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49:13
Transcript
0:17
Okay, let's uh let's start. Um
0:21
So, what you have there in that picture
0:22
is uh is the result of a survey to a
0:26
bunch of economists
0:27
on which are asked to assess the
0:30
probability that there is a recession
0:31
within the next 12 months.
0:34
Recession means essentially a decline in
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0:37
aggregate output.
0:38
Um and well, the first thing to notice
0:41
here is that you know, it's not very
0:43
good news. There is a very high chances
0:45
at at least according to
0:48
this expert that that the US enters a
0:50
recession within the next 12 months or
0:53
so. Pretty high probability.
0:55
You can see that that number typically
0:57
is very very low and it goes very high
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0:59
sort of real next to recessions.
1:01
And now we're not in a recession, but
1:03
but there is a sort of very high per se
1:05
probability that we may
1:08
go into recession in the near future.
1:10
So, how is that these people come up
1:12
with this forecast? Well,
1:15
at some level, either explicitly or
1:17
implicitly, they must have some model
1:20
uh
1:21
that of the determination of equilibrium
1:23
output. I mean, you know, they need to
1:24
understand
1:26
they need to see certain things that
1:28
suggest
1:29
when you go through a model that output
1:32
will decline.
1:34
Um so, that's what we're going to start
1:36
doing today. And
1:38
and in fact, that's what we're going to
1:40
do
1:40
throughout this course. It's we're going
1:42
to try to find ever more complex perhaps
1:46
or or richer models of
1:49
uh output determination, aggregate
1:51
output determination. So, that's
1:53
essentially what this course is about.
1:55
Uh
1:56
and so, and understanding sort of we're
1:58
going to try to understand what is it
1:59
that drives that equilibrium output and
2:01
how is it that we get to one specific
2:03
level of output.
2:05
That's what it means to find the
2:06
equilibrium level of output.
2:08
Um and we're going to do it sort of in
2:10
three stages.
2:11
In the first part of the course, that is
2:13
up to quiz one,
2:15
uh we're going to focus on on on the
2:17
very short run. How output is determined
2:19
in the very short run, say within a year
2:22
or so.
2:23
Uh
2:24
uh
2:25
well, a little more even, but but that
2:27
type of frame time frame.
2:29
Then we're going to focus on the medium
2:31
run. That's sort of is
2:34
at the beginning of
2:35
of of the second part of the course.
2:38
Uh
2:38
and by the medium run, simply we're
2:40
going to mean by the time in which
2:41
prices begin to adjust sufficiently.
2:44
Okay? Before that, is most of the action
2:47
happens in in quantities. There is
2:49
little movement in goods prices. There's
2:52
lots of movement in asset prices, but
2:53
little movement in goods prices.
2:55
And in the last part of the course,
2:57
we're going to look at how output is
2:59
determined over the long run, which is
3:00
quite different from how output is
3:02
determined in the short run.
3:04
The determination of output in the short
3:06
run is what we mostly mean by business
3:08
cycle analysis. Okay? And short or
3:11
medium run, the way we're going to
3:12
define it here, is what we mean by
3:14
business cycle. The country's in a
3:15
recession, it's in a boom, it's an
3:17
expansion. Those are all terminologies
3:19
of the short run
3:20
or short or medium run.
3:23
The determination of equilibrium output
3:24
in the long run is when we think about
3:26
growth. When we talk about why is it
3:29
China grows faster than the US today?
3:31
Well, that's a that's a question not
3:32
about the business cycle. It's a
3:34
question about the long-run determinants
3:37
of output growth. Okay? And and they're
3:40
even different class of models.
3:42
In more advanced models, if you were
3:44
doing a PhD, those things are a lot
3:46
closer to each other and and and but but
3:48
in this course, they're going to be very
3:50
different type of models. It's easier to
3:52
analyze these things with different type
3:54
of models than trying to integrate all
3:56
in one big machine. Okay? But let's
3:59
start with the the simple part. In the
4:01
short run,
4:02
the key mechanism, something that will
4:04
will keep showing up uh in all the
4:08
models and sub models we analyze
4:10
uh
4:11
in the first eight lectures or so or
4:13
seven lectures of the next seven
4:15
lectures or so, is this mechanism. In
4:17
the very short run,
4:19
output, that is equilibrium output, the
4:21
thing that these economists are
4:23
forecasting that will decline in the
4:25
next 12 within the next 12 months,
4:27
is determined primarily
4:30
by act what we call demand.
4:32
Okay?
4:33
So, demand will determine output. That's
4:35
the change in demand that will change
4:37
production.
4:39
But when production changes, that will
4:41
also change income. That you know from
4:43
national accounts. Remember we said that
4:44
we could measure output from the
4:47
production side, but we also could
4:49
measure the income side. And they're
4:50
exactly the same. More production,
4:52
somebody has to receive the proceeds of
4:54
that. Workers and owners, capital
4:57
owners, the government, whatever.
4:59
But so, changes in in So, the second
5:02
step we're going to make is those
5:02
changes in production that were brought
5:04
about by the changes in demand will lead
5:07
to a change in income.
5:08
But when income changes, that will
5:10
change demand again.
5:11
And so on and so forth. Okay? So, that's
5:14
essentially that's quintessential
5:16
short-run macro. It's to to try to
5:18
understand this
5:19
aggregate demand, because that's the
5:21
main driver, and then how it gets
5:23
multiplied
5:24
uh in the short run. Okay? And
5:27
in this lecture, we're going to talk
5:28
about just about that.
5:30
You know, primarily about that. Okay?
5:31
But that's that's when So, when I mean
5:33
short-run macro, that's the structure I
5:35
have in mind and that's the structure
5:36
most people have in mind. Something
5:38
where aggregate demand will determine
5:39
that. That's the reason why in the short
5:41
run you worry a lot about whether
5:42
consumer confidence is high or low.
5:45
That's demand. If consumers are very
5:46
depressed, they tend to reduce demand.
5:48
If consumers are very bullish, that will
5:50
tend to increase
5:52
demand. And since in the short run
5:54
output is determined by demand, the
5:56
business cycle, whether we have got a
5:58
recession or not, depends on about how
6:00
demand feels. So, if somebody's
6:02
forecasting a recession within the next
6:03
12 months, he's forecasting really that
6:07
demand will decline within the next 12
6:09
months. Okay?
