MACROECONOMICS

Gross domestic product (GDP) can be dened mainly in three ways, the widely known one is the aggregate expenditure approach, the denition with which we are going to start with. Aggregate expenditure denition: Gross Domestic Product (GDP) is the current market value of all new commercial nal goods and services (sold or unsold does not matter), plus the raw material produced by businesses and sold to the others and yet awaiting to be assembled into nal products, and plus the value of households labor bought by the government sector (the only non-commercial product that goes in to GDP). All products should be currently produced, say within a quarter or a year, within the geographical border of the country. Also not that the productive resources can be both domestic as well as foreign. In other words, your GDP has border limitation but no resource limitation. Since this GDP is measured in current periods dollar value, it is also known a nominal GDP or current dollar GDP. Why governments purchases of labor but not buy Coke-Cola goes in GDP? When Coke-Cola hires you to produce coke, it recoups your salary by selling coke to us. Government produces services and do not sell for money direct, therefore, government expenditures on labor services goes to GDP. When government hires one more labor, GDP goes up. When Government pays a family food-stamps, family income goes up, but in the process of transaction nothing new is created, therefore, government AID does not show up in GDP, although it is government expenditures. Points to remember: Some activity costs some party and generates income for someone else but produce nothing new, will not show up in GDP. For example if you pay me $100 to nd out your lost wedding ring that was produced years back, will not show up in GDP. Although, you may issue me a W2, this income is taxable and will show up in personal income (will be discussed later on). The huge interest payment that government pays to service its debt does not produce anything new, will not show up in GDP. Where it will show up? The answer again in personal income.

The amount unsold goes into inventory investment and inventory investment is positive, the amount oversold comes from our existing inventory and inventory investment is negative (please note that inventory investmentIMPORTAANT, we shall discuss it again) What you produce for yourself is not included in GDP. However, what you buy from business people to produce something for yourself is included in GDP, only your labor and some home-grown input that you may use are not included in GDP. Any second hand transaction is not included in GDP. You sell your car, house, the proceeds will not be include in GDP. However, if the transaction of old goods creates new services or prot, they will be included in GDP. Selling your home through an agent creates income for the agent, involves closing cost, and many other fees will be included in GDP. If the production of a nal good overlaps two periods (say two years), the GDP will be shared between two periods. For example, if Dell Computer Company produces a computer in 2005 using $100 chips that was manufactured in 2004, that $100 will belong to 2004 GDP, and the rest will go for 2005 GDP. When you do not work, you buy leisure, your leisure is not included in GDP. It should be limited within the border, regardless who produces it. Should be limited to a particular time frame (a year). Do not include both values of our and cakeonly cake. If you do so our will be counted twice and GDP is inated. Gross National Product (GNP) is the current market value of all new commercial nal goods and services currently produced by countrys resources (GNP has no border limitation but resources limitation) all over the world. If I am a Japanese working in America, my product will be in American GDP not in GNP but in Japans GNP . How to calculated GNP: 2

GNP =GDP + [Americans shares in foreign GDPs Foreigners shares in American GDP] GNP =GDP + net Americans foreign shares or income An intermediary good is an input toward the production of some commercial nal good/serviceour purchased by a baker to make cake for business. Note that an intermediary good is sold with the product it produces. Final good sold to ultimate consumerautomobile purchased from GM by Mr. Kee (not a dealer but a consumer), cake purchased from Kroger by a consumer (not by another grocer or retailer). Flour purchased by Mr. Eater, lumber purchased by Mr. Homemaker are example of nal goodsnot intermediary. Final and intermediary goods have no clear denitions, it depends on purpose, circumstances, and situations. Note that whatever a household buys is a nal good. Business people buy investment good (nal good) and intermediary good (raw material). In other words, businesses buy both nal and intermediary goods. Real Gross Domestic Product (RGDP): First why do we need it? Over time GDP may increase due to either quantity increases of goods and/or services or due to increases in prices or both. Economists and national planners are concerned not about GDP value but in economic growth reected by increases in physical product of goods and services. GDP growth does not necessarily mean increases in physical goods and services produced and therefore cannot serve the purpose. In order to serve this purpose, we need some indicator that enables us to see whether we are better o over timei. e., more goods and services (more income) will be shared by the people of the country. In order to accomplish this purpose, we need to compute the value of each years new 3

commercial nal goods and services by one set of prices, i.e., the prices of a particular year called the BASE PERIOD. Such a measure is called Real Gross Domestic Product (RGDP). Real gross domestic product RGDP is the value of all new commercial nal goods and services (sold or unsold) currently produced within the geographical border of the country evaluated at the base period prices. RGDP is adjusted for ination and is sometimes called constant dollar GDP. The current base period in America is the year 2000 and this years price set is used to compute RGDP of all years. Notes that with time base period changes. Across RGDP, there is no ination, therefore, RGDP is adjusted against ination. Let us make an attempt to calculate GDP and RGDP Suppose a simple economy produces four goods, and we have data on price and quantity produced for the base year 2000, 2002, 2003. For simplicity, let us symbolize them as follows

A =Loaf in pound B = Eggs in dozen C =Wine in bottles D = Hair Cut Pb =Base period 2000 prices Qb =Base period 2000 quantity produced P2 =Price of year 2002 Q2 =Quantity produced of year 2002 P3 =Price of year 2003 Q3 =Quantity produced of year 2003 G =denotes goods T = denotes total

G A B C D T

Pb 0.8 1.2 3.0 3.5

Qb 12 15 8 12

Pb Qb P2 9.6 18.0 24 42 93.6 2.0 2.0 5.0 5.0

Q2 20 12 20 25

P2 Q2 Pb Q2 P3 40 24 100 125 289 16 14.4 60 87.5 177.9 2.5 1.5 7.5 7

Q3 22 10 18 20

P3 Q3 Pb Q3 55 15 135 140 345 17.6 12 54 70

153.

