ECO 120- Macroeconomics by jizhen1947


									ECO 120- Macroeconomics
         Weekend School #1
           21st April 2007

        Lecturer: Rod Duncan
  Previous version of notes: PK Basu
       Topics for discussion
• Module 1- macroeconomic variables
• Module 2- basic macroeconomic models
• Module 3- savings and investment

• What will not be discussed
  – Answers to Assignment #1 (use the CSU
    forum for this)
         Forms of economics
• Microeconomics- the         • Macroeconomics- the
  study of individual           study of the behaviour
  decision-making               of large-scale
  – “Should I go to college     economic variables
    or find a job?”             – “What determines
  – “Should I rob this            output in an
    bank?”                        economy?”
  – “Why are there so           – “What happens when
    many brands of                the interest rate
    margarine?”                   rises?”
    Economics as story-telling
• In a story, we have X happens, then Y
  happens, then Z happens.
• In an economic story or model, we have X
  happens which causes Y to happen which
  causes Z to happen.
• There is still a sequence and a flow of
  events, but the causation is stricter in the
  economic story-telling.
Kobe, the naughty dog
           Modelling Kobe
• Kobe likes to unmake the bed.
• Kobe likes treats.
• We assume that more treats will lead to
  fewer unmade beds.
      (Not a very good) Model:
           Treats↑ → Unmaking the bed↓
• We can use this model to explain the past
  or to predict the future.
      Elements of a good story
•   All stories have three parts
    1. Beginning- description of how things are
       initially- the initial equilibrium.
    2. Middle- we have a shock to the system, and
       we have some process to get us to a new
    3. End- description of how things are at the
       new final equilibrium- the story stops.
•   “Equilibrium”- a system at rest.
     Timeframes in economics
• In economics we also talk in terms of three
  – “short run”- the period just after a shock has occurred
    where a temporary equilibrium holds.
  – “medium run”- the period during which some process
    is pushing the economy to a new long run equilibrium.
  – “long run”- the economy is now in a permanent
    equilibrium and stays there until a new shock occurs.
• You have to have a solid understanding of the
  equilibrium and the dynamic process of a model.
   What are the big questions?
• What drives people to study macroeconomics?
  They want solutions to problems such as:
  –   Can we avoid fluctuations in the economy?
  –   Why do we have inflation?
  –   Can we lower the unemployment rate?
  –   How can we manage interest rates?
  –   Is the foreign trade deficit a problem?
  –   [How can we make the economy grow faster?] Not
      taken up in this class. This class focuses on short-run
           Economic output
• Gross domestic product- The total market
  value of all final goods and services
  produced in a period (usually the year).
  – “Market value”- so we use the prices in
    markets to value things
  – “Final”- we only value goods in their final form
    (so we don‟t count sales of milk to cheese-
  – “Goods and services”- both count as output
           Measuring GDP

• Are we 40 times (655/16) better off than
  our grandparents?

  – Australian GDP in 1960- $15.6 billion
  – Australian GDP in 2000- $655.6 billion

• What are we forgetting to adjust for?
           Measuring GDP
• Population- Australia‟s population was 10
  million in 1960 and 19 million in 2000.
  – GDP per person in 1960 = $15.6 bn / 10m
                           = $1,560
  – GDP per person in 2000 = $655.6 bn / 19m
                           = $34,500
• Prices- $1,000 in 1960 bought a better life-
  style than $1,000 in 2000.
     Nominal versus real GDP
• So how to correct for rising prices over
  – Measure average prices over time (GDP
    deflator, Consumer Price Index, Producer
    Price Index, etc)
  – Deflate nominal GDP by the average level of
    prices to find real GDP

