FINAL- MACRO
What are the 3 costs associated with purchasing capital
(1) the price of capital goods (2) cost of depreciation (3) the interest payments to finance the purchase of capital goods
Expect to work for another 40 years and live for another 50 years what is my MPC
.80 (B/N)
How do taxes affect disposable income? How do they affect the after-tax real interest rate? The Incentive to Save?
1) Higher taxes lower disposable income (Y^d = Y + Tr - T (*T is lump sum here*) 2) Lower the after tax interest rate so lower rates ( (1-t)*r = after tax real interest rate btw ) t = tax rate here 3) as r goes UP down then incentive to save will go down: Taxes on income earned from saving reduce the after tax real interest rate and so reduce the incentive to save;
How do other variables change as the business cycle changes?
1. Porcyclical variable: economic variable that moves in the SAME direction as real GDP - increasing during expansions and decreasing during recessions (employment , investment spending ,spending on durable goods tend to increase during expansions and decrease during recessions so these are PROCYCLICAL) 2. Countercyclical Variable: An economic variable that moves in the OPPOSITE direction as real GDP - decreasing during expansions and increasing during recessions (unemployment rate tends to decrease during expansions and increase during recessions.)
Alternating periods of economic expansion and economic recession.
2 key facts about business cycles Unemployment rises and employment falls during a recession unemployment falls and employment rises during an expansion 2) real GDP declines during a recession and real GDP increases during an expansion
How do taxes affect disposable income
As T^ -> Y^d = Y-T goes DOWN and -> Savings goes DOWN T = lump sum taxes
If you completely smooth consumption so that it is the same during each year of life, then your consumption equals the sum of your initial wealth and your lifetime income divided by number of years you expect to live. If you each Y each year and expect to work B years. lifetime income is *BY* If you expect to live for N years then consumption is
C = (Wealth +BY ) / N C = (1/N) * Wealth + (B/N)*Y 1/N = how much spending increases when wealth increases by 1$ B/N = the marginal propensity to consume out of income MPC
according to Okun's law, as real GDP increases by 1 percentage point relative to POTENTIAL gdp, cyclical unemployment decreases by ____________ percentage points
Cyclical Unemployment Rate = -.5 x Output Gap .5 percentage points
Explain the difference in the interest effect for BORRWERS and FOR LENDERS:
For Borrowers: substitution and income effects work in the same direction when someone is a borrower. An increase in *real interest rate* causes a decrease in income so current consumption decreases Barry the Borrow-> Real interest rates rise - Income and sub work same - > decrease current consumption Lary the Lender: an increase in real interest rate increases or decreases income. If real interest rate increases, the lender will have more income at the end of the year than if the interest rate was lower. The substitution and income effect move in opposite directions for lenders.
increased stability of real GDP after the early 80's as well as the mildness of the recessions of 1991-1992 and 2001 led some to describe period as
Great Moderation; In economics, the Great Moderation is the reduction in the volatility of business cycle fluctuations in developed nations starting in the mid-1980s, compared with the decades before.
What factors affect future MPK
If firm expects the demand for its product will decrease in future - > the expected MPK curve will shift to the left and desired capital stock will decrease Changes in uc also cause the desired capital stock to change. An increase in the real interest rate increases the UC so the user cost of capital will shift up. Desired capital stock decreases. an increase in either the depreciation rate or the real price of capital would also increase the user cost of capital and reduce desired capital stock .
Permanent Income=
Income that households expect to receive each year
What in tarnation is an IRA?
Individual Retirement Accounts(IRAS) reduce taxes and* increase the after-tax real interest rate* .
Which is more volatile: Investment or Consumption
Investment def more volatile: Although households and firms are forward looking in their decisions, their behavior can be quite different. Consumption and investment behave quite differently during a recession;
The perspective that business cycles represent disequilibrium or nonmarket-clearing behavior: ________ economics the perspective that business cycles can be explained using equilibrium Analysis: CLASSICAL ECONOMICS
Keynesians egruigriuh
The theory that households use financial markets to borrow and save to transfer funds from high income periods, such as working years to low income periods such as retirement years or periods of unemployment
Life cycle hypothesis
Marginal Propsensity to Consume: The amount by which CONSUMPTION increases when DISPOSABLE INCOME increases by $1
MPC consists of
Change in equilibrium GDP divided by change in autonomous expenditure
Multiplier.
