ECON 203 Introduction to Macroeconomics Lecture Notes

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Part 1

Lecture Notes on the Circular Flow and the Basic Keynesian Model

Second Edition

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ECON 203, Winter 2010

Hany Fahmy1

Lecture Notes on The Circular Flow of Income and the National Accounts In this note I introduce brie y the main indicators of macroeconomic performance. In particular I focus on output, general price level and employment. The handout starts with an introduction and a review of the basic macroeconomic concepts. After that, the circular ow of income and the national accounts are discussed in detail.

E-mail address: hany.fahmy@hf-consultingco.com

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Introduction and Basic Macroeconomic Concepts

A. Nominal and Real Gross Domestic Product (GDP)
Nominal GDP, GDPN ; is the value of all nal goods and services produced in an economy in a specic period of time, usually one year. GDPN = P Y; (1)

where P is the general price level and Y is the quantity of nal goods and services produced. Real GDP, GDPR , is the quantity of nal goods and services produced in an economy in a specic period of time measured in the market price of the base year. GDPR = and GDPN GDP def lator (2)

GDPN 100: (3) GDPR Consider an economy producing two goods, x and y , such that in 2006, the base year, 20 units of x are sold at $5 each, and 8 units of y are sold at $50 each. In 2007, 25 units of x were produced at a price of $20 per unit, and 10 units of y were produced at a price of $100 per unit. Given the previous information, we can calculate the real and nominal GDP in both years as: GDPN (2006) = (20 5) + (8 50) = $500; GDP def lator = and GDPR (2006) = (20 5) + (8 50) = $500: Observe that both the real and nominal GDP values are exactly the same in the base year. It follows then, the GDP de ator in the base year is always 100. This can be seen from equation (3) above, where GDP Def lator(2006) = As for 2007, we have: GDPN (2007) = (25 20) + (10 2
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GDPN GDPR

100 =

500 500

100 = 100:

100) = $1500;

and GDPR (2007) = (25 5) + (10 50) = $625: Using equation (3) above, we can nd the GDP de ator in 2007 as GDP Def lator(2007) = GDPN GDPR 100 = 1500 625 100 = 240:

B. The Rate of Growth

The rate of growth in real GDP is the annual percentage change in real GDP dened as rate of growth in real GDP = GDPR (year 2) GDPR (year 1) GDPR (year 1) 100%:

Following our previous example, the growth rate of real GDP from 2006 to 2007 is calculated as Rate of growth in real GDP = GDPR (2007) GDPR (2006) GDPR (2006) 625 500 100% = 25%: = 500 100%

C. The Real GDP Percapita

The real GDP percapita is simply dened as Real GDP percapita = GDPR : P opulation

It is simply the share of each individual of the real GDP of the economy. It is a measure of welfare; the higher the real percapita real GDP, the higher the share of each individual of the real GDP of the economy. One disadvantage of real percapita GDP is that it does not re ect the income distribution in the economy.

D. The Price Level and the In ation Rate

The general price level is a measure of the average prices of all goods and services produced in an economy. There are many price indexes used; for instance, the Consumer Price Index, CPI, is a weighted average of the prices of a basket of goods and services produced in an economy over a period of time and is calculated as CP Icurrent year = Cost of base year quantities at current prices Cost of base year quantities at base year prices 100:

The In ation rate, , is the percentage change in the price level from one period to another and is calculates as CP It CP It 1 100%: t = CP It 1 The following is an illustration of how to compute the CPI. 3
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Example 1 Assume for simplicity that our basket consists of only two goods: wheat and cloth, were 2003 and 2004 prices are reported in the following table Wheat Cloth P (2003) P (2004) 4 5 12 16

Assume further that the representative consumer in the Canada buys 5 units of each consumer good. Compute the 2004 CPI using 2003 as the base year. Based on the previous information, we can compute the following. The value of the bundle (basket) at the base year is (5 wheat The value of the bundle in 2004 is (5 wheat The CPI in 2003 is Index2003 = and the CPI in 2004 is Index2004 = 5) + (5 cloth 80 80 16) = 105: 4) + (5 cloth 12) = 80:

100 = 100: 100 = 131:25:

