Modify Model PC

Modify the PC model we covered in lectures to allow for the simulation of a stagflation-type episode in the economy

Stagflation occurs where there is a combination of rising prices (inflation) and stagnation (slow economic growth and rising unemployment) such as what occurred to the world economy in the late 70’s and early 80’s. The main cause of this is an adverse supply-side shock (eg. Increase in oil prices, natural disaster etc.) or inappropriate macroeconomic policies (wikipedia.org).

PC Model Transactions Matrix





Equation List for Model PC (endogenous system)

Y = G + C (1)
YD = Y − T + r−1 • Bh−1 (2)
T = θ• (Y + r−1 • Bh−1) (3)
V = V−1 + (YD − C) (4)
C = α1 • YD + α 2 • V−1, 0 < α 1 < α 2 < 1 (5)
Hh/V = (1 − λ0) − λ 1 • r + λ 2 • (YD/V) (6)
Bh/V = λ0 + λ 1 • r − λ 2 • (YD/V) (7) Hh = V − Bh (8)
ΔBs = Bs − Bs−1 = (G + r−1 • Bs−1) − (T + r−1 • Bcb−1) (9)
ΔHs = Hs − Hs−1 = ΔBcb (10)
Bcb = Bs − Bh (11)
r = r* (12)

α3 = α 2 • (1 − α 1)/ α 2 (13)
ΔV = α 2 • (α 3 − V−1) (14)
V*/YD*= α 3 (15)
R*= (B*h • r/V*) (16)

Modify to allow for possibility of stagflation

Inflation is given by π = (p1 - p0/p0), where p is the price level.

The PC model assumes that AD=AS. For stagflation to occur this implies the economy is in disequilibrium, due to the causes mentioned above. In the case of an adverse supply side shock this would imply shortage of supply and excess demand ie. AD>AS. To allow for this the model must be adjusted. Consumption (C) can be increased in nominal terms to become (C.π). This can be substituted into the model instead of C. This includes inflation in the model. Increased inflation will cause a decrease in C which, with G held constant,will lead to a decrease in output/GDP. In a stagflation environment this will lead to an increase in unemployment.

Adverse Supply Side Shock



Figure 1

Figure 1 shows an example of an adverse supply side shock. The AS curve shifts up to the left which results in a fall in GNP, a rise in unemployment (U) and an increase in inflation (π). The linear increase in U and π is contrary to that expected by the Phillips Curve. (Leddin and Walsh 2003, p.31)

Assignment Week 5

Question1

Chapter 4: Overview

The section entitled, Government money and portfolio theory, essentially introduces government bills, interest payments, and a central bank (as independent entity from the government sector) to the pre-existing Model SIM. However, unlike Model SIM the transactions flow matrix includes two financial assets and there is also interest payments due on debt. Finally, in Model SIM any change in total wealth is primarily a function of money, while in Model PC this is the difference between income and consumption. As a result of these additions Model PC undoubtedly strives to portray a more realistic picture of a modern macro-economy.

At the outset, Godley and Lavoie (2007, p.99) state “Agents make a portfolio choice between money and other possible financial assets”. It is important acknowledge the significance of this statement, as it is undoubtedly the premise upon which Model PC is developed.

Model PC
The opening equation (4.1) of the model basically states that production is equal to consumption plus government expenditure. Equations (4.2) and (4.3) define disposable income and taxable income respectively.

Y = C + G (4.1)
YD = Y – T + r-1. Bh-1 (4.2)
T = Ơ . (Y + r-1 . Bh-1) (4.3)

Households must make a two step decision: 1.determine how much of their income they will save and then 2. the proportion of their wealth to allocate between money and bills (V is total wealth), in the steady state, the public sector does not make any payments of interest on debt; nevertheless, household borrowers do. This means that the quantity of cash money kept by households equals the amount provided by the central Bank.

V = V-1 + (YD – C) (4.4)

Consumption now includes total wealth (as stated previously).