Who decides when a recession begins and ends? How do they decide
NBER private research group - 9 economists determine beginning and ending of recessions .. a recession begins when the economy reaches a peak of activity and ends when the economy reaches its trough. Between trough and peak the economy is in an expansion. they use data on payroll employment, aggregate hours worked, real income excluding transfer payments, monethly estimates , and GDP and GDI but they don't use these two series exclusively because they are released later. they are the most reliable though. but they use a shish ton of others
Do households really smooth consumption?
Nah only like half other do. Households do tend to smooth goods ands ervices , nondurable goods
Hypothesis that household consumption depends on permanent income and that households use financial markets to save and borrow to smooth consumption in respese to fluctuations in transitory income:
Permanent-Income Hypotheisis
Extra Saving by households to protect themselves from unexpected decreases in future income due to job loss, illness or disability
Precautionary Saving
The price of current consumption relative to future consumption: *Price of current consumption relative to future consumption*
Real Interest Rate
When the real interest rate INCREASES, individuals reduce current consumption and increase FUTURE consumption (price of current consumption increase) is this Income effect of Sub effect
Substituion Effect
if r = - and households prefer to smooth consumption perfectly
Sum of consumption in both years equals the sum of your income from both years. Perfectly smooth consumption ie equalize the consumption in both years : C1 = C22
The ratio of the market value of a firm to the replacement cost of its capital
Tobin's Q
How would a consumer treat an unexpected windfall?
Transitory income positive and save most Unexpected Job Loss : transitory income negative -> Borrow How would a consumer smooth consumption in each of these cases: save or borrow in financial market (assume no constraints)
Expected real cost to a firm of using an additional unit of capital during a period of time
User cost of capital(uc)
How can expansions create inflation? (hint think about potential gdp)
Yt > Potential Y -> Resources fully employed -> Prices go UP
if the multiplier is 1.1, what does this mean
a one percentage point increase in *expenditure as a percentage of potential GDP increases real GDp by 1.1 percentage points relative to potential GDP
Periods of irrational pessimism and optimism that affect the investment behavior of firms
animal spirits
Spending that does NOT depend on income ->
autonomous expenditure examples of changes in autonomous expenditure are like change in government purchases or taxes, decline in consumer spending as a result of a decline in consumer confidence , or a decline in investment spending resulting from firms becoming more pessimistic about future profitability of capital
a shock changes _________ __________ (consumer confidence, investor confidence, and government spending)
autonomous spending
ARE business cycles related across countries?
business cycles across countries are related but not perfectly synchronized. 1 ) countries trade with another so a downturn in one can spread to other coutnries 2. shocks such as oil price shocks are often global in nature
The entire amount of a *change in income* is unlikely to be spent on current consumption
consumption smoothing
the restriction of credit by lenders such that borrowers cannot obtain the fundi they desire at a given interest rate
credit-rationing
okun's law : a statistical relationship discovered by Arthur Okun between the ___________ _______ rate and the B)
cyclical unemployment output gap
The difference between the unemployment rate and the natural unemployment rate =
cyclical unemployment. oakum's law : a statistical relationship discovered by Arthur Okun between the cyclical unemployment rate and the output gap
When expectations about future profits decrease substantially, there is a decrease in tobin's q which can cause firms to
decrease Investment. When expectations about future profits increase -> there is an increase in tobin's q and level of investment. So if investors' expectations of the future profitability of firms are volatile, investment will also be VOLATILE
What factors could affect future MPK
demand for the product may change(Y) Government policy(Tax regulation) (A) Y = AK^a*L^1-a
The decrease in housing wealth should reduce the consumption of older households, but a decrease in household prices increases the wealth of both younger households that are more likely to be renters and households planning to purchase and live in households that are more expensive than current. Whether arggrage consumption or decreases
depends on the mix of households and the marginal propensity to to consume out of wealth for these groups
level of capital stock that maximizes firm's profits
desired capital stock
Which is more volatile; durable goods or non-durable goods:
expenditure on durable goods like cars and furniture are more volatile than nondurable goods such as food and clothing Durable = More volatile
How does the MPC for current disposable income change for households?
f a household is credit-rationed: the MPC out of transitory income may be high. A household that is credit rationed would like to consume MORe but cannot because it cannot borrow money (Credit rationed if they cannot borrow money against future income at the current interest rate)
How does uncertainty affect investment
if aggregate shocks (oil, monetary policy) - > uncertainty goes up -> firms wait -> I goes down for most firms -> magnifies shock - big sWINGS
Why does the price of a share of stock increase?
if expected future profits go up -> price of a share of stock goes up -> market value of the firm goes up - > tobin's q goes up and INVESTMENT GOES UP
How do taxes affect the after tax real interest rate ? The incentive to save?
