Topic 4

A country loses much of its capital stock to a war. a) What effect should this event have on the country's current employment, output, and real wage? b) What effect will the loss of capital have on desired investment? c) Assume that the desired saving function does not change. What effect the loss of capital have on the country's real interest rate and the quantity of Investment?

(a) With a lower capital stock, the marginal product of labor is reduced, so the labor demand curve shifts to the left from ND1 to ND2 in Figure 4.8. Then the new equilibrium point is one with lower employment and a lower real wage. With lower employment and a lower capital stock, full-employment output will be lower. • (b) Because the capital stock is lower, the marginal product of capital will be higher, so desired investment will increase. • (c) The increase in desired investment shows up as a shift to the right in the I d curve, from I 1 to I 2 in Figure 4.9. Then the new equilibrium (assuming no change in desired saving) is at a higher level of investment and a higher real interest rate

What two parts are investment made up of?

- Desired net increase in the capital stock over the year ( ) * K K t - § Investment needed to replace depreciated capital

What happens when there is higher tax? What about investment tax incentives?

- Higher corporate income taxes on profits decrease the money available for reinvestment and DECREASE incentives to invest by diminishing the expected profitability of investment. - Similarly, investment tax incentives tend to INCREASE investment

What are the affects of interest rate?

- Higher real interest rates encourage saving rather than spending, so they result in lower spending, especially on durable goods

What is the difference between national income and GDP

..... Disposable income = National income - Net taxes where "net taxes" are equal to taxes minus transfer payments, we can write: National income GDP Disposable income Net t = = + axes If we assume that net taxes do not change as national income changes, we have the result that any change in disposable income is the same as the change in national incom (slide 24)

What affects to price levels have on ag. ex.?

1. rising price level decrease real value of household wealth - causing consumption to fall 2. price levels rise in US faster than other countries, net exports fall (exports fall, imports rise) 3. when price rises, firms + households need more money to finance buying and selling. Interest rate rises --> causes investment falls so rising price levels decrease aggregate expenditures, while falling price levels increase aggregate expenditures.

Why is spending on durable goods so volatile? 5 reasons

1.Durable goods are long-lived—households can postpone buying them when incomes are down. 2. Good substitutes exist—like used cars/RVs. 3. High prices make them risky purchases—in times of uncertainty, the risk of not being able to pay back loans is important for consumers. 4. Pent-up demand typically follows a recession—purchases postponed during a recession will eventually be made. 5. Interest rates fluctuate—rising rate in an expansion (discouraging large purchases), and falling during and after a recession (encouraging those purchases).

What is the expected real after-tax interest rate? *NOTE SLIDE 35-36

= (1 - tax rate) x nominal interest rate - expected inflation

Do changes in the tax rate have a significant effect on investment?

A 1994 study by Cummins, Hubbard, and Hassett found that after major tax reforms, investment responded strongly; elasticity about -0.66 (of investment to user cost of capital). - A tax change that lowers the user cost of capital by 10% would raise aggregate investment by about 6.6%

Economists often argue that a temporary increase in government purchases-say, for military purchases-will crowd out private investment. Use the Saving -investment diagram to illustrate this point, explain why the curve(s)shift. Does it matter whether the temporary increase in military spending is funded by taxes or borrowing?

A temporary increase in government spending reduces national saving. • Whether the spending is financed by current taxes or by borrowing (and raising future taxes), consumption falls, but not by the full amount of the spending. Since S = Y - Cd - G, national saving declines. • This is shown in Figure 4.13 as a shift to the left in the saving curve. The real interest rate must increase to get S = I, so I declines as well. It makes no difference whether the temporary increase in spending is funded by taxes or by borrowing

Using the Saving -Investment diagram to analyze the effects of the following on national saving, investment, and the real interest rate. Explain your reasoning. a) Consumer become more future oriented and thus decide to save more. b) the government introduces an investment tax credit. c) A large number of accessible oil deposits are discovered, which increases the expected future marginal product of oil rigs and pipelines. It also causes an increase in expected future income

A- As Figure 4.5 shows, the shift to the right in the saving curve from S1 to S2 causes saving and investment to increase and the real interest rate to decrease. B- The investment tax credit encourages investment, shifting the investment curve from I 1 to I 2 in Figure 4.6. Saving and investment increase, as does the real interest rat C- The increase in expected future income decreases current desired saving, as people increase desired consumption immediately. The rise of the future marginal productivity of capital shifts the investment curve to the right. The result, as shown in Figure 4.7, is that the real interest rate rises, with ambiguous effects on saving and investment.

