A Review of the Basics

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 Learning Objectives
1. Understand the concept of the National
Income Identities (Mankiw & Taylor Chap.2)
2. Understand the definition of Unemployment
(Mankiw & Taylor Chap.2)
3. Understand the definition of a price index
(Mankiw & Taylor Chap.2)
4. Understand the concept of Economic
equilibrium and how it is influenced by
expectations
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 1. NIE Identities
• Before we get into models of economic
behaviour we need to look some definitions
and some issues in measurement
• Measurement economic quantities may seem
boring…
– But it can give crucial insight even without a
model of behaviour
– Example: the euro crisis

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 NIE Identity (1)
• We measure macroeconomic activity primarily by looking at annual
(or quarterly) flows of Output (O), Income (Y) and Expenditure (E).
• These are different ways of measuring the same thing, so they sum to
identical totals
– Basic Identity: YO E
• Think of why this is the case
– Income and Product are identical: Product is Value-Added in Production, i.e. sales
minus purchases from other firms, which = payment of incomes to Factors (Wages,
Interest…)
– Expenditure equals Income, because any production not sold is counted as
Inventory Investment, and is thus part of Expenditure (the firm purchases its own
output from itself)
• Note this is an identity not an equilibrium condition
– An identity holds for all values
– An equilibrium condition holds only for some values i.e. in equilibrium
– Distinction important later

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 NIE Identity (2)
• The Income Identity
– YC+S+T
– Accounting rule: Income is either spent, saved or taxed
• The Expenditure Identity
– E  C + I + G + NX
– Accounting rule: add up the components of expenditure
• NX is also net foreign investment and is (almost) equal to the current account
of the balance of payments
• Combine the two
• C + I + G + NX  C + S + T
• Thus:
• I + G + NX  S + T
• We can re-write it in several ways
• (G – T)  (S – I) – NX
• (G – T) + NX  (S – I) etc.
• (T - G) + (S - I)  NX  BOP Current A/C
• (T - G + S) - I  NX  BOP Current A/C

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 The Magic Identity
• Robert Gordon calls it the magic identity
because it is so useful
• In the US it is often known as the twin deficits
identity
• Even though it doesn’t involve any model or
description of economic behaviour it can be
informative
• It is true by definition so it is always true
• But it doesn’t tell you which variable causes
what 6
 Using the Identity
• Implication: a current account surplus can only
occur if there is an excess of national savings
• (T - G + S) - I  NX
• If government has a deficit then it must be
financed by excess private savings (S>I and NX=0)
• G-T  (S-I)-NX
• … or by foreign borrowing (NX<0)
• G –T  (S– I)-NX

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The Identity, China and Donald Trump
• The US has trade deficit (especially with China)
– Some US politicians blame this on currency
manipulation by Chinese government
• The identity shows that the deficit could not exist
without the US having low savings
• (T - G + S) - I  NX
• NX<0 if (T-G)+S < I
• China trade surplus equates to surplus Chinese
savings
• Smarter US politicians want China to increase
consumption and reduce savings
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 The Identity and Ireland
• Ireland had a property boom from 1997-2007
• Property is a type of “Investment”
• Domestic savings were very low
• (T - G + S) - I  NX
• So NX became negative

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 Savings

35.00%

30.00%

Personal
25.00%
Corporate
Gov
20.00% Inv
CA

15.00%

10.00%

5.00%

0.00%
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

-5.00%

-10.00%

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 2. Unemployment
• The labour force (L) = employed (E) +
unemployed (U)
• The unemployment rate u% = U/L or U/(E + U)
• Letting the population of Labour-force Age = P,
we also have:
• The Labour force participation rate: LFPR% =
L/P

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 Unemployment
• Key Issue: have to “want” to work to be unemployed as
distinct from not working
• The precise details of how surveys and other measures are
constructed will differ from country to country. Survey
methods are generally more comparable.
• Surveys try to capture this: “active search”
– Issue of how active
– Discouraged worker effects
• There is a difference between what economists’ definition of
U and rest of society
• Claimant counts do not – may include people NILF

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 Measuring Unemployment
• Surveys: household
– QNHS in Ireland, quarterly household survey
– CPS in USA;
– business surveys for employment (“Non-Farm Payrolls”)
• Administrative: related to benefit claimants
– Ireland: “Live Register”
– China registers those eligible for benefits
• Survey better
• Administrative does not correspond to what we mean as
“unemployment”

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 3. Prices
• Some components of GDP have well-known measures of
inflation: the CPI for household consumption
• For a more comprehensive measure the implicit price deflator
for GDP is used: this relates to all items in the GDP
• A price index is a weighted average measure of price changes
• Two questions arise: (i) what is included (ii) what kind of
weighting system to use
– Ex: For Consumption the Irish CPI includes a measure of housing costs,
the Eurozone HIPC does not
• Generally if an index uses base-year weights (Laspeyre), the
resulting inflation is higher than if current year weights are
used (Paasche)
– CPI is Laspeyre