C = α1 . YD + α2 . V-1 0< α2< α1<1 (4.5)

Therefore, wealth is allocated between bills and money (Portfolio Choice). However, the allocation must sum to one in order to satisfy the following formulas;

Hh/V = (1- λ0) – λ1 . r + λ2 . YD/V (4.6A)
Bh/V = λ0 + λ1 . r - λ2. YD/V (4.7)

Households will hold a certain proportion (λ0) of wealth as bills and a certain proportion (1 - λ0 ) as money. This is a fundamental of the portfolio choice. The two primary factors that influence the allocation are: Interest rates and the liquidity preference. As illustrated in tutorials, higher interest rates results in higher bill coupon payments and consequently households will allocate more of their wealth to bills than money. Alternatively, the lower the households level of disposable income, the lower the proportion of wealth that will be held in bills. In this model, the rate of interest is assumed to be constant (so bill prices remain constant), therefore is an exogenous variable, stating the equilibrium point of the supply and demand for bills, if it were not constant, symmetry in the allocation decision would be impossible.
Following on, equations (4.8) to (4.11) concern the government and central bank.

∆Bs = Bs – Bs-1 = (G + r-1 . Bs-1) – (T + r-1 . BCB-1) (4.8)
∆Hs = Hs – Hs-1 = ∆Bcb (4.9)
Bcb = Bs - Bh (4.10)
R = r (4.11)

Equation (4.8) relates to the government budget constraint. Equation (4.9) depicts the capital account of the central bank. Equation (4.10) and (4.11) illustrates that the central bank is the residual purchaser of bills, the
Hh = Hs (4.12)
Consequently, in light of the above analysis and in accordance with equation (4.12) it is possible to ascertain that the cash held by households is equal to that supplied by the central bank.

Question 2

1. How does Keynes define liquidity-preference?

He defines it as:

“ a schedule of the amounts of his resources, valued in terms of money or of wage-units, which he will wish to retain in the form of money in different sets of circumstances” (Keynes 1936)

He essentially sees it as the degree and form a householder will want to keep command over future consumption of held income (ie. not already consumed). The choice is between immediate liquid command (money or some equivalent) or deferred command for a specified or indefinite period (ie. Future market conditions will determine any future conversion to liquidity). He analysed the reasons for holding money under three motives (Leddin and Walsh, 2003 p. 144):

1. transaction: where people need money for everyday use;
2.precautionary: which is the desire to hold money in case of emergencies, and;
3.speculative: which is where the object is to earn a profit by 'knowing better than the market what the future will bring forth' (Keynes 1936).

Keynes also says the interest rate is ‘the reward you get for parting with liquidity for a specified period’ and hence helps determine liquidity preference. When this is factored in along with the quantity of money, he defines liquidity-preference (demand for money) as:

“a potentiality or functional tendency, which fixes the quantity of money which the public will hold when the rate of interest is given; so that if r is the rate of interest, M the quantity of money and L the function of liquidity-preference, we have M = L (r)”
(Keynes 1936)

References:
Keynes, J.M. (1936) The General Theory of Employment, Interest and Money,Chapter 13. London: Macmillan.

Leddin, A. J. and Walsh, B. M. (2003) The Macroeconomy of the Eurozone: An Irish Perspective, chapter 8. Dublin: Gill & Macmillan.

2. Is PC a faithful representation of Keynes’ original vision of household decision-making? If so, why? If not, why?

Yes as the allocation decision process is based on Keynes’ liquidity-preference theory (see above). Similar to Keynes, the PC model splits the household consumption decision between (1) how much to save and (2) where to consume and on what (or in what form as Keynes states).

In both models the rate of interest is the equilibrium in the desire to hold wealth in cash form and the availability of cash.

Where they differ is the fact that the PC model does not include bonds whereas in Keynes analysis he uses bonds in conjunction with his 'normal rate of interest' in deriving the demand for money function incorporating the three afore-mentioned motives. keynes also considers uncertainty.

