Learning MBA Master Degree

WRITER: In Module I we discussed the most important macroeconomic variables. We will now develop a conceptual model of the economy.

STUDENT: What for, Writer?

WRITER: Macroeconomics is based on a theory. To develop, confirm and apply a theory you need a model. At least at the beginning, this model must necessarily be simple. With this model we will begin to study how the economic variables described in Module I are interrelated, and why they behave in a certain way. We will define the forces that shape the GDP and the general price level.

STUDENT: If your intention is to scare me, you are almost succeeding!

WRITER: No reason to be scared. We will start with a very simply structured model, and add more elements as we progress.

To develop a model it is necessary to make certain assumptions. As the model becomes more sophisticated, some of these assumptions are changed or abandoned, and new ones are added.

The way we will work will be to rather closely follow the way the macro branch of economics developed from its inception in the mid 1930’s. This means that we will move in the following Modules from the simple models formulated by the founders of the discipline, to contemporary macro’s sophisticated models.

STUDENT: What you mean to say is that I can not just read Module II and go ahead and formulate macro policies.

WRITER: Right. Let’s go on and describe the basic foundations of macro, and build a very simple model of national income determination. For this we will have to make a few special assumptions; you may feel they are too simplistic, but we need them for a start. Later on, as I said before, we will turn more realistic.

Potential and actual GDP

This is a simple concept. At a given time, an economy has a potential GDP; the level the GDP could reach if all means of production were fully employed with the current systems of production. The last phrase is important: we are not considering potential as including possible innovations, increases in productivity, or improved production methods. We define the potential GDP as the amount attainable with the normal utilization of land, capital goods and labor. Potential GDP is also called full (or high) employment income. For short, we will call it level P GDP.

At any given time, we have an actual GDP level; the aggregate value of what the economy is in fact producing. Let’s call it level A GDP.

Now let me ask you a simple question, Student. How would you calculate the gap between the potential and the actual GDP?

STUDENT: An easy question indeed. The value of P minus A is the gap; the difference between the potential aggregate production of the economy and what is actually produced. G (gap) = P-A. But I am not sure if P minus A can be a negative or positive figure,

WRITER: If P is larger than A, calculating P-A will result in a positive figure (+). The figure can also be negative (-) when A is larger that P, because we define level P as the potential GDP at normal utilization of the means of production. But it is possible, and actually happens, that during a boom those means are over-utilized; i.e., workers do a lot of overtime, normal maintenance of equipment is delayed, etc.

STUDENT: I see. Do these two types of gaps have special names?

WRITER: Yes. When G is a positive figure (P larger than A), means of production are under-employed, and prices tend to fall. This situation is called a deflationary or recessionary gap.

On the other hand, if G is a negative figure (P smaller than A), prices tend to rise and we call this situation an inflationary gap.

Variations in the Potential GNP

While potential GDP is fixed at a given moment, it changes over time. Capital investment, innovation, a larger and more productive labor force among other factors cause a growth in P over time. Unfortunately it is also possible that disinvestment, excessive emigration, wars or natural disasters may cause a fall of P over time. But let’s look at the bright side: the value of P during the years 1950 to 2000 in the developed economies grew constantly. As for developing areas, we find very different situations; in some P grew much faster and in others at a much slower rate than in developed areas.

I will show you a picture illustrating the tendency of P and how A moved around P over time in the world at large, oscillating from inflationary to deflationary gaps and vice-versa. The graphic is not based on actual figures, it is intended to illustrate the general growth tendency of P and the fluctuation of A around P.

The goods and services not produced during the deflationary gaps are lost forever. The value of this negative G is sometimes called the deadweight loss of unemployment.

Macroeconomics concentrates in explaining and finding ways to minimize the GDP gap, while the branch of economics which aims to explain the long-term trend in potential GDP is called growth theory.

Basic Assumptions for building a Macroeconomic Model

As we said before, we need to build a simple model. To that end, we need some simplified assumptions.

1. In macro, we assume that there is a single productive sector. The output of this single sector is homogeneous; it produces the same good. We imagine that there are many competitive firms all producing the same good. All these firms are aggregated and form a single productive sector. When national output expands or contracts, this single sector represents all sectors which expand and contract together.

We used the word "goods" above in a general sense of physical products and services. However as a matter of convenience in general the single producing sector is analyzed as if it were a manufacturing industry.
2. Rather obviously, if we assume that only a single good is produced and sold, we also assume that all aggregate expenditure is spent on this single product.