6:12
Why they're forecasting that, that's
6:14
something we're going to learn in the
6:15
steps
6:16
uh as we go through the course. What
6:17
what are the kind of things that they
6:19
may be thinking about? What are the
6:20
drugs on aggregate demand that are
6:22
likely to depress demand?
6:25
Uh and so on and so forth. But that
6:26
we'll we'll get there. Okay?
6:30
Anyways, first let me tell you about the
6:31
components of aggregate demand.
6:34
Uh
6:35
the first and one of the and the largest
6:37
component of aggregate demand is
6:39
consumption. Okay? And when I mean
6:41
aggregate demand, okay,
6:43
I'll be
6:45
I'll pause for a for a slide. Let me let
6:47
me go over the definition. Consumption,
6:49
we're going to denote by C,
6:51
is the goods and services purchased by
6:53
consumers. Okay? Households and so on.
6:57
Investment, which we're going to denote
6:59
by I,
7:00
is the sum of non-residential and
7:02
residential investment. So, equipment
7:05
and establish and and and you know,
7:08
factories
7:09
on one side, and then residential
7:11
investment is houses.
7:12
Stuff like that, apartment buildings and
7:14
so on.
7:15
Which is also these are goods and
7:17
services as well. They're just capital
7:19
goods and so on, but they're also goods
7:21
and services.
7:22
Government spending, that's what we're
7:24
going to denote by G, are purchases of
7:26
goods and services by the federal,
7:28
state, and local government. Okay?
7:31
Excluding, and that's important,
7:32
government transfers.
7:35
What is a government transfer? Many of
7:36
you may have received that during COVID.
7:38
You know, the government sent you a
7:39
check, for example. Okay?
7:42
Well, that check that is not part of
7:43
government expenditure. That check is
7:45
like a
7:46
it's a negative tax and it's going to
7:48
enter somewhere else.
7:50
When we mean government
7:51
expenditure is is things the government
7:54
purchases, services the government
7:57
acquires and so on. Okay?
8:00
Um
8:01
then exports, X, which will play no role
8:05
until seven lectures or eight lectures
8:07
from now, or actually 10 lectures from
8:09
now probably,
8:10
is purchases of US goods and services,
8:13
that is goods produced by US factories,
8:17
uh
8:18
uh
8:19
by foreigners. Okay?
8:24
I am is the other side of the story.
8:26
Imports is the purchase of foreign goods
8:30
and services by US consumers, US firms,
8:32
US government. Okay? So, when you buy
8:35
something that is produced in Germany,
8:36
well, that's an import. When the Germans
8:39
buy something that is produced in the
8:40
US, that's an export. Okay?
8:42
And then the last component is something
8:44
we're going to going to pay any
8:45
attention whatsoever in this course,
8:47
which is inventory investment. Inventory
8:49
investment is certainly
8:51
it's almost accidental. There is some
8:53
planning on it, but but there is a lot
8:54
of it's just from the difference between
8:56
sales and production. And over the very
8:58
short run, there's lots of difference. I
9:00
mean, you're not
9:02
producing unless you're in a bakery, you
9:03
know, you're not producing and selling
9:05
immediately. There is there is certain
9:07
certain lags.
9:08
That's a small thing. It it's volatile,
9:10
but it's a small thing, so we're going
9:11
to ignore it
9:13
for this this course. We're going to
9:15
assume actually, unless we explicitly
9:17
say the contrary, and that could show up
9:18
in a piece that it would never show in a
9:20
quiz,
9:21
because it's not that important, we're
9:23
going to assume that this inventory
9:24
investment is equal to zero.
9:26
Also, for this part of the course, until
9:29
further notice, we're going to assume
9:30
that exports and imports are equal to
9:32
zero as well.
9:34
That's not realistic, but it's easier to
9:36
analyze what we call a closed economy.
9:39
Okay? An economy that is not interacting
9:41
with the rest of the world. In the in
9:44
again, 10 lectures from now, we're going
9:45
to open the economy to the rest of the
9:47
world, and then we're going to have to
9:48
talk about
9:49
things like import, export, exchange
9:51
rates, things of that kind. But for now,
9:53
let's keep it simple. Okay?
9:55
So, now you So, you get a sense this is
9:57
for 2018, but I I mean the the totals
10:00
change, but the composition doesn't
10:02
change very much
10:03
of GDP.
10:05
Okay.
10:08
Of of GDP
10:11
output
10:12
aggregate demand they're all the same
10:16
in equilibrium, but we'll get there.
10:19
GDP you see that consumption accounts
10:21
for a big chunk close to 70% of
10:24
aggregate demand. That's the reason
10:26
people worry so much about consumer
10:28
sentiment and so on. The
10:30
University of Michigan
10:32
has many claims to fame, but one of them
10:34
is they produce this index of consumer
10:35
sentiment, and everyone is watching that
10:37
thing. Anyone that worries about macro
10:39
or finance is watching that thing
10:41
because it tells you a lot about one of
10:43
the main drivers of output equilibrium
10:47
output. Then you see investment is
10:49
substantially smaller, but it's large in
10:52
particular non-residential investment.
10:55
Government expenditure is a big
10:56
component of aggregate demand. And then
11:00
I'm not going to worry too much about
11:01
for a country like the US the open
11:04
openness part is is relatively small.
11:07
If you go to uh you know
11:11
small a small economy typically will
11:14
have sort of very large exports relative
11:16
to GDP and so on. But that's not the
11:18
case of the US.
11:21
And there you see why we're going to set
11:23
in inventory investment to zero. It's a
11:25
small thing. It it moves a lot more than
11:27
than its size, so it can account for for
11:30
fluctuations in in
11:32
sort of the monthly level of GDP, but
11:34
it's not that important
11:36
in a slightly longer periods of time.
11:39
Okay. So, that's more or less the story.
11:41
So, now this is the this is the model.
