports	n	=	No influence
ForY	=	Foreign National Income
INFt-1	=	Last Year’s inflation rate
ForINFt-1	=	Last year’s foreign Inflation rate
ExgeRatet-1		Last Year’s Exchange Rate

Foreign Demand

The higher is ForY greater amount goods and services foreigners will buy includes our exports

Growth rate of ForY affects the growth of exports.

Domestic versus Foreign Prices

Lower prices of our goods compared to the prices of foreign goods the higher will be our exports

Differences between domestic and foreign price levels prevails during the year after inflation occurred. – 1 year lag

Exchange Rate

The price of DM in terms of Pounds changes

Combination of Changes

Depreciation of the pound is accompanied by Inflation Rate (INF) being greater that Foreign Inflation Rate (ForINF)

Large enough difference between Inflation Rate (INF) and Foreign Inflation Rate (ForINF) could cancel out the combined effects of depreciation and growth in Foreign National Income (ForY), causing Export (X) to fall

Exports will grow when

ForY increases

INF_t-1 is less than ForINF_t-1

The Dollar depreciates

And vice versa

Factors Effecting Imports

Same as factors effecting exports except in reverse

Imports also affected by the proximity of Actual Output (Y) to Potential Output (Q) and the tax structure

Managing Imports

Z = f(Yⁱ,INFⁱ_t-1,ForINF^e_t-1,+ExgeRateⁱ)

Where
F	=	function of (depends on)	c	=	Direct
Z	=	Imports	n	=	No influence
Y	=	National Income	i	=	Indirect
INFt-1	=	Last Year’s inflation rate
ForINFt-1	=	Last year’s foreign Inflation rate
ExgeRatet-1		Last Year’s Exchange Rate

Relationship between Actual Output (Y) and imports is not simple:

Amount spent on imports out of an additional Pound of income (the marginal propensity to import, can vary significantly

1) when tax rate is reduced people have higher disposable income (Y_d) from given Income (Y) buy more of all goods and services including imports given Actual Output (Y), the lower is Tax Rate the higher will be Import (Z)

2) When Unemployment Rate (U) falls below 6% buying imported goods When Actual output (Y) exceeds Potential Input (Q) domestic producers are not able to meet all demand

Policies have direct effect on imports i.e. large Tax Rate cut reduces Unemployment (U) below 6% would cause an increase in Imports (Z) for three reasons

1) increased Actual Output (Y)

2) increased disposable income

3) Actual Output (Y) > Potential Output (Q)

Imports will grow when

Y increases

INF_t-1 is greater than ForINF_t-1

The Dollar appreciates

And vice versa

Estimating the Balance of Trade

Understanding international sector can make the difference between relatively high and relatively low Welfare score

Being aware of the variable which affect Export (X) and Import (Z)

Some variables lagged

Most import decisions made today which determine imports the following year – using best estimates of what goods cost in foreign currencies and exchange rate.

Ratio between domestic and foreign prices and/or exchange rate alter, changes affect import and export in the following year.

Variables which affect Export (X) and Import (Z) with one year lag are INF, ForINF and the exchange Rate.

International Effects on Actual Output (Y) are Lagged

Suppose in Year 1 INF > ForINF Effect in year 2 Export (X) will fall, Import(Z) will increase

Suppose in Year 1 because of BP surplus the pound appreciates effect in year 2 Export (X) will fall, Import(Z) will increase

INF > ForINF pound appreciates, negative impact on Actual Output (Y) following year unless redial action to stimulate demand large loss in Welfare could occur because of High Unemployment (U) and low Actual Output (Y)

INF>ForINF pound depreciates, impact of INF > ForINF cancelled out be increase in Export(X) and decrease in Import (Z) caused by depreciation - Factors act in different directions net effect on Export (X) and Import (Z) small false sense of security concerning how well international sector is doing.

Y=C+I+G+X-Z

Export (X) will be lower than otherwise for 2 reasons

Import (Z) will be lower than otherwise for 2 reasons

Net Capital Flows

Depend on relative domestic and foreign real interest rates IF Interest Rate (R) > Foreign Interest Rate (ForR) inflow of capital in response to higher rate of return and vice versa

The Determination of the Exchange Rate

Exchange rate is the price of pounds in terms of foreign currency which would equalize demand for and supply of pound in international money

Market.

BP = 0	no cause exchange rate to change
BP = 0	does not necessarily mean both the balance of trade and capital flows are zero Imbalance in trade accounts offset by equal and opposite imbalance in capital account
BP > 0	demand for pound exceeds supply of pound at existing exchange rate pound appreciate
BP < 0	pound depreciate

Capital flow can have a significant impact on exchange relate, ‘overvalued’ or ‘undervalued’ – exchange rate not set on basis of the values of exports and imports alone.

Capital Flow 0 Exports (X) > Import (Z) Currency would appreciate

Following year

Exports (X0 would be more expensive to foreigners and Imports (Z) cheaper to home consumers

Capital Flow negative appreciation would not have been so high

Currency deprecate if BP < 0 currency would be ‘undervalued’ the following hear and Exports (X) would continue to exceed Imports (Z)

Change in exchange rate also affect domestic price level because of the effect on Import (Z) prices.

For each 1% depreciation in the exchange rate INF increases by .1% and vice versa

Final Word on Policy Making

2 main variable to concentrate are:

Potential Output (Q): the supply potential of the economy

Actual Output Y: the demand for the economy’s output

There is not much you can do about Potential Output (Q), but lot you can do about Actual Output (Y). Given Potential Output (Q)

If you get Actual Output (Y) Right

Then you get Unemployment (U) right

And then you get Inflation (INFD) right in the long run

And it is easier to balance the budget

And the International sector will tend to stabilize

Apart for the impact of exogenous shocks, economic problems typically start will divergence between Potential Output (Q) and Actual Output (Y). Short term answer to economic problems may not be to attempt to equalize Potential Output (Q) and Actual Output (Y)

Fiscal Policy

Operates directly on expenditure

Government Expenditure (G)	Government spend on purchasing goods and service in the market
Tax Rate	Taxes levied on income paid to factors of productions ie wages, rent, interest, dividentds. Marginal tax rate levied on additional income, levels between individuals and firms
VAT Rate	Value Added Tax expenditure levied on consumption investment goods , price increase on final goods and services to consumers and firms.

Monetary Policy

Operates indirectly on consumer and investment expenditure through changes in the interest rate.

Government and central bank – Rate of interest ® is not directly under your control because it is determined by the demand for as well as the supply of money.