STUDENT: Is the government part of the productive sector?

WRITER: In macro we ignore whatever production the government itself does, and we assume that...

3. Government is treated as a purchaser of the output of private industry


STUDENT: I see the need of such a simple model, but is it not too simplified?

WRITER: Well, it is not meant as a description of reality, it is a theoretical abstraction. In this way we can simplify our study maintaining the basic nature of the situation we are analyzing.

STUDENT: Returning to the assumption that all expenditure is made on a single product, is that also realistic?

WRITER: Let me make an important point. The assumption is that all expenditure has the same effect on the GDP. We are not assuming that the motivation of all consumption is the same. In fact macro is very much concerned with the different motives for the various expenditure flows.

Introducing some "short run" confusion

The concept of the "short run" is different in micro than in macro economics. In micro short run is used to describe the period when a firm has a fixed amount of capital and can only change its inputs of labor and materials.

In macro short run is the period during which there is a GDP gap. This of course means that the "short" run can in fact last several years.

In macro, the short run is the period it takes the economy to return to its potential GDP once it has deviated from it.

STUDENT: Quite confusing indeed, Writer.

WRITER: True. To create some more confusion, let’s define the long run in micro and in macro. In the case of micro it is not too hard: since we said that "in micro short run is used to describe the period when a firm has a fixed amount of capital and can only change its inputs of labor and materials", it is natural to call long run the period during which the firm can change its capital.

In macro the long run is the period during which the economy is producing at its potential level (GDP gap equal to zero). This situation can be static (potential output does not change) or dynamic (potential output changes).

A few more assumptions... but these are only temporary!

1. The price level is fixed. This is so for prices of end products as well as for all inputs.
2. The economy is assumed to have excess (unused) capacity. It could be perfectly possible to produce more goods and services with the existing stock of capital and labor. Under these conditions, the only factor affecting the aggregate output is demand, since there are no restrictions on the productive side.

STUDENT: Any special reasons for assumption # 2?

WRITER: Yes. The first is historical; macro was invented to help solve the big problems recessions caused to society. The second reason is that in general macro analysis is needed more in a situation of recession. Full employment (GAP zero) situations are not considered an urgent problem, and during booms people are in general rather happy.

STUDENT: True, but a zero G may not necessarily be good; it may be an equilibrium situation where most people have a job but are poor nonetheless. And as for booms, people may be happy while they last, but policy makers should be aware that a recession will eventually occur and act accordingly.

WRITER:. Very good thinking. But remember we are only starting. Your former concern is addressed by growth theory. And assumption #2 is also valid if we are studying a boom situation, since demand is also an important determinant of production during this "short run in the macro sense" situation of positive G.



3. For a very short time, we will assume that the economy is closed. Under conditions of zero imports, exports and international payments, domestic expenditure and domestic output are exactly the same.
4. Also for a short time, we will have no government purchases or taxes.

STUDENT: So what is left on this model?

WRITER: A single productive sector producing an homogeneous output. Prices are fixed. There is no government acting in the market, and the economy is closed. A totally fixed structure.

STUDENT: Let me rephrase my question. What is left that can be dynamic in this model?

WRITER: Something very important: the effect of aggregate final expenditure (demand) on GDP. Since from the first days of macro it was assumed that recessions and depressions were caused by a lack of demand, the focus was concentrated on this factor as the single variable.

Examining Aggregate Expenditure

We already know that GDP is equal to the four components of expenditure: consumption, investment, government and net international trade.

Le me introduce the concept of desired expenditure, also called planned or intended expenditure. It is important to stress that these concept does not refer to what people would desire or plan to spend if they had an imaginary income; it refers to what people desire (plan, intend) to spend with the purchasing power they actually can command.

Naturally, actual expenditure does not necessarily coincide with planned expenditure. There may be deviations in the total as well as in the components; reality often causes intended expenditure to change from one component to another. A firm may produce a quantity of consumer goods expecting a certain demand and if the actual demand is lower the result will be an increase in unintended and undesired investment in inventory.

National income accounts measure actual expenditures in each of the four components (consumption, investment, government and net international trade).

The theory of GDP determination studies the desired expenditures in those four categories.

As said before, while in our model the effect of the expenditures is the same since all go to purchase the same single output, the motivations for the spending are different, and the agents doing the spending are different.