    Real GDP = Nominal GDP / GDP Deflator
    Nominal versus real GDP
• We use prices to value output in
  calculating GDP, but prices change all the
  time. And over time, the average level of
  prices generally has risen (inflation).
  – Nominal GDP: value of output at current
  – Real GDP: value of output at some fixed set
    of prices
Some Australian economic history
             Business cycle
• The economy goes through fluctuations over
  time. This movement over time is called the
  “business cycle”.
  – Recession: The time over which the economy is
    shrinking or growing slower than trend
  – Recovery: The time over which the economy is
    growing more quickly than trend
  – Peak: A temporary maximum in economic activity
  – Trough: A temporary minimum in economic activity.
Australian business cycle
• To be officially counted as “unemployed”,
  you must:
  – Not currently have a job; and
  – Be actively looking for a job
• “Labour force”- the number of people
  employed plus those unemployed
• “Unemployment rate”
  – (Number of unemployed)/(Labour force)
• Working age
  population = Labour
  force + Not in labour
• Labour force =
  Employed +
• Inflation is the rate of growth of the
  average price level over time.
• But how do we arrive at an “average price
  – The Consumer Price Index surveys
    consumers and derives an average level of
    prices based on the importance of goods for
    consumers, ie. a change in the price of
    housing matters a lot, but a change in the
    price of Tim Tams does not.
       Consumer Price Index
• Then the CPI expresses average prices
  each year relative to a reference year,
  which is a CPI of 100.
  CPIt = (Average prices in year t)/(Average
   prices in reference year) x 100
• Inflation can then be measured as the
  growth in CPI from the year before:
  – Inflationt = (CPIt – CPIt-1) / CPIt-1
            Calculating GDP
• Gross domestic product- The total market value
  of all final goods and services produced in a
  period (usually the year).
• Alternates methods of calculating GDP
  – Income approach: add up the incomes of all members
    of the economy
  – Value-added approach: add up the value added to
    goods at each stage of production
  – Expenditure approach: add up the total spent by all
    members of the economy
• The expenditure approach forms the basis of the
  AD-AS model.
      Expenditure approach
• GDP is calculated as the sum of:
  – Consumption expenditure by households (C)
  – Investment expenditures by businesses (I)
  – Government purchases of goods and services
  – Net spending on exports (Exports – Imports)
  Aggregate Expenditure: AE = C + I + G + NX
    Consumption and savings
• We assume consumption (C) depends on
  household‟s disposable income:
  – Disposable income YD = (Income – Taxes)
• The consumption function shows how C
  changes as YD changes.
• Household savings (S) is the remainder of
  disposable income after consumption.
• The savings function shows how S
  changes as YD changes.
     Properties of a consumption
• What assumptions are we going to make about
  aggregate consumption of goods and services in
  an economy?
  – An aggregate consumption function is simply adding
    up all consumption functions of all individuals in
  – If personal income is 0, people consume a positive
    amount, through using up savings, borrowing from
    others, etc, so C(0) should be greater than 0.
  – As personal income rises, people spend more, so the
    slope of C(Y) should be positive.
       Consumption function
• Consumption is a function of YD or C =
  C(YD). We assume that this relationship
  takes a linear (straight-line) form
                 C = a + b YD
  where a is C when YD is zero and b is the
  proportion of each new dollar of YD that is
• We assume that C is increasing in YD, so
  0 < b < 1.
  A linear consumption function
• C(Y) = a + b Y, a > 0 and b > 0


 C(0) = a, so
 even if
 Y=0, C > 0.
                a          Slope is b > 0,
                           so C is
                           increasing in Y.

   Graphing a function in Excel
• This subject use a lot of “quantitative data”
  (which means lists of numbers measuring
• Students will need to develop their quantitative
  – Graphing data
  – Using data to support an argument
  – Modelling in Excel
• We will be using Excel during this subject. You
  must become familiar with Excel.
            Savings function
• Household savings is a function of YD or S =
  S(YD). We assume
                     S = c + d YD
  where c is S when YD is zero and d is the
  proportion of each new dollar of YD that is saved.
• We assume that S is increasing in YD, so 0 < d <
• But also households must either consume or
  save their income, so C + S = YD. This can only
  be true if c = -a and b +d = 1.
            More terms
• Average Propensity to Consume (APC)
  is consumption as a fraction of YD:
                 APC = C / YD
• Average Propensity to Save (APS) is
  savings as a fraction of YD:
                 APS = S / YD
• Since all disposable income is either
  consumed or saved, we have:
                APC + APS = 1
              More terms
• Marginal Propensity to Consume (MPC) is the
  change in consumption as YD changes:
      MPC = (Change in C) / (Change in YD)
• Marginal Propensity to Save (APS) is the
  change in savings as YD changes:
      MPS = (Change in S) / (Change in YD)
• For our linear consumption and savings
  functions, MPC = b and MPS = d. If YD
  changes, then consumption and savings must
  change to use up all the change in YD , so
                  MPC + MPS = 1.
        Graphing the functions
• When YD = 0, C + S = 0,
  so at point A, the
  intercept terms are both
  just below 2 and of
  opposite sign.
• The 45 degree line in the
  top graph shows the level
  of YD. At point D, C is
  equal to YD, so S = 0.
• MPC = 0.75 is the slope
  of the C function.
• MPS = 0.25 is the slope
  of the S function.
    What else determines C?
• Household consumption will also depend
  – Household wealth
  – Average price level of goods and services
  – Expectations about the future
• Changes in these factors will produce a
  shift of the whole C and S functions.
    Shifts of C and S functions
• A rise in household
  wealth will increase C
  for every level of YD,
  so C shifts up.
• A rise in average
  prices will lower the
  real wealth of
  households and so
  lower C for every
  level of YD, so C shifts
     Example: Alice and Sam
• Question: Alice and Sam are a typical
  two-income couple who live for ballroom
  dancing. Their combined salaries come to
  $1,400 per week after tax. They spend:
    •   $300 per week on rent,
    •   $300 per week on car payments,
    •   $200 per week on ballroom dancing functions and
    •   $200 per week on everything else.
• (a) Calculate their APC, APS, MPC and
      Example: Alice and Sam
• Sam injures his back and is forced to take a
  lighter work-load, so their combined incomes
  drop to $1,000 per week. Due to the back injury,
  Alice and Sam are forced to stop their ballroom
  dancing, however their spending in the
  „everything else‟ category rises to $300.
• (b) Calculate their APC, APS, MPC and MPS.
  Create graphs to show this information.
          Consumption function
•    The consumption function relates the level of
     private household consumption of goods and
     services (C) to the level of aggregate income
•    We can represent the consumption function in
     three different and equivalent ways.
    1. An mathematical equation
    2. A graph
    3. A table
•    For example the consumption function could
    –   C = $100bn + 0.5Y
          Consumption function
• We can represent this same function with
  a graph.

