EC6012 Homework 1

Aggregate Demand relation: In economics, aggregate demand is the total demand for final goods and services in the economy (Y) at a given time and price lever. This is the demand for the gross domestic product of a country when inventory levels are static. In a general aggregate supply-demand chart, the aggregate demand curve (AD) which describes the relationship between price levels and the quantity of output that firms are willing to provide. (http://en.wikipedia.org/wiki)


An aggregate demand curve is the sum of individual demand curves for different sectors of the economy. The aggregate demand is usually described as a linear sum of four separable demand sources.

AD=C+I+G+(X-M)
C= Personal consumption expenditures or "consumption," demand by households and unattached individuals
I= Gross Private domestic investment, such as spending by business firms on factor construction.
G=Gross government investment and consumption expenditure.
(X-M)=Net export, such as net demand by the rest of the world for the country

Keynesian cross diagram

Animal Spirits:
(http://farmer.sscnet.ucla.edu/NewWeb/JournalArticles/ANIMAL%20SPIRITS.pdf)

The term “Animal Spirits” is closely associated with John Maynard Keynes who used it in his 1936 book, The General Theory of Employment Interest and Money to capture the idea that aggregate economic activity might be driven in part by waves of optimism or pessimism: (although Robin Mathews 1984, points out that Keynes would have been aware of its use by David Hume 1739, Part iv, Section vii).

"Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits - a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities."
(The General Theory of Employment Interest and Money, 161-162)

The idea that waves of spontaneous optimism might drive business cycles was not new to Keynes and can be traced at least as far back as Henry Thornton who attributed a central role in his theory of credit to “… that confidence which subsists among commercial men in respect to their mercantile affairs…” (Thornton 1802, p. 75).

Bank Run: A bank run (also known as a run on the bank) is a type of financial crisis. It is a panic which occurs when a large number of customers of a bank fear it is insolvent and withdraw their deposits. (http://en.wikipedia.org/wiki)


If many or most banks suffer runs at the same time, then the resulting chain of bankruptcies can cause a long economic recession.


Bond: A debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by companies, municipalities, states and U.S. and foreign governments to finance a variety of projects and activities.

Bonds are commonly referred to as fixed-income securities and are one of the three main asset classes, along with stocks and cash equivalents..

The indebted entity (issuer) issues a bond that states the interest rate (coupon) that will be paid and when the loaned funds (bond principal) are to be returned (maturity date). Interest on bonds is usually paid every six months (semi-annually). The main categories of bonds are corporate bonds, municipal bonds, and U.S. Treasury bonds, notes and bills, which are collectively referred to as simply "Treasuries". (http://www.investopedia.com/terms/b/bond.asp)

Two features of a bond - credit quality and duration - are the principal determinants of a bond's interest rate. Bond maturities range from a 90-day Treasury bill to a 30-year government bond. Corporate and municipals are typically in the three to 10-year range.


Capital Account: In economics, the capital account is one of two primary components of the balance of payments, the other being the current account. The capital account is referred to as the financial account in the IMF's definition; the IMF has a different definition of the term capital account. http://en.wikipedia.org/wiki/Capital_account)

Capital Account= Increase in foreign ownership of domestic assets
- Increase of domestic ownership of foreign assets
= Foreign direct investment
+ Portfolio investment + Other investment

Debt to GDP Ratio: Debt to GDP Ratio is a measure of a country's federal debt in relation to its gross domestic product (GDP). By comparing what a country owes and what it produces, the debt-to-GDP ratio indicates the country's ability to pay back its debt.

(http://en.wikipedia.org/wiki)


Various debt to GDP ratio can be calculated. The most commonly used ratio is the National Debt divided by the Gross Domestic Product (GDP).The ratio can also be calculated by dividing total debt by the Gross Domestic Product (GDP). This suppresses the bias due to differences in consumer debt levels.

If a country were unable to pay its debt, it would default, which could cause a panic in the domestic and international markets. The higher the debt-to-GDP ratio, the less likely the country will pay its debt back, and the higher its risk of default.


Effective Demand: Effective demand (in macroeconomics usually regarded as synonymous with aggregate demand), is an economic principle that suggests consumer needs and desires must be accompanied by purchasing power (money) to be considered effective in discussions of supply and demand for the determination of price.

(http://en.wikipedia.org/wiki)

According to Keynesian economics, weak demand results in unplanned accumulation of inventories, leading to diminished production and income, and increased unemployment. This triggers a multiplier effect which draws the economy toward underemployment equilibrium. By the same token, strong demand results in unplanned reduction of inventories, which tends to increase production, employment, and incomes. If entrepreneurs consider such trends sustainable, investments typically increase, thereby improving potential levels of production


Deflation: Rate at which the price level falls in percentage terms. Opposite to Inflation. (Macroeconomics ninth edition, Dornbusch, Fischer, Startz, 2004)

After over a decade of Boom in the Irish Property Market house prices began to drop by between 5% and 15% in 2007. This deflation is expected to continue in 2008 amid fears of continued slowing down of the construction industry.