Desired consumption expenditure

WRITER: Now please tell me something, Student. What can you do with the money you receive as disposable income?

STUDENT: Well, it is not a lot, but I can pay rent, buy food and clothing, go to the cinema, and so on. I spend my income the same way most people do.

WRITER: Fine. Apart from spending it, you could also save part of your income, of course. But what else could you do with your income, apart from spending or saving?

STUDENT: I can’t think of any other alternative.

WRITER: Naturally, because there isn’t any other alternative. Disposable income can only be spent or saved. Once you decide how much to spend, you have actually decided how much to save, and vice-versa.

We said that in the economy decisions to spend and to invest are made by different people for different reasons.

Now the subject of our study is to determine why people decide how much to spend and how much to save. The different factors influencing people may be classified in two categories,

1. The consumption function, and
2. The saving function


The consumption function

Consumption and disposable income

In our simple model, since there are no taxes, disposable income is equal to national income. We will talk about the effect of taxes later on.

Rather obviously, consumer expenditure is in direct relationship with disposable income. But although this is true in general for most individuals, the way in which this relationship works is quite different.

We can simplify the study by describing two prototypical individuals.

The first individual spends all his or her disposable income, and as this income varies, so does the amount spent.

The second type of individual plans for the future and his or her spending is related to long-range expectations of income. Part of the income can go to savings, but also sometimes this person will borrow to maintain a living standard, paying back the debt later as income increases. By the same token a temporary fall in income will be supplemented by the utilization of savings, again to maintain the usual standard of living.

In short, the first individual’s spending will be very closely related to his or her disposable income, while the second individual’s spending will not vary substantially in the short run with fluctuations of disposable income.

And now, allow me to mention the ideas of John Maynard Keynes.

STUDENT: I was wondering when you would do it. A course in economics, much less in macro, without mentioning JMK would be unthinkable, wouldn’t it?

WRITER: Possibly, because Keynes developed the basic theory of macroeconomics and gave his name to a school of thought called Keynesian economics. Nowadays there are several so-called non-Keynesian schools of thought in economics. But in the opinion of this writer, this is not exactly true. All those schools of thought are basically Keynesian, the only difference being that some are "more Keynesian than others".

The Keynesian consumption function is based on the assumption that all individuals belong to the "spend all my income" category. This is natural given that Keynes wrote during the Great Depression and actually at that time the immense majority of people did exactly that. And since the basic reasoning was that the Depression was caused by a failure of demand, and there was no chance of motivating people to spend more because they were already spending all their income, Keynes recommended government deficit spending as the only remedy. Much later Franco Modigliani and Milton Friedman won a Nobel prize for describing the "prudent individual" consumption function (life-cycle theory or permanent-income theory).

STUDENT: If you allow me to introduce a thought, Writer, I feel that in reality most people behave in both ways, over time. There is no such clear-cut division.

WRITER: True, especially when income is higher that the minimum to cover basic needs. Up to that point, in general people have no other choice that to spend all their income.

In our simplified model we will use the Keynesian consumption function; more sophisticated functions will be used later. In general, we will see that in most countries and most of the time the personal disposable income and the consumer’s expenditure series are closely related.

STUDENT: For my benefit, would you summarize what the "consumption function" is?

WRITER: Of course. It is the relationship between consumption and the variables that influence it. In our simple model, consumption is determined almost exclusively by disposable income.

St. Thanks. But what about people who have zero income? They have to consume something, at least some food.

WRITER: Of course. They may borrow or use savings or get some type of help. We call this type of consumption autonomous because it exists even if the person has no income. The "normal" consumption which is related to income we call induced because it is a function of income.

The propensity to consume

* Average propensity to consume

The definition is very simple: TC/TDI=APV. In other words, APV (Average Propensity to Consume) equal total consumption TC over (divided by) total disposable income TDI. If TDI=1000 and TC=900, the average propensity to consume is 0.9. Which simply means that at this level of TDI people spend 90% of their disposable income.

* Marginal propensity to consume

MPC is the change in TC produced by a change in TDI . If TDI increases from 1000 to 1100, and TC changes from 900 to 950, the marginal propensity to consume at this point is 50/100=0.5; it means that at this point, people will spend half of the change (increase in this case) of their TDI.

Please, student, what is your common sense perception of the behavior of consumption and savings as disposable income rises?