What is Fisical Policy? (tax + spending from fisical side of government) *NOTE THIS SLIDE

Affects desired consumption (based on disposable income) through changes in current and expected future income - directly affects DESIRED NATIONAL SAVING Sd = Y - Cd - G example - taxes from fiscal policy can affect consumption

What is the relationship between price level and GDP? What is the relationship in the aggregate demand curve?

Aggregate demand (AD) curve: A curve that shows the relationship between the price level and quantity of real GDP demanded by households, firms, and the government (both inside and outside the country). There is an inverse relationship between the price level and real GDP.

define the aggregate expenditure model

Aggregate expenditure model: A macroeconomic model that focuses on the short-run relationship between total spending and real GDP, assuming that the price level is constant. This model will focus on short-run determination of total output in an economy.

What are the affects of price level?

As prices rise, household wealth falls. Consequently, higher prices result in lower consumption spending.

What is the desired capital stock?

Desired capital stock is the amount of capital that allows firms to earn the largest expected profit - Desired capital stock depends on costs and benefits of additional capital - Since investment becomes capital stock with a lag, the benefit of investment is the future marginal product of capital (MPKf )

How do you determine the desired capital stock?

Desired capital stock is the level of capital stock at which MPKf =UC MPKf falls as K rises due to diminishing marginal productivity uc doesn't vary with K, so is a horizontal line - (MPK always negative slope) UC is a horizontal line benefit = cost

what is the importance of consumption and saving?

Desired consumption: consumption amount desired by households - Desired national saving: level of national saving when consumption is at its desired level:

What is the goods market equilibrium condition? *NOTE

Differs from income-expenditure identity, as goods market equilibrium condition need not hold; undesired goods may be produced, so goods market won't be in equilibrium The real interest rate adjusts to bring the goods market into equilibrium. - desired saving = desired investment

what factors shift the capital stock *NOTE slide 40

Factors that shift the MPKf curve or change the user cost of capital cause the desired capital stock to change - These factors are changes in the real interest rate, depreciation rate, price of capital, or technological changes that affect the MPKf (Next two Fig. shows effect of change in uc; and effect of change in MPKf )

What is cash flow? What is the largest contributor to cash flow?

Firms often pay for investments out of their own cash flow, the difference between the cash revenues received by a firm and the cash spending by the firm. - The largest contributor to cash flow is profit. During recessions, profits fall for most firms, decreasing their ability to finance investment.

What happens if the economy experiences change in inventories as unplanned, increased or decreased?

If ... then ... the economy does not experience an unplanned change in inventories, actual investment equals planned investment. the economy experiences an unplanned increase in inventories, actual investment will be greater than planned investment. the economy experiences an unplanned decrease in inventories, actual investment will be less than planned investment.

Alternatively, Suppose that the temporary increase in government purchases is for infrastructure (roads, sewers, bridges) rather than military purposes. The military Spending on infrastructure makes private investment more productive, increasing the expected future MPK at each level of capital stock. Use the saving investment diagram to analyze the effects of government infrastructure spending on current consumption, National saving, investment, and the real interest rate.

In the case of infrastructure spending, MPKf rises, so investment increases. Saving shifts from S1 to S2 and investment shifts from I 1 to I 2 in Figure 4.14. • With upward shifts in both saving and investment, the new equilibrium is one with a higher real interest rate. However, saving and investment at the new equilibrium may be higher or lower. The effect on consumption is unclear as well. The higher real interest rate reduces consumption, but future income is higher, which increases consumption.

What is the effect of changes in real interest rate? *NOTE on this

Increased real interest rate has two opposing effects Substitution effect: Positive effect on saving, since rate of return is higher; greater reward for saving elicits more saving § Income effect - For a saver: Negative effect on saving, since it takes less saving to obtain a given amount in the future (target saving) - For a borrower: Positive effect on saving, since the higher real interest rate means a loss of wealth Empirical studies have mixed results; probably a slight increase in aggregate saving

What is considered: Expectations of future profitability When do we see changes in expectations of future profitability?

Investment goods, such as factories, office buildings, machinery, and equipment, are long-lived. Firms build more of them when they are optimistic about future profitability. - Purchases of new housing are included in planned investment. In recessions, households have reduced wealth and hence less incentive to invest in new housing

What is known as Marginal Propensity to save? MPS

MPC + MPS = 1 *two sides of the same coin - what you do not consume - you save

What do these equations mean? AE = C + I + G+ NX GDP = C + I+ G + NX

Macroeconomic equilibrium simply means the left side (real GDP) must equal the right side (planned aggregate expenditure). The difference is that in the first equation, I is planned investment, whereas in the second, I is actual investment. Macroeconomic equilibrium occurs when planned investment equals actual investment, i.e. no unplanned change in inventories.