So depending on how strictly you define 'faithful' PC may not represent Keynes original vision, though it does initially to a large degree.

Assignment Week 4

Question 1

1) Explain the difference between SIM and SIMEX when both models are in their steady states.

In the steady state both models converge towards the same steady state levels, however the path followed may vary. Furthermore, the SIM model converges more quickly to the steady state as a result of the role of expectations in the SIMEX model.

The wealth stock in the SIMEX steady state is higher than that of the SIM model. This is largely because the role of money in this model is of greater significance. If income is higher than expected, the accumulation of wealth is also higher than expected, and therefore consumption will increase to a point where wealth is so high that additional consumption is equal to the consumption lost for mistaken expectations. This is a sequential system with a built in mechanism for correcting mistakes.

If Yd is underestimated, realized income is above expected and households will add it to their cash balances, so the stock of cash people find themselves holding at the end of each period is not the outcome of a plan. Consequently, savings is higher than expected and the stock of wealth increases faster than in perfect foresight, causing consumption to rise up to C*.

2) What does it mean for stability of the model when the presences of mistakes allow households’ income to suffer? Can you draw any general conclusions about the real world from this model?

The same expected mistake could happen but in the opposite direction, in this case the expected Yd is overestimated, so households will have to take some extra cash from their cash balances, reducing savings and decreasing wealth and decreasing consumption. Eventually, the steady state is reached at the same levels as in the SIM model, but since savings decreased during the process, wealth is lower.

In reality incorrect expectations can occur. Therefore, savings represent a cushion that ensures consumption levels are in a constant growth rate. However, households are rational agents and therefore have either adaptive expectations or rational expectations (taking into account all new information), so expecting Yd at a constant level would be rather unusual.


3) Solve SIMEX for the following values for 3 periods: G=30, alpha1 = 0.6, alpha2 = 0.4, tax rate = 0.2.



Question 2

1) Is it possible to specify a version of SIM that replicates the ISLM model?

Yes. The ISLM model relates investment, savings, liquidity and money supply with a consumption function given as C = α0 + α1YD. α0: represents autonomous consumption.

The consumption function for the SIM model is given by Cd = (α1 ) (YD) + (α2)(Hh-1) where α1 = the marginal propensity to consume and α2 is the marginal propensity to consume out of opening stock of money (Hh-1). Since the ISLM model does not include money from the previous period Hh-1 becomes zero. Details below.

2) Write one down and comment on the stability of this model.

The Consumption Function is depicted by the following: C = α0 + α1YD

α0: represents autonomous consumption, independent of current income, and
α1 represents the Marginal Propensity to Consume.

It was illustrated in tutorials that the above consumption function is not stable as it does not take into account money generated in previous periods. In other words, the consumption function outlined above does not facilitate growth through the model. Therefore, in order for the model to be stable, the level of income and consumption would have to remain constant, and the following relation would hold (C = YD).


Reading:

Leddin, J.A. and Walsh, B. M. (2003) The Macroeconomy of the Eurozone: An Irish Perspective, chapter 17.

Godley and Lavoie (2007) chapter 3.



Websites:
http://pages.stern.nyu.edu/~nroubini/NOTES/CHAP9.HTM#topic1
web.mit.edu/rigobon/www/Cursos/islmclosed.pdf
http://www.egwald.com/macroeconomics/basicislm.php

Assignment Week 3

Behavioural Transactions Matrix

Figure 1

As a precursor to the following two questions it is important to note that the behavioral matrix (figure 1) adheres to the fundamental principle of accounting. That is, all columns and rows concerning assets and liabilities must naturally sum to zero.



Q1.1 Why must the Vertical Columns sum to zero?

"The vertical columns must necessarily sum to zero, because the change in the amount of money held must always be equal to the difference between households' receipts and payments." (Godley & Lavoie, 2007, p.62)

In other words, reading column one vertically it is possible to deduce that households primary source of funds are through wages (WB). Alternatively, in this model there are only three possible outflows: consumption, taxes and saving (∆H). Therefore, in light of the introductory statement all vertical columns sum to zero.