I am dening these GDP and RGDP using some ugly notations hoping that they help you GDP = Pc Qc RGDP = Pb Qc . Base Year (2000): GDP=RGDP=93.6 Current Year 2002: GDP=289; RGDP=177.9 Current Year 2003: GDP=345; RGDP=153.6. Note that 2000s price set (shown by under bar) is used to calculate RGDP of all yearsRGDP is measured in base periods dollar (constant dollars GDP) See the two consecutive Year 2002 and 2003, GDP of 2003 is much higher than GDP of 2002are we better o in 2003 than 2002?-NO! Why? Because RGDP of year 2003 is less than that of RGDP of year 2002. If RGDP of current year is greater than that of previous yearwe can say for sure that country has more goods and services this year compared to the year before. But still we do not yet know whether we are better o or not. Because we have not yet checked the population growth of the country. The percentage increase in RGDP growth. Economic growth EGR ( EGRt = is a measure ) 100. of economic

RGDPt RGDPt1 RGDPt1 5

Example: In our previous table t=2003, and t-1=2002 ) RGDP2003 RGDP2002 = 100 RGDP2002 ( ) 153.6 177.9 = 100 = 13.66%. 177.9 (

EGR2003

Economic growth in the year 2003 is -13.66%limbo!! Per capita real output = RGDP total population.

Now see if RGDP goes up but population grows at faster rate, the per capita RGDP may even fall. GDP deator is the ratio of GDP to RGDP GDP . RGDP In the textbook, there is a multiplier of 100, in other words, it is express as percentage. P = In our example P2000 = 1.00, P2002 =
289 177.9

= 1.62, P2003 =

345 153.6

= 2.25.

GDP deator is the best measure of aggregate price, however, there are also other measures. In our example P2002 = 1.62 which means what goods and services could be bought for a dollar in the base period 2000, will cost $1.62 in 2002a 62% increase in seven years time span. Is it ination? No!ination is the percentage price increase between two consecutive periods. Aggregate price level P is a kind of average price level of all goods and services produced in the current period. GDP deator is a good proxy of aggregate price. Ination is an increase in aggregate price level, its opposite is deation, and no change in price level is called price stability. A numerical measure of ination is called ination ratethe percentage increase in aggregate or overall price level 6

( INt = In our example, IN2003

Pt Pt1 Pt1

) 100.

) P2003 P2002 = 100 P2002 ( ) 2.25 1.62 = 100 = 38.89%. 1.62

Now you see between 2002 and 2003, price level has increased by about 39%, which is the cause of increased GDP for the year 2003. Also go back and see our calculation of growth rate for 2003 which was 13.66%, we produced less but prices went up. If economic growth rate is positive and ination rate is positive, only then we can say for sure, that GDP of this year is higher than last year. Otherwise we cannot say anything about GDP over time. Productivity of labor: The amount of real GDP produced per laborhour. In U.S. economy, this information is published once in each quarter. Symbolically, Labor Productivity = RGDP . number of labor-hours required to produce it

In the U.S. in the recent past, we lost millions of jobs, still our growth rate is positive. What makes it possible? The technological innovations have helped improved labor-productivity signicantly. In the third quarter of 2003, labor-productivity was higher than seven percentage points. Employment Cost Index (ECI): Real cost of producing one unit of real GDP. Symbolically real cost of producing RGDP . RGDP In the U.S. government announces this information once in every quarter. If ECI goes up, implies it is more costly to produce real output, and therefore, ECI = 7

there will increased pressure on aggregate price levelpossibility of higher ination. Unemployment A qualied worker: Any person in the age group 16-67 who either has a job (part-time, full-time or more than one) or is actively looking for one if unemployed. An unemployed worker: any qualied worker without a job. Total unemployed labor-force Nu is the number of qualied workers without jobs. Employed labor-force Ne is number of qualied workers having jobs (part-time, full-time or more than one). Labor-force Nt is the sum of employed and unemployed workers, symbolically Nt = Ne + Nu . New entrant: A qualied worker who enters the job market for the rst time. Reentrant: A qualied worker who was o the labor-force for certain period of time and then again reenter in the job market. Discouraged worker: A qualied worker who has given up looking for a job thinking no job for her/him. Note carefully, a discouraged worker is not in the labor-force (not in the unemployed labor pool). CP, if the number of discouraged workers goes up, countrys unemployment rate goes down even though economy is not improving. In last three years, even we lost millions of jobs, unemployment rate did not go up signicantly, because total labor-force shrunk for discouraged workers. The business people working for themselves and not earning a constant stream of incomes (monthly salary) are not in the labor force. Unemployment rate UR is the percentage of total labor-force without job, symbolically 8

( UR =

Nu Nt

) 100 =

Nu Ne + Nu

) 100. (1)

The employment rate ER is dened as ( ER = Check U R + ER = 100. If you divide (2) by (1), you get another interesting formula ER Ne = . UR Nu For example, ER = 4 (say), in words, on an average, out of every four UR qualied workers working, there is ONE qualied worker unemployed. You may use this information to nd the unemployment (employment) rate. In this example, for every ve qualied workers ONE is unemployed, therefore, in other words you may take Nt = 5 and Nu = 1 ( ) 1 UR = 100 = 20%. 5 ( ) ER = 1
ER UR + ER UR

Ne Nt

) 100 =

Ne Ne + Nu

) 100. (2)

100.

The same think when we write in a dierent form UR Nu = . ER Ne

UR For example, EU = 0.25 (say), in words, on an average, for every 0.25 qualied worker unemployed, ONE worker has a job. In this example, Nt = 1.25 and Nu = 0.25, therefore ( ) 1 ER = 100 = 80%. 1.25

( UR = 1

UR ER UR + ER

) 100.

Example: Unemployed work-force size is 170, total work-force is 3400, ( UR = 170 3400 ) 100 = 5%.

This means out of each 100 workers, 5 workers on an average are without jobs. Example: The ratio of employment rate to unemployment rate is 16, if the total labor force of the country is 85 million, how many qualied workers are without jobs. We know Nt = Ne + Nu = 85,

Out of every 17 workers one is without job out of 85 million workers, number without jobs = 1 85 = 5 million 17

Example: The ratio of unemployment rate to employment rate is 0.16, if 20 million qualied workers have jobs, nd the countrys total labor-force Nt . We know Nt = Ne + Nu , in this problem Ne = 20 million, all we need to nd Nu and then add it to Ne and get the answer.

U R Nu = ER Ne 0.16 Nu = 1 20 cross multiply 0.16 20 =Nu 3.2 million =Nu Therefore, Nt = 20 + 3.2 = 23.2 million. 10

Example: A country is having an unemployment rate of 3.5%. If 60 million qualied workers have jobs in the country, nd the countrys total laborforce, also nd the number of qualied workers without jobs. Given information, U R = 3.5% implies ER = 96.5%, Ne = 60 million. You may go by two separate methods, I report you decide which one minimizes pain. ) Ne ER = 100 Nt ( ) 60 96.5 = 100 Nt 60 0.965 = Nt 0.965Nt =60 60 Nt = = 62.18 million 0.965 (

Nu = Nt Ne = 62.18 60 = 2.18. See smartness pays o a whole lot more. Labor-force Participation Rate (LFPR): measures the labor-force as a percentage of total population in the working age-group 16-67. As per our previous denition, Nt be the labor-force and Npt is the total population in the working age-group, then ( LFPR = Nt Npt ) 100.