if r goes DOWN then C goes UP and S goes DOWN After tax rate of return (1-t)*r is lower -> S goes DOWN as t goes up. (T = lump sum taxes , t = tax rate)
An increase in the real interest rate increases the UC so user cost of capital curve shifts up. An increase in UC due to an increase in either price of capital or the depreciation rate would have same effect
increase in r , d , or p(k) or corporate income tax rate shifts up line. *Tax adjusted user cost of capital goes up -> so does uc curve)
How does the multiplier effect work?
initial shocks end up having a larger effect on the economy through spending roughts change in AE x Multiplier = Change in Real GDP
What is the budget that tells us how much a household can consume given lifetime income? It is a budget CONSTRAINT that applies to *consumption and income in MORE THAN ONE IME PERIOD*
intemporal Budget Constraint Y1 = C1 + S1 C1 = amount we consume this year C2 = amount consume next year C2 = Y2 + (1+r)S1 C1 C2/(1+r) = Y1 + Y2/(1+r) If we sub the expression for SAVING in period 1 (S1= Y1 - C1) into expression for consumption in Period 2 C2 = Y2 + (1+r)S1 , we get that that C2 = Y1 + (1+r)(Y1-C1) then dividing by 1+r gives us all of that.
The volatility in the growth rate of investment is much greater than the volatility in the growth rate of consumption so like
investment usually decreases much more than consumption.
Suppose there is an increase in uncertainty about the future price of output , the future price of inputs ,future interest rates, or regulation. In that case, the value to firms of waiting to acquire additional information also increases and current investment is likely to decrease. When aggregate shocks such as oil prices increases , changes in monetary policy or changes in housing prices occur, the value of waiting to obtain more info increases. As a result, some firms may postpone investment projects thereby magnifying the initial effect of the shock.. The fact that
investments are irreversible an can be delayed makes investment more volatile
What is the output gap? How is it measured?
it is the percentage deviation of actual real GDP from potential GDP (Y-Potential GDP)/Potential GDP measures HOW FULLY the economy is employing its resources such as labor natural resources physical and human capital. when output gap = 0 , the economy is producing at its long run capacity so is producing the maximum sustainable level f goods if output gap is greater than zero - economy is operating at a level that is greater than it can sustain in the long run..
How are investments irreversible
k goes down by depreciation you can't sell k
Potential GDP : DEFiNE ME
level of real gDP attained when firms are producing at capacity and labor is fully employed.
Because of the multiplier effect a reduction in C or like housing prices
may reduce real GDP for years into the future.
How can business cycles affect the balanced growth path of real GDP
more uncertainty -> Investment goes DOWN -> Real GDP on balanced growth path goes DOWN(from slow model)
What is the net effect of higher interest rates ->
overall consumption will fall even though we don't know how much C will increase as part of the income effect for lenders
How are the permanent income hypothesis and life-cycle hypothesis similar
people give up C in present to save so they can consume in future
As r goes up, the opportunity cost of consumption goes UP
present consumption goes DOWN and future consumption goes UP - substitute future C for present C (substitution effect) current consumption goes DOWN for future consumption
Market Value of the Firm / Replacement Cost of Capital = q if q > 1 , firms should ______ capital q < 1 firms should ________ decrease
q >1 == increase capital q <1 == decrease capital Apple market value = 640$/share * 1 billion shares == 640 billion Replacement cost of capital = 80 billion 640b / 80b = 8.
How can you measure ACTUAL real GDP
real GDP = Potential GDP + Deviation from Potential GDP Deviation of actual real gdp as best measure of the size of economic fluctuations associated with business cycle
Can a firm affect pk r or d ALAWYS GONNA PAY R even if they don't borrow anything hahahaha SUX
rpk = interest cost to firm : even if firm does not borrow to purchase the capital good , it still pays this cost because it could have loaned those funds to receive interest income dpk = depreciation cost : capital stock wears out each period due to normal use, so firms pay this capital cost uc = rpm + dpk
credit rationing suffers from that
same problem of asymmetric information
How quickly do firms adjust their capital stock
slowly because costly to adjust K*(t) - Kt-1 = gap between desired and actual capital stock z = constant fraction of the gap between K* and K which is eliminated through invesmtment where 0<z<1 I = z(K*t - K*t-1) gross investment = I
How would a tax cut (such as increasing the amount of investment that can be depreciated for tax purposes) affect investment?
t DOWN -> uc DOWN -> K* goes UP -> Investment goes UP by z(K*t-K*t-1) + dkt-1 Hard but know.
tax cut -> t down, uc down, Lsar up , I goes up by z
t goes down - > uc goes down -> k goes UP -> I goes UP by Z
If the government increases corporate income tax rate , the
tax adjusted user cost of capital will INCREASE , and desired capital stock will DECREASE
four things that shift up uc
taxes, depreciation rate, pk, and real interest rate r
In the late nineteenth century, the US economy spent as much time in recession as it did in expansion but AFTER the 1950's
the US economy exerpienced long expansions interrupted by relatively short recessions.
