Blogwork 5

"Modify the PC Model to allow for the simulation of a stagflation-type episode in the economy"

Stagflation describes a prolonged period of inflation combined with slow or negative growth. Episodes of stagflation occurred in the world economy in the late 1970s and early 1980s, and much of the current macroeconomic news points to it taking place in the US at the moment. Stagflation is typically thought to be caused by unfavourable supply side shocks or inappropriate macroeconomic policies, both of which (arguably) have occurred during 2008. Firstly, the price of oil is at historic highs due to both OPEC restricting oil supplies and commodities in general being a natural hedge against inflation. Secondly, in attempting to remedy recent market turmoil and stave off recessionary fears, the federal reserve has aggressively cut interest rates and injected hundreds of billions into the money markets. It is the effects of these interest rate cuts in particular on model PC that is addressed here.

The equation system for model PC is given below.

It is assumed in model PC that the price of bills do not change during the duration of their lives (r = rbar, eq12). This assumption has to be relaxed to allow for the Fed's recent cutting of interest rates, which, as noted above, could be a cause of stagflation. When interest rates fall, the price of bills rise. This increase induces an immediate increase in wealth. A fall in interest rates also increases demand for a time. This could be achieved by an increase in consumption expenditure through an increase in the wealth term in the consumption function (eq5). Thus, interest rate decreases have a positive effect on real demand, but this positive effect is only a temporary one. The long-run effect of decreasing interest rates is in fact lower aggregate income, despite the initial positive wealth effect. What happens is that the lower yields on government debt decrease the flow of payments that arise from the government sector, which will eventually lead to less consumer spending on the part of households. Furthermore, a decrease in the desire to hold bills (a decrease in gamma zero in eq7) will decrease the proportion of government debt taking the form of bills, and hence lower the average rate of interest payable on the overall amount of government liabilities, thus leading to a decrease in the steady state value of national income.

If economic stagnation as described above is combined with a supply-side shock as described below and currently thought to be happening with commodities (most notably oil and gold), then the result is stagflation.

Blogwork 4

Question 1 - Model PC - summary of Godley & Lavoie, pages 99-107:

In model PC, households make a portfolio choice between money and short-term government securities. The quantity of money held thus depends on the rate of interest obtainable on Treasury Bills. The table below shows the new balance sheet matrix with the addition of the new row for T-bills, and an additional column introducing a central bank. The sum of household wealth is now V, which also equals public debt. There is no production as this is still a pure service economy, where capital is instantaneously created and destroyed (haircut economy). In model PC the central bank is considered as an institution in its own right. It purchases bills from government, provides money to households and has zero net worth.

In the transaction matrix for model PC below, the rows and columns once more sum to zero but now the flow of funds accounts comprises two financial assets. We also have to take account of interest payments arising from government debt. Interest payments each period are generated by stocks of assets at the end of the previous period, at a rate set at the end of the last period, t-1. The central bank sector has a current account describing inflow and outflow of interest payments, and a capital account describing changes in the balance sheet of the central bank, for instance when it purchases new bills. The central bank’s net worth is zero as all profits are paid to the government. Therefore, the government only pays interest on debt held by households.

The model below is built on perfect foresight. The national income identity in Eq1 is thus unchanged. Disposable income is enlarged by the interest payments households receive on government debt (Eq2). Taxable income is similarly enlarged (Eq3). Eq4 states that the difference between disposable income and consumption is equal to the change in wealth, not just money as was the case of model SIM. Similarly, the consumption function of model PC now has wealth instead of money as its second argument. The key behavioural assumption made in this new model is that households make a two stage decision; first on how much they will consume, and second on how they will allocate their wealth, including any newly acquired wealth. The quandary of how wealth is allocated between money and bonds has thrown up two prevailing theories – the quantity theory of money and liquidity preference theory, which are embodied in Eq6, Eq7 and Eq8. If households wish to hold a certain proportion l0 of their wealth in bills, they must want to hold 1-l0 in money. However, the proportions are modulated by the interest rate on T-bills, and YD relative to wealth. For example if interest rates increase, then households will want a higher proportion of their wealth yielding this higher return. Conversely, if household disposable income comprises a high proportion of total wealth then households will hold the majority of their wealth in cash.

Eq9 describes an endogenous credit money economy. It is the budget constraint of the government as per column 3 – the deficit is financed by bills newly issued by treasury department. Eq10 describes the capital account of the central bank as per column 4 – additions to the stock of high-powered money are equal to the additions in the demand for bills by the central bank. In this sense, the central bank sector is said to provide cash money on demand. Cash money is therefore endogenous (internal) to the system. The interest rate on the other hand is said to be exogenous (external) or, put another way, a facet of monetary policy. It is assumed interest rates remain constant throughout the life of a T-bill (eq12), for example 3 months. If eq12 were not to hold true, there could be capital gains arising form price changes, to which no transaction between different sectors correspond. The transactions matrix above will therefore not balance without a memo for capital gains. If eq12 holds, we have 10 independent equations and 10 unknowns. The interest rate represents monetary policy, and is given of that policy.