Q1.2 Why must the Horizontal Rows sum to zero?

In the opening chapter of Godley & Lavoie (2007, p.6) the authors state that “everything comes from somewhere and everything goes somewhere”. Therefore, in horizontal row one the production sector generates funds from the supply of products or services while alternatively this represents a net outflow for households.

References
Godley, W., and M. Lavoie (2007) Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth, Palgrave Macmillan.



Q. 2

1. Consumption

According to the Consumption function:
Every period, households consumption is formed by from the flow of the disposable income (which depends on the wage received minus the taxes paid, ) plus of the opening stock of money formed by the wealth accumulated from previous periods.
This money is assumed to be completely expended on goods produced in an equal quantity, so the sum of the roe is zero.

2. Government Expenditures

In this model Gd is an exogenous variable, set by the autonomous decision of government, once the government has determined its own expenditure, it equals the amount of money received by the producers, leading the total sum of zero.

3. Output

Since Y is not a transaction between two sectors, it only appears once, and represents the total amount of goods an services produced in that period.

4. Factor Income

This represents labour in the economy. As with any firms (the production column) employ the workers (the household column, as workers are expected to come from households). The firms require labour to produce goods and services which will earn them income while households supply labour to earn income to purchase the goods and services they demand. Wages are paid, in some monetary form, by the firms to the households as compensation for this provision of labour. The wage bill is denoted by the wage rate (W) times employment (N). The cost of this labour to the firms is represented as –W.Nd (negative as it is an outflow funds). The income earned (wages) by the households is denoted by +W.Ns (positive as it is an inflow of funds). Both are exactly offset which is why the row will sum to zero. The s and d represent supply and demand.

5. Taxes

To provide for public services Governments must earn an income. This income is gained through income taxing the households who will directly or indirectly benefit from these services. The income tax received is denoted by +Td (positive as it is an inflow to the Government). The income tax paid by the Households is denoted by –Td (negative as it is an outflow from the households).

6. Change in Money Stock

This describes the changes in stocks of financial assets and liabilities from period to period (Godley and Lavoie 2007, p.60). The Government prints money and in this model all transactions occur in government money. Money (H) is an asset to a household but a liability to the Government as it constitutes debt. In this model the Government is the only issuer of financial assets so households must purchase from the Government to acquire these. This occurs when households use their surplus disposable income to purchase these instruments. This is denoted by –ΔHh (change in H or high-powered money, h for households held). Although stocks of cash are assets to households, the change here is negative as by the model households cannot issue cash/financial instruments nor derive any inflow (source) of funding. Thus the minus signifies an outflow (use) of funds. Conversely the corresponding inflow (+ΔHs) appears in the Government column, again positive as it is a source of funding. It also represents the difference between the Governments receipts and expenditure.

References
Godley, W., and M. Lavoie (2007) Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth, Palgrave Macmillan. Chapter 3.

Assignment Week 2

1. Aggregate Demand relation: is the total demand for final goods and services in the economy (Y) during a specific time period. In a general aggregate supply-demand chart, aggregate demand (AD) slopes downward. An aggregate demand curve is the sum of individual demand curves for different sectors of the economy. The aggregate demand has five main parts:
where
· is consumption = ac Y+ bc*(Y - T),
· is Investment,
· is Government spending,
· is Net export,
· is total exports, and
· is total imports = am + bm*(Y - T),.
It is the demand for the gross domestic product of a country when, and only when, it is in equilibrium.
In Keynesian economics, not all of gross private domestic investment counts as part of aggregate demand. Much or most of the investment in inventories can be due to a short-fall in demand (unplanned inventory accumulation or "general over-production"). The Keynesian model forecasts a decrease in national output and income when there is unplanned investment. (Inventory accumulation would correspond to an excess supply of products; in the National Income and Product Accounts, it is treated as a purchase by its producer.) Thus, only the planned or intended or desired part of investment (Ip) is counted as part of aggregate demand. http://www.thefreedictionary.com/


So for example, the “X” economy has the following figures:
· = ac Y+ bc*(Y - T)
= .6 (460) + .4 (460- 160)
= 396
· = 125,
· = 350,
· = 200
We can calculate the Aggregate Demand =
856 = 396+125+135+200

Assuming the expectations are equal through time so the aggregated demand equals the total production.