Explain investment in inventories and housing

Marginal product of capital and user cost also apply, to equipment and structures

How do you find net investment? *NOTE to formula sheet

Net investment = gross investment (I) minus depreciation: where net investment equals the change in the capital stock

What is expected future income? What happens when future income is expected to be higher?

People prefer to keep their consumption fairly stable from year to year: Consumption- smoothing motives higher expected future income leads to more consumption today so savings fall

What is the equation for planned investment?

Planned Investment = actual investment - unplanned inventory

net exports is affected by

Price level in U.S. versus the price level in other countries • U.S. growth rate versus growth rate in other countries • U.S. dollar exchange rate U.S. net exports have been negative for the last few decades. The value typically becomes higher (less negative) during a recession, as spending on imports falls. quality of our products

What do real government purchases include and what are transfer payments?

Real government purchases include purchases at all levels of government: federal, state, and local. • Not transfer payments; only purchases for which the government receives some good or service.

What does the Paradox of Thrift imply?

Recall the savings identity: savings equals investment. • This implied that savings were the key to long-term growth. what appears to be favorable in the long-run may be counterproductive in the short-run

What shifts the saving curve? *NOTE ON SLIDE 63

Saving curve shifts right due to a rise in current output, a fall in expected future output, a fall in wealth, a fall in government purchases, a rise in taxes (unless Ricardian equivalence holds, in which case tax changes have no effect) - Example: Temporary increase in government purchases shifts S left - Result of lower savings: higher r, causing crowding out of I (investment)

Why is the interest rate important? What are the affects of high interest rates?

Since business investment is sometimes financed by borrowing, the real interest rate is an important consideration for investing. - Higher real interest rates result in less investment spending, and lower real interest rates result in more investment spending.

Explain lags and investment?

Some capital can be constructed easily, but other capital may take years to put in place § So investment needed to reach the desired capital stock may be spread out over several years

What is the effective tax rate?

The Tax Cut and Jobs Act of 2017, reduced the statutory corporate tax rate from 35 percent to 21 percent the effective tax rate—the tax rate on firm revenue that would have the same effect on the desired capital stock as do the actual provisions of the tax code

What is Marginal propensity to consume? MPC *NOTE THE EQUATIOn *slide 23

The graphs showed that consumers seem to have a relatively constant marginal propensity to consume. Marginal propensity to consume (MPC): the slope of the consumption function: the amount by which consumption spending changes when disposable income changes. The marginal propensity to consume is the slope of the consumption function.

Summarize the multiplier effect

The multiplier effect occurs both for an increase and a decrease in planned aggregate expenditure. 2. Because the multiplier is greater than 1, the economy is sensitive to changes in autonomous expenditure. 3. The larger the MPC, the larger the value of the multiplier. 4. Our model is somewhat simplified, omitting some real-world complications. For example, as real GDP changes, imports, inflation, interest rates, and income taxes will change

What is the replacement cost?

The replacement cost is an amount that a company pays to replace an essential asset that is priced at the same or equal value. The cost to replace the asset can change, depending on the market value of the asset and how much it costs to get the asset up and running, once purchased.

Analyze the effects of a temporary increase in the price of oil (a temporary adverse supply shock) on current output, employment, the real wage, National Saving, investment, and the real interest rate.

The temporary increase in the price of oil reduces the marginal product of labor, causing the labor demand curve to shift to the left from ND1 to ND2 in Figure 4.10. At equilibrium, there is a reduced real wage and lower employment. The productivity shock results in a reduction of output. Because the shock is temporary, the only effect on desired saving or investment is due to the reduction in current output, causing desired national saving to fall. This shifts the saving curve to the left, raising the real interest rate and reducing the level of desired investment, as well as desired national saving, as shown in 4.11

If US GDP grows faster than foreign GDP

US net exports decrease - US demand for imports rises faster than foreign demand for exports

If $US rises in value relative to other currencies ...

US net exports decrease Imports are cheaper, and our exports are more expensive. So imports rise and exports fall.

How strong is the relationship between income and consumption?

VERY STRONG - a straight line describes this consumption function: households spend a consistent fraction of each extra dollar on consumption

How can you estimate MPC?

We can estimate the MPC by estimating the slope of the consumption function: change in consumption / change in disposable income.

What happens in the short term if people save more?

What happens in the short-term if people save more: consumption decreases, and hence incomes decrease, so consumption decreases... potentially pushing the economy into recession.

When do we say investment has been crowded out?

When increased government purchases cause investment to decline, we say investment has been crowded out. Because government is using more real resources, some of which would otherwise have gone to investment.

What is the important roles of inventories?