Question 2.1

John Maynard Keynes defined liquidity preference as the relationship between the quantity of money the public wishes to hold and save and the interest rate. According to Keynes, the public holds money for three purposes:

1. Transaction motive: this is the need for cash for the current transaction of personal and business exchanges.

2. Precautionary motive: this is the desire for security and the holding of cash for extraordinary situations e.g. Sickness.

3. Speculative motive: this is the opportunity to take advantage of a profit making opportunity.

The most significant point of Keynes theory was essentially that when interest rates are cut, increases in the money supply set aside will not encourage further investment but instead will be absorbed by increases in people's approximate balances. This will occur because the interest rate is too low to induce wealth holders to exchange their money for less liquid forms of wealth and because in the long run people expect interest rates to rise in the future.

In the diagram, we show the quantity of money on the horizontal axis and the interest rate on the vertical axis. For example, if the rate of interest is Re, people hold Ms1 of money, whereas if the rate of interest were to go down to R0, people would increase their assets to Ms2 or Ms3.With a potentiality or functional tendency L, which fixes the quantity of money which the public will hold when the rate of interest r and income level y are given, the schedule of liquidity preference (represented by quantity of money held M) in relation to interest rate and income is presented as follows: Md = L1(y) + L2(r), where transaction and precautionary motive mainly are influenced by y while speculative motive by r.

Source: (http://courseware.ecnudec.com/zsb/zgs/zgs02/zgs023/zgs02303/zgs023030.htm)

Keynes used the concept of liquidity preference to explain the prolonged depression of the 1930s.

Question 2.2

Definitely, PC model is a good representation of Keynes’ original vision of household decision-making. The model includes Keynes three elements of liquidity preference the precautionaty, transitionary and speculative motives.

Firstly, the PC model distinguished between disposable income and consumption and idea also inbuilt in Keynes’ theory. The equation V= V-1+ (YD-C) straightforwardly exemplifies that the difference between disposable income and consumption is equal to the change in total wealth. Keynes writings also bounced upon this thought, in his words “how much of his income he will consume and how much he will defer or save in some form of command over failure consumption.” (Keynes, 1936)

Secondly, the PC decision has two steps, Savings is decided on and how savings is allocated respectively which are made within the same time frame in the model. In the both of these models, the rate of interest is the equilibrium in the desire to hold wealth in cash form and the availability of cash.

According to PC theory, Hh/V= (1-λ0)-λ1*r+λ2*(YD/V) and Bh/V=λ0+ λ1*r -λ2 (YD/V) are established. These equations exhibit the following features: the cash holdings over the wealth is negatively related to the interest rate and positively related to disposable income.
This exactly reflects Keynes’ liquidity preference: transaction and precaution motives for cash holdings positively correlate with income Y and speculative motive is negatively related with interest rate r. Clearly we can see Hh/V+ Bh/V=1, which implies wealth must be divided into cash and bills.

Furthermore, PC model assumes the money supply is endogenous and demand-led which can be expressed with these equations: Bs= Bs-Bs-1= (G+r-1*Bs-1) - (T+r-1*Bcb-1); ΔHs=Hs-Hs-1=ΔBcb; Hcb=Bs-Bh; r is exogenous. One thing is clear: central bank acts as residual purchaser of bills--- It purchases all the bills issued by the government that households are not willing to hold given the interest rate. In other words, the central bank is providing cash money to those who demand it. While introducing money into Keynes’ liquidity preference, we can also see autonomic mechanism would change the quantity of money supplied necessary to maintain a given rate of interest. (Godley & Lavoie, 2007:103-107).

Homework 3

Question 1.
1. Model SIM used the strong assumption that consumers have perfect foresight with regard to their income – something which is inconceivable in a world dominated by uncertainty. Therefore, expected disposable income is substituted for actual disposable income in the model SIMEX. At the beginning of a period, households decide on the amount of additional money they desire to hold by the end of the period. If realised income is above expected income, households will hold the difference in the form of larger than expected cash money balances. However, despite mistakes in expectations, as time goes on, the steady state achieved with SIMEX will be the same as that achieved with SIM (Figure 1). This is because, as period succeeds period, households will amend their consumption decisions as they find their wealth stocks unexpectedly excessive or depleted, and as their expectations about future income get revised.