2. Animal Spirits: The name Keynes gave to one of the essential ingredients of economic prosperity: confidence. According to Keynes, animal spirits are a particular sort of confidence, "naive optimism". He meant this in the sense that, for entrepreneurs in particular, "the thought of ultimate loss which often overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectation of death". Where these animal spirits come from is something of a mystery. Certainly, attempts by politicians and others to talk up confidence by making optimistic noises about economic prospects have rarely done much good.
http://www.Economics.com

"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."
(Keynes, J. M. (1936) The General Theory of Employment Interest and Money, pp. 161-162)

A good example of this is the Consumer´s Confidence Index, a survey by the Conference Board that measures how optimistic or pessimistic consumers are with respect to the economy in the near future.
The idea is that if the consumers are optimistic, they will tend to purchase more goods and services. This increase in spending will inevitably stimulate the whole economy.

Here is an abstract of the recent behavior of this Index:

The Conference Board Consumer Confidence Index Declines in January
January 29, 2008
The Conference Board Consumer Confidence Index, which had improved moderately in December, gave back the gain in January. The Index now stands at 87.9 (1985=100), down from 90.6 in December. The Expectations Index declined to 69.6 from 75.8. The Present Situation Index, however, increased to 115.3 from 112.9 in December.
Consumers' appraisal of present-day conditions, despite the slight improvement, is less than favorable. Those claiming business conditions are "bad" rose to 20.0 percent from 18.8 percent, while those claiming business conditions are "good" decreased to 20.7 percent from 21.2 percent. Consumers' assessment of the job market was slightly more positive. The percentage of consumers saying jobs are "hard to get" eased to 20.1 percent from 22.7 percent, while those claiming jobs are "plentiful" edged up to 23.9 percent from 23.6 percent in December.
Consumers' short-term outlook, which had improved moderately in December, turned more pessimistic. Those expecting business conditions to worsen over the next six months increased to 16.0 percent from 14.1 percent, while those anticipating business conditions to improve decreased to 11.6 percent from 13.8 percent. The outlook for the labor market was also less favorable. The percent of consumers expecting fewer jobs in the months ahead rose to 21.5 percent from 19.9 percent, while those anticipating more jobs eased to 10.5 percent from 10.9 percent. The proportion of consumers expecting their incomes to increase declined to 17.6 percent from 20.2 percent.

3. Bank Run: 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. A run on the bank begins when the public begins to suspect that a bank may become insolvent. As a result, individuals begin to withdraw their savings. This action can destabilize the bank to the point where it may in fact become insolvent. Banks retain only a fraction of their deposits as cash ( fractional-reserve banking): the remainder is issued as loans. As a result, no bank has enough reserves on hand to cope with more than the fraction of deposits being taken out at once. As a result, the bank faces bankruptcy, and will 'call in' the loans it has offered. This can cause the bank's debtors to face bankruptcy themselves, if the loan is invested in a plant or other items that cannot easily be sold.