11:44
Please stop me say if you Is there
11:47
anything here you don't understand
11:48
because any everything that we'll build
11:50
from here to
11:51
quiz one
11:53
will build on understanding this what
11:56
I'm about to say. Very simple, but if
11:58
you miss a step here everything is going
12:00
to be confusing in the next few
12:01
lectures. So,
12:02
and you're not supposed to understand it
12:04
in the first run. So, so it's okay that
12:05
you ask me. But let's make sure that you
12:07
understand what's going on here.
12:10
Okay. So, that's aggregate demand. First
12:12
definitions. We're going to denote
12:14
aggregate demand by this Z, okay? Letter
12:17
Z.
12:18
And aggregate demand is going to be When
12:21
we say aggregate demand, remember what
12:23
what what is the exercise we're trying
12:25
to do. Ultimately, what we want to
12:27
determine is the output the production
12:30
of the US economy, say.
12:32
So, when we mean when we talk about
12:34
aggregate demand, we're trying to
12:35
determine the demand for domestically
12:38
produced goods for goods produced in the
12:39
US.
12:41
That's what we're trying to pin down.
12:43
And so,
12:44
that's the reason aggregate demand looks
12:46
like that. It's well, consumers.
12:48
Consumers are going to demand goods.
12:50
Investment
12:52
G plus exports. If foreign demand US
12:55
goods, that's also increases US
12:56
production.
12:57
Minus imports because imports is
13:01
uh goods and services that consumers,
13:04
firms, and governments sort of buy from
13:06
foreigners, but they're not produced by
13:08
by US companies. So, they are not affect
13:10
the determination of equilibrium output
13:12
in the US. Okay? That's the reason you
13:14
subtract it. Now, that distinction is
13:17
not going to matter
13:19
uh until 10 lectures from now because
13:21
we're going to set X and IM equal to
13:23
zero from the point of view of modeling.
13:25
So, all demand is demand for
13:27
domestically produced goods in this part
13:29
of the course. Okay? So, aggregate
13:31
demand for us will be this C plus I plus
13:34
G. So, we need to understand what
13:36
determines C plus I plus G.
13:39
And at least initially, we're going to
13:41
keep it very very simple. We're not
13:43
going to think too much about what
13:44
determines investment. In fact, we're
13:46
going to assume it's a constant is
13:48
given. So, it's determined somewhere
13:49
else not in the model I'm about to
13:51
solve.
13:53
Government expenditure
13:55
the same. I'm going to assume you know,
13:56
it's determined by some other
13:58
priorities, you know, green agendas and
14:00
stuff like that. It has very little to
14:01
do with with with what we're doing here.
14:05
And then taxes is something that doesn't
14:07
show up there, but it will show up very
14:08
shortly. We're also going to assume that
14:10
they're being determined somewhere else.
14:12
In pieces and later on in the course
14:14
we're going to endogenize all that, but
14:16
not now. Let's assume I'm trying to come
14:19
up with a the simplest possible model of
14:21
aggregate demand.
14:22
And I'm making two of these terms
14:24
trivial just constants. Okay? And I'm
14:27
going to focus all my effort here in
14:30
this component here, which I already
14:31
told you is the most important component
14:34
of aggregate demand, which is
14:35
consumption. Okay?
14:37
So, we're going to assume here we're
14:39
going to have a function. Something has
14:41
to move so for the model to be
14:42
interesting. So, this this this we're
14:44
going to assume that consumption
14:47
is an increasing function of disposable
14:49
income. I'm about to define what
14:51
disposable income is, but you can
14:52
imagine what it is. It's something you
14:53
can use to consume and so on. So, very
14:56
naturally, if you have a higher
14:58
disposable income, you're going to
14:59
consume more. That's what this says.
15:01
Okay?
15:03
In reality, that consumption function is
15:05
a lot more complex. There are lots of
15:07
things that enter there that that we're
15:09
not modeling for now. But let's
15:11
start from the basics. Okay? So, that's
15:14
going to be the only behavioral
15:15
assumption we're going to make for a
15:17
while.
15:18
That that the consumers consume more
15:21
when they have more disposable income.
15:24
Okay.
15:27
And I'm going to make it even simpler.
15:29
I'm going to assume that consumption is
15:31
a linear function of disposable income.
15:34
Okay? So, there's going to be some
15:36
constant C0, which captures lots of
15:38
things that we're not modeling here. For
15:40
example, the fact that for any given
15:42
level of disposable income,
15:44
if you know, if you if you
15:47
if you're richer, suppose you have some
15:48
shares and now the shares double in
15:51
value, you probably are going to consume
15:52
more as well.
15:53
Okay? There are lots of other things
15:55
that affect
15:56
consumption, which are different from
15:58
aside from your disposable income.
16:01
But we're not going to model that. So,
16:02
that's we're going to call it
16:03
autonomous. Autonomous in the sense that
16:05
we're not going to determine it here.
16:07
We're going to take it as a parameter
16:08
that comes from somewhere else. We may
16:10
do some experiments moving that variable
16:12
around, but it's not going to
16:15
be part of what we model.
16:17
C1 is a more interesting parameter for
16:19
this part of the course, and it's what
16:21
we call the marginal propensity to
16:23
consume
16:25
out of disposable income in this case.
16:27
That is C1 tells you the share if you
16:30
get an extra dollar of disposable
16:32
income, how much of that do you spend in
16:34
consumption? Okay? So, say you get an
16:37
extra dollar of income, if you spend
16:41
60 cents in in the things you normally
16:44
consume of that extra dollar, well, then
16:47
your C1 is .6. Okay? That's the marginal
16:49
propensity to consume.
16:51
And that's what gives us our increasing
16:52
function. You get an extra dollar,
16:54
you're going to do you're going to save
16:55
part, but some of it you're going to
16:56
spend. That part you're going to spend
16:58
is the C1 that we have there. Okay?
17:02
Good.
17:04
Uh
17:07
And I
17:08
Now, let me tell you what how we define
17:10
disposable income. Disposable income is
17:12
just equal to income, which is equal to
17:14
production, you
17:16
minus taxes. That's disposable income.
17:18
Okay? It's whatever you earn as a either
17:20
as a worker as a capital owner,
17:24
well, then the government takes its
17:25
something out of it. That's your
17:27
disposable income, and that's where you
17:29
have to decide how much to save and how
17:31
much to consume.
17:32
Okay?