CP, if labor-force participation rate goes up, the likely scenario is that RGDP will go up. Problem: A county has a total population of 20,000. In this country 12,000 adults are in the labor force and 2000 adults are neither working nor looking for jobs. Find the labor-force participation rate for this country. 11

See in our labor-force participation game, total population has no role to play, this number is oered to confuse you. We need Npt and Nt . The question oers you Nt = 12, 000, but not Npt dirty trick. Can you nd it from the information given. Yes total adults equals labor-force plus adults not working and not looking for jobs, therefore Npt = 12, 000 + 2, 000 = 14, 000 ) ( ) ( 12000 Nt 100 = LF P R = 100 = 85.71%. Npt 14000 Problem: An economy has an unemployment rate of 5%, and in this economy 300 qualied workers are without jobs. The number of adults that are not in the labor force is 1800. Find the labor force participation rate. To nd LFPR we need Nt and NP t , this problem oers none of itdirty trick. What it oers U R = 5% and Nu = 300, there is a reason for that, try to nd it out. ) Nu UR = 100 Nt ) ( 300 100 5= Nt 0.05 300 = 1 Nt 0.05Nt = 300 300 Nt = = 6000 0.05 one puzzle is sloved still we need Npt , can we nd it? (

(cross multiply)

Npt = NT + number of adults not in the labor-force Npt = 6000 + 1800 = 7800 ( ) 6000 LF P R = 100 = 76.92%. 7800 Note that each problem will have a little of big dirty trick, you need to gure it out. 12

Types of unemployment: Frictional unemployment: unemployment arising from normal turnover in the labor market, such as workers changing jobs or locations, getting laid o, new entrants are entering the job market everyday. This type of unemployment is short-lived and does not pose any serious problem for the country. Structural Unemployment: unemployment due to structural problems such as lack of skills, obsolete profession, geographical preference, etc. If it exists, it is relatively longer-lived. Government training program to train these workers in marketable skills may help reduce the problem signicantly. Seasonal Unemployment: Some workers are unemployed at some particular seasons or period of the year because demand for their skills are seasonalConstruction and agricultural workers, etc. Cyclical unemployment is associated with uctuations in overall economic activities (needs more clarications). If I loose jobs because of no fault of mine but due to overall economic down turn, then I am cyclically unemployed. Note that this always related to the overall economy. Natural rate of unemployment (Full employment rate): The unemployment rate that exists when there is neither a recession nor a boom. U.S. economy now believes this gure should be in the neighborhood of 56%. Full capacity utilization: If the country uses any capacity to the north of 85% we call it full capacity utilization. Potential, trend, natural, or full employment output: The RGDP the economy is able to produce at the natural (target) rate of unemployment and using the full capacity utilization is called FULL EMPLOYMENT, POTENTIAL, TREND, OR NATURAL OUTPUTwhat the national economic planners can predict well into the distant future. Okuns Rule of Thumb: decrease in unemployment rate by 1% will result in 2% increase in output and reverse is the case for increase in unemployment rate. 13

Price Index (PIN): measures the current value of all new commercial nal goods and services as a percentage of their base period value. Which is nothing but the percentage of GDP to RGDP. ( P IN = GDP RGDP ) 100 = Price-deator 100.

Producer Price Index (PPI): measures the current whole sales value of all new commercial nal goods (not services) as a percentage of their base period whole sales value. Note PPI is similar to PI except that it excludes services and only considers the whole sale prices (instead of retail price), - it connects producers to retailers. ( PPI = ) 100.

current wholesale value of domestically produced goods base periods wholesale value of same goods

Consumer Price Index (CPI): measures the current value of all consumers basket of new goods and services as a percentage of their base periods value. How it diers from PIN? PIN encompasses all domestically produced goods and services while CPI includes only the consumers basket of goods and services produced both domestically and imported goods and services. ( CPI = ) 100.

current value of consumers basket of goods/services base periods value of same basket

= CP, CPI goes up implies your cost of living has gone up and you need more money to maintain the previous standard of living. Your employer sometimes uses this index to gure out your pay raise. = CPI and PPI are monthly indicators and sometimes CPI is used as proxy of aggregate price to compute the ination rate. ( ) CP It CP It1 INt = 100. CP It1 14

Expected Ination is the ination people expect or forecast to occur IN e The dierence between the actual and expected ination is called ination surprise. Note that ination is not that a big problemination surprise is. Hyper ination when the annual ination rate runs triple digits. Real Business Cycles (RBC): The movement of actual RGDP around the potential (target or full-employment) RGDP. RBC is characterized by four phases. = The time span over which RGDP is increasing is called economic expansion. = The time span over which RGDP is declining is called economic contraction. = The time point at which economy reverses from expansion to contraction is called the peak. = The time point at which economy reverses from contraction to expansion is called the trough. = The time interval between to successive peaks or toughs is called an economic cycle. = Note that economic cyclic are not necessarily of equal length or periodic. HERE YOU NEED COUPLE OF STORIED DIAGRAM. = Unemployment and movement of RBC are inversely related. That is, during economic expansion unemployment rate declines and increases during contraction phase. When actual RGDP is equal to potential RGDP, unemployment rate is equal to natural rate of unemployment. = When actual RGDP is above the potential RGDP line, actual unemployment is less than natural rate of unemployment. The dierence between actual unemployment rate and natural rate of unemployment is called the Cyclical Unemployment rate and can be both positive and negative.

