1. A Review of the Basics

2. Learning Objectives
Understand the concept of the National Income Identities
Understand the definition of Unemployment
Understand the definition of a price index
Understand the concept of Economic equilibrium and how it is influenced by expectations

3. 1. NIE Identities Review GDP defn in Mankiw 2.1
Before we get into models of economic behaviour we need to look some definitions and some issues in measurement
Measurement economic quantities may seem boring…
But it can give crucial insight even without a model of behaviour
Example: the current crisis

4. NIE Identity
We measure macroeconomic activity primarily by looking at annual (or quarterly) flows of Output (O), Income (Y) and Expenditure (E).
These are different ways of measuring the same thing, so they sum to identical totals
Basic Identity: Y  O  E
Think of why this is the case
Income and Product are identical: Product is Value-Added in Production, i.e sales minus purchases from other firms, which = payment of incomes to Factors (Wages, Interest…)
Expenditure equals Income, because any production not sold is counted as Inventory Investment, and is thus part of Expenditure (the firm purchases its own output from itself)
Note this is an identity not an equilibrium condition
An identity holds for all values
An eqm condition holds only for some values i.e. in eqm
Distinction important later

5. NIE: GDP vs GNP Open economy: GNP v GDP GNP  GDP + NFIA
(NFIA is net factor inc from R.O.W., i.e. inflows minus outflows)
GNY  GNP + EUtrasfers – EUtaxes
GNDY  GNP + NTA (NTA is all net Transfers from R.O.W. incl EU)
GDP + NFIA + NTA  GNDY
Note: Irish GNP was approx 85% of GDP (2007)
For many other countries the distinction is not relevant
Can lead to lots of debate of which is best measure in Ireland

6. NIE: SAVINGS & INVESTMENT IDENTITY
The Income Identity
Y  C + S + T
Accounting rule: Income is either spent, saved or taxed
The Expenditure Identity
E= C + I + G + NX
Accounting rule: add up the components of expenditure
Combine the two
C + I + G + NX  C + S + T
Thus: (G – T)  (S – I) – NX
or: (G – T) + NX  (S – I) etc.
clearly, adding in net foreign factor and transfer income, including them in the totals for T and S etc as appropriate, and changing signs we get:
(T - G) + (S - I)  NX  BOP Current A/C
Note: the 2 left hand expressions are National Savings

7. NIE: SAVINGS & INVESTMENT IDENTITY
This is often known as the twin deficits identity
Even though it doesn’t involve any model or description of economic behaviour it can be informative
Implication: a current account surplus can only occur if there is an excess of national savings
Application 1: The US
The US has trade deficit (esp with China)
This is inescapable given it has insufficient savings
China surplus equates to surplus Chinese savings
Application 2: Ireland’s Bubble
We had a bubble (high investment)
Insufficient savings
So high current account deficit

9. 2. Unemployment See Mankiw 2.3
The labour force (L) = employed (E) + unemployed (U)
The unemployment rate u% = U/L or U/(E + U)
Letting the population of Labour-force Age = P, we also have:
The Labour force participation rate: LFPR% = L/P
Measuring Employment and Unemployment
Surveys: household QNHS in Ireland, quarterly household survey (CPS in USA); business surveys for employment.
Administrative: “Live Register” (Ireland); related to benefit claimants

10. Unemployment
The precise details of how surveys and other measures are constructed will differ from country to country. Survey methods are generally more comparable.
Key Issue: have to “want” to work to be unemployed as distinct from not working
Surveys try to capture this: “active search”
Issue of how active
Discouraged worker effects
There is a difference between what economists’ defn of U and rest of society
Claimant counts do not – may include people NILF

11. 3. Prices
Mankiw 2.2
Some components of GDP have well-known measures of inflation: the CPI for household consumption
For a more comprehensive measure the implicit price deflator for GDP is used: this relates to all items in the GDP
A price index is a weighted average measure of price changes
Two questions arise: (i) what is included (ii) what kind of weighting system to use
For Consumption the Irish CPI includes a measure of housing costs, the Eurozone HIPC does not (why?)
Generally if an index uses base-year weights (Laspeyre), the resulting inflation is higher than if current year weights are used (Paasche)
CPI is Laspeyre