                                      C(Y) = $100bn + 0.5Y


   $100bn                 Slope is 0.5
                         The MPC is 0.5

                $100bn               Y
         Consumption function
• Or we can       Y       C(Y) = 100 + 0.5Y    C
  the same            0        100 + 0.5 (0)   100
  function with
                  100        100 + 0.5 (100)   150
  a table.
• Three ways      200        100 + 0.5 (200)   200
  of              300        100 + 0.5 (300)   250
  ing the         400        100 + 0.5 (400)   300
                  500        100 + 0.5 (500)   350
        Exogenous variables
• Exogenous variables are variables in a
  model that are determined “outside” the
  model itself, so they appear as constants.
• For the aggregate expenditure model, we
  treat as exogenous:
  – Investment (I)
  – Government consumption (G)
  – Taxes (T)
  – Net Exports (NX)
      Aggregate expenditure
• In a closed (no foreign trade) economy:
               AE = C(Y) + I + G
• In an open economy:
            AE = C(Y) + I + G + NX
• Changes in a or the exogenous variables
  (I, G, T or NX) will shift the AE curve. A
  change in b will tilt the AE curve.
• Equilibrium occurs when goods supply, Y,
  is equal to goods demand, AE.
            Two sector model
• Aggregate expenditure (AE) in the two sector
  model is composed of consumption (C) and
  investment (I).
   AE = C + I
• In this model, we treat I as exogenous, so it is a
• Let‟s use the same simple linear consumption
   C = 100 + 0.5Y
   I = 100
   AE = C + I = 100 + 0.5Y + 100 = 200 + 0.5Y
Aggregate expenditure function
• This equation is a relationship between
  income (Y) and aggregate expenditure
  (AE).                           AE = 200 + 0.5Y


   $200bn                   Slope is 0.5

                   $100bn                  Y
 Aggregate expenditure function
• But we      Y     C     I     AE
  could         0   100   100    200
  also use    100   150   100    250
  the table
  form.       200   200   100    300
              300   250   100    350
              400   300   100    400
              500   350   100    450
 Equilibrium in two sector model
• Equilibrium in a model is a situation of “balance”.
  In our AE model, equilibrium requires that
  demand for goods (AE) is equal to supply of
  goods (Y).
   Y = AE = C + I
• For the equilibrium we are looking for the value
  of GDP, Y*, such that goods demand and goods
  supply are equal.
• In our two sector AE model that means that we
  can look up our AE table and find where AE = Y.
• The equilibrium value of Y will be our prediction
  of GDP for our AE model.
• The             Y       C     I     AE
                      0   100   100   200
  value of
  GDP is          100     150   100   250
                  200     200   100   300
                  300     250   100   350
                  400*    300   100   400*
                  500     350   100   450
• We could accomplish the same by using
  our graph of the AE function.
  – The AE line shows us the level of goods
    demand for each value of Y.
  – The 45 degree line represents the value of Y
    or supply of goods.
  – Equilibrium will occur when the 45 degree line
    and the AE line cross. At the crossing, goods
    demand is equal to goods supply for that level
    of Y.
                                 • The equilibrium
                  Y                value of Y is
                                   where the 45
               AE = 200 + 0.5Y
                                   degree line and
                                   the AE line
400                                cross. Y* is at