15

U Ra = U Rn + U Rc , where U Ra =actual unemployment rate, U Rn =natural unemployment rate, and U Rc =cyclical unemployment rate. Potential real GDP gap: The dierence between real potential and actual RGDP is know as potential real GDP gap, symbolically Potential real GDP gap = Y N Y a , where Y N =real potential GDP and Y a =actual realized real GDP. When actual real GDP is above the trend line, RGDP gap is negative, positive when it is below, and zero when on the trend line. The value of RGDP-gap and unemployment are positively related. Economic Recession economic down turns continued for at least six months (two consecutive quarters) of a year. During recession growth rate is negative (real output declines), unemployment increases, price level is likely to decrease. Economic Depression is a prolonged recession and I dont know when a recession will be declared as depression but when unemployment rate is 12% or moredepression is in. Leading economic indicators: These indicators tell about the future overall economic health that is likely to occur in 12 to 15 months from the current period. 1. Average workweek for manufacturing sectorhigher value is a good sign. 2. Average weekly unemployment insurance claimlower value is preferred for better economic health. 3. New orders for consumer goodshigher value is better for good economic sign. 4. Index of consumer expectation (condence)higher means consumers are sizzlinggood time ahead. value

5. New orders for non-defense durable goodshigher valuegood time ahead. 6. Number of new building permits issued for private housing unitshigh value is good. 16

7. Stock priceS&P 550, NASDAQ, AMEX etc.their going up means companies are doing well and stock holders assets are going high in values. 8. Interest rate spread: 2-year government bond rate less federal funds ratehigher value is preferred.

17

Measuring GDP National income accounting-a set of rules and denitions for measuring economic activity in the aggregate economythat is, in the economy as a whole (is the work of S. Kuznets and R. Stone-won Noble Prize). Value added approach to compute GDP: I shall start with an example to impart this concept. Suppose life starts from the farmers and ends at Kroger. Activity Farmers sell wheat to miller miller sells Flour to baker Baker bakes cake and sells to Kroger Kroger sells Cake to Mr. Eater sell $1.00 $1.50 $2.50 $4.00 GDP contribution $1.00 $0.50 $1.00 $1.50

If we conne ourselves to nal good approach, the nal good is the cake and its value is $4.00=GDP. According to value added approach it takes only value added part in each sector of production which is the dierence in values between sell and raw material purchase given in column 3. Add all the gures in this column, they add to also $4.00. Aggregate expenditure approach of GDP computation Nominal interest rate (R): The interest quoted in current dollars. For example, a 7% rate of return on CD. This rate is not adjusted against ination. Real interest rate (r) is adjusted for ination and is the dierence between nominal rate and ination rate, i.e., r = R IN, 18

where R is nominal interest rate and IN=ination rate. For example in 1999 the nominal interest rate was 7% and the ination rate was 2.5%, the real interest rate in this year was (7-2.5)%=4.5%. Your investment decision should be based on real interest rate not on nominal interest. During hyper or rising ination time lenders lose and borrowers gain. If ination is galloping, do not put money in the bank, buy goods and services immediately that you need. In order to achieve this goal, we need to know couple of new concepts that help explain it. Private domestic consumption on durable & non-durable new goods (C): Total purchases on new domestically produce and imported goods (durable and nondurable) and services by all households. What new purchases are excluded from this component? The purchases of new residential homes is excluded from this component. Purchases of new residential homes show up in residential investment. C is the biggest component in our aggregate expenditure approach and counts for about 67% of GDP (real or gross). 1. Ceteris paribus(CP), as marginal propensity to consume mpc= C . 2. CP, as real interest r , people switch some consumption to saving, implies C . 3. CP, as tax goes down, people have more income to spend, implies C . 4. CP, as Y(=RGDP), implies C . Investment: Purchase of new machineries (both domestically produced and imported) in real terms is called investment that I dened earlier. Investments are of three types: Fixed, inventory, and residential investments. Note that purchase of intermediary goods by the business sector goes into nal good and gets sold with the product. Gross Private Fixed Investment (I): Purchases of new real new machineries

19

by business rms to be used to produce goods and services. Or we can say addition to the existing stock of capital. Example: Total capital stock at the end of 1999 is K99 = 225, and total capital stock at the end of 2000 is K00 = 300, the gross private investment in 2000 is I00 = K00 K99 = 300 225 = 75. It = Kt Kt1 . Depreciation : The old capital stock wears and tears out due to use (capital used up). We need to spend money to keep it in new condition. The fraction of one unit of old capital stock that is used up in a year is called the depreciation rate . Net Investment (NI): Gross investment minus total depreciation of old capital stock, and is given by

N It =Kt Kt1 Kt1 =Kt (1 + )Kt1 . Example: Suppose in country the total capital stocks for the years 2000 and 2001 were respectively 540 and 610 units. If the capital depreciation rate is 5%, nd the gross and net investments for the year 2001. Gross investment I = K01 K00 = 610 540 = 70, here = 0.05, N I01 = K01 (1 + )K00 = 610 (1 + 0.05)540 = 43. Note that net investment can be negative if the total depreciation Kt1 exceeds gross investment It = Kt Kt1 . The price (opportunity cost) of investment is the real interest that rms pay. When real interest rate goes up the quantity demanded of investment goes down rt It (a negative relationship between investment and real interest rate). The law of demand applies for investment. 20

Residential Investment: The purchases of new residential homes by households iscalled residential investment. Inventory investment Iu is dened as the changes in inventories, which are the goods on store shelves, on showroom oors awaiting sales, or raw material in warehouse that have not yet been sold or assembled into nal form of sale. Positive inventory means inventory is rising and negative inventory means inventory is falling. Goods produced this year but not sold get into inventory investment in next year.

Total Planned Invest = Fixed + residential + Inventory . Actual Versus Planned Investment: A rm may not always end up investing exact amount that it planned to, the reason being, rms do not have much control over inventory investment (which depends on us, the buyers of their products). Therefore, there is a discrepancy between planned and actual investment, note that actual investment produced the actual amount of real GDP. Government spending (G): total expenditure by the local, state, and federal government on new goods and services (both domestically produced and imported). The purchase of labor services supplied by the household sector (only noncommercial product that goes in GDP) is also included in government spending. Note that for this money spent, the government gets work done. Government transfer payment (F): total spending of the governments on some welfare projects (school lunch, WIC, food-stamp, Medicaid, foreign aids, etc.). Note that beneciaries of these programs earn this as income for which they dont need to work for governmentgovernment does not get any work done against this spending. Tax Revenue Collection (TRC): total personal income tax, corporate tax, and many other fees that governments collect. Net Tax Revenue (T): The dierence between TRC and F is called the net tax revenue T = T RC F. 21