105 80

E. Employment and the Labor Force

The employed, E;are those who worked part-time or full-time during the past week; the unemployed, U N;are those who were not employed during the past week but actively searched for work at some time during the last four weeks. The labor force, L; is L = E + U N: The total population consists of those who are in the labor force and those who are not in the labor force. People in the labor force are either employed or unemployed. Those who are outside the labor force are the children, retirees, and those who decided not to be in the labor force. Therefore, the unemployment rate is calculated as U nemployment rate = Labor F orce Employed Labor F orce 100%;

and the participation rate is the labor force divided by the working age population. Problem 2 In an economy, 100,000 people are in the labor force and the unemployment rate is 25%. As this economy moves out of a recession and jobs increase, 10,000 discouraged workers become encouraged to search for jobs. What is the new unemployment rate? Solution 3 See solution in class. 4
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F. The Business Cycle and the Trade o Between In ation and Unemployment
The business cycle shows how the economic activity, i.e., the GDP, changes over time. A cycle starts from a trough (minimum point) and ends at a trough. The economy is said to be in an expansion phase if it is moving from a trough to a peak along the business cycle. The economy is said to be in a recession if it is moving from a peak towards a trough. A depression is a severe recession. According to the Keynesian school, there is always a trade-o between in ation and unemployment; if the economy is featuring a recession, for instance, in ation will decrease but unemployment will increase and vice-versa in expansion. Although, the trade-o between in ation and unemployment can be observed along the business cycle, yet this is not always the case; an economy might feature high in ation and high unemployment at the same time. This phenomenon is known as stagation.

G. The Full Employment Level of Output, Yp, and the Natural Rate of Unemployment UN
when all resources in the economy are fully utilized, the economy is said to be at the potential (full employment) level of output, denoted Yp : This is the optimal level of output that we like to have. If this level is achieve, unemployment should be zero, however, this is not completely true. The idea is that there exist a level of unemployment even if all resources are fully utilized. This unemployment rate that exists at the potential level of output is called the natural rate of unemployment and denoted UN : UN exists because of frictional, structural, and seasonal unemployments.

Frictional, Structural, and Seasonal Unemployment

Frictional Unemployment is a type of unemployment that exists when individuals leave jobs for other jobs (between jobs). Structural Unemployment is another type of unemployment that exists due to a change in the structure of the economy. For instance, A computer specialist located in a small town, where people hardly use computers, is unemployed because the structure of the economy does not provide a suitable job in his eld. A third type of unemployment occurs when the individual is specialized in a seasonal job. Natural unemployment can be justied on the basis of any of the three previously mentioned types of unemployment.

Cyclical Unemployment
A fourth type of unemployment is resulting from uctuations on the business cycle; it is called cyclical unemployment. For instance, laying o worker in a recession is classied under cyclical unemployment. Remark 4 The equilibrium level of unemployment (the level of unemployment that exists

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at Yf ) is never zero. This is mainly because of the frictional, seasonal, and structural unemployment. Remark 5 The equilibrium level of unemployment in Canada is about 6%. Example 6 Say, for instance, that the current unemployment rate is 11%. Assume further that you learned that 2% is due to frictional unemployment, 4% is due to structural unemployment, and 5% is due to cyclical unemployment. Then, you can deduce that the natural rate of unemployment, UN , is 6%.

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The Circular Flow and National Accounts

The circular ow of income is a diagram that shows how real resources and money payments are channeled between households and the business sector. The diagram is omitted here.

A. Three Approaches to Measuring GDP

A.1. The Output Approach to GDP
GDP is measured as the value of all nal goods and services in an economy in a specic period of time, usually one year. Therefore, according to this approach GDP = P Y:

A.2. The Expenditure Approach to GDP

1. The GDP is measured as the aggregate expenditures in an economy as GDP = C + I + G + X where: C Consumption expenditures is spending by households on currently produced goods and services. I Investment expenditures is expenditure by business on currently produced nal goods and services, e.g., I includes the value of machines, buildings, equipment, and inventories used by business. Note that I here is gross investment, i.e., it does not consider depreciation. N et Investment = Gross Investment depreciation: M;

G Government expenditures is the purchase of currently produced nal goods and services by the government. X M Exports are expenditures by foreigners on our domestic goods and services. Imports are expenditures by domestic residents on foreign products.

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A.3. The Income Approach to GDP

We know that at equilibrium Y = GDP; where Y is the income earned by all factors of production. Therefore, we can measure the GDP from the income side. To this end, we dene the following Net domestic income = employment income + prots and business income + interest and investment income or N DI = W + BI; where: 1. W BI Employment Income is the sum of all wages, salaries, and benets paid to labor. Business Income is the sum of prot, interest, investment and business income.