      400         Y
• Finally, if you are comfortable with the
  mathematics, you can solve for the
  equilibrium value of Y using the equations:
  Y* = AE = 200 + 0.5Y*
  Y* – 0.5Y* = 200
  0.5Y* = 200
  Y* = 400
• You arrive at the same answer no matter
  which way you use to derive it.
    Autonomous expenditure
• In our model we have two part of
  aggregate expenditure:
  AE = $200bn + 0.5Y
  – One part does not depend on the value of Y-
    the $200bn. This portion is called
    “autonomous expenditure”.
  – The other part does depend on the value of Y-
    the 0.5Y.
• In our model part of autonomous
  expenditure is C and part is I.
    Scenario: Investment falls
• What happens if I    Y       C     I   AE
  drops from 100           0   100   50 150
  to 50 perhaps
  because of          100      150   50 200
  uncertainty due
                      200      200   50 250
  to terrorism
  scares?             300*     250   50 300*
• Equilibrium GDP     400      300   50 350
  drops to 300.
                      500      350   50 400
• But you could also find the same answer
  with some algebra:
  AE = C + I = 100 + 0.5Y + 50 = 150 + 0.5Y
  Y* = AE = 150 + 0.5Y*
  Y* – 0.5Y* = 150
  0.5Y* = 150
  Y* = 300
• Find the answer in the way you feel most
• So a $50bn drop in investment (or
  autonomous expenditure) leads to a
  $100bn drop in equilibrium GDP.
• The ratio of the change in GDP over the
  change in autonomous expenditure is
  called the multiplier:
  Multiplier = (Change in GDP)/(Change in I)
         Expenditure multiplier
• Imagine the government
  wishes to affect the
  economy. One tool
  available is government
  consumption, G, or
  government taxes, T.
  This is called “fiscal
• Any change in G (∆G) in
  our AE model will
• If mpc=0.75, then the
  multiplier is (1/0.25) or 4,
  so $1 of new G will
  produce $4 of new Y.
• Our multiplier is equal to
• Since 0<MPC<1, our
  multiplier will be greater
  than 1.
• The larger is the MPC,
  the larger is our multiplier.
       Three sector AE model
• Now we make our model slightly more
  complicated by bringing in the government. The
  government has two effects on our model:
  – The government raises tax revenues (T) by taxing
    household incomes.
  – The government purchases some goods and services
    for government consumption (G).
• We treat the levels of T and G as exogenous to
  our AE model. Government policy determines
  what T and G will be, and policy is not affected
  by the equilibrium level of GDP.
          Three sector model
• Household consumption depended on
  household income, Y, in our two sector model.
• In the three sector model, the income that
  households have available to spend or save is
  now income net of taxes, Y – T. We call this
  amount “disposable income”, YD.
• The consumption function will now depend on
  disposable income, not income.
  C = C(Y – T) = C(YD)
          Three sector model
• Our new aggregate expenditure function
  includes government purchases of goods and
  services, so we have:
  AE = C + I + G
• Let‟s assume we have the same linear
  consumption function as before, but now in
  disposable income:
  C = 100 + 0.5 (Y – T)
• Let T = G = 50 and let I = 100. We can follow
  the same steps as before to find our AE function
  and then to find equilibrium GDP.
Aggregate expenditure function
• Our AE function is:
  AE = C(Y – T) + I + G
  AE = 100 + 0.5(Y – 50) + 100 + 50
  AE = 100 + 0.5Y – 25 + 100 + 50
  AE = 225 + 0.5Y
• We can also represent this as a table. Our
  C function with disposable income is:
  C = 100 + 0.5(Y-50) = 75 + 0.5Y
              Table form
Y     C = 75 +    I         G        AE
    0        75       100       50        225
100        125        100       50        275
200        175        100       50        325
300        225        100       50        375
400        275        100       50        425
500        325        100       50        475
• If we want to find equilibrium GDP in our three
  sector model, we need to find the level of GDP,
  Y*, for which goods demand (AE) is equal to
  goods supply (Y).
• If we look at our table, we see that for an income
  level of Y of 400, AE is 425 which exceeds Y. At
  an income level of Y of 500, AE is 475 which is
  less than Y.
• We would guess that the equilibrium value of Y
  lies between 400 and 500.
• We construct a new table of values of Y between
  400 and 500.
Y   C = 75 +   I         G        AE
400      275       100       50        425
425    287.5       100       50    437.5
450*    300        100       50    450*
475    312.5       100       50    462.5
500     325        100       50        475
• The equilibrium value of Y is 450.
• We could find the answer with our
  AE = 225 + 0.5Y
  Y* = AE = 225 + 0.5Y*
  Y* - 0.5Y* = 225
  0.5Y* = 225
  Y* = 450
    Scenario: Investment falls
• What happens if we have the same drop in
  investment in the three sector model? So I drops
  from 100 to 50?
• Using our equations:
  AE = 100 + 0.5(Y - T) + I + G
  AE = 75 + 0.5Y + 50 + 50
  AE = 175 + 0.5Y
• Solving for Y*, we get:
  Y* = AE = 175 + 0.5Y*
  Y* = 350
• Our multiplier = 100/50 = 2 as before.
    Deriving aggregate demand
• How do average prices affect demand for goods and
   – Real balances effect: higher prices means our assets have less
     value so people are poorer and consume less.
   – Interest-rate effect: higher prices drive up the demand for
     money and so drive up interest rates, at higher interest rates,
     investment falls (see later)
   – Foreign-purchases exports: at higher Australian prices, foreign
     goods are cheaper, so net exports falls (see later)
• As the average price level rises, demand for goods and
  services should fall, with all else held constant.
                  Deriving AD
• So as P↑, we expect:
   – C↓ (real balances)
   – I↓ (interest rate)
   – NX↓ (foreign-
• So as P↑, we expect:
   AE = C↓ + I↓ + G + NX↓
• The AE curve shifts
• Equilibrium Y* falls.
          Aggregate demand
• We would like to have
  a relationship
  between the demand
  for goods and
  services and the price
  level. We call this the   P0
  “aggregate demand”
  (AD) curve.               P1
• The AD curve is
  downward-sloping in            Y0   Y1        Y
  aggregate price.
         Shifts of the AD curve
• Factors that affect the AE curve will affect the
  AD curve. For example, if household wealth
  rose, then C would increase for all levels of
  disposable income. Demand would be higher
  for all levels of prices, so the AD curve shifts to
  the right.
   – C: household wealth, household expectations about
     the future
   – I: interest rates, business expectation about the
     future, technology
   – G and T: changes in fiscal policy
   – NX: the currency exchange rate, change in output in
     foreign countries
         AD and the multiplier
• A change in I will shift
  the AE curve up. This
  will produce a shift to
  the right of the AD
• The shift in the AD
  curve will be the
  change in I times the
           Aggregate supply
• The aggregate demand curve showed the
  relationship between goods demand and the
  average level of prices.
• The aggregate supply (AS) curve shows the
  relationship between goods supply and the
  average level of prices.
• By goods supply, we are thinking about all of the
  goods and services provided by all the
  producers in the economy.
• How does the aggregate price level affect the
  aggregate level of goods and services supply?
        Deriving the AS curve
• We will differentiate between goods supply in the
  short-run (SR) and in the long-run (LR).
• The crucial difference between the two time
  periods is that we will assume that nominal
  wages for employees are fixed in the SR.
  Workers’ money wages do not change in the
  SR. But workers’ wages are free to move in
  the LR.
• So we will have two different AS curves- the
  SR AS and the LR AS curves.
        Fixed nominal wages
• How can we defend the assumption that wages
  are fixed in the SR?
  – All wages in a modern economy are set either via
    contracts between employers and employees or via a
    labour agreement between unions and employers.
  – These contracts specify well in advance (a few
    months to several years) what the wages of a worker
    will be in nominal terms.
  – These contracts are usually very difficult to change.
    Supply of an individual firm
• So what effect will this assumption of fixed
  wages have? To think about this, we will think
  about the supply of a small firm in our economy.
• Intuition: If the output price for a firm rises, but
  the cost of labour stays the same, a firm will
  want to increase profits by producing more
  output. But if the output price and the cost of
  labour both rise by the same amount, a firm will
  not increase output.
     Deriving the SR AS curve
• In the short-run (“SR”), since wages are
  fixed, a rise in P will have no affect on W,
  so individual firms will find it profitable to
  increase output.
• As all firms are raising output, aggregate
  supply will increase in the SR if aggregate
  prices rise.
• So the SR AS curve is upward-sloping in
  aggregate prices.
     Deriving the LR AS curve
• We assume that workers are interested in their
  real wages (wages relative to prices W/P).
• If P rises, workers will demand a compensating
  W rise, so as to keep real wages the same as
• In the LR, real wages are unchanged by
  changes in P, so output is not affected by
  changes in P.
• The LR AS curve is vertical at the “natural rate of
                  The LR AS curve
                              • The LR AS curve is
P          LR AS
                                vertical, so long-run Y
    High            Low         does not depend on
    U/E             U/E         prices.
                              • The long-run Y is
                                determined by:
                                 –   Labour skills
                                 –   Capital efficiency
            YLR           Y
                                 –   Technology
                                 –   Labour market rules
                                 –   And others…
    Review: Aggregate supply
• There will be a short-run AS curve which is
  upward-sloping in prices.
• The SR AS (or usually just “AS”) is
  used to model scenarios.
• The long-run AS curve is vertical at the
  level of potential output, since wages will
  change proportionately to price changes.
• The LR AS is used (mostly) to talk
  about unemployment.
                     • Equilibrium occurs at
                       a price level where
                       goods demand (AD)
                       is equal to goods
P0                     supply (SR AS).