Why do households save:
to accumulate assets necessary to purchase a house, pay for college or pay for consumption during retirement..Expectations about future affect consumption decisions today
______ income: Income that households DO NOT expect to receive each year
transitory Y = YPerm + Ytrans
What is effect on user cost of capital if the government increases the corporate income tax rate
uc = (r+d)pk / (1-t) if t goes UP ,UC goes UP
As r goes up for BORROWIERS:
y goes DOWN and consumption will FALL; Overall effects of sub and income will fall
Income Effect for lenders as r goes up
y goes up and consumption would go up. so income effect here is saying C goes up
What are the 2 federal programs to reduce taxes on savings? *These REDUCE taxes on savings*
1. IRA's - these reduce taxes and increase the after tax real interest rate. it'll incentive savings 2. 401(k) : Income contributed to 401(k) account isn't taxed until the contributor withdraws the funds during retirement. So 401(k) also increases the after-tax real interest rate on saving. AST goes up -> Yd = (Y-T)goes down and savings goes DOWN as r goes down -> C goes up and S goes DOWN
Why are prices sticky in the short run
1. Imperfectly competitive marketts so like prices aint gonna automatically adjust -- if perfectly then it would automatically adjust to changes in p and d 2. Menu Costs (printing catalogues,) customer dissatisfaction, long term contracts. ie *cost to firms of changing prices ==menu costs *
Why don't the costs of business cycle average out over time?
1. Magnitude * a business cycle consists of expansions and recessions but recessions do not necessarily have same magnitude as expansions 2. Skills if workers are unemploye for long periods of time , skills will deteriorate 3. Low Income Workers unemployment and lost income resulting from a recession is concentrated among low income workers. 4. Long Lasting Effects negative effects of recession on workers can last many years
What assumptions do economists make about households and firms
1. Rationality ( objective of households is to maximize utility or wellbeing and objective of firms is to maximize profits. 2. Forward Looking
What may explain why the US economy has been relatively stable since the 1950's
1. The increasing importance of services and decling importance of goods 2. The establishment of unemployment insurance and other government transfer programs that provide funds to the unemployed 3. Active federal government policies to stabilize the economy 4. The increased stability of the financial system.
When do these variables change? 1. Leading Indicators 2. Coincident Indicators 3. Lagging indicators
1. like stocks tend to decrease prior to the beggining of a recession - leading indicators 2. economic variables that tend to rise and fall at the same time as real gdp 3. Lagging indicators: economic variables that tend to rise and fall after real GDP.
Economists assume that households and firms share two important characteristics:
1: they act rationally to meet their objectives. Economists assume that the objective of households is to maximize utility, or well-being, and that the objective of firms is to maximize profits. 2:, they are forward looking - that is, they take into account the future when making decisions. Expectations about the future affect consumption decisions today.
Should we care about the fluctuations in real GDP that occur during the business cycle? As real GDP per capita increases over time, the effects of economic growth should overwhelm effects of business cycle on average person's well-being. The business cycle results in real GDP sometimes being BBELOW potential GDP but is also results in periods during which Real GDP is above potential. It might seem that these costs of economic fluctuations SHOULD average out but ECONOMIC RESEARCH says effects of recession on workers and firms indicate teat economic fluctuations have costs. and the costs can be large
Business cycles may affect the level of potentialGDP too.
Households and firms are _______ -_________: that is they take into account the future when making decisions
Forward looking
Economic variables that tend to rise and fall in advance of real GDP
Leading Indicators:
What is the effect on the user cost of cpital if the government increases the corporate tax rate (ON expected MPK)
MPKe = (r + d)pk / (1-t) t goes UP (1-t) gets smaller and desired level of capital goes DOWN. K* BYE.