The values of G, F, and T depend on congress and senate. Budget surplus (BS): the excess of net tax revenue T over government spending G. BU S = Spub = T G. Another name of budget surplus is called public saving. Fiscal Policy: Any policy pertaining to G, T, and BUS to bring about economic stability is known as Fiscal Policycongress and senate do undertake scal policy. Fiscal policies are of two types: expansionary and contractionary (wait we shall get there). Private Saving (Sp ): The income left to the households after paying for C and T. Households saving funnels as investment. The relationship between saving and real interest rate is positivert St ( i.e., real interest rate goes up quantity supplied of Total countrys saving: The sum of private and public saving are called countrys total saving. We shall prove it later on. The last concept we need is the net exports NX, have already been discussedplease recall that concept. Indirect business taxes: It is non-income taxes-any taxes except corporate and personal income taxes. Businesses are actually acting as governments agents in collecting the sales tax, which in turn passes on to the government. This taxes therefore represents a business expense and are included in GDP. Note that if you do not shopyou don not pay these taxes. ONE IMPORTANT ISSUE: all components C, G, F, TRC, T, NI, I, and S are all expressed in real terms and in one common unit (base period 92s dollars). In macroeconomics, one machine is one base period dollar. How can we convert one $0.8 million new machine into a real term investment? Suppose the GDP deator is 1.6, this nominal term can be converted to real term dividing it by the price deator, in this example investment contribution from this purchase of new machine is 0.8/1.6=0.5 In macroeconomics, the ows of incomes from one sector to another is like 22

blood circulation in and out of heartif there is no leakage, total blood is same (read the ow chart in textbook). The rms are the heart of macroeconomic resource circulation system. In aggregate expenditure approach rms are the recipients of C, G, NX, the gross investment component (part or all of which is private savings) is also with the rms, therefore RGDP=Y can be written as Y = C + I + G + N X. Note that if we multiply both sides by the price deator we get GDP. Moving from RGDP to GDP or from GDP to RGDP is not at all dicult (division or multiplication by deator) According to this approach we only need business rms information to compute GDP or RGDP. Why we call it Gross Domestic Product? The answerit includes gross investment instead of net investment. Below we trying to arrive at take-home income of all households. Net Domestic Product N DP = GDP total capital depreciation Note: total capital depreciation is also called capital consumption allowance.

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National Income (NI): The indirect taxes that initially come to household as income and is spent on nothing, i.e., this spending does not bring in anything in return to the household. National Income is the dierence between NDP and indirect business taxes N I = N DP indirect business taxes. Personal Income (PI): Some income we earn but dont receive it (social security contribution), some income we dont earn but receive it (social security benet, welfare payments). If we adjust NI for these, we get PI,

P I = N I + (social security benet payment + other government aids (corporate taxes + social security contributions + corporate retained earnings) = N I + total income received not earned total income earned but not received = N I + total transfer payment total income earned but not received = N I + F total income earned but not received. Disposable income DI DI = P I personal income taxes. Out of disposable (DI) income we consume and save, i.e., DI = C + Sp . Where Sp stands for Private saving. Income Approach to GDP calculation: Income approach calculates National Income NI, with it if we can add indirect business taxes and total depreciation, we end up with RGDP. NI is the sum of the following components: 24

1. Compensation of employees (labor income) W : wages (payments to workers by hours), salaries (paid by month), and fringe benets (retirement, health, and other benets). 2. Rental income R: income from property received by households (not by rms). It includes the implicit rental value of owner-occupied houses (imputed rent), royalties received from copyrights, patents, and assets such as oil wells. 3. Interest income i: Income received by households by lending their money to business rms and corporations (from CD, bonds, dividend on stock purchased, etc.). Interest received by rms and corporations go into their prot and therefore dont show up here. Interests paid by the government on government debt are not included here too. 4. Prots P R: the amount left to rms after paying employees compensation, rents, and interest on debt. (GDP calculation takes accounting prots not economic prot) Note that prots earned by unincorporated businesses are called proprietors income. The income approach provides national income NI, not real GDP. However, if we know total depreciation and indirect business taxes, we can arrive at RGDP from NI. According to this approach N I = W + R + i + P R. simultaneously zero. To make N I = P I = RGDP , we assume the following total depreciation = 0 indirect business taxes = 0 social security benets = 0 social security contributions = 0 corporate taxes and corporate retained prots = 0 government transfer payments = 0. Under these assumptions, NI, PI and RGDP all will be equal. Under this strict assumption we can say, when our income PI is equal to expenditure we have EQUILIBRIUM and at the equilibrium 25

Expenditure

Y = C + G + I + NX

is true from expenditures side and Income P I = C + T + Sp is true from income side. When we are in EQUILIBRIUM, THEN INCOME=EXPENDITURES. What I am discussing now is TRUE only at the equilibrium. C + Sp + T = C + G + N X Sp + T G = I + N X now T G = Spub Sp + Spub = I + N X Sp + Spub = S stands for national saving S = I + NX note that this is only true at the equilibrium S I = NX If S > I = N X > 0 capital outows If S < I = N X < 0 capital inows above is the case for us for decades that is why we are the biggest borrowing county Expansionary scal policy and its role on Net Exports. CP, if G implies S implies N X . Similarly T implies S which also implies N X . Therefore, expansionary scal policy is equivalent to borrowing a big time from the rest of the world. Says Law : Many notable classical economists supported consumption austerity and higher production for economic prosperity. This involves more saving less consumption. Less consumption lowers the AD, then fear arose that AD may fall sort of LAS, to ameliorate this problem the economist Says came up will a law and is stated as Supply create its own demand. According to this law aggregate demand will always intersects aggregate supplyAD will never fall short of LAS. 26

Aggregate Demand (AD): Using our aggregate expenditure approach, the dierent real aggregate expenditure Y the country will incur at dierent aggregate prices P. CP, P goes up Y goes downa negative relation between P and quantity demanded law of demand. AD is similar to a demand for a good that we are already familiar with. But the factors aecting AD are dierent. The AD depends on government spending G, net tax revenue T, budget surplus T-G, money supply M, net exports NX(e), and investment I(r). Symbolically: AD : Y = f (P, G, T, T G, M, N X(e), I(r)). What substantiate that AD is down sloping? 1. Wealth eect: CP, if P , real value of your asset holdings go downwe feel poorerbuy less, and opposite is the case when P . Therefore, CP, as P goes up, C , N X , expenditure Y demanded goes down and opposite is the case as P goes downa negative relationship between Y and P. 2. The international (open economy) eect: CP, if P , our goods are expensive to foreignersexports goes down, and foreign goods are relatively cheaper to usimports goes upNX(e) goes down, aggregate expenditure (Y=C+I+G+NX) goes downa negative relationship between price and aggregate expenditures. Note that your exchange rate e also behaves the same way as aggregate price P does. 3. The interest rate eect: CP, P , we know interest has to go up with it, when r implies I(r) , C , therefore, quantity of aggregate expenditure (Y=C+G+I(r)+NX(e)) demanded goes downa negative relationship between P and Y. The factors shifting AD: 1. CP, G , the quantity of aggregate expenditure (Y=C+G+I+NX) increases at all aggregate prices, AD , AD shifts right (this is known as an expansionary scal policy or stimulant). 2. CP, T , peoples disposable income goes up, which in turns increases 27