     Y0          Y
          LR AS
                              • The gap between the
                                “natural rate of
                                output” and current
                                output is called the
P0                              “recessionary gap”.
                  Unemployment• The level of

                                depends on the size
     Y0    YLR            Y
                                of this gap.
Shift in AD (C↑ or G↑ or T↓ or I↑ or
                 Shift in AD
• We start with an economy of $10tr and a price
  level of 110.
• A change in autonomous expenditure causes
  the AE curve to shift from AE0 to AE1. We move
  to a new AD curve at AD1.
• At the old price level of 110, AD > AS by $2tr, so
  prices rise, pushing AD down and AS up until we
  reach out new equilibrium.
• Our new equilibrium will have higher P and Y
  than when we started.
Shift in AD
     Shift in AS (rise in oil prices)
                           • A rise in oil prices
                             raises the cost of
                   AS0       production for all
P1                           producers and shifts
P0                           the SR AS curve
                             up/to the left.
                           • At the old prices, AD
                             > AS, so prices rise
       Y1   Y0         Y
                             and output falls.
             Business cycle
• Over the business cycle, we will have periods of
  high output (booms) and periods of low output
• In booms, output is high and unemployment is
  low, while in recessions, output is low and
  unemployment is high.
• The “natural rate of unemployment” is the level
  of unemployment in a “normal” period of the
  economy. This is achieved when output is at
  full-employment or the LR AS level.
     A “Boom” in the Economy
     LR AS
                         • An economy in a
                           boom is an economy
                           with an output level
                           higher than the
P0                         natural rate of output.
                         • Unemployment is
                           below the natural rate
                           in a boom.
     YLR   Y0        Y
            A “Recession”
          LR AS
                           • An economy in a
                             recession is an
                             economy with an
                             output level below the
P0                           natural rate of output.
                           • Unemployment is
                             above the natural rate
                             in a recession.
     Y0    YLR         Y
      Sample AD-AS question
• The small country of Speckonamap is in long-
  run equilibrium with its aggregate demand (AD)
  and short-run aggregate supply (AS) curves
  intersecting on the long-run aggregate supply
  curve (ASLR). The dot-com bubble in
  Speckonmap’s industry bursts. Business
  investment drops.
• a. Explain the short- and long-term
  consequences of this bursting bubble using the
  AD-AS diagram. Be as clear and complete as
  you can.
     Sample AD-AS question
• b. What policies could the government of
  Speckonamap pursue to counter the
  collapse of business investment? Think of
  two different ways that the government
  could shift the AD-AS curves.
• Investment can refer to the purchase of new
  goods that are used for future production.
  Investment can come in the form of machines,
  buildings, roads or bridges. This is called
  “physical capital”.
• Another type of investment is called “human
  capital”. This is investment in education,
  training and job skills.
• Usually when we talk about investment, we
  mean investment in physical capital, but
  investment should include all forms of capital.
   Investment decision-making
• How to determine profitability of investment?
• Example: An investment involves the current
  cost of investment (I). The investment will pay
  off with some flow of expected future profits.
  The future stream of profits is R1 in one year‟s
  time, R2 in two year‟s time, … up to Rn at the nth
  year when the investment ends.
• Net Present Value (NPV) = Present Value of
  Future Profits (PV) – Investment (I)
   Investment decision-making
• What determines investment?
  – Businesses or individuals make an investment if they
    expect the investment to be profitable.
• Imagine we have a small business owner who is
  faced with an investment decision.
• The small business owner will make the
  investment as long as the investment is
• How to determine profitability of investment?
   Profitability of an investment
• Example:
   – An investment involves the current cost of investment (I).
   – The investment will pay off with some flow of expected future
   – The future stream of profits is R1 in one year‟s time, R2 in two
     year‟s time, … up to Rn at the nth year when the investment
• Imagine you are the business owner. How do we decide
  whether to make the investment? Can we simply add up
  the benefits (profits) and subtract the costs (investment)?