Most economists see the business cycle as resulting from the response of households and firms to _______ ____________. : an unexpected exogenous event that has significant effect on an important sectors of the economy or on the economy as a whole
Macroeconomics Shock financial crisis, collapse of housing bubble, significant innovation in information technology, significant unexpected increase in oil prices , or unexpected change in monetary policy of fiscal it's gotta be unexected
How often do firms in western europe and the US change prices? Does manufacturing differ from services? Is a shock to the aggregate market or the specific sector more important in changing prices?
Most firms in Western europe and US change prices just one or twice a year, with firms in the service sector typically changing prices less frequently than manufacturing firms Firms that are more likely to change prices as a result of shocks to the firms's sector than as a result of shocks to the aggregate economy... okay . .book publishers would respond faster to changes in cost of paper but slowly to the change i the demand for books that results from the bursting housing bubble.
The effect of shocks are amplified through : ________ __________ a series of induced increases (or decreases) in consumption spending that results from an initial increase(or decrease) in autonomous expenditure; this effect amplifies the effect of the economic shocks on real GDP
Multiplier Effect
Does housing wealth affect consumption?CBO estimate
Wealth in addition to income and interest rates plays an important determinant of consumption; CBO estimates that a 1$ increase in housing wealth increases consumption by .07$ some argue that is too high and that a decrease in housing wealth has little effect on aggregtae consumption
How much does a person consume under life-cycle hypothesis in order to smooth C
Y = amount a person earns each year B= number of years person expects to work BY = lifetime income N = number of years person expects to life Consumption = (wealth + by )/ N or ( wealth + lifetime income ) / (number of years left to live)
dependence off investment on the state of the economy ==
financial accelerator
After tax profits( rather than before tax profits) affect a
firm's decision making Incorporating taxes, the equation for desired level of capital becomes (1-t)*MPKe = (r+d)p MPKe = (r +d)p / (t-t)
when nominal wages and prices are ______ , markets absorb shocks so shocks do not have a large effect on real GDP
flexible but when nominal wages and prices are sticky, quantities in individual markets respond to these shocks and these changes reverberate trough the economy because as output changes, so does income. Changes in income can lead to changes in spending and further changes in output and employment.
Keynes thinks that the increase in cyclical unemployment during a recession primarily represents the
involuntary unemployment, or workers who are unable to find jobs at the current wage rate . So quantity of labor supplied is greater than quantity of labor demanded. if classical view is correct then market for goods and services remain n equilibrium during business cycle.ALthough employment and output decline during recession , they do so because of voluntary decisions of households to supply less labor and firms to suppl fewer goods and services.
Milton Friedman argued that the level of consumption depends primarily on
permanent income C = a*YPerm where a is a constant and represents the fraction of permanent income that households consume Consumption though responds more to changes in permanent income than to changes in transitory
Extra saving by households to protect themselves from unexpected decreases in future income due to job loss, illness, or disability
precautionary saving an increase in uncertainty about the future will increase the desired level of wealth and lead to lower consumption until the households have attained the new level of wealth. A decrease in uncertainty about the future will lead to higher spending until households have a trained the new lower level of wealth. Uncertainty can affect aggregate consumption and help cause economic fluctuations. think about like if wealth > desired level then consumption will go up and wealth will go down and save less and vice versa Uncertainty goes up -> desired level of wealth goes UP and C goes down cus I'm saving more (S)
For the multiplier effect to operate there must be what
some idle resources s that firms can hire more labor, capital , and other inputs when demand increases. The further real GDP is below potential GDP, the greater the amount of idle resources and the larger teh multiplier effect may be. The worse the economy is performing, the larger the multiplier effect will be.. cool Shock -> Spending response by households and firms -> Multiplier effect -> change in Real GDP assumes there are idle resources so that firms can hire more inputs when demand increases (input prices don't change)
Tax adjusted user cost of capital:
the after tax expected real cost to a firm of purchasing and using an additional unit of capital during a period of time
The user cost of capita;: expected real cost to a firm of using an additional unit of capital during a time periods depends o n real price of capital good, the real interest rate of borrowing to finance the purchase of the capital good and the depreciation cost associated with actually using the capital good. *depcreciation rate d is determined bu technology that a firm uses and not by the quantity of capital goods*
uc = rp&k& +dp&k& = (r +d)*p&k&) rp&k& is the interest cost to a firm and represents cost of borrowing funds to purchase a capital good --even if firm doesn't borrow they still incur a cost because could have loanded the funds to other firms or households and receive interest income SO IT IS LIKE THE OPPORTUNITY COST dpi = some capital wears out each period due to normal use so firms incur(non-cash) depreciation equal to dp&k&