Consumption Function: Equation relating consumption to disposable income. (Macroeconomics, ninth edition, Dornbusch, Fischer, Startz, 2004)

The Keynesian Consumption Function
Disposable Income (Yd) = Gross Income - (Deductions from Direct Taxation + Benefits)

The standard Keynesian consumption function is as follows:

C = a + c Yd where,

C= Consumer expenditure

a = autonomous consumption. This is the level of consumption that would take place even if income was zero. If an individual's income fell to zero some of his existing spending could be sustained by using savings. This is known as dis-saving.

c = marginal propensity to consume (mpc). This is the change in consumption divided by the change in income. Simply, it is the percentage of each additional pound earned that will be spent.
http://www.tutor2u.net/economics/content/topics/consumption/consumption_theory.htm



Consumer Price Index: Fixed weight price index that measures the cost of goods purchased by the urban family. (Macroeconomics, ninth edition, Dornbusch, Fischer, Startz, 2004)

Consumer Price Index (Base Mid-December 2001=100)
http://www.cso.ie/statistics/consumpriceindex.htm


Investment Function: The investment function is a summary of the variables that influence the level of aggregate investments. It can be formalized as follow:
I = I(r, ΔY, q)
- + +
Where r is the real interest rate, Y the GDP and q is Tobin’s q. The signs under the variables simply tell us if the variable influences investment in a positive or negative way.

(Burda, Wyplosz (2005): Macroeconomics: A European Text, Fourth Edition, Oxford University Press)

For example: if real interest rates were to rise, investments would correspondingly fall.


Fiscal Expansion: An expansionary fiscal policy means lower taxes and higher government spending. The effect of these policies would be to encourage more spending and boost the economy.
http://www.econlib.org/library/Enc/FiscalPolicy.html

As part of his 2008 State of the Union address George Bush announced a $168 billion economic stimulus package for the US economy. This involves tax rebates for tax payers and tax breaks for businesses. The aim of this is to encourage spending and to help revive the US economy.



GDP Deflator: The GDP deflator can be viewed as a measure of general inflation in the domestic economy. Inflation can be described as a measure of price changes over time. The deflator is usually expressed in terms of an index, i.e. a time series of index numbers. Percentage changes on the previous year are also shown.

http://www.hm-treasury.gov.uk/Economic_Data_and_Tools/GDP_Deflators/data_gdp_index.cfm


A price deflator of 200 means that the current-year price is twice its base-year price - price inflation. A price deflator of 50 means that the current-year price is half the base year price - price deflation.

http://en.wikipedia.org/wiki/GDP_deflator

Imports: Goods and Services that are produced abroad and sold domestically.

Monetary Contraction: Monetary Contraction is a monetary policy that seeks to reduce the size of the money supply. http://en.wikipedia.org/wiki/Contractionary_monetary_policy

In the United States in 1931 during the Great Depression the Federal Reserve deliberately contracted the money supply and raised interest rates. This decline in the money supply caused by Federal Reserve decisions had a severely contractionary effect on output and contributed further to the depression.

http://www.britannica.com/eb/article-234443/Great-Depression


Nominal GDP: Value of all Fiscal goods and services produced in the economy; not adjusted for inflation. (Macroeconomics, ninth edition, Dornbusch, Fischer, Startz, 2004)

Propensity to Consume: The marginal propensity to consume (MPC) refers to the increase in personal consumer spending (consumption) that occurs with an increase in disposable income (income after taxes and transfers). http://en.wikipedia.org/wiki/Marginal_propensity_to_consume

For example, if a household earns one extra dollar of disposable income, and the marginal propensity to consume is 0.65, then of that dollar, the family will spend 65 cents and save 35 cents.


Short Run: The concept of the short-run refers to the decision-making time frame of a firm in which at least one factor of production is fixed. Costs which are fixed in the short-run have no impact on a firms decisions.

For example a firm can raise output by increasing the amount of labour through overtime.

A generic firm can make three changes in the short-run:
Increase production
Decrease production
Shut down

http://en.wikipedia.org/wiki/Short-run

Real Exchange Rate: Purchasing Power of Foreign Currency Relative to the Domestic Currency.

$ is the Domestic Currency

€ .6813 £ .5105 Yen 106.605
$ 1 $ 1 $ 1


Trade Surplus: An Excess of Exports over Imports.

What do you think will happen the steady state value of output when Ө changes? Why does this happen?

When Ө, the personal income tax rate changes the steady state value of output will also change. If there is a reduction in Ө, the steady state value of output will increase. However, if there is an increase in Ө, the steady state value of output will fall.

If the personal income tax rate falls, individuals will have more money to spend after tax depending on their marginal propensity to consume. This will result in extra money in the economy causing an increase in output. However, if the personal income tax rate increases, individuals will have less money to spend after tax causing output to fall.

There is a major problem with reducing the personal income tax rate in order to increase the steady state value of output. When income tax rates are reduced the government may have to use some of their savings to keep the public sector financed, money which will be needed if the economy enters into a recession