Once we know the N DI; the GDP at basic price and at market price can be obtained as GDP at basic price = N DI + CCA; and GDP at market price(GDPN ) = N DI + CCA + N et TIN ; where CCA denotes the capital consumption allowance which measures the depreciation in capital stock and N et TIN denotes net indirect taxes which are the sales and excise taxes minus subsidies as N et TIN = Sales and Excise T axes Subsidies:

B. GDP versus GNP

GDP is the income or output produced inside the country boarders regardless of citizenship or borders. Gross National Product (GNP) and Gross National Income (GNI) are equal and represent the GDP plus the net foreign property income as GN P = GDP + (Inf low outf low) of f oreign properties:

Remark 7 Caution when calculating the GDP. The following points should be taken into account when calculating the GDP using any of the previously mentioned approaches: 1. Final goods and services only should be included in the calculations of GDP. Intermediate goods should not be included in the calculations of GDP. The value added approach is used to avoid double counting problems. The value added, V A; is the sum of the dierences between the market value of output, O; and the cost of inputs purchased from other businesses, I; at each stage of production. X VA= (O I ): 8
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2. Goods that are resold do not enter the GDP calculations because they have already been recorded 3. Many goods and services are excluded from the GDP calculations since they are not marketed and thus hard to measure. These include home cleaning, unreported jobs, maintenance, and other households activities. 4. Transfers of ownership are not included in GDP calculations. Purchase of shares is an example Remark 8 Nominal GDP can be expressed, using the previously mentioned three approaches, as GDPN = N DI + CCA + N et TIN ; or GDPN = P or GDPN = P Hence GDPR = Y = C + I + G + N X: [C + I + G + N X ]: Y;

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ECON 203, Winter 2010 Lecture Notes on The Analysis of AD and the AD-AS Model

Hany Fahmy1

In this note I give three versions of Aggregate Expenditure (AE) model. In each version, I consider (1) the AE function, (2) the equilibrium level of output, and (3) the Multiplier. The analysis is then followed by a detailed discussion of the AD-AS model. The aggregate demand (AD) and the aggregate supply (AS) model is a framework used to explain the behavior of real output and prices in an economy. The interaction between AD and AS yields the actual equilibrium level of output and prices.

E-mail address: hany.fahmy@hf-consultingco.com

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The Keynesian AD Analysis

Version 1: No Government and No Foreign Sector
The Model
AD GDP AE = C + I; C = c0 + cY; I = I0 ; where: c0 is the autonomous consumption, which is the level of consumption that does not depend on income; 4C M P C is the marginal propensity to consumer (MPC). It explains the change c= 4 Y in consumption caused by a change in income. In other words, it shows how much out of each additional increase in income by one dollar is devoted to consumption. MPC is always a fraction, i.e., 0 < M P C < 1: Example 1 If M P C = 0:8, this means that an increase in aggregate income by one dollar will cause an 80% increase in aggregate consumption, that is, 80 cents out of the dollar increase in income will be allocated for consumption. This, of course, leaves 20 cents allocated for savings. Remark 2 Note that the marginal propensity to save, M P S , and the M P C should add to one. M P S + M P C = 1: Remark 3 Also note that cY is called the induced consumption, which is the part of the consumption function that depends on income.

(1) The AE Function of Version 1

We can derive the AE function by simply substituting the consumption function, C = c0 +cY , and the investment, I0 , into the AE identity. This yields AE = A0 + cY; where A0 = c0 + I0 is the autonomous expenditure. 2
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(2) The Equilibrium Level of Output in Two Dierent Ways

We are after the aggregate equilibrium level of output, i.e., the output level at which the aggregate demand, AD; is equal to the aggregate supply, AS: In general, the AD and AS equations are expressed as follows: AD and AS So, at equilibrium we have Y = C |{z} AE GDP = C |{z} +I +G

Cons: Expenditure

+ S + T:

P lanned Cons:

G + I + C = AE = Y = C + S + T: Now, back to our model, the equilibrium condition is then AE = Y Using the AE = A0 + cY , we can solve for the equilibrium level of output, Y : An alternative way to express the equilibrium level of output can be obtained by noting that also at equilibrium I = S: Investment is constant (autonomous), but saving is not; it depends on income. Consequently, we need to derive the saving function. Since saving appears only in the AS equation, AS Y = C + S , then we can use the denition of the consumption function and express the saving function as S = Y C = Y [c0 + cY ]: Rearranging yields S= where (1 c0 + (1 c)Y;