STUDENT: Assuming that I am an average person, I would both spend more and save more as my disposable income rises. At my present "level of poverty" I would spend more and continue saving nothing for a time. Then, as my income continues to rise, I would save more in total and as percentage of my income.

WRITER: Excellent. In academic terms, as disposable income rises, both total consumption and savings rise. Marginal propensity to save (the opposite of marginal propensity to consume) also rises at each point of the TDI curve.

STUDENT: Right. Let me see if I understood. Let’s assume that at a given time I am earning $10,000 and saving 10% of my income. If I land a better job with a 50% salary increase to $15,000 I will be inclined to save 15% of my income instead of just 10% as before.

WRITER: Correct, understanding that your figures are just to illustrate the situation, not realistic figures. And we are of course assuming the your increase in salary was in real terms, meaning that the general level of prices did not change.

The Saving Function

Since we know that a person has only two possible things to do with disposable income, spending it or saving it, we can deduce that the Saving Function relationship with total disposable income is exactly the same as the relationship of the Consumption Function.

The average propensity to save and the marginal propensity to save are exactly parallel to their "cousins" in the Consumption function.

Wealth and the Consumption function

Simply put: if you are or feel richer, you will spend a higher proportion of your disposable current income, since you feel safe due to your wealth. This "wealth effect" on consumption was believed to be the main driver of the consumption boom of the 1990’s, as the stock markets created a lot of paper wealth. Strangely enough, the crash of 2000 did not substantially reduce consumption in the US. Can this be interpreted as that the wealth effect does not exist? Not really. Value of stock portfolios sank, but prices of homes increased. Interest rates fell, and people refinanced the mortgages on their homes at lower rates, which put more cash into their pockets, an increase in disposable income.

Investment expenditure

This is the most volatile component of the GDP. As firms detect a possible decrease in demand and therefore in sales and profits, they modify their "desired investment expenditure". Using the 2000 recession in the US as example again, it was basically caused by a fall in investment, not in consumption. Consumers for several years "saved" the economy from falling into a severe depression by maintaining their spending pattern.

Influence of the real interest rate in investment

Here again a common sense conclusion is that investment tends to be in inverse proportion to the real interest rate. The higher the interest rate, the less inclined firms will be to invest, and vice-versa.

Equilibrium GDP

If at a given point firms are producing the same aggregate value of goods that are effectively demanded, the GDP is at equilibrium at that point. The word effectively means that consumers and firms desire and are able to make this level of aggregate consumption and investment expenditure.

The equilibrium level of GDP means that the aggregate desired expenditure equals total output. If the former is higher than the latter, the GDP will tend to rise, and vice-versa.

STUDENT: Why?

WRITER: Because as demand increases firms will see their sales and profit margins grow and will start investing to expand production facilities, and will hire more workers. And vice-versa, of course.

STUDENT: I can draw two conclusions from your explanation. First that Economics is not purely an exact or mathematical science, because while numbers are important, the basic reason things happen in an economy are due to people’s behavior in different circumstances: decisions to spend, to invest, etc.

WRITER: Right. Economics (if a science at all) is a behavioral science. And the second conclusion?

STUDENT: That I see Keynes’ point very clearly. An increase in aggregate desired consumption expenditure will push the equilibrium level of the GDP up. During a depression desired investment expenditure will not respond immediately but eventually it will also increase. We shall then have an increased total aggregate expenditure tending to rise the equilibrium point of the GDP.

WRITER: Very well. The question now is how much should a government stimulate the economy to help it get out or recession or to grow at a sustainable rate without excessive inflation?

No one has an exact answer to that, and one of the reasons why is something called the multiplier.

The Multiplier

A simple example. The government loans firm A $10,000 to expand a plant. This will initially add $10,000 to the GDP. But as the firm spends the money, it will go to more wages and profits for suppliers, which will increase demand and in turn motivate other firms to invest. Calculating the exact number of the multiplier is difficult because it depends on several factors as the marginal propensity to consume at this point of GDP. In more sophisticated models we would see that some industries, such as auto manufacturing and construction, have a higher multiplier than others basically because they demand a lot of components from other industries. For now, it will be sufficient to:

1. Grasp the concept of the multiplier; the final result of an increase in spending has an effect in total spending and GDP higher that the value of the initial increase.
2. Understand that the multiplier M is inversely proportional to the Marginal Propensity to Save: M=1/MPS. This formula is called the Simple Keynesian Multiplier.

And now let us go relax, if you are tired.