Macro Exercise 1
1

- First class for the Macroeconomics part
- Hand-out corrected
- Receive some model solutions with some general comments.
2

• Why is the aggregate equilibrium condition Y = E?
What happens if E <Y? If E>Y?
– Definition: Y =total supply, defined as the value of all goods and services produced in a year, or other fixed unit of time
– Definition: E = total demand, i.e., total spending that same period of time
– So condition Y = E is a simple equilibrium condition, that supply equals demand.
- If E < Y: less spending than value of output. Producers produce less? Spenders spend more?
- Where do the adjustments come from?
- Note that Y = P * Q, so equilibrium can be achieved by changes in P or in Q.
3

• Note aside:
• In an open economy: Y = E
D
+ E
F
• Output is absorbed by domestic spending or foreign spending.
In case Y < E
D
, we could have that the difference is absorbed by foreign spending in form of exports.
4

• Why is it important to know the equilibrium level of GDP?
• Knowing the equilibrium level of GDP helps guide policy.
– If the economy is capable of producing higher GDP in equilibrium, then macroeconomic policy might raise aggregate demand to achieve that higher GDP level.
– If, on the other hand, the economy’s equilibrium GDP level is lower than currently observed, the economy might be close to already experiencing unnecessarily high inflation: in that case, macroeconomic policy might lower aggregate demand. That’s why knowing evolution of P is of key importance!
– In either case, again, knowing the equilibrium level of GDP helps guide policy.
5

• Why is it useful to split up E into C, I, G, X, and M?
• Total demand (or, in equilibrium, total output) is usefully split into its different components C , I , G , X , M because the behaviour of each of these is driven by different economic considerations.
- Consider Consumption:
- C(Y D ) = c
0
+ mpc Y D
- An increase in taxes reduces disposable income, but is likely not going to have a direct effect on X or M or investment I
- So studying these elements separately is very important as it allows us to isolate the effects of certain policies.
- Consider G
- If the share of G in total output is large – is this good or bad?
6

• What does the analysis so far suggest might be done to prevent the high unemployment of the 1930s?
• We will discuss this a lot further, I just want to give a little preview here – we do not have the whole model set-up yet to be able to discuss this in a lot of detail.
7

• The government could have expanded its share of expenditure, by increasing G.
• This is a policy instrument, that many governments did employ following Lehman brothers.
• Can you think of some problems?
– How do governments finance their spending?
– Imagine that governments need to access private savings to finance their expenditure <> this may increase the interest rate, which could affect private Investment
– Need a model to capture savings…
8

• Given the analysis so far, explain intuitively why an increase in government spending G increases GDP by more than the initial rise in
G.
9

• Given the analysis so far, explain intuitively why an increase in government spending G increases
GDP by more than the initial rise in G.
– Each additional dollar of consumption is somebody else‘s income , out of this additional one unit of income mpc*1 is additionally consumed by this agent, again, this is somebodys income who is consuming
1*mpc*mpc of it and so on and so forth.
– This infinite geometric series has a finite and closed form sum as long as mpc is between 0 and 1.
10

• Where is the multiplier coming from?
C
 c
0
 c
1
( Y

T )
Y
=
C
+
I
+
G
= c
0
+ c
1
( Y
-
T )
+
I
+
G
Þ
Y
=
1
1
c
1
( c
0
+
I
+
G
c
1
T )
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• Where is the multiplier coming from?
C
 c
0
 c
1
( Y

T )
Y
=
C
+
I
+
G
= c
0
+ c
1
( Y
-
T )
+
I
+
G
Þ
Y
=
1
1
c
1
( c
0
+
I
+
G
c
1
T )
12

• Explain the government spending multiplier in your own words. What is the significance of this multiplier having value greater than one?
• The government spending multiplier is the increase in
GDP from an increase in government spending, expressed as a proportion of that government spending increase. That the multiplier exceeds 1 means the government has an effective instrument in its spending decisions for guiding changes to GDP.
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What about changes in TAXES?
C
= a
+ b ( Y
-
T )
Y
=
PE
=
C
+
I
+
G
+
( X
-
M )
= a
+ b ( Y
-
T )
+
I
+
G
+
( X
-
M )
Þ
Y
=
1
1
b
( a
+
I
+
G
bT
+
X
-
M )
So tax multiplier is:
b
1
b
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What about changes in IMPORTS?
C
= a
+ b ( Y
-
T )
Y
=
PE
=
C
+
I
+
G
+
( X
-
M )
= a
+ b ( Y
-
T )
+
I
+
G
+
( X
-
M )
Þ
Y
=
1
1
b
( a
+
I
+
G
bT
+
X
-
M )
So import multiplier is:
-
1
1
b
15

Suppose you increase TAXES by same amount as you increase G – what is the net effect?
The G multiplier is:
The T multiplier is:
1
1
b
b
1
b
What is the NET EFFECT:
1
1
b
b
1
b
=
1
16

So GDP still increases by 1 unit --- why?
The government consumes all, whereas if taxes are reduced the households save a fraction of this new income. Hence, the multiplier is lower as the initial agents who gets higher income does not consume all of it but only mpc*dT of it.
The Government is a more „effective” consumer.
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