2. Mistaken expectations concerning income make no difference to the stability of the model.

If income turns out to be continually higher than expected, the accumulation of wealth also continues to be larger than expected, which makes consumption grow. Growth ceases when wealth has risen to a level at which additional consumption out of wealth is exactly equal to consumption which is lost because of mistaken expectations about income. Therefore, it doesn’t matter if expectations are falsified because there is a sequential system with a built in mechanism for correcting mistakes. For example, assuming a permanent step increase in government expenditures, consumption eventually reaches, albeit slower, the same steady state value that it would have reached in a perfect foresight model (Figure 2). If expectations about income never adapt to the new circumstances, which is a real world possibility given households would not intuitively equate an increase in government spending with an increase in consumption, then wealth increases – faster than it would otherwise have done – and it is this which causes consumption to rise (Figure 3). This rise only tails off as consumption reaches its new steady state. Actual wealth and therefore public debt would be larger than that of an economy where forecasts are correct.

Question 2:

2.1
It is possible to specify a version of SIM that replicates the ISLM model. The point of intersection of the IS curve (market for goods and services) and LM curve (money market) represents a simultaneous equilibrium in both the goods and money markets as illustrated below.

Source: (http://www.staff.ncl.ac.uk/david.harvey/AEF116/2.4/ISLM.GIF)

This point of equilibrium can be compared to the steady state of the SIM model.WhereYD*= C*; and both models have comparable consumption functions.

Private consumption C depends on three factors. First, there is some exogenous level of private consumption (defined by c0) even at zero levels of disposable income. Second, consumption depends on disposable income (Y-T) according to the parameter "b" that represents the marginal propensity to consume: i.e.if b=0.8, when income goes up by a dollar, consumption goes up by 80 cents. Third, consumption is a negative function of the interest rate r; as interest rates go up, consumers will save a larger fraction of their income and consume a smaller fraction of their income.

C=c° + b(Y-T) – a r

Source: (http://pages.stern.nyu.edu/~nroubini/NOTES/CHAP9.HTM)

2.2

Consumption Function Equation: C = α0 + α1YD

Where...

α0 represents: a positive constant, which represents autonomous consumption, independent of current income;α1 represents: the Marginal Propensity to Consume;YD represents: Disposable Income.

This version of SIM replicates the ILSM model and will allow us to obtain a coherent stationary state. This is because the average propensity to consume can be unity, i.e. we can have C = YD in the stationary state even though the marginal propensity to consume out of disposable income is below 1. This is due to the constant term α0 which plays a role similar to that of the consumption out of wealth.

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

Q3 Show changes in U-VH space if parameters changes

Changes in U-VH space if alfa set from 0.3 to 0.7

Changes in U-VH space provided interest rate on bond set from 0.07 to 0.1

Homework 2 (amendments made on 05/05/08 are in bold)

1. Fill in the blanks

Behavioral Transactions Matrix for SIM

1.1 Why must the Vertical Columns sum to zero?
The zero-sum rule for each column represents the budget constraint for each sector. The budget constraint for each sector describes how the balance between flows of expenditure, factor income and transfers generate counterpart changes in stocks of assets and liabilities, i.e. everything comes from somewhere and everything goes somewhere. The matrix shows how any sector’s financial balance - the difference between inflows and outflows – must be exactly matched by the sum of its transactions in stocks of financial assets.
1. Households: Their factor income can be spent in three ways: consumption, tax and financial assets investment. The accumulation of households’ wealth is determined by their financial balance – the excess of disposable income over expenditure. Amendment (05/05/08) - Thus, the change in the amount of money held must always be equal to the difference between households' receipts and payments.

2. Production: Producers earn income by providing services to households and government equal to its wage bill. Based on assumptions of the model - no goods in the economy provided, no capital equipment needed, no intermediate costs of production, no inventories and only three sectors included, such equilibrium can be established. Amendment (05/05/08) - Thus, as they are assumed to hold no cash, producers' receipts from sales must equal their outlays on wages.

3. Government: Its source of funding from taxes and public debt equals its spending. Government expenditure that is not covered by taxes must be covered by the issue of debt. Cash money is that debt. Amendment (05/05/08) - Thus, the amount of money created must always be equal to the difference between the governments receipts and outlays.

1.2 Why must the Horizontal Rows sum to zero?
The rule enforcing that all rows must sum to zero is such that each row represents the flows of transactions for each asset or for each kind of flow. The matrix shows that every component must have an equivalent component, or a sum of equivalent components, elsewhere. Amendment (05/05/08) - However, it cannot be just assumed in advance that the horizontal entries sum to zero, i.e. that supply equals demand. There must be a mechanism that makes it so. To that end, the so-called Keynesian, or Kaleckian, quantity adjustment mechanism 'allows' production to be the flexible element of the model. In other words, producers produce exactly what is demanded. Hence, there are no inventories and the equality between supply and demand is achieved by an instantaneous quantity adjustment mechanism. Rows 1 & 2 therefore embody the mainstream, or neo-classical, equilibrium between aggregate supply and aggregate demand. The system as a whole is now closed in the sense that every flow and every stock variable is logically integrated to such a degree that the value of one item is implied by the values of all the others taken together. Amendment (05/05/08) - The system is founded on two behavioural assumptions. Firstly, firms sell whatever is demanded. Secondly, there are no inventories.