  Profits today = R1 + R2 + … + Rn – I?

• What is wrong with this calculation?
         Present value concept
• Imagine our rule about future values was simply to add
  future costs and benefits to costs and benefits today.
• Scenario: A friend offers you a deal:
   – “Give me $10 today, and I promise to give you $20 in 1 years
• If we subtract costs ($10) from benefits ($20), we get a
  positive value of $10. Does this seem like a sensible
• Scenario: A friend offers you a deal:
   – “Give me $10 today, and I promise to give you $20 in 100 years
• If we subtract costs ($10) from benefits ($20), we get a
  positive value of $10. Does this seem like a sensible
         Present value concept
• Not really. The problem is that a $1 today is not the
  same as a $1 in a year‟s time or 100 years‟ time.
• We can not directly add these $1s together since they
  are not the same things. We are adding apples and
• We need a way of translating future $1s into $1s today,
  so that we can add the benefits and costs together.
• The conversion is called “present value”.
• In making the decision about our friend‟s deal, we would
  compare $10 today to the present value of the $20 in a
  year or 100 years.
        Present value concept
• An investment is about giving up something
  today in order to get back something in the
• So an investment decision will always involve
  comparing $1s today to $1s in the future.
• Investment decisions will always involve present
  values. If we subtract the present value of future
  profits from costs today, we get net present
  Net Present Value (NPV) = Present Value of Future
   Profits (PV) – Investment (I)
          Net present value
• The investment rule will be to invest if
  and only if:

 NPV ≥ 0

• Or

  Present Value of Future Profits (PV) –
   Investment (I) ≥ 0
              Interest rates
• Interest rates are a general term for the
  percentage return on a dollar for a year:
  – that you earn from banks for saving
  – that you pay banks for borrowing or investing
• For example, the interest rate might be
  10%, so if you put $1 in the bank this year,
  it will become $(1+i) in one year‟s time.
• Or if you borrow $100 today, you will have
  to repay $(1+i)100 next year.
Interest Rates
     Discounting future values
• How do we place a value today on $1 in t years‟
• This is called “discounting” the future value.
  One way to think about this question is to ask:
  – “How much would we have to put in the bank now to
    have $1 in t years‟ time?”
  – Money in the bank earns interest at the rate at the
    rate i, i>0. If I put $1 in the bank today, it will grow to
    be $(1+ i)1 in one year‟s time, will grow to be
    $(1+i)(1+i)1 = $(1+i)2 in two years‟ time and will grow
    to $(1+i)n in n years‟ time.
                Bank account
                Year   Value          i=.10
• If we start
  with $1 in    0      $1             $1
  our bank      1      $1(1+i)        $1.10
                2      $1(1+i)(1+i)   $1.21
  happens to    3      $1(1+i)3       $1.33
  our bank      …      …              …
  account       n      $1(1+i)n       $(1.1)n
  over time?
     How much is a future $1?
• In order to have $1 next year, we would have to
  put x in today:
                    $1 = (1+ i) $x
                   $x = 1/(1+i) < 1
• $1 next year is worth 1/(1 + i) today. Since i>0,
  $1 next year is worth less than $1 today.
• In order to have $1 in n years‟ time, we would
  have to put x in today:
                x = 1/(1+i)n = (1+i)-n
• $1 in n years‟ time is worth 1/(1+i)n < 1 today.
                  PV of $1
Year   i=0.01      i=0.05     i=0.10     i=0.20
0      1           1          1          1
1      0.99        0.95       0.91       0.83
2      0.98        0.91       0.83       0.69
3      0.97        0.86       0.75       0.58
10     0.91        0.61       0.39       0.16
n      (1.01)-n    (1.05)-n   (1.10)-n   (1.20)-n
            Net present value
• NPV = R1/(1+i) + R2/(1+ i)2 + … + Rn/(1+ i)n – I
• If NPV >=0, then go ahead and make the
  investment. If NPV < 0, then the investment is
  not worthwhile.
• As i rises, the PV of future profits will drop, so
  the NPV will fall. If we imagine that there are
  thousands of potential investments to be made,
  as i rises, fewer of these potential investments
  will be profitable, and so investment will fall.
• We expect then that I falls as i rises.
         Investment decision
• Imagine we are the small business owner
  we were discussing before. We have a
  new project which we might invest in:
  – An investment involves the current cost of
    investment (I).
  – The investment will pay off with some flow of
    expected future profits.
  – The future stream of profits is R1 in one year‟s
    time, R2 in two year‟s time, … up to Rn at the
    nth year when the investment ends.
        Investment decision
Year   Benefit   Cost   PV
0      0         I      -I
1      R1        0      R1/(1+i)
2      R2        0      R2/(1+i)2
3      R3        0      R3/(1+i)3
…      …         …      …
n      Rn        0      Rn/(1+i)n
           Net present value
• The NPV of the investment is the sum of
  the values in the far-right column- the PVs.
  NPV = R1/(1+i) + R2/(1+ i)2 + … + Rn/(1+ i)n – I
• If NPV ≥ 0, then go ahead and make the
  investment. If NPV < 0, then the
  investment is not worthwhile.
• Let‟s look at a more concrete example that
  we can put some numbers to.
           Example of NPV
• Example: A small business in Bathurst
  that owns photo store is considering
  installing a state-of-the-art developing
  machine for digital photographs.
  – Cost = $12,000 (after selling current machine)
  – Future benefits = $2,000 per year in extra
    business every year for 10 year life-span of
    machine (assume benefits start next year)
           Example of NPV
Year   Benefit   Cost   PV

0      0         I      -$12,000
1      $2,000    0      $2,000/(1+i)
2      $2,000    0      $2,000/(1+i)2
3      $2,000    0      $2,000/(1+i)3