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 Laspeyre vs Pasche
• A Laspeyre index of prices uses the quantities prevailing in some base (e.g.
survey) year to weight prices. The index takes the form:
• (p1q0 / p0q0)x100
• Note: base-year quantities (q0) are used to compare prices in the two
years (p1 and p0 )
• A Paasche index of prices uses the quantities prevailing in the terminal
year to weight prices. The index takes the form:
• (p1q1/ p0q1)x100
• Note: current-year quantities (q1) are used to compare prices in the two
years (p1 and p0)
• As relatively cheaper are substituted for dearer goods, the Laspeyre index
of prices has an upward substitution bias.
• So CPI inflation is biased upwards

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 4. Equilibrium
• Key concept in economics
– illustrate with the simplest possible macro model
• Equilibrium is a point of balance or stability
– Specifically in economics it is a point where economic
agents’ plans are mutually consistent and therefore
are realised
• An economic model is a description of the plans
of producers, consumers, government, etc.
– Enables us to look at how the plans affect each other

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 Disequilibrium
• Might be easier to think of the opposite
• “Out of Equilibrium”
• plans are inconsistent
– then someone’s plans are not realised
– Somebody is disappointed
– Behaviour will change
– The economy will change
• so not stable or balanced
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 MACROECONOMIC EQUILIBRIUM

• Our simple model will have a very simple description of people’s plans
• Output
– Firms have a plan for how much to produce
– Very simple: they produce a fixed amount
• There will also be Planned Expenditure (Ep)
– the amount of Expenditure which agents plan to make
– Agents: Households, firms, the Government and foreigners
– Note: Aggregate Demand is another name for Ep
• In equilibrium plans are consistent
Y = Ep
• Later we will see that sometimes Output does not equal planned
expenditure: this corresponds to a disequilibrium
• Key point: in equilibrium the forces acting on some variable (Y) are
balanced and hence Y will not change.

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 Planned Expenditure
• Conventionally we look at separate components of planned expenditure:
C, I, G, NX. This is because they behave differently.
• Crucially C (Consumption) depends partly on Income: so part of
Expenditure depends on Income
• Other components of Expenditure are Autonomous: this means it depends
on something that is not in our model.
– Things that we ignore
– This is necessary to keep the model simple
– Note : “Autonomous” is sometimes called “exogenous”
• We have
– an Autonomous component of Consumption (Ca)
– Investment (I)
– Government purchases (G)
– Foreign demand (NX)

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 Consumption Function
• An equation that describes consumption plans
• Consumption depends on Disposable Income
(Y minus net taxes, T).
• More specifically: C = Ca + c(Y – T)
• Ca is the autonomous part of consumption
• Little “c” is called The Marginal Propensity to
Consume (MPC)
– 0<c<1
– 0 < dC/d(Y – T) = c < 1
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 Consumption Function
• This is a model of consumption
• It is a simplified representation of how people
make their consumption plans
• In words
– People consume a fixed cash amount and then a
percentage of their income
• It is very simple (even simplistic): no interest
rates, future income, life cycle
• It doesn’t say that plans will be successful

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 THE CONSUMPTION FUNCTION (2)
• Note: Ca is “Autonomous” consumption; C/(Y-T) (APC) falls as Y increases
provided c (MPC) is < APC.

Ca + c(Y – T)

Slope = c
Ca

0 (Y-T)

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 Macro
• The consumption function brings up the issue of
aggregation or “adding up” we talked about
• The logic of the consumption function is explained by
relying on an individual behaviour
• But in Macro we look at consumption for all individuals
in a country
• Assumption that everybody behaves in a similar way
• This is what Macro does
• We will be doing it for every equation in the course
• A lot of arguments between macroeconomists are
about when it is ok to do this kind of thing

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 Equilibrium
• As always equilibrium is where plans are consistent
• Specifically in this case planned production is equal to planned demand
Y = Ep
• Substitute in equation for planned expenditure (“Aggregate Demand”)
Ep = C + I + G + NX
• To get Y = C + I + G + NX
• Substitute in consumption function
• To get: Y = Ca + cY – cT + I + G + NX
• cY is the one part of Expenditure which depends on Income
• The other components (Ca – cT + I + G + NX) are autonomous planned
spending
– in that they do not depend in Income (at least for now…)
– Alternatively we might term them the Endogenous and Exogenous components of
planned spending.
– Key point: we don’t describe the plans that lead to autonomous planned spending

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 Equilibrium vs Idenitity
• Earlier we had an accounting identity:
Y  C + I + G + NX
• This is different from the equilibrium condition
• The equilibrium condition describes planned magnitudes
– These plans may or may not be realised
• The identity describes what actually happens
– This may or may not have been what was planned
• Thus the equilibrium condition is true only for certain values of the
variables
• The identity is true always
– Best thought of as an counting rule
• Note that we have two parallel line for equilibrium condition but three for
the identity