C at all prices, increasing the aggregate quantity demanded, therefore, AD , AD shifts right (this is known as an expansionary scal policy or stimulant) 3. CP, BU S = T G (this is equivalent to either lowering T or increasing G), AD , AD shifts right (this is known as an expansionary scal policy or stimulant). 4. CP, M , which means more money at peoples hands, they consume more, C , aggregate expenditure goes up at all prices, AD , AD shifts right (an expansionary monetary policy or stimulant of Federal Reserve System). 5. CP, e (our $ is stronger) N X(e) , aggregate expenditure goes down at all prices, AD , AD shifts left. 6. CP, r = I(r) , aggregate expenditure is lower at all prices, AD , AD shifts left (a contractionary monetary policy of fed). Now we are going to discuss short-run Aggregate Supply (AS). Before I do it, I would like to say that horizontal AS in the textbook is oversimplication and I shall be back to it after we discuss the normal SAS. Quantity of aggregate output Y supplied in the short-run depends on many factors: The aggregate price P, technology Te , input cost mainly labors money wage W, investment I(r), government policy on business specially corporate taxes Tc , etc. Symbolically short-run aggregate supply (SAS) can be written as:

SAS : Y = f (P, Te , W, I(r), Tc ). Denition: CP, dierent quantities of real output Y in the short-run the nation will supply at dierent prices. As price goes up quantity supplied Y goes uppositive relationship between P and quantity supplied Ylaw of supply. Factor aecting SAS 1. CP, P quantity supplied Y , no change in supply (positive relationship between P and Y). 28

2. CP, as technology improves, SAS increases, curve shifts right. 3. CP, if W , (input cost increases), the SAS decreases, curve shifts left (supply shock). Note that in early 70s the oil price increased to four-fold within a very short time, price level went up, output went down, unemployment went uppushed the economy into a recession. Adverse supply shock results in higher ination and unemployment ratea situation called STAGFLATIONvery bad for the economy (I shall give you the graphical representation of it in class). Stagation caused by adverse supply shock is also called cost-pushed ination. 4. CP, if investment goes up, the SAS increases, curve shifts right. Note that in order to stimulate investment, the government needs to lower the real interest rate-an expansionary monetary policy of Federal Reserve System. 5. CP, if congress lowers the corporate and private business taxes (an expansionary scal policy), SAS will increasecurve shifts right. Two schools of Macroeconomic Thoughts: (a) Classical economists and (b) Keynesian economists: Classical economists: 1. Classical economists believed in long-run analysis of economic issues. 2. Unlike mercantilists, classical economists believed in real factors (physical goods and services) in determining the wealth of nationstheir analysis was primarily real analysis. 3. Money played a role in facilitating transactions as a means of exchangemoney works as veil and has no intrinsic value. They believed if money supply increases say by 5%, aggregate price will increase by 5%no better o or worse omoney is neutral. 4. In the short-run if the economy moves away from long-run results, and is left undisturbed it will come back to long-run results automatically self-correcting economy a situation called Laissez-faire (leave it alone). No government intervention in stabilizing the economy. 5. Nominal prices and wages are perfectly exible while long-run real wage is constant. 29

6. In case of any short-run disturbance in the aggregate demand, the aggregate supply will adjust to move to the long-run results. Their approach is called supply-side economylong-run aggregate supply is vertical at the full-employment output. Keynesian economic approach: 1. Keynesian approach developed against the background of The Great Depression (1929-41), when in U. S. economy unemployment ran no less than 10% and peaked to 25.2% in 1933, RGDP fell 30% between 192933. Keynes caught the classical economists bare footedtheir long-run model were wrong. 2. He concluded the high unemployment in U.S.A., Britain, and other countries was the result of a deciency in aggregate demand. 3. He postulated that since unemployment is always positive, workers are willing to work at the market wage rate, therefore it is not required to pay higher wage to employ more workerwage rigidityper unit cost of production is fairly constantaggregate supply curve is horizontal over a fairly long range of output as opposed to vertical according to classical economists. 4. If aggregate demand can be stimulated, output will go up, unemployment will go down without having inationprice is rigidaggregate demand-side economy. 5. Who can help stimulate the aggregate demandhe strongly advocated the governments role in this regard. Government can take expansionary scal and monetary policies (decrease taxes, increase government spending, and decrease budget surplus) to take the economy out or recession or depression. 6. According to Keynes, the equilibrium income (output) and potential income are not the same. Classical long-run aggregate supply curve (LAS): To understand the concept well, let us start the initial short-run equilibrium at the potential output Yn (without graphs the concept will not be clear). 1. CP, as AD , equilibrium real output Y is greater than the potential 30

output Yn , new equilibrium price is greater than previous equilibrium value P , the unemployment rate will go down and will be below the natural unemployment U N . 2. Equilibrium real output Y is greater than the potential output Yn which indicates negative potential real GDP-gap and is know as inationary or expansionary economic gap (p. 571). 3. This price increase resulting from increased AD which is accompanied by lower unemployment rate is called Demand Pull Inationgood for the economy. 4 . Similarly, if AD , equilibrium real output Y is less than the potential output Yn , unemployment rate is above natural rate of unemployment U n . Potential real GDP-gap is positivea recessionary economic gap (p. 570). Consider our rst bullet and study the price and wage adjustment process. P , a good news for employers in the short runnot a good news for workers. When workers come to realize about the higher ination (of course the workers come to know it a little later)bargain for a higher wage, implies W = SAS . As a result P , and Y , U . Another round of wage bargain, this do loop continues until the potential RGDP-gap reduces to zero. Carefully see that in the long run the aggregate output is equal to potential output. That substantiate the fact that classical long-run aggregate supply (LAS) is a vertical line at the potential output. You also notice in the adjustment process only SAS adjusts justifying that it is supply-side economy. Few Classical views we can clarify from above discussions (see pp. 571-72, the economy beyond potential): 1 Classical economists believes that long-run aggregate supply (LAS) is vertical at the potential output. Over time, LAS shifts to the right through technological innovations, more and better resources endowment. 2 In response to price increase, nominal wage increasesholding the real wage w = W a constant. P 3 Classical economists do not believe in RBC, any shock in the economy