…      …         …      …

10     $2,000    0      $2,000/(1+i)10
            Example of NPV
• NPV = -$12,000 + $2,000/(1+i) + $2,000/(1+i)2 +
  $2,000/(1+i)3 + … + $2,000/(1+i)10
• Our NPV then depends upon the interest rate, i,
  facing the small business.
• For a small business, the relevant interest rate
  would be the rate that it cost raise the money,
  say by taking out a bank loan.
• So the interest rate would be the bank small
  business loan rate.
            Example of NPV
• The NPV varies with the interest rate:
  – At i=0.05, NPV = $3,443, so go ahead with
  – At i=0.08, NPV = $1,420, so go ahead with
  – At i=0.10, NPV = $289, so go ahead with investment.
  – At i=0.12, NPV = -$700, so don‟t go ahead with the
• Somewhere between a 10% and a 12% interest
  rate, NPV = 0. NPV < 0 for all interest rates
  greater than 12%.
          Example of NPV
• Another way of thinking about this problem
  is to ask “Can I repay the loan and still
  make money?”
• The small business owner borrows
  $12,000 from the bank and uses the
  $2,000 in extra business each year to
  repay the loan.
• Would the business owner repay the loan
  before the machine needs to be replaced?
  Example of NPV- bank loan
      Year         0.05       0.08        0.1       0.12
          0     -12000     -12000     -12000     -12000
          1     -10600     -10960     -11200     -11440
          2      -9130     -9836.8    -10320    -10812.8
          3     -7586.5   -8623.74     -9352    -10110.3
          4    -5965.83   -7313.64    -8287.2   -9323.58
          5    -4264.12   -5898.74   -7115.92   -8442.41
          6    -2477.32   -4370.63   -5827.51   -7455.49
          7     -601.19   -2720.28   -4410.26   -6350.15
          8    1368.75     -937.91   -2851.29   -5112.17
          9    3437.19     987.06    -1136.42   -3725.63
          10   5609.05    3066.03     749.94    -2172.71
Value          3443.47    1420.16     289.13     -699.55
  Example of a NPV- bank loan
• So for interest rates of 10% and below, the bank
  loan is repaid before the machine wears out, so
  the investment is worthwhile.
• For interest rates of 12% and above, the bank
  loan is not repaid by the time the machine needs
  to be replaced, so the investment is not
• The bottom line shows that the remainder in the
  bank account at the end of 10 years is the NPV
  of the investment decision.
• So another way to think of NPV is as the money
  left in an account at the end of a project.
          Investment demand
• Instead of thinking about a single small
  business, think of a whole economy of
  businesses and individuals making investment
• Some of these investment decisions will be very
  good ones and some will be very poor ones.
  There is a whole range.
• As i rises, the PV of future profits will drop, so
  the NPV will fall. If we imagine that there are
  thousands of potential investments to be made,
  as i rises, fewer of these potential investments
  will be profitable, and so investment will fall.
          Investment demand
• If we graphed the investment demand for goods
  and services (I) against interest rates, it would
  be downward-sloping in i. The higher is i, the
  lower is investment demand.
• What can shift the I curve? Factors that affect
  current and expected future profitability of
  – New technology
  – Business expectations
  – Business taxes and regulation
   Shifts in investment demand
• Example: An increase in business
  confidence/expectations raises the
  expected future profits for businesses.
• At the same interest rates as before, since
  the Rs are higher, the NPVs of all
  investment projects will be higher.
• The investment demand curve is shifted to
  the right. I is higher for all interest rates.
         Uses of PV concept
• Housing valuation: We can use the PV
  concept to estimate what house prices should
• What do you have when you own a home? You
  have the future housing services of that home
  plus the right to sell the home.
• Value of housing services should be the price
  people pay to rent an equivalent home. Rent is
  the price of a week of housing services.
• Let‟s say your home rents for $250 per week.
         Housing valuation
• If you stayed in your home for 50+ years,
  your house is worth the PV of 50 years of
  52 weekly $250 payments plus any sale
  value at 50 years. How do we calculate
  the PV of such a long stream of numbers?
• Trick: For very long streams, the sum:
• PV = ($250 x 52) + ($250 x 52)/(1+i) + …
• Is very close to:
• PV = ($250 x 52) / i = $13,000 / i
             Housing valuation
• So we get the house values:
  –   At i=0.02, PV House = $650,000
  –   At i=0.03, PV House = $433,000
  –   At i=0.05, PV House = $260,000
  –   At i=0.06, PV House = $217,000
  –   At i=0.07, PV House = $186,000
• At a house price above this price, you are better
  off selling your house and renting for 50 years.
  At a house price below this price, you are better
  off owning a house.
            Housing valuation
• You can also see how sensitive house prices are
  to the interest rate. When i rose from 6% to 7%,
  the value of the house dropped $31,000.
• You can see why home owners care so much
  about the home loans rates.
• But what about the resale price at 50 years?
  – The PV of the house sale in 50 years time is (Sale
    Price) / (1+i)50, which for most values of i is going to
    be a very small number- 8% of Sale Price at 5%
    interest and 3% of Sale Price at 7% interest.
       Housing price bubbles
• Sometimes the price of housing can vary from
  this PV of housing services price. Some
  analysts argue that today‟s housing prices is one
  case- these periods are called “bubbles”.
• Example: At 6% interest rates our house was
  worth $217,000. Let‟s say Sam bought the
  house for $300,000 in order to sell the house
  one year from now.
• In order to be able to repay the $300,000, Sam
  has to gain $18,000 (6% of $300,000) by holding
  the house for a year.
        Housing price bubbles
• Since Sam gets $13,000 worth of housing
  services from the house, the value of the house
  has to rise $5,000 to $305,000 in next year‟s
  sale for a total gain of $18,000.
• Even though the house is unchanged, the
  “overpayment” for the house has to rise- the
  house is still only worth $217,000 in housing
  services- but it now sells for $305,000.
• So in a “bubble”, if people are overpaying for a
  house, the overpayment has to keep rising.
  Eventually people realize that the house only
  generates $217,000 in services.
        Housing price bubbles
• Example: In Holland in 1636, the price of some
  rare and exotic tulip bulbs rose to the equivalent
  of a price of an expensive house. People paid
  that much in plans to resell at even higher
• In 1637, prices for tulips crashed and by 1639,
  tulip bulbs were selling for 1/200th of the peak
• Bubbles tend to crash fast and dramatically.
    Example: Bond Valuation
You can save money at the bank and earn a
  10% yearly return on your savings. What
  is the most you would be willing to pay for
  (include your calculations and explain
a. a promise of a $1 in one year’s time
  (assume that this promise will not be
         Example question
b. a 10 year $100 savings bond (the bond
  will pay you $100 in the year 2015, where
  2015 is known as the ‘maturity date’) and
  do a graph of the value of the 10 year
  $100 maturity in 2015 savings bond as we
  get closer to the maturity date; and
          Example question
c. a 10 year $100 savings bond that also
  pays you $5 per year for every year that
  you hold the bond (including the 10th
• There are many resources available to you.
  Often students hurt themselves by not taking
  advantage of the resources they have.
• Books: There are plenty of macroeconomics
  principles books. If you don‟t understand
  Jackson and McIver‟s coverage, get to a library
  and read a different textbook. There is also a
  study guide by Bredon and Curnow referenced
  in the subject outline.
• Online: There is an enormous amount of
  material on the Web. Just use a search engine
  and look around.
• Forum: Get into a habit of reading the CSU
  forums once a week. Post questions on the
  forum and join in the discussion.
• Official websites: Have a look at the websites for
  government agencies like the Reserve Bank of
  Australia or the Australian Bureau of Statistics.
• CSU help: Student Services at CSU has a lot of
  help it can provide students with problems- look

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