These are some relative examples of this phenomenon:

In early August 2007, the American firm, Countrywide Financial suffered a bank run as a consequence of the subprime mortgage crisis. On 13 September 2007, the British bank Northern Rock arranged an emergency loan facility from the Bank of England, which it claimed was the result of short-term liquidity problems. The bank's defenders claimed its cash shortage was the result of over-exposure to the failing US sub-prime mortgage market, while its critics argued that it was the result of NR's own careless lending practices.. A run began the following day, Friday, with reports of its internet banking site being overloaded, and long queues outside branches that day, Saturday morning and the following Monday. News reports on 17 September stated that an estimated £2 billion GBP of retail deposits had been withdrawn by customers since the bank had applied for emergency funds.
Later that day the Chancellor of the Exchequer, Alastair Darling, announced that the Treasury would guarantee all currently deposited savings held with Northern Rock, exceeding the pre-existing capped guarantee of £31,700 per depositor per institution offered by the Financial Services Compensation Scheme. This had the effect of ending the run.
The free dictionary

So for example if a Bank is required to keep 15% of the capital aside as a reserve ratio for every loan (assuming all loans have a relative good quality) that means that if the total amount of loans is 100, and the depositors wish to withdraw their money all at once, the bank will only have in cash 15, and since it wont be enough for everyone a bank run will start.



4. 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.
http://www.thefreedictionary.com/

Example, Sabritas s.a. de c.v. issues a bond with the following characteristics: Face Value 250 pesos , 10 year, semi annual coupon, 20%.

The interest rate could be considered high, because it has to reflect the company quality, Sabritas is a new Spanish company and 10 years might be long enough to imply risk which would have to be compensated by the issuer.


5. Capital Account: The capital account is one of two primary components of the balance of payments, the other being the current account. The capital account records all transactions between a domestic and foreign resident that involves a change of ownership of an asset. It is the net result of public and private international investment flowing in and out of a country. This includes foreign direct investment, plus changes in holdings of stocks, bonds, loans, bank accounts, and currencies. From a domestic point of view, a foreign investor acquiring a domestic asset is considered a capital inflow, while a domestic resident acquiring a foreign asset is considered a capital outflow. Along with transactions pertaining to non-financial and non-produced assets, the capital account may also include debt forgiveness, the transfer of goods and financial assets by migrants leaving or entering a country, the transfer of ownership on fixed assets, the transfer of funds received to the sale or acquisition of fixed assets, gift and inheritance taxes, death levies, patents, copyrights, royalties, and uninsured damage to fixed assets.
http://www.thefreedictionary.com/

Example
The following transactions affect Brazilian Capital Account:
* Brazilian international company buys new buildings in Mexico -$100 (outflow)
* American Investors buys Brazilian Government Bonds +$370 (inflow)
* Canadian car company buys an manufacture plant in Brazil +$700 (inflow)
* Brazilian government buys Chinese computer systems -$640 (outflow)
-------------------------
The Brazilian Capital Account would be = +$330

6. 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. The ratio is a coverage ratio on a national level. http://www.investopedia.com/

Example:
Here is a fraction of the article “Macroeconomic Situation and External Debt in Latin America” http://www.imf.org/external/np/speeches/2006/020106.htm


…. So to achieve a position from which counter-cyclical fiscal policy can operate, there is a need to reduce debt to manageable levels over the medium term and thus enable built-in stabilizers to offset part of the impact of shocks. Brazil's efforts to reduce its debt burden by maintaining a high primary surplus, and by restructuring its debt, both in terms of its maturity structure and its foreign currency exposure.
Several other countries have similarly been seeking to reduce their debt burdens. Indeed, between 2003 and 2005, the average primary surplus in Latin America was 3.25 percent—double the average of the previous decade and marking a better performance than in most other emerging markets. But that only brought average debt to GDP ratios down from 65.5 percent of GDP in 2003 to 52.3 percent in 2005, still above the level of a decade earlier.

Although as I noted earlier Brazil has made great strides in reducing its debt to GDP ratio from more than 65 percent in 2002: it is a little over 50 percent.
Similarly, Mexico has reduced its debt to GDP ratio by about 10 percentage points from the levels of the late 1990s: but the ratio is still around 45 percent.
Colombia's debt to GDP ratio is on a declining path: but at around 50 percent of GDP it is still close to double the level of a decade ago.
Bolivia and Uruguay both have debt ratios of around 70 percent of GDP.
In some Central American and Caribbean countries, debt to GDP remains at uncomfortably high levels. Jamaica, for example, has public debt close to 140 percent of GDP; and Panama's debt to GDP ratio is still above 70 percent as of 2004, the latest year for which we have figures….

