Macroeconomics: Basic Model Tom Porter, 2014

1. The Production Function Wealth ultimately depends on society’s ability to produce goods and services. Long-term growth is entirely a result of production. The following two slides from Chapter 7 in Mankiw Macro textbook show the relationships.

Productivity  Recall one of the Ten Principles from Chap. 1: A country’s standard of living depends on its ability to produce Goods & Services.  This ability depends on productivity, the average quantity of goods & services produced from each hour of a worker’s time.  Y = real GDP = quantity of output produced  L = quantity of labour  Y/L = productivity (output per worker)

Production Possibilities Function  The production function is a graph or equation showing the relation between output and inputs: Y = A f (L, K, H, N) f ( ) – a function that shows how inputs are combined to produce output “A” – the level of technology  “A” multiplies the function f ( ), so improvements in technology (increases in “A”) allow more output (Y) to be produced from any given combination of inputs.

2. National Accounting Equations The distribution of resources at a macroeconomic level are in the form of expenditures on consumption and investment. There is production (Y, or gross domestic product) and there are expenditures (C + I + G + NX, and NX = exports – imports). Production is on the supply side of the aggregate market and expenditures are on the demand side. The identities show aggregation: these do not show causality.

2. National Accounting Equations Y = C + I + G + NX C is consumption I is investment (in physical assets) G is Government consumption NX is net exports which is exports (foreign consumption of domestic production) minus imports (domestic consumption of foreign production) Taxes may be added to government funds and subtracted from private funds. So: Y = (C-T) + I + (G+T) + NX

2. National Accounting Equations Private saving =The portion of households’ income that is not used for consumption or paying taxes = Y – T – C Public saving =Tax revenue less government spending = T – G

2. National Accounting Equations National saving =private saving + public saving = ( Y – T – C) + (T – G) = Y – C – G = the portion of national income that is not used for consumption or government purchases

2. National Accounting Equations Y = C + I + G + NXaccounting identity Y – C – G = I + NXrearranging terms S = I + NXsince S = Y – C – G S = I + NCOsince NX = NCO  When S > I, the excess loanable funds flow abroad in the form of positive net capital outflow.  When S < I, foreigners are financing some of the country’s investment, and NCO < 0.

FIGURE 8.1: The Market for Loanable Funds Private and Public Savings Investment

FIGURE 13.3: The Real Equilibrium in a Small Open Economy

Closed Economy Saving, Investment, and the Relationship to the International Flows  Saving, investment, and international capital flows are inextricably linked.

3. Aggregate Supply and Demand There is Aggregate Demand: Aggregate Demand = C + I + G + NX There is Long-run Aggregate Supply (LRAS), also called the natural level of output: LRAS = Y N = A f (L, K, H, N) There is Short-run Aggregate Supply (SRAS): SRAS = Y = Y N + a (P – P E )

FIGURE 14.8: The Long-Run Equilibrium

4. Money There are two dimensions to money and two markets used to understand money. 1.Money Markets – Supply and Demand for money determines the price level. 2.Loanable Funds Markets – Savings and investment create the supply and demand for loanable funds. Remember that Savings is the Supply of loanable funds.

FIGURE 11.1: How the Supply and Demand for Money Determine the Equilibrium Price Level

Money Supply and Demand The two additional key money equations: 1. Quantity Theory of Money: M x V = P x Y 2. Fisher Equation: R = π + r This relates interests rates and inflation (noted as π) and leads to the second market – for loanable funds.

5. Prices There are three sets of questions to remind ourselves with respect to prices. 1.Price versus Non-Price Events 2.Relative versus General Price Changes 3.Actual versus Expected Price Changes Copyright © 2014 Dr. Tom Porter 20

5.1 Price versus Non-Price Events This difference is usually a simple problem. –Supply and demand graphs show the relationship between price and quantity of a good or service. –Price changes appear on the graph as a movement along a line. –Non-price changes appear as a shift of the line. Potential Confusion –Price changes of other goods are “Non-Price” events. –A shift of a line (due to a non-price event) becomes a price event for the other side of the market. Copyright © 2014 Dr. Tom Porter 21

5.2 Relative versus General Price Changes This difference is key to everything. –General price changes occur because the supply of money is changing relative to money demand. –The price of everything including income and wages are changing so there are NO real effects on the economy. –Relative price changes mean that someone is better off compared to someone else in the economy. –This could be a shift between sectors or a shift in favour of inputs (commodity price increases relative to labour of vice versa). Copyright © 2014 Dr. Tom Porter 22

5.2 Relative versus General Price Changes (continued) Problem: Reality Bites Back –There is only one price. –No one can easily distinguish between relative and general price changes until after the fact. Copyright © 2014 Dr. Tom Porter 23

5.3 Actual versus Expected Price Changes This difference is about the past or the future, but not about the present. –Actual prices refer to reality – what price is actually paid for things. The issue that people face is to determine whether observed price changes are relative or general changes. –Expected prices are those that affect decisions – particularly investment decisions or major consumption decisions like a car or a home. –Investments produce future benefits, and the decisions are based on expectations about what prices may prevail in the future. –This is the difference between the short and long run.

5.3 Actual versus Expected Price Changes (continued) Problem: Our decisions may go badly. –By making a mistake about future prices (expected), then an investment may fail and we may lose some of the benefits from the original investment. –During optimistic periods, people expect higher prices and we see greater investment and vice versa. –Higher investment, even if we make mistakes, leads to some growth. Lower investment always means low growth. –Governments want to see higher investment and encourage optimism. They may even help encourage (mislead) higher price expectations.

5.3 Actual versus Expected Price Changes (continued) Problem: expected prices are not prices. –Changes in expected prices are “Non-price events” for supply and demand curves. –Expected prices are expectations about the future only. –Supply and demand curves show the relationship between actual prices and quantities. –Input cost changes – including wages – are relative price changes that shift the short-run supply curve.