17:34
That's
17:35
So, so that means that our consumption
17:37
function is
17:38
can be written that way
17:40
after all these assumptions I made, you
17:43
know, equal to this autonomous component
17:45
plus C1 the marginal propensity to
17:47
consume times
17:49
uh income output minus taxes.
17:56
Is it clear?
17:59
Yes?
18:00
So, all these are assumptions. Now,
18:01
they're not crazy assumptions in the
18:03
sense that you know, that we know that
18:04
that there is a relationship between
18:06
these two things. Again,
18:07
the consumption function in practice is
18:09
much richer than that.
18:11
And there is lots of randomness random
18:13
terms around and so on, but that's not
18:15
what we're about here.
18:17
But that's if you want to start with a
18:18
consumption function, this is a pretty
18:20
reasonable one to start with. Okay?
18:24
Okay. So, that's going to look in the
18:25
space of disposable income or income. I
18:28
could have put income there not
18:30
disposable income. So, it's going to
18:31
look like that.
18:33
Okay?
18:34
So, C0 is that autonomous consumption is
18:37
some something you're going to consume
18:39
regardless of your level of disposable
18:40
income. I mean, there is a minimum
18:41
consumption you have to have. You know,
18:43
say. And then
18:46
and then
18:47
the slope of that is is the marginal
18:50
propensity to consume, which is C1,
18:52
which is a number between zero and one.
18:57
Okay. So, let's let's determine
18:59
equilibrium output.
19:02
So, we have aggregate demand, which is C
19:04
plus I plus G. Okay?
19:07
There we are.
19:09
That's that was our definition of
19:11
aggregate demand.
19:12
Uh I'm going to stick in now the
19:14
functional forms. Well, these guys are
19:16
very boring. They're constants. And I'm
19:18
plugging in here the the consumption the
19:20
consumption function. Okay? So, what we
19:23
have here is that aggregate demand
19:27
is an increasing function of output or
19:29
income. Okay?
19:32
It's also a function of taxes,
19:33
investment, and so on, but but it's an
19:35
increasing function of output. And And
19:37
this is important because I'm Remember,
19:39
the the goal of this is to find
19:42
equilibrium output.
19:44
So, here I have on the right hand side
19:46
of my aggregate demand
19:48
output. That's good. I have one equation
19:51
in which output shows up.
19:53
Okay? Now, I cannot find equilibrium
19:55
output just from this equation. Why is
19:57
that?
20:00
So, I'm Remember, we're trying to build
20:02
a model
20:03
to find
20:05
equilibrium output.
20:07
That's our goal. That's what will tell
20:09
us whether we're in a recession or not.
20:11
Output is low, recession. Output is
20:13
high, we're in a boom.
20:15
Obviously, I cannot solve it from this.
20:17
I have two unknowns.
20:19
What are my two unknowns?
20:23
Two unknowns, one equation.
20:25
What is my second unknown there?
20:37
Aggregate demand, of course. We have to
20:39
determine Z and Y.
20:41
Okay?
20:42
So, how are we going to do that?
20:45
Well,
20:46
using a second equation, which is the
20:48
equilibrium condition. It's not a
20:50
function. This is a function. This is
20:52
not a function. This is an equilibrium
20:53
condition. It says, "In equilibrium, not
20:56
outside equilibrium. In equilibrium,
20:59
output is equal to aggregate demand."
21:02
Okay?
21:03
That's what this
21:05
equilibrium condition tells us. Off
21:07
equilibrium, this doesn't hold. That's
21:08
the reason this is not a function. This
21:10
holds everywhere. It's a function.
21:12
This is an equilibrium condition. It
21:14
says, "At equilibrium, aggregate demand
21:16
is equal to output."
21:18
So, now we're done because we have two
21:19
equations with two unknowns. Okay?
21:24
Good.
21:25
And the reason I post on this is that I
21:27
see that mistake made often.
21:29
Okay?
21:30
That this is interpreted as a function.
21:32
It's not. It's an equilibrium condition.
21:34
At equilibrium, it holds. And that you
21:36
can see, actually, I'm going to
21:38
illustrate the same point in in the
21:40
diagram. So, this is the
21:42
Let me Let me keep going. So, this is
21:44
clear, no? So, this is This is just a
21:46
summary of what we had in the previous
21:48
slides. It's
21:50
And this is the new thing here, which is
21:53
in equilibrium, output is equal to
21:55
aggregate demand.
21:56
And and and the and the
22:00
And again, that's what makes
22:02
this a really a short
22:04
short-run model. You see, I'm saying
22:07
output in the short run is whatever
22:08
demand wants it to be.
22:12
Which is different from from from
22:15
the long run that says, "No, no. Hold on
22:17
a second. I mean, but you
22:18
How much output you can produce is a
22:20
function of the capital you have, of the
22:21
workers you have." Yeah, yeah, that's
22:23
true in the long run. But in the short
22:24
run, you have lots of flexibility
22:26
because you have lots of unused capacity
22:27
and so on.
22:29
Okay? So, this is pretty It's a big
22:31
assumption, and there is schools of
22:33
thoughts within microeconomy that split
22:35
by this assumption, whether you believe
22:37
that that that in the short run, output
22:40
is aggregate demand determined or not.
22:43
At MIT, we tend to believe that in the
22:45
short run. The long run, no. But in the
22:47
short run, that's what it does.
22:48
Now, sometimes the long run gets to you
22:51
very quickly. And at this point, we're
22:53
in a situation like that. That's the
22:54
reason we're seeing inflation and so on,
22:55
but that's something you'll understand
22:57
later on.
22:58
Okay? But but but for now, so this is
23:01
this is important. We're going to We're
23:03
saying here
23:04
output I don't need another equation. I
23:06
could have done aggregate demand like
23:07
this, and then output a function of
23:08
capital, labor, lots of things.
23:11
I'm not going to even do that. I'm going
23:12
to say, "No, no. Output will be whatever
23:14
demand wants it to be." Okay?
23:17
And that means in equilibrium, they have
23:18
to be equal.
23:20
Good.
23:21
You had a question.
23:28
No, they are the same for us.
23:31
That's our definition. GDP for us is
23:33
output.
23:35
So, when I say aggregate output, I mean
23:38
GDP.
23:39
Remember? Real GDP. We're talking all
23:41
about real GDP. Okay?