7. 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/Effective_demand)

A key conceptual notion of Keynesian economics stipulating that the aggregate expenditures on real production is based on existing or actual income rather than the income that would be generated with full employment of resources. Effective demand is embodied in the aggregate expenditures line, which has a positive slope, but a slope of less than one.
(http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=effective+demand)

Example: while demand is defined as the goods and services consumers are willing and able to buy at a given price effective demand incorporates purchasing power by taking account of consumers’ ability to buy. In a developing country an individual may demand 10kgs of food per day but may only be able to afford 5kgs per day. Hence here the effective demand is 5kgs while the actual demand is 10kgs.


8. deflation: is the opposite of inflation. It refers to a decrease in the general price level over a period of time (Barro and Grilli 1994, p. 142).

Example: Following the Wall Street Crash in 1929 the US experienced deflation of approximately 10% p.a. during the period from 1930-1933 (http://www.wikipedia.org/). Say that in Ireland the annual rate of deflation is 4%. This means that goods costing €100 this year will cost around €96 next year.

9. consumption function: The consumption function can be written as C = α +mpc X Yd , where α is the intercept term, Yd is disposable income (ie gross income (Y) less taxation (T)) and mpc is the marginal propensity to consume. C is consumption expenditure (Leddin, A. and Walsh, B. (2003), p.49).

Example:

The function represents a linear relationship between consumer expenditure and disposable income. The intercept term is seen as an autonomous spending element. The graph of this relationship is a straight line with slope equal to mpc. Given the following data what is α equal to?

Table 1.
C =5,000
Yd =7,000
Mpc* =0.6
α =?

Solve for α: C = α + mpc X Yd
= 5000 = α + (0.6)(7000)
= 5000 = α + 4200
= α = 800

The graph below is found by solving for a second point in the line taking Yd as 8,000.

Figure 1 Sample Consumption Function

*calculated by ΔC/ΔYd

10. consumer price index: An inflationary indicator that measures the change in the cost of a fixed basket of products and services, including housing, electricity, food, and transportation. The CPI is published monthly and is also called the cost-of-living index.
(http://www.investorwords.com/1062/Consumer_Price_Index.html).

Example: In Ireland the Central Statistics Office (CSO) collects approximately 50,000 price quotations from a fixed panel of service and retail providers. These prices are averaged on the basis of their relative importance. The base year of measurement is set to 100. Subsequent changes are compared relative to this base year.

11. investment function: Economics concept which explains how the changes in national income induce changes in investment patterns in the national economy. It is often written as a function of income (Y) and interest rates (r). ie .I=f(Y,r)
http://www.businessdictionary.com/definition/investment-function.html

Example: The introduction of the IFSC in Ireland in 1987 saw huge increased investment as due to a lower rate of corporation tax companies annual income was increased.

12. fiscal expansion: raises aggregate demand through (1) increasing government is purchases, with taxes unchanged or (2) by cutting taxes or increases transfer payments, people's disposable income rises, and they will spend more on consumption. This rise in consumption will, in turn, raise aggregate demand. http://www.econlib.org/library/Enc/FiscalPolicy.html

Example: Recent expansionary fiscal policy in the US has seen the Government increase spending (via tax rebates) to shift the aggregate demand curve to the right and prevent a recession.

13. GDP deflator: or implicit price deflator for GDP, is a measure of the change in prices of all new, domestically produced, final goods and services in an economy. The GDP deflator equals [(Nominal GDP/Real GDP)*100].

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

Example: Using the GDP deflator nominal GDP is deflated into real terms. So if real GDP equals €200bn and Nominal GDP equals €220bn then the deflator is 110.