31

is temporary (short-run blips), the long-run output is the potential output, long-run unemployment rate is natural rate of unemployment, and real wage is constant over time. Keynesian Aggregate Supply: As stated earlier, aggregate supply according to Keynesian postulation is horizontal at a given price which is consistent with the textbook AS. Now using this AS let us try to study the eect of scal and monetary policy on aggregate output, unemployment, and price level. 1. CP, government reduces tax (budget surplus will decrease or decit will increase), AD will increase. As a result output will go up and unemployment rate will go downexpansionary scal policy. Opposite will be the case when govt. increases taxcontractionary scal policy. 2. CP, govt. increases spending G, AD will go up, both output and employment will go upexpansionary scal policy. 3. CP, govt. reduces the BUS (through manipulation of either T, G or both), AD will go up, output and employment both will go up expansionary scal policy. 4. CP, real interest r goes down, investment will go up, AD will increase both output and employment will go upexpansionary monetary policy. 5. CP, if govt. injects more liquidity (which can be done many ways: through printing more new money, buying back govt. bonds, lowering federal fund rate and/or discount rate, lowering reserve requirement) into the economy AD goes upboth output and employment will increaseexpansionary monetary policy. The Paradox of Thrift: If people lower the consumption in an attempt to save more, aggregate demand will decrease which will lead to lower equilibrium output and higher unemployment. Peoples income will fall far enough so that once again saving and investment will in equilibrium, but then the economy could be at an almost permanent recession. Keynes at such a situation calls for government help.

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Multiplier model Marginal Propensity to Consume (mpc): The fraction of a $ disposable income that goes into consumption C. For example if mpc=0.8, it means, CP, if my disposable income increases by a dollar, my consumption will go up by $0.8. CP, mpc = C , which in turns increases aggregate expenditure AE = C + I + G + N X, and leads to an increase in AD, P and Y , therefore, U . It seems, we are trying to say, increased consumption is good for the economy. Yes, folks, two-third of U.S. GDP comes from private households consumption. That being said, we never recommend that you go into debt to stimulate the economy. We need saving, otherwise there will be no private investment and hence no job growth. Marginal Propensity to Save (mps): The fraction of disposable income that goes into saving. For example if mps=0.2, it means, CP, if my disposable income increases by a dollar, my saving will go up by $0.2 (mps=1-mpc). From these two denitions, it is apparent that mpc + mps = 1. To make our life easy, throughout our analysis we shall assume our tax T is Lump-sum (xed) and does not depend on income Y which is contrary to what we know of on April 15 of each year. Under this unrealistic assumption mpc = C C S = , and mps = 1 mpc = . DI Y Y

33

Consumption function (little extra than from your textbook): Let us start with an example: Note that under the assumption of lump-sum tax T, DI = Y . DI 0 100 200 250 300 400 C 50 130 210 250 290 3700 C DI mpc=
C DI

S=DI-C -50 -30 -10 0 10 30

80 80 40 40 800

100 100 50 50 100

0.8 0.8 0.8 0.8 0.8

In this example, when your DI=0, WHAT is your consumption? Answer is 50, and is called the autonomous consumption. In other words, your consumption at ZERO disposable income DI is called the autonomous consumption. If you plot, DI along the horizontal axis and C along the vertical axis, you will get a straight line, with intercept 50 and slope 0.8(=mpc). The slope of your consumption function is nothing but mpc. In this example you start with a debt of 50, as your DI goes up, your consumption C goes up with it. But every dollar increase in your DI, you save $0.2 (=1-mpc), and gradually pay o your dept. Your DI goes up, C goes up, and saving goes up (debt goes down). In this example when your DI is $250, you pay o all your debt of $50 and are break-even (equilibrium). If your disposable income goes above the equilibrium income, your saving is positive, and is negative below equilibrium income. QUESTION: CP, in this example if you are required to spend more than 80% of your DI, list what will happen. Now let us give a general mathematical shape to the issue: The general consumption function

34

C = a + mpc DI. where a is the autonomous consumption, DI(=Y-T) disposable income, and mpc is marginal propensity to save. A little bit more algebra

DI =C + S DI C =S DI [a + mpc DI] =S DI a mpc DI =S DI(1 mpc) =S + a DI mps =S + a S+a DI = . mps When S=0, we are break-even and reached the equilibrium, therefore, at the equilibrium, DI = a . mps

Question: If mpc=0.8, a=200, what is the equilibrium DI? Question: If a=200, mps=0.25, Y=3500, and we are at equilibrium, what is the value of lump-sum tax T? Question: a = 500, S = 90, mpc = 0.9, and T = 300, what is the value of real output Y? Solve them, the answer will be in the class. Multiplier Analysis with overall economy that considers the PAE. In the following analysis: The government spending G, net exports NX, and lump-sum tax T are given exogenously (i.e., given from outside sources and if there is any change is also determined exogenously). The households consume C, government consumes (spending) G, businesses investment is planned Ip and either be equal to, less than, or greater than actual investment Ia . Note that Ia produces actual real output Y (which goes along the 35

450 in the diagram I shall draw. The planned aggregate expenditure PAE is given by P AE = C + Ip + G + N X = a + mpc DI + Ip + G + N X = a + mpc (Y T ) + Ip + G + N X = (a + Ip + G + N X mpc T ) + mpc Y = AE + mpc Y, where AE = a + Ip + G + N X mpc T. P AE = Aggregate autonomous expenditures+ Real income induced expenditures AE = aggregate autonomous expenditures mpc Y = real income induced expenditres From above formulation, the overall planned aggregate expenditure function is P AE = AE + mpc Y. When countrys aggregate output (RGDP) is zero (Y = 0), the country aggregate expenditure P AE = AE, and AE is called autonomous aggregate expenditure, the other component mpc Y is called real income induced expenditure. Note that the autonomous aggregate expenditure is the key in understanding our AD. Any policy that results in increased AE, AD will increase. Therefore, if you can remember it, you can do many things like a piece of CAKE. In our diagram, when the PAE line lies above the 450 line, countrys P AE is greater than its actual output Y, i.e., P AE > Y , which indicates, countrys actual investment Ia is less than what was planned, i.e., Ia < Ip . The country spends from previous periods inventory investment, current inventory investment Iu is negative (Iu < 0) . The inventory investment is dened as Iu = Ia Ip = Y P AE. In our diagram, when the AE line lies below the 450 line, countrys AE is less than its actual output Y, i.e., Y > AE, which indicates, countrys actual investment Ia is greater than what was planned, i.e., Ia > Ip . The countrys extra output over its aggregate expenditure adds to inventory 36

investment, current inventory investment Iu is positive (Iu > 0). Note, this Iu exactly behaves as private saving S we discussed in the households consumption function. Using this we can nd expression that helps to nd many crucial things.