23:43
Uh
23:44
And it's also equal to income. Not
23:46
disposable, but it's equal to income.
23:47
Remember when we did those little tables
23:49
where we look on our
23:50
the three different ways of doing it?
23:52
Well, the first two were output.
23:55
And the last one was income, and they
23:56
had to be the same.
23:58
Okay?
23:59
So, why is real GDP for us?
24:04
That's real GDP.
24:07
What happens in the table I show you,
24:11
I already used the fact that real GDP is
24:13
equal to aggregate demand, and that's
24:14
the reason I show you the different
24:15
components of Z.
24:17
I show you that, that, and that.
24:20
Okay? But in equilibrium, they're equal.
24:28
There's really a figure that that will
24:30
clarify, I think, a lot of that. But
24:32
let's Let me keep solving this. So,
24:34
we have that And so, what I'm going to
24:36
do next is just solve it. So, we have
24:38
this equilibrium condition. I'm going to
24:39
plug in my aggregate demand function
24:42
here,
24:43
and so I can solve out for equilibrium
24:45
output. And here we have the first for
24:47
the first time in this course, an
24:48
equation for equilibrium output.
24:50
There you are. That's your equilibrium
24:52
output in this economy.
24:56
Okay?
24:58
Now, this guy here
25:01
is very famous,
25:02
and is very macro.
25:04
Doesn't happen in micro. It happens in
25:06
macro only. Okay? This guy here.
25:11
Another guy there is called the
25:13
multiplier.
25:16
Okay?
25:19
And it's a very important macro concept.
25:20
A huge concept in macro.
25:24
Now, why do you think it's called a
25:26
multiplier?
25:28
Well, obviously, it multiplies
25:29
something, but a multiplier sounds like,
25:32
you know,
25:34
that multiplies that makes something
25:36
bigger, no?
25:39
So, what happens if C1 is
25:42
uh greater than zero?
25:48
Is What happens if C1 is greater than
25:50
zero? Remember, it's between zero and
25:51
one. But what happens if it's greater
25:53
than zero? What happened with that
25:54
number there, one over one minus C1?
26:02
It's greater than one. That's what this
26:04
is. It multiplies. Okay? So, that's the
26:06
reason we call it a multiplier. There's
26:07
not nothing deep there. Uh okay? So,
26:09
this thing here is sort of autonomous
26:11
stuff, you know? It's what the
26:12
government spends, what firms are
26:14
spending, capital.
26:15
This is autonomous consumption. Uh
26:19
And this Actually, this is a typo there.
26:21
There should be a C1 in front of that.
26:24
Typo.
26:25
It comes from there. C1 times
26:28
T.
26:29
So, fix that typo, please. I I'm going
26:31
to upload the slides again with with the
26:33
typo fixed. Okay?
26:36
I'm just It comes from here. C1 times T.
26:40
Okay, so that's what this does. It
26:42
multiplies. So, whatever it is that that
26:44
is happening here, whatever it is that
26:45
the government is spending or whatever,
26:47
this term multiplies it. And that's a
26:49
huge thing. Uh There was a big debate uh
26:53
almost always when you're trying to get
26:55
out of a recession and the governments
26:57
are spending, a big question is, "Well,
26:58
how big is the multiplier?" If the
27:00
multiplier is small, you're going to
27:02
have to spend a lot to get the economy
27:03
out of the recession. If the multiplier
27:05
is large,
27:07
then then uh
27:09
you you're going to have have to spend
27:11
very little, and then the multiplier
27:13
will take you away from from that
27:14
recession.
27:16
So, what is it that makes the multiplier
27:18
large or small?
27:23
Well, mechanically, when is it that
27:25
multiplier large?
27:27
When C1 is closer to one. So, when when
27:30
people are spending more of their income
27:31
on Exactly. When C1 is large.
27:34
And that that gives you the logic, and
27:35
that's very important in macro. It's
27:38
Why is it that a big multiplier? Well,
27:40
because think what happens in macro. If
27:42
the government spends,
27:45
that increases output.
27:47
But now, output increases income. And if
27:49
consumers spend a big share of their
27:51
extra income
27:52
in output and consumption again, then
27:55
that increases output again, which
27:57
increases income again, and
27:59
you keep going.
28:00
Okay?
28:01
So, that's the sequence. On the
28:03
contrary, if consumers are very scared,
28:04
they don't want to spend any extra
28:06
dollar they receive, anything of the
28:07
extra dollar they receive, then you
28:09
don't get any multiplier because this
28:11
initial increase in output that comes
28:13
from the government expansion, that does
28:16
lead to increase in income, but if
28:17
consumers don't spend it, it doesn't
28:19
recirculate into the economy, and then
28:20
you don't get a multiplier. Okay? So,
28:22
that's that's the reason we call it the
28:24
multiplier.
28:27
So, that diagram is is an important
28:29
diagram. I'm just
28:32
uh
28:34
doing this, actually. In that diagram,
28:37
I'm plotting the aggregate demand
28:39
function,
28:40
and then this equilibrium condition,
28:42
output equal to aggregate demand,
28:44
in the space
28:46
of
28:47
uh
28:48
aggregate demand and output, production,
28:51
and income here. But remember, income is
28:53
equal to production. Okay?
28:55
So, there's your aggregate demand,
28:58
and that's your 45 degree line because
29:01
this output equal to So, whatever is in
29:03
this axis is equal to that axis. That's
29:05
the 45 degree line.
29:07
Okay? That's your equilibrium condition.
29:09
It says, "At equilibrium, this guy here,
29:12
aggregate demand Z, will have to be
29:13
equal to Y." Those are That's straight
29:16
there.
29:17
This is aggregate demand.
29:20
Why is this line flatter than that?
29:25
Why is aggregate demand flatter than
29:30
Uh because people don't spend their
29:32
entire dollar on Exactly. Because C1 is
29:34
less than one.
29:36
So, the slope of the aggregate demand in
29:38
this space is C1.
29:40
It's the marginal propensity to consume.
29:42
How much more they demand if they get an
29:44
extra dollar? Well, And don't get They
29:46
don't demand one one extra unit they
29:48
demand C1 unit and C1 is less than one.