When planned aggregate expenditure is less than real GDP, firms will experience unplanned increases in inventories. • Then even if spending returns to normal levels, firms have excess inventories to sell, and they will do this instead of increasing production to normal levels.

What is the yield curve?

Yield curve: relationship between life of a bond and the interest rate it pays

Which model uses planned investment? What is planned investment vs Actual investment?

aggregate expenditure models use planned, not actual investment. The difference is that planned investment spending does not include build up inventories

What is household wealth?

assets (homes, stocks, banks, etc) MINUS liabilities (loans, etc.) Greater wealth = more consumption

How to consumers respond to tax rebates (Observers sometimes refer to a "tax rebate" as a refund of taxpayer money after a retroactive tax decrease. These measures are more immediate than tax refunds because governments can enact them at any time during the year.)

consumers did not increase spending much in 2001\\ even though consumers originally saved much of the tax rebate, later they increased spending and increased their credit card debt younger people increased their purchases on credit cards the most of any group in response people with high credit limits also tended to pay off more of their balances and spent less

Which component of expenditure is the largest in the US?

consumption - next, investment and government expenditures roughly being similarly sized

sharp changes in stock prices affect ____ and _____

consumption spending (wealth effect) and capital investment (Tobin qs)

If US price level rises faster (slower) than foreign price levels then US Net exports ---

decrease (increase) - us goods become more expensive relative to foreign goods, so imports rise and exports fall. (opposite)

what two uses does national saving have?

increase the capital stock by domestic investment increase the stock of net foreign assets by lending to foreigners

what are the factors that shift the investment curve?

investment curve shifts right due to the fall in effective tax rate or a rise in expected future marginal productivity of capital

*RICARDIAN EQUIVALENCE NOTE if future income loss exactly offsets current gain ____ change in consumption Tax change affects the timing of taxes not their _______ In practice, people may not see the future taxes will rise if taxes are cut today, then a tax cut leads to ______

no ultimate amount (present value) increased desired consumption and reduced desired national saving

decline in future income may ______ in current income, desired consumption could rise or fall

offset increase

What is current disposable income?

personal income - personal income taxes + transfer payments - income expands most years so consumption does too

What role does investment have and what affects investment? *NOTE

plays a crucial role in growth - increased over time but it has not increased smoothly - fluctuates sharply over the business cycle 1.Expectations of future profitability 2. The interest rate 3. Taxes 4. Cash flow

As the demand for the product rises we expect what two things?

production increases and price increases price increases because increase in expenditure increases price level --> causes aggregate expenditure to fall, and decreases in price level causes aggregate expenditures to rise

What is the consumption function relationship?

relationship between consumption spending and disposable income

what are the trends of consumption and what affects the level of consumption? *NOTE THIS SLIDE

relatively smooth upward trend, its growth declines during recessions levels are affected by 1. current disposable income (taxes) 2. household wealth 3. expected future income 4. price level 5. interest rate

Higher MPK increases the future earnings of the firm so V - a falling real interest rate also raises ____ as people buy stocks instead of bonds a decrease in the cost of capital pK (replacement cost) raises ___ *NOTE SLIDE 80

rises V (stock market value) q

Equilibrium in the economy occurs when __________ is equal to the value of output produced; that is:

spending on output Aggregate expenditure GDP

What is the user cost of capital? *NOTE SLIDE 38

the desired capital stock = the user cost of capital =real cost of using a unit of capital for a specified period of time = real interest cost + depreciation

What happens with taxes? *NOTE SLIDE 43

the return to capital = (1 - tax rate) x MPK = uc tax -adjusted user cost of capital is uc/(1-t) an increase in t raises tax-adjusted user cost and reduces the desired capital stock

Aggregate expenditure (AE) is total spending in the economy: The sum of

the sum of consumption, planned investment, government purchases, and net exports.

What is Tobin's q? *NOTE slide 79

the value divided by replacement cost If market value > replacement cost, then firm should invest more if q > 1, invest more if q < 1, don't invest

what happened to consumption during the 1987 crash?

there was a temporary decline in confidence about the future, but it was recovered quickly the small response may have been because there had been a large run-up in stock prices - the crash mostly erased this run-up: more of a correction

What happens when ag ex is equal, less, or greater than GDP

when euqal, inventories unchange; the economy is in macroeconomic equilibrium. less - inventories rise; GDP and employment decrease. greater -inventories fall; GDP and employment increase

what are the affects of government purchases on consumption and saving?

when there is a temporary increase - higher G financed by higher current taxes reduces after-tax income, lowering desired consumption even true if financed by higher future taxes, if people realize how future incomes are affected Since Cd declines less than G rises, national saving declines SO government purchases reduce both consumption AND desired national saving