12. Laspeyre vs Pasche
A Laspeyre index of prices uses the quantities prevailing in some base (e.g. survey) year to weight prices. The index takes the form:
(p1q0 / p0q0)x100
Note: base-year quantities (q0) are used to compare prices in the two years (p1 and p0 )
A Paasche index of prices uses the quantities prevailing in the terminal year to weight prices. The index takes the form:
(p1q1/ p0q1)x100
Note: current-year quantities (q1) are used to compare prices in the two years (p1 and p0)
As relatively cheaper are substituted for dearer goods, the Laspeyre index of prices has an upward substitution bias.
So CPI inflation is biased upwards

13. 4. Equilibrium Key concept in economics
illustrate with the simplest possible macro model
Mankiw 11
Equilibrium is a point of balance or stability
Specifically in economics it is a point where economic agents’ plans are mutually consistent and therefore are realised
Disequilibrium
plans are inconsistent
then someone’s plans are not realised
Somebody is disappointed
Behaviour will change
The economy will change
so not stable or balanced

14. MACROECONOMIC EQUILIBRIUM
First, Output (which equals Income) is a function of inputs: for simplicity, Capital (K) and Labour (L)
Y = f(K, L)
This is the amount firms plan to spend
There will also be Aggregate Demand or Planned Expenditure (PE)
the amount of Expenditure which agents plan to make
Agents: Households, firms, the Government and foreigners
In equilibrium plans are consistent
Y = PE
Later we will see that sometimes Output or Income do not equal planned expenditure: this corresponds to a disequilibrium
The general idea is that in equilibrium the forces acting on some variable (Y) are balanced and hence Y will not change.

15. Planned Expenditure
Conventionally we look at separate components of aggregate (planned) expenditure: C, I, G, NX. This is because they behave differently.
Crucially C (Consumption) depends partly on Income: so part of Expenditure depends on Income: hence the term Induced (Consumption) Expenditure
Other components of Expenditure are Autonomous: this should be understood as depending on something other than Income.
We have
an Autonomous component of Consumption (Ca)
Investment (I)
Government purchases (G)
Foreign demand (NX)

16. Consumption Function An equation that describes consumption plans
Very Generally, Consumption depends on Disposable Income (Y minus net taxes, T).
More specifically: C = Ca + c(Y – T)
the “Autonomous” and “Induced” elements are on the right-hand side.
For simplicity Mankiw leaves out Ca
The coefficient c (The Marginal Propensity to Consume) is > 0 and < 1, implying that for any given increase or decrease in disposable income C will change in the same direction, but by a lesser amount.
i.e < dC/d(Y – T) = c < 1
This is a model of consumption insofar as it is a simplified representation of how people make their consumption plans
It doesn’t say that plans will be successful
It is very simple (even simplistic): no interest rates, future income, life cycle

17. THE CONSUMPTION FUNCTION (2)
Note: Ca is “Autonomous” consumption; C/Y (APC) falls as Y increases; c (MPC) is < APC. C
45 (C = Y)
Ca + c(Y – T)
Slope = c Ca
(Y-T )

18. Equilibrium As always equilibrium is where plans are consistent
Specifically in this case planned production is equal to planed demand
Y = PE,
Sub in equation for planned expenditure (“Aggregate Demand”)
PE = C + I + G + NX
To get Y = C + I + G + NX
Sub in consumption function
To get: Y = Ca + cY – cT + Ip + G + NX
Note
cY is the one part of Expenditure which depends on Income
The other components (Ca –cT + I + G + NX) may be termed autonomous planned spending, in that they do not depend in Income (at least for now…)
Alternatively we might term them the Endogenous and Exogenous components of planned spending.

19. Eqm. Vs Idenitity We have an accounting identity: Y = C + I + G + NX
This different from the equilibrium condition
The equilibrium condition describes planned magnitudes
These plans may or may not be realised
The identity describes what actually happens
This may or may not have been what was planned
Thus the equilibrium condition is true only for certain values of the variables
The identity is true always
Best thought of as an account rule

20. DISEQUILIBRIUM
To illustrate the concept of equilibrium consider a numerical example
Suppose we have Ca = 50, c = 0.8, T = 150, I = 40, G = 150, NX = 60
Suppose we have Y = 600
Is Income at equilibrium?
Calculate Planned expenditure (Aggregate Demand)
PE = Ca + c(Y – T) + I + G + NX
= (450)
= 660
So Planned Production (Y) < Planned Expenditure (PE)
Somebody’s plans will not be realised
Production is not sufficient to meet demand