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 DISEQUILIBRIUM
• To illustrate the concept of equilibrium
consider a numerical example
– Suppose we have Ca = 50, c = 0.8, T = 150, I = 40,
G = 150, NX = 60
– Suppose we have Y = 600
• Is this an equilibrium?
• Calculate Planned Expenditure (Aggregate
Demand)
• Ep = Ca + c(Y – T) + I + G + NX
• = 50 + 0.8(450) + 40 + 150 + 60=660

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 Disequilibrium
• So Planned Production (Y) < Planned
Expenditure (Ep)
– Somebody’s plans will not be realised
– Production is not sufficient to meet demand
• Plans must be updated
• How?
– We will assume that production will be
increased to meet demand
– Note we assume prices don’t change
– Will provide empirical evidence later
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 Adjustment
• This is a key assumption
• We will spend much of the course looking at
how plans are updated
• This will depend on expectations and
timeframe (LO 3)
• In this simple model we assume that plans
cannot be updated by changing prices
• This turns out to be valid in the short term but
not in the long term
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 EQUILIBRIUM
• What is Equilibrium Y in this case?
• We could try by trial and error
• Or we could solve the equations
• By definition equilibrium is where planned production equals planned
expenditure:
Y = Ep
Y = Ca + c(Y – T) + I + G + NX
Y – cY = Ca – cT + I + G + NX
Y(1-c) = Ca – cT + I + G + NX
Y(1 – c) = Ap – cT
• Where Ap = Autonomous planned spending = Ca + I + G + NX
• Plug in numbers
– Y = Ap /(1 –c) –cT/(1-c)= (50+40+150+60)/(0.2)-120/0.2 = 300/0.2-120/0.2 = 900
• One can re-check by plugging in all the components of Ep when Y = 900
and getting Ep = 900, i.e. equilibrium

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 EQUILIBRIUM
• This can all be illustrated graphically
• When Ep > Y, Y < Ye hence Y rises: similarly when Ep < Y…..

Ep 45 (Ep = Y)
Ep = Ap + c(Y – T)

Ap

0 Ye Y

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 Comment
• The process is self sustaining
– If we are not at equilibrium there is an automatic adjustment
process that will bring us into equilibrium
– If this were not the case no point in studying eqm
• If not at eqm we are heading there
• We assume for the moment that the adjustment process works by
producers changing out put to meet demand
• We also assume that prices don't change
– Seems counter intuitive
– This model effectively assumes that prices are fixed
• We will
– provide empirical evidence alter that this is approximately true
in the short run
– and spend much of the rest of the course discussing when and
how it isn't true

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 A CHANGE in AGGREGATE SPENDING (1)
• Suppose I and therefore Ap fall by 40, Ye1 falls to Ye2 by a multiple of 40
(Ye >  Ap)

Ep 45 (Ep = Y)
Ep 1 = Ap1 + c(Y – T)

Ep 2 = Ap2 + c(Y – T)

Ap1
Ap2

0 Ye2 Ye1 Y

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 A CHANGE in AGGREGATE SPENDING (2)
• Initial Equilibrium is: Y1 = Ap 1 + c(Y1 – T)
• Following Shock to PA: Y2 = Ap 2 + c(Y2 – T)
• Subtracting: Y2 – Y1 = Ap 2 – Ap1 + c(Y2 – Y1)
• i.e. Y =  Ap + c Y
• so Y(1 – c) =  Ap
• And thus: Y/Ap = 1/(1 – c) or 1/s
• So if c = 0.8, s = 0.2, multiplier = 5: etc….
• Intuitively: an increase in Ap (say G) is spent: it becomes income to someone
who re-spends c times the increase, etc…
• Y = G(1 + c + c2 + c3 + ….. + cn)
•  cY = G(c  c2  c3 - ….. - cn+1) then adding
• And Y(1  c) =G(1) (the other terms cancel)
• So Y/G = 1/(1-c)
• You should have seen this before. If not review it in your first year book (also in
Mankiw & Taylor chap. 11)

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 A CHANGE in TAXES
• In the previous example, an increase in G of 100 produced an increase of
500 in Y.
• Now what happens if T were reduced by 100 instead of increasing G?
• Initial Equilibrium is: Y1 = Ap + c(Y1 – T1)
• Following cut in T: Y2 = Ap + c(Y2 – T2)
• i.e. Y = c.Y – c.T
• So Y(1 – c) = – c.T
•  Y/ T = – c/(1 – c)
• Thus if c = 0.2, –c/(1 – c) = – 0.8/0.2 = – 4.
• Note sign, size (intuition of this)

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 Conclusions
1. Understand the concept of the National Income
Identities
– Accounting rule so true by definition for all values
2. Understand the definition of Unemployment
– NILF vs U
3. Understand the definition of a price index
– CPI inflation biased upwards
4. Understand the concept of Economic equilibrium and
how it is influenced by expectations
– Plans are consistent
– What adjusts when plans are not consistent?

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 What’s Next?
• We will spend the rest of the course expanding
on L.O. 4
– We will add more detailed accounts of how plans are
formed
– Progressively more complicated models
– We will also carefully consider what adjusts when
plans are inconsistent
• Next topic provides more detail on how
consumption and investment plans are made
specifically we take into account interest rates.

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