29:51
Okay, that's the reason this.
29:53
So, if C1 is very small,
29:56
this line is going to be very flat.
29:58
If C1 is very large, very high marginal
29:59
propensity to consume, this is going to
30:01
be very steep,
30:02
the red line.
30:03
The other one doesn't change, the 45°
30:05
line.
30:06
Okay? And what I said is that
30:09
at equilibrium So, you see if I take an
30:11
off-equilibrium level of output, say
30:13
this,
30:14
aggregate demand is different from
30:15
output.
30:16
It's only at equilibrium that these two
30:19
things will hold.
30:22
Okay?
30:23
This function I can plot it everywhere.
30:27
But this one will hold only at
30:28
equilibrium.
30:30
Okay?
30:31
That's when these two things are equal.
30:35
So, what I solve here,
30:39
here I just found this point.
30:41
Okay?
30:42
So, parameters here are C0,
30:46
uh
30:46
C1 * T, and G. They all shifters of this
30:50
aggregate demand up and down.
30:53
Okay?
30:55
And and that point here
30:59
is exactly that. And those all those
31:01
things are parameters in my aggregate
31:03
demand.
31:11
I really want you to internalize this
31:12
diagram.
31:15
Any questions about
31:19
Just stare at this little bit because
31:21
it's going to show up repeatedly.
31:24
And and later on it's not going to show
31:25
up, but whenever you get confused, the
31:28
way to get yourself out of that
31:29
confusion is going to be to go back to
31:31
the diagram.
31:32
You'll see. I'll remind you when when
31:34
when that's likely to happen.
31:37
Okay? So, so you better understand
31:39
this diagram. Play with it. Move
31:42
Here the only thing you can move around
31:44
is the ZZ, the the the aggregate demand
31:46
curve. Okay?
31:48
The other thing is our equilibrium
31:49
condition. You can't move that that 45°
31:52
line. But ZZ you can move it around. So,
31:55
let's do a a few exercises. Well, one,
31:58
the most obvious.
32:00
Suppose that C0 increases by 1 billion.
32:05
Okay? So, autonomous consumption, that
32:06
is that level of consumption which is
32:07
independent of income, goes up by 1
32:09
billion.
32:10
And that could be, you know, we're all
32:12
in a better mood. You know, okay,
32:14
disposable income is whatever it is
32:16
today, but you know, there's great
32:18
expectation that that in the that the
32:20
economy will enter a boom next year.
32:24
And so, then you feel richer and so on,
32:26
and you may decide to consume not wait
32:28
until next year, you may decide to
32:29
consume more today. That kind of thought
32:31
experiment can be captured by a C0 type
32:34
shift, go up. And that's when you I talk
32:36
about consumer sentiment. Well, consumer
32:38
sentiment is about a lot about C0. For
32:41
any given level of income, will
32:42
consumers are likely to to to consume
32:45
more than they would otherwise or or
32:47
less.
32:48
And that's what C0 captures.
32:50
So, let's go
32:52
everything in this model, there's no
32:53
dynamics
32:54
in this simple model, so we immediately
32:57
but we know is if just were to solve the
32:59
equation,
33:00
and I tell you what happens to if output
33:03
what happens to output if C0 goes up by
33:05
1 billion,
33:07
you know that output will rise by how
33:09
much?
33:12
Let's keep it simple.
33:14
I
33:15
just staring at that equation. If I tell
33:17
you autonomous consumption goes up by 1
33:19
billion,
33:20
what happens to equilibrium output? Goes
33:22
up by more or less than 1 billion?
33:25
Or or exactly 1 billion?
33:33
Exactly. And the multiplier is greater
33:35
than one. So, we know that the output
33:37
will increase by more than 1 billion.
33:40
Will increase by 1 billion times the
33:41
multiplier.
33:43
If C1 is .5, then it will increase by 2
33:46
billion dollars equilibrium output.
33:49
Now, I'm going to get you to from the 1
33:51
billion to the 2 billion in a steps
33:54
using the diagram. That's what I intend
33:55
to do next.
33:58
Okay? So,
34:00
this shift here, so we're starting from
34:02
this equilibrium output here.
34:04
This shift here,
34:06
boom,
34:08
is increasing C0. That's a 1 billion.
34:10
So, distance A to B is 1 billion. That's
34:14
it will be because what I did is for any
34:16
given level of output I shift this
34:17
aggregate demand up by 1 billion. That's
34:20
autonomous consumption up.
34:22
Okay?
34:23
Well,
34:24
because output is whatever demand wants,
34:27
that immediately increases output
34:30
by 1 billion. So, B, the distance
34:32
between B and C is also 1 billion.
34:35
Okay?
34:36
Demand increase by 1 billion, boom,
34:38
output immediately catches up.
34:41
So, output increases by 1 billion.
34:45
But if output increases by 1 billion,
34:48
what has happened to income?
34:56
It also increased by 1 billion. Income
34:58
is the same as output.
35:01
So,
35:02
income has increased by 1 billion.
35:04
Well, if income has increased by 1
35:05
billion and C1 is different from zero,
35:09
that means part of that extra billion is
35:11
going to be spent
35:12
in consumption, second round.
35:15
So, say C1 is .5, then now you get 500
35:18
million dollars more of expenditure.
35:21
But if it's of consumption, and if
35:22
there's 500 dollars that's that's a C
35:25
CD.
35:26
Shift, that's 500 million.
35:29
Obviously, this C1 here is is less than
35:31
.5 because otherwise
35:33
you know, this would be half of that,
35:35
but but it's not. Anyway,
35:37
you get 500 million more.
35:39
But if you if now there's 500 million
35:41
more of demand, since output does
35:43
whatever production does whatever demand
35:45
wants, then you get 500 more of
35:47
production.
35:49
And if you have 500 more million dollars
35:51
more of production, then you have 500
35:52
million more of income.
35:54
And if you have 500 more of income and
35:56
so your C1 is greater than zero,
35:57
say .5, you're going to spend 250
36:00
million more.
36:02
But 250 million more will generate 250
36:05
million dollars of production, which
36:06
also will generate 250 million dollars
36:09
more
36:10
of
36:11
income,
36:13
which will generate 125 million more
36:16
of consumption, and blah blah blah blah
36:17
blah. You you you get your Okay?