14. Imports: The total goods and services that a country purchases from other countries (Parkin 2003, p.436).

For example, the United Kingdom is Ireland’s largest trading partner, and accounts for 31% of total Irish imports. Furthermore, in 2003 alone the UK-sourced imports grew by a staggering 9% to reach €16 billion (http://www.finfacts.com/).

15. Monetary Contraction: refers to monetary policy that seeks to reduce the size of the money supply. In most nations, monetary policy is controlled by either a central bank or a finance ministry (http://www.wikipedia.org/).

One of the greatest examples of monetary contraction occurred in the US in the early 1930s. Effectively, the federal government placed a sizable tax on bank checks which resulted in the massive switch in from bank deposits to currency (Lastrapes and Selgin, 1996).

16. Nominal GDP: The value of the final goods and services produced in a given year valued at the prices that prevailed in that same year (Parkin 2003, 441).

(http://www.wikipedia.com/)
The above table illustrates the rankings of the top five counties of the world by their Gross Domestic Product (nominal) per capita for 2006. It is important to note that the data sourced is calculated with respect to a country’s average population. With respect to Ireland, its low population and attractive corporation tax environment justify its current ranking.

17. Propensity to Consume: The fraction of a change in disposable income that is consumed. It is calculated as the change in consumption expenditure divided by the change in disposable income (Parkin 2003, p.578).

Suppose that an employee at Dell receives a Christmas bonus of €600. Assume that this individual spends €450 and saves the remaining €150. Therefore, one can ascertain that this individual’s propensity to consume is 0.75 (€450/€600).

18. Short-Run: The short run in microeconomics had two meanings. For the firm, it is the period of time in which the quantity of at least one input is fixed and the quantities of the other inputs can be varied. The fixed input is usually capital-that is, the firm has a given plant size. For the industry, the short-run is the period of time in which each firm has a given plant size and the number of firms in the industry is fixed (Parkin 2003, p.214).

Firstly, it is important to note that the short-run does not refer to a specific period of time, but rather it is a notion of flexibility. For instance, to increase output in the short-run a firm must increase the quantity of its variable inputs. Labour is often referred to as a variable input; therefore to produce more output in the short-run a firm needs only to hire more staff.

19. Real Exchange Rate: The real exchange rate (є) is the nominal exchange rate adjusted for relative prices. The real rate is a measure of whether a country is becoming more or less price competitive to trading partners over time (Leddin & Walsh 2003, p.189).

The real exchange rate (є) can be calculated as the ratio of domestic and foreign prices expressed in a common currency. The graph below illustrates the US Dollar to Brazilian Real exchange rate. From the data sourced it is possible to ascertain if one converts 1 US dollar to a Brazilian Real you will end up with a total of 1.74 Brazilian Real’s.

20. Trade Surplus: A positive balance of trade is known as a trade surplus, or in other words where a country’s net exports exceed its net imports.

Countries like Germany and China are renowned for a balance of payments surplus. However, recently Germany’s trade surplus has decreased to €15.6bn in light of a stronger Euro exchange rate (http://news.bbc.co.uk/). However, in spite of this Germany has managed to retain its position as the world’s leading exporter.



EXERCISE 3

For a government to have a self financing steady state implies to have an optimal tax level G= *. Assuming that the sum of the output of workers is the output of an economy, in the long run Y= G/ .

So, if changes it will have an inverse effect on the Y, thus if is increased Y will decrease, this could help an overheated economy and at the same time would be a fount of funds for the government to be spent in future crises on downsides in the economy.
Whereas, if is decreased, Y will actually increase, but might not be a sustainable growth because goods and services provided by the government will decrease in quantity and quality. Therefore the Y* could be changed to a lower figure.

Revised Team Members

SHANE QUINLAN 0340251
MARIA RAMIEZ 0702124
WARREN SYMES 0355828

Team Members

SARAH CORCORAN 0714577
SHANE QUINLAN 0340251
MARIA RAMIEZ 0702124