21. Disequilibrium Plans must be updated Note this is a key assumption
How?
We will assume that production will be increased to meet demand
Note we assume prices don’t change
Will provide empirical evidence later
Note this is a key assumption
We will spend much of the course looking at how plans are updated
This will depend on expectations and timeframe (LO 3)
In this simple model we assumes that plans cannot be updated by changing prices
This turns out to be valid in the short term but not in the long term

22. EQUILIBRIUM What is Equilibrium Y in this case?
We could try by trial and error
Or we could solve the equations
By definition equilibrium is where planned production equals planned expenditure:
Y = PE
Y = Ca + c(Y – T) + I + G + NX
Y – cY = Ca – cT + I + G + NX
Y(1-c) = Ca – cT + I + G + NX
Y(1 – c) = PA
Where PA = Autonomous planned spending = Ca – cT + I + G + NX
Plug in numbers
Y = PA/(1 –c) = ( )/(0.2) = 180/0.2 = 900
One can re-check by plugging in all the components of PE when Y = 900 and getting PE = 900, i.e. equilibrium

23. EQUILIBRIUM This can all be illustrated graphically
When PE > Y, Y < Ye hence Y rises: similarly when PE < Y….. Ep
45 (PE = Y)
PE = PA + c(Y – T) Ap Ye Y

24. Comment The process is self sustaining
If we are not at equilibrium there is an automatic adjustment process that will bring us into equilibrium
If this were not the case no point in studying eqm
If not at eqm we are heading there
We assume for the moment that the adjustment process works by producers changing out put to meet demand
We also assume that prices don't change
Seems counter intuitive
This model effectively assumes that prices are fixed
We will
provide empirical evidence alter that this is approximately true in the short run
and spend much of the rest of the course discussing when and how it isnt true

25. A CHANGE IN AGGREGATE SPENDING (1)
Suppose Ip and therefore PA fall by 40, Ye1 falls to Ye2 by a multiple of 40 (Ye > PA) Ep
45 (PE = Y)
PE1 = PA1 + c(Y – T)
PE2 = PA2 + c(Y – T)
PA1
PA2
Ye2
Ye1 Y

26. A CHANGE IN AGGREGATE SPENDING (2)
Initial Equilibrium is: Y1 = PA1 + c(Y1 – T)
Following Shock to PA: Y2 = PA2 + c(Y2 – T)
Subtracting: Y2 – Y1 = PA2 – PA1 + c(Y2 – Y1)
i.e Y = PA + c Y
so Y(1 – c) = PA
And thus: Y/PA = 1/(1 – c) or 1/s
So if c = 0.8, s = 0.2, multiplier = 5: etc….
Intuitively: an increase in PA (say G) is spent: it becomes income to someone who re-spends c times the increase, etc…
Y = G(1 + c + c2 + c3 + ….. + cn)
 cY = G(c  c2  c3 + ….. + cn+1) then adding
And Y(1  c) =G(1) (the other terms cancel)
So Y/G = 1/(1-c)
You should have seen this before . If note review it in your fits year book or in Mankiw

27. CHANGES IN SAVINGS, TAXES
In the previous example, an increase in G of 100 produced an increase of 500 in Y.
As T is given this means that (Y – T) increased by 500, and C increased by c.Y so savings increased by s.Y = 100
Financing the increased G by selling Bonds to Savers??
Now what happens if T were reduced by 100 instead of increasing G?
Initial Equilibrium is: Y1 = PA + c(Y1 – T1)
Following cut in T: Y2 = PA + c(Y2 – T2)
i.e Y = c.Y – c.T
So Y(1 – c) = – c.T
 Y/ T = – c/(1 – c)
Thus if c = 0.2, –c/(1 – c) = – 0.8/0.2 = – 4.
Note sign, magnitude (intuition of this)

28. Conclusions Understand the concept of the National Income Identities
Accounting rule so true by definition for all values
Understand the definition of Unemployment
NILF vs U
Understand the definition of a price index
CPI inflation biased upwards
Understand the concept of Economic equilibrium and how it is influenced by expectations
Plans are consistent
What adjusts when plans are not consistent?

29. What’s Next? We will spend the rest of the course expanding on L.O. 4
We will add more detailed accounts of how plans are formed
Progressively more complicated models
We will also carefully consider what adjusts when plans are inconsistent
Next topic provides more detail on how consumption and investment plans are made specifically we take into account interest rates.