36:20
So, that's and that's what is happening
36:22
here.
36:24
Boom.
36:25
Yeah.
36:29
From C
36:30
to D. Okay. So, this is initial
36:34
shift in aggregate demand up, 1 billion.
36:38
That
36:39
lead to leads to
36:41
uh
36:42
1 billion more of production as well,
36:45
which means 1 billion more of income.
36:48
Okay? But now these consumers not only
36:50
have this C0 1 billion higher in C0, but
36:53
they also have 1
36:55
uh billion more of income.
36:57
And since they have 1 billion income and
36:59
they're going to spend part of it, C1
37:01
times that, and I assume C1 was .5,
37:03
that's what gives me CD.
37:06
That's the the extra five 500 million
37:09
dollars.
37:10
And then this that thing here there is
37:12
also 500 million dollars, and then there
37:13
was 250 million, 250 million, 125, 125,
37:18
62 and a half, blah blah blah.
37:20
That's that's the way you get there.
37:24
There's an alternative way of
37:26
finding equilibrium output, which is
37:28
entirely equivalent. And it's the way it
37:30
was initially done, by the way.
37:32
Uh and and and you'll see later on a
37:34
very important curve in this course will
37:37
be
37:38
the IS curve, which is a curve that
37:40
describes all the equilibrium in goods
37:43
markets. We'll get there.
37:45
But but the reason it's called IS is
37:47
because of this alternative way of
37:48
deriving the same I have derived,
37:50
which is
37:52
through you you can arrive to the same
37:54
equilibrium by saying, "Look,
37:55
equilibrium output is that output at
37:58
which investment is equal to saving."
38:01
That's the reason that curve is going to
38:03
be called IS, investment equal to
38:05
saving, S.
38:07
So, let me very quickly do it for you
38:08
and and then make a point and connect
38:10
the two things.
38:11
So, say private saving is, you know,
38:14
what con- sumers do and so on,
38:16
and firms, is just disposable income
38:19
minus consumption. That's your saving.
38:21
Okay?
38:22
So, it's equal to Y minus T, that's
38:24
disposable income, minus C.
38:27
Government saving is taxes minus
38:31
government expenditure. So, if the
38:32
government has a deficit, that thing is
38:34
negative. Governments often have
38:36
negative saving. Okay? If you have a
38:38
surplus, then taxes are greater than G,
38:42
then you have a fiscal surplus. Again,
38:45
rarely happens in the US
38:47
or in the Americas in general. Okay?
38:49
Happens a lot in Asia, but not doesn't
38:51
happen very much in this part of the
38:53
world.
38:54
But there we are. So, in equilibrium,
38:57
investment, I,
39:00
has to be equal to saving. So, that's
39:02
what you are going to use the saving
39:03
for, to invest. Okay?
39:06
So, investment is equal to the sum of
39:08
savings.
39:09
I can replace all that in here, and you
39:11
see that I get exactly the same
39:14
equilibrium condition I had before.
39:16
Output equal to aggregate demand.
39:18
Okay? So, this is an entirely equivalent
39:21
way
39:22
of deriving this, and I just want to
39:24
show you this
39:26
because it's the way it was originally
39:28
done, and and and and and you'll
39:31
understand better the terminology we use
39:32
later on
39:33
if you see that this is an equivalent
39:35
way. This is also a nice way of
39:38
illustrating something why macro can be
39:40
counterintuitive sometimes.
39:41
Microeconomics is very intuitive. I
39:43
mean, things make sense.
39:45
It's like physics, it makes sense. Macro
39:47
is can be confusing.
39:49
For example, there's the well-known
39:52
paradox of saving in the short run, not
39:54
in the long run. In the short run, you
39:55
have the paradox of saving.
39:57
So, you know, we all think that you save
40:00
more is a good thing. Our parents teach
40:02
us that it's a good thing to save more
40:03
and so on.
40:05
And in general,
40:06
that is true. You'll do better in life
40:08
if you save a little more and so on.
40:10
But it's not true for the macro in the
40:12
short run.
40:16
You know, it's not good for
40:18
macroeconomics in the short run
40:20
unless you are in a overheated economy.
40:22
Now, it could help.
40:24
But otherwise, it's not very good for
40:27
equilibrium output. Let me show you that
40:30
very quickly with the expression I just
40:32
showed you. Remember that I said
40:33
equilibrium output is pinned down by
40:35
investment equal to saving. And saving
40:38
of the private saving here is an
40:40
increasing is an increasing function of
40:41
output, okay? It is equal to actually 1
40:45
- c The function has a slope of 1 - c1.
40:48
C1 is the share of income that you spend
40:51
in consumption. Therefore, 1 - c1 is the
40:53
share of your income that you spend in
40:55
saving, okay? So, this function is
40:57
increasing with a slope of 1 - c1.
41:01
So, suppose I tell you now that all we
41:03
decided to to we learn the lessons of
41:05
our parents and say, "Okay, we should
41:06
all save more."
41:08
So, that means for any for any given
41:11
level of income, now we all decide to
41:12
save more. That means the the S function
41:15
shifts up.
41:17
For any given level of income,
41:19
we save more. But
41:21
we have a problem there because now we
41:22
have more saving than investment.
41:26
So, how how do we restore equilibrium?
41:28
That's not an equilibrium.
41:29
How do we restore equilibrium?
41:37
So, now we all decide to be more prudent
41:39
and save a little more.
41:42
At the level of the economy as a whole,
41:45
now we have more saving than investment.
41:47
That can happen. It can It's not an
41:49
equilibrium.
41:51
What restores equilibrium?
41:55
Well,
41:55
in this very simple model, our
41:57
investment is fixed. So, I nothing can
41:59
adjust on the investment side because
42:01
it's fixed. Later on, it's going to
42:02
move, but now it's fixed.
42:04
Nothing can adjust in the public saving
42:06
part because, you know, it can't move.
42:09
We assume that it's exogenous.
42:10
So, something has to happen endogenously
42:12
here that that reverses the increase in
42:15
savings. That's the only thing that can
42:17
happen. And the only thing that can
42:18
happen endogenously here is a declining
42:20
output.
42:22
Output declines, saving declines.