Y P AE = Iu Y [AE + mpc Y ] = Iu Y AE mpc Y = Iu Y mpc Y = AE + Iu Y (1 mpc) = AE + Iu Y mps = Iu + AE Iu + AE Y = mps K=

1 mps

is called a multiplier.

When Iu = 0, we are at the intersection of PAE line and the 450 lines, our economy is in equilibrium, and Ye = AE . mps

From above you see, CP, if you can increase AE, your income will go up. Take an example, mps=0.2, AE=20, your equilibrium income is Ye = AE 20 = = 100. mps 0.2

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Autonomous aggregate expenditure multiplieran easy way Suppose economy 1 is characterized by Y = AE + 10 . 0.2

AE 0 1 2 3 10

Y 50 55 60 65 100

CP AE goes up by one your Y goes up by 5, very good business 80% prot. Now take economy 2 is characterized by Y = AE + 10 . 0.1

AE 0 1 2 3 10

Y 100 110 120 135 200

For this economy, CP AE goes up by one your Y goes up by 10, very good business 90% prot. Now ask yourself where from this funny numbers 5 and 10 coming from. These two economies only dier in consumption pattersn. The rst economy consumes 80% while the economy 2 consumes 90%. The answer lies on the consumption patterns. 38

1 1 = =5 mps 0.2 1 1 For economy 1 = = 10 mps 0.1 we got the answer. For Economy 1

AE = Change in autonomous aggregate expenditures Y = Resulting change in Y Y 1 = .. the above is autonomous expenditures multiplier) ( AE mps Y = 5 say AE CP, AE goes up by ONE, Y goes up by 5 Autonomous Expenditure Multiplier is dened as, Y 1 = = K. A mps Note that your autonomous multiplier K changes when the countrys consumption behavior changes, i.e., mpc changes. Example: For a country mpc=0.8 (mps=0.2), and the autonomous expenditure decrease by 7.5, what will be the change in income Y. Here AE = 7.5 mps = 1 mpc = 1 0.8 = 0.2, K = Put everything in the formula
1 0.2

= 5, Y =?

Y 1 = =5 AE 0.2 Y 5 = 7.5 1 Y = 5 7.5 = 37.5. 39

The countrys real output Y will decrease down by 37.5. CP, mpc = mps = K , a positive relation between mpc and K and negative relation between mps and K. I have given you the general change in autonomous expenditure AE, ask your self, how AE can be changed. In order to answer it clearly, let me write the expression of AE again here AE = a + G + Ip + N X mpc T. Now if government spending G goes up by some amount say, G, then autonomous expenditure AE goes up by the full amount, i.e., AE = G, now if you replace AE by G in the autonomous multiplier formula, we get government spending multiplier. And is given by 1 Y = = K, G mps govt. spending multiplier.

Intuition: Suppose mps=0.2, if govt. increases its spending by one dollar, and person 1 receives it, he spends $0.8 (received by person 2) and saves $0.2, person 2 spends $0.64 (person 3 receives it) and saves $0.16 and so on. If you add $(1+0.8+0.64+....)=5, multiplier is 5. Income propagates and creates income. Example: Suppose government increases its spending by 5, and mpc=0.75, what will be change in income Y. Here G = 5(note govt. decreases its spending then G should be given a negative sign, and you put negative sign), mps = 0.25, Y =?, put all you have in the govt. spending multiplier, Y 1 = G mps Y 1 = 5 0.25 5 Y = = 20. 0.25 40

The countrys real output (RGDP) increases by 20. Example: In an economy mpc=0.9, and the govt. wants to decrease countrys real income by 100, what is the needed change in its spending. List all you have and what you need to accomplish. mps = 0.1, Y = 100, G =?, now put everything in the machine

Y 1 = G mps 1 100 = G 0.1 100 G = = 10. 10 Govt. needs to cut spending by 10. Now suppose the govt. increases net tax collection T by T , as a result your autonomous expenditure AE will go down by AE = mpc T. In place of AE, put mpc T , then you have

Y 1 = AE mps Y 1 = mpc T mps Y mpc = , Govt. tax multiplier T mps Example: In an economy, mps=0.4, govt. increases tax by 10, what will be associated change in real income Y. Here mps=0.4, mpc=0.6, T = 10, Y =?, put everything in the tax 41

multiplier formula, Y mpc = T mps Y 0.6 = 10 0.4 6 Y = = 15, 0.4 i.e. income will go down by 15. Example: The economy is in boom, which may result in ination. The current expansionary gap is 100, govt. needs to reduce this expansionary pressure by changing tax only. If mps=0.2, what is the needed change in tax collection. Here govt. wants to reduce Y by 100, means Y = 100, T =?. Put everything in the tax multiplier formula, Y mpc = T mps 0.8 100 = = 4 T 0.2 100 T = = 25, 4 i.e., govt. needs a tax hike of 25 to do the job. HW: If the govt. wants to accomplish the same task by changing its spending what will be need change in G. Balanced Budget Multiplier: Add the govt. spending and tax multipliers, i.e., Y Y 1 mpc 1 mpc mps + = = = = 1. G T mps mps mps mps This called the balanced budget multiplier. It says that if govt. increases its spending by 1 and at the same time increases tax by 1 to nance the increased spending, so that govt. budget is balanced (i.e., govt. is neither a gainer nor a loser), the countrys income will go up one. Is it not something 42

wonderful? Govt. can help the country out of nothing? Fry sh in sh oil. Note that this is true for any value of mpc or mps. Note if govt. increases spending by G and simultaneously increases tax T = G, then income will go by G. HW: Currently the economy is facing a recessionary gap of 300, and govt. wants to ll this gap, i.e., wants to increase the income Y by 300. If mpc=0.8, what is the needed change in either spending or tax that will do the job.

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