Macroeconomics Topic 2

What is the definition of Value Added?

Value Added is the difference between production and intermediate goods.

What are the three definitions of aggregate output?

1. Value of final goods and services produced in the economy.

2. Sum of value added (VA) in the economy.

3. Sum of incomes paid to the factors of production.

What is consumption? What is the consumption function?

• It is a function of disposable income.

• C(Y_D)

If you replace Y_D in the disposable income equation with C, what does it give you?

Y_D=Y - T

—> C=C₀ + C₁(Y - T)

What is C₁?

The marginal propensity to consume. It gives the effect an additional euro of disposable income has on consumption.

What is C₀?

This is what people would consume if their disposable income was zero.

• This parameter is still positive, money is still being spent even if disposable income is zero (people still need to eat).

How would you draw the graph for Consumption and Disposable Income?

The slope is C1.

The consumption function: C=C_{0 + C}1 Y_D.

What is the algebraic expression for equilibrium output using C₁ and C₀?

What is autonomous spending? What is the formula?

It is the part of demand that does not depend on output.

Autonomous spending is positive, this is due to:

• C₀ and I are positive.

• T=G (balanced budget)

• C₁ is positive but less than 1

• This leads to (G-C₁T) being positive.

What is the formula for the multiplier?

1/(1-C₁)

• C₁ is between 0 and 1, meaning that the multiplier is a number greater than 1.

• The closer C₁ is to 1, the larger the multiplier.

How much will output increase if C₁ = 0.6 and there is an increase of consumption by 1 million?

1/(1-0.6) = 2.5

2.5 × 1,000,000 = 2,500,000

What does the multiplier actually result in?

Any change in autonomous spending, from a change in investment, to a change in government spending, to a change in taxes - will have the same qualitative effect.

It will change output by more than its direct effect on autonomous spending.

How is equilibrium output determined?

It is determined by the condition that production is equal to demand.

What happens graphically if C₀ increases by £1 billion.

The ZZ line (demand) shifts up to ZZ’, there is a new equilibrium of A’. The 45 degree line remains the same.

What are the stages if C₀ increases by £1 billion?

1. First round increase in demand / First round increase in production.

2. First round increase in income.

3. Second-round increase in demand, due to the multiplier. This increase equals (£1 billion multiplied by C₁)

4. Third round increase in demand, again, due to the multiplier. This then compounds.

How can you work out the increase in production after an increase in C₀?

The total increase in production after n+1 rounds is equal to $1 billion multiplied by the sum:

1+ C₁+C₁²+ C₁ⁿ

What is the relationship between production, demand and income?

Production depends on demand, which depends on income, which is itself equal to production.

What does an increase in demand lead to?

An increase in demand leads to an increase in production and income, which in turn leads to a future increase in demand.

How can you describe the increase in output if C₀?

The increase in output is larger than the initial shift in demand, by a factor equal to the multiplier.

How long does it take for output to increase by an amount equal to the multiplier if C₀ increases by £1 billion?

Instantaneous adjustment isn’t really plausible. How long the adjustment takes depends on how fast consumers respond to changes in income and how fast firms respond to changes in sales.

The adjustment of output over time is called the dynamics of adjustment.

What is an alternative way of thinking about equilibrium? What are the formulas?

An alternative way of thinking about equilibrium focuses on investment and saving.

• Private saving (S): S = Y_D - C = Y - T - C

• Public saving: T - G

What is the equation for the IS relation? What does it stand for?

I = S + (T - G)

Investment equals saving.

What are the two equivalent ways of stating the condition for equilibrium in the goods market?

1. Production = Demand

2. Investment = Saving