4S M P S: 4Y Figure 1 illustrates the realization of general equilibrium using the two previously mentioned ways. c) = Problem 4 Suppose that consumption is $20,000 when income is $31,000, and consumption increases to $20,800 when income increases to $32,000, what is the marginal propensity to save? Solution 5 See solution in class. Problem 6 Suppose that T = 0 and Z = 0. If M P C = 0:6, then we can say that as aggregate income increases by one unit, aggregate consumption will increase by 60%: Solution 7 See solution in class. 3
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(3) The Multiplier

4Y The multiplier, ( 4 ); is the ratio of the change in equilibrium income Y due to the change A0 in any of the components of the autonomous expenditure A0 :

Claim 9 The multiplier in version is

1 : 1 MP C

Proof. 3 To see this, impose the general equilibrium condition and solve for the equilibrium level of income as follows. At equilibrium Y = AE = C + I; (1) where C = c0 + cY and I = I0 : (2) and (3) in (1) yields Y = (c0 + I0 ) + cY: solving for Y yields Y = or and thus 1 1 1 c (c0 + I0 ) )A0 ; (3) (2)

Y =(

1 c

4Y 1 : = 4A0 1 c 1 slope of AE

In general the multiplier can be obtained from the following general form. M ultiplier = 1

Version 2: Introducing the government

The Model
AD GDP AE = C + I + G; T; C = c0 + cY d; Yd = Y T = tY; I = I0 ; G = G0 ; where: Yd is the disposable income (income after tax); t is the tax rate.
3

The proof is not required.

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(1) The AE Function of Version 2

We can derive the AE function by simply substituting the consumption function, the investment, and the government expenditure into the AE identity. This yields AE = A0 + c(1 where A0 = c0 + I0 + G0 is the autonomous expenditure. t)Y;

(2) The Equilibrium Level of Output

At equilibrium we have AE = Y: Using the AE function derived in (1) above, we can solve for the equilibrium level of output, Y :

(3) The Multiplier

Using our general formula, the multiplier in version 2 is obtained as M ultiplier = 1 1 = slope of AE 1 1 [M P C (1 t)] :

Remark 10 Notice that the multiplier in version 1 is higher than the multiplier in version 2.

Version 3: An Open Economy

The Model
AD GDP AE = C + I + G + X C = c0 + cY d; Yd = Y T = tY; I = I0 ; G = G0 ; X = X0 ; Z = zY;
4Z where z = 4 M P Z is the marginal propensity to import (MPZ). It explains the change Y in expenditure on imports caused by a change in national income.

Z;

T;

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Tax Multiplier
We have seen the expenditure multipliers associated with the above three models. The tax multiplier is dierent than the expenditure multipliers that we have seen. The tax multiplier simply shows the eect of changing taxes on real GDP. Since taxes aect output negatively, the tax multiplier has a negative sign and is obtained as T ax M ultiplier = MPC 1 MPC

Remark 14 It is easy to see that if the government changed both the government spending and taxes by the same amount and in the same direction, then output will change by the same value, that is, 4Y = 4T = 4G

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The AD-AS Model

A. The Short-Run AD-AS Model
In the short-run, factor prices, supplies of factors of production, and technology are xed by assumption. Denition 15 The AD is the planned aggregate expenditures; that is what we plan to spend on Canadian goods and services at dierent price levels. AD = Y = C + I + G + N X: The AD curve slopes downward with a negative slope indicating the negative relation between the general price level and the planned aggregate expenditures; a higher price level reduces the expenditures panned by households, business, residents of other countries and vice-versa.

A.1. Three Explanations for the Negative Slope of the AD Curve

1. The Wealth Eect An increase in the general price level reduces the purchasing power of the households and business sectors, i.e., they can buy less in real terms, and thus reduces the planned aggregate expenditures. 2. The Substitution Eect A rise in the domestic price level increases the price of domestic goods relative to foreign goods. This may cause some households and businesses to substitute foreign goods for domestic goods, which, in turn, reduces the aggregate planned expenditures. 3. The Interest rate eect An increase in the general price level, P; will cause households and businesses to demand more money in order to undertake transactions (the demand on money balances, M d ; increases), which, in turn, pushes the interest rate, i, to increase. As the interest rate increase, consumption and investment expenditures decrease and thus aggregate planned expenditure goes down. P ") M d ") i ") C # and I #) AE #) AD # : Denition 16 The AS is the output of nal goods and services businesses would produce at dierent price levels given that wage rates, net indirect taxes are constant. The AS curve slopes upward with a positive slope because the higher the general price level the more the producers are willing to increase output of real goods and services. 9
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