42:24
So, here you end up in a situation in
42:26
which we all decided to be sort of, you
42:28
know, better people, save a little more,
42:30
and we end up sinking the economy in a
42:32
recession.
42:34
Yeah,
42:35
output declines.
42:36
Okay, that's the reason it's called the
42:37
paradox of saving.
42:41
That's not going to happen to you
42:42
individually, but to an economy as a
42:44
whole, that's the reason I said it's
42:46
counterintuitive.
42:47
It it can happen.
42:52
I get
42:53
So, I
42:54
Look, if you don't like this way of
42:57
uh
42:57
and it's not the main way we're going to
42:59
use. If you don't like this way of
43:00
finding equilibrium output, just ignore
43:02
it. I I just wanted you to know it. Go
43:04
back to The thing you really need to
43:06
understand is not this, it's it's this,
43:08
that, that that you need to understand.
43:10
So, let me
43:11
illustrate the paradox of saving
43:14
in in the model we're using, in the one
43:16
I want you to really remember.
43:19
Well,
43:20
the paradox of saving, I can capture by
43:23
a declining c0.
43:25
Okay? For any given level of income, now
43:27
we decide to consume less. If we consume
43:29
less for any given level of income, that
43:31
means we're saving more.
43:33
Okay?
43:34
So, I can capture in this diagram
43:38
uh
43:39
the the fact that we all all become sort
43:41
of more prudent by a declining aggregate
43:44
demand.
43:46
But if aggregate demand declines, so
43:48
suppose we start at this equilibrium
43:49
level of output and then all of a sudden
43:51
we say, "Okay, enough is enough. We need
43:53
We need to start saving more."
43:55
Then,
43:56
what happens? Well, aggregate demand
43:58
declines.
44:00
I mean, for any given level of income,
44:02
if you're going to save more, that means
44:03
you're going to consume less. So,
44:04
aggregate demand declines.
44:06
But what happens when aggregate demand
44:07
declines?
44:11
Output declines.
44:13
What happens when out when output
44:14
declines?
44:18
Income declines.
44:19
What happens when income declines?
44:25
Well, part of that income you consume,
44:27
so you're going to consume less.
44:28
C1 times that. So, then and then you get
44:31
the multiplier working against you. So,
44:33
not only if now we all decide to save
44:35
more, not only output falls
44:38
by the same amount that that we increase
44:41
savings,
44:42
but actually it declines by more than
44:44
that because you get the multiplier
44:45
working against against you.
44:47
Okay?
44:49
That's the reason I'm a big role of
44:51
policy makers really in recession is to
44:54
try to maintain the calm, the you know,
44:57
because you can get into this kind of
44:58
things. If everybody gets scared and and
45:00
you know, we all get scared, so the
45:02
economy can implode just out of bad
45:04
sentiment. Uh
45:06
and so on.
45:14
Now, we're on the opposite side of the
45:16
cycle. We would want output to decline a
45:18
little because we are having other
45:20
problems, inflation and so on, again,
45:22
something we'll discuss later.
45:24
So, now you may want to scare consumers
45:26
a little. And in fact,
45:28
uh
45:32
the the governors of the Federal
45:34
Reserve, and the same is happening in
45:35
other places in the world, are doing
45:36
just that. I mean, when they go out
45:38
there, say the economy is too hot,
45:42
uh we're going to have to mess up this
45:44
economy a little. And then they're
45:45
telling us that.
45:47
And and and the first ones to listen to
45:49
these things are is the financial
45:50
markets. So, every time they come out
45:52
and make a speech of that kind, equity
45:54
markets decline.
45:56
Well, equity markets capture before the
45:59
mood that consumers will have in the
46:00
future. They capture it early. But
46:02
that's the message.
46:03
Okay? So, they're trying to At this
46:06
moment, really,
46:08
uh
46:08
policy makers, at least the the central
46:11
banks, are trying to do just that.
46:13
Depress a little bit consumers.
46:15
So so so we can
46:17
cool off the economy a bit.
46:19
Okay?
46:22
Any questions?
46:24
Again, very important lecture because
46:26
we're going to build on on this and and
46:28
later on this is going to be always in
46:30
the background.
46:32
And
46:33
of this until we actually go to the
46:35
third part of the course,
46:36
the key model will be this. This will be
46:38
in the background. More More things will
46:40
be happening on top,
46:42
but but whenever I ask you a question,
46:45
for example, later on, one example, what
46:48
else would produce a
46:50
this a situation like this?
46:54
What else would What What could have
46:56
What kind of policy
46:59
would generate
47:01
that
47:02
that movement? Well, at this point, we
47:04
haven't introduced monetary policy, so
47:06
you cannot talk about monetary policy.
47:09
But we do we do have
47:11
other kind of policy we could talk
47:12
about.
47:24
Remember?
47:30
Here.
47:32
Fiscal policy.
47:35
Okay?
47:36
Fiscal policy, G and T. Those are fiscal
47:38
parameters.
47:40
When when G goes down or T goes up, we
47:43
call that contractionary fiscal policy.
47:45
Why contractionary? Because it contracts
47:47
aggregate demand.
47:49
If If G goes down, clearly aggregate
47:51
demand goes down immediately. If T goes
47:54
up, well, disposable income for any
47:55
given level of income goes down, and
47:57
therefore consumption goes down. So, so
47:59
we call an increase a declining G or an
48:02
increasing T a contractionary fiscal
48:04
policy.
48:05
The opposite, if G goes up and T goes
48:08
down, we call that an expansionary
48:10
fiscal policy.
48:11
So, I take you back to this diagram
48:14
here,
48:16
and I ask you the question again.
48:18
What kind of fiscal policy will generate
48:20
this type of
48:22
this picture?
48:24
Contractionary or expansionary?
48:32
Contractionary. Contractionary. I mean,
48:34
good mnemonic, the output declined.
48:37
You know? So, contractionary So, that is
48:39
a declining a reduction in G, in
48:41
government expenditure,
48:43
or an increase in taxes
48:45
will shift that curve down, and then the
48:47
multiplier will make it even more
48:49
contractionary than the initial fiscal
48:52
impulse.
48:57
Very good.
48:58
I'll see you on Wednesday.
— end of transcript —
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