2 Write out an explanation for each row.
All sources of funds appear with a plus sign (incoming flows of money) and all uses of funds appear with a minus sign.
Row 1, Consumption: The household sector demands consumption services (outflow of funds) that the production sector supplies (inflow of funds). Therefore Cs = Cd.
Row 2, Government: Similarly the government sector demands the services that the production sector supplies. Therefore Gs = Gd.
Row 3, [Output]: This is not a transaction between sectors and hence only appears once. Total production is defined either as the sum of all expenditures on goods and services or as the sum of all payments of factor income. Therefore Y = C + G = WB.
Row 4, Factor Income: The production sector demands a certain volume of employment at a wage rate exogenously determined and this is provided by the household sector. Therefore Ns = Nd.
Row 5, Taxes: The government demands taxes that the household sector pays. Therefore Ts = Td.
Row 6, Change in Money Stock: Because there is only a single financial asset and because there are no tangible assets in this economy, outflows (additions) to cash holdings constitute the saving of households. This asset has a counterpart liability in the issuance of money by the government, i.e. change Hh = change Hs. This states that saving must be equal to investment. In model SIM, there is no investment. This implies that social saving; the saving of the overall economy must be equal to zero. Here the term ‘change Hh’ represents household saving: the term ‘change Hs’ stands for government fiscal deficit, and hence government dissaving. For overall saving to be zero, the two terms must equal each other. Amendment (05/05/08) - However, model SIM contains no equilibrium condition which makes the two equal to each other. To that end, the watertight accounting, combined with the two behavioural assumptions, allows us to logically infer their equality by all the other rows and columns summing to zero (Walrasian principle).

References:
Monetary Economics, Godley & Lavoie, chapters 2 & 3.

Homework 1 [amendment to "Exercise 3" at the end of this post (05/05/08)]

1. Aggregate Demand relation
Aggregate Demand refers to the total amount that all consumers, business firms, government agencies, and foreigners wish to spend on all final goods and services at a given time and price level. It is often called effective demand or abbreviated as ‘AD’. (http://en.wikpedia.org/wiki/Aggregate_demand)
(William J. Baumol and Alan S. Blinder. 1997. “Macroeconomics Principles and Policy”. pp143)

The following equation clearly exhibits the relationship between aggregate demand and its relevant factors: AD= C + I + G + (X-IM)

Where C stands for consumption, I symbols investment, G relates to government purchases of goods and services and (X-IM) represents net exports, all of which positively correlate with AD: If C increases, it means the total demand for all consumer goods and services would rise; If I (the purchase of some new, physical assets) goes up, it will lead to additional demand for newly produced goods and greater productive capacity; If G is enhanced, employment should be given a positive injection and the ripple effect (boost) also spreads to other industries although to some extent it may squeeze certain part of private investment; If the total demand for goods and services originating beyond borders minus domestic desire for goods and services outbound is fortified, AD will also increase. Besides another important factor--- price level must be taken into account to determine the level of aggregate demand, that is, the higher the price level the lower the aggregate expenditure is.

Graphical Example:
Aggregate Demand Curve
Along the curve---if price level changes Shifting the curve---if C, I, G, X-IM change
Source:(http://www.amosweb.com/cgi-in/awb_nav.pl?s=wpd&c=dsp&k=aggregate%20de%20mand%20curve)


2. Animal Spirits
Animal Spirits are a particular sort of confidence “naïve optimism” towards economic prosperity given by Keynes. He meant in particular for entrepreneurs, “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”.
(http://www.economist.com/research/Economics/alphabetic.cfm?letter=A)

A better example in economic area is the overreaction of people in stock market. Here in practical world one of the assumptions in economics “rational investors” seems to be deviated. Herd effect and follow-up tendency intensify blind expectations of price movements for equities which would result in bubbles and severe devastation to the whole economic. As it’s well-know, in 2000 the collapse of American network stocks rightly demonstrates the irrationality of people including both individuals and government and investors’ over-optimistic attitudes towards technology.

3. Bank Run
It refers to a situation when the customers of a bank fear that the bank would become insolvent, they rush there to take out their money as quickly as possible to avoid losing it, which would spread quickly around.
(http://economics.about.com/cs/economicsglossary/g/bank_run.htm)
It is a game playing between depositors. Actually some of them have no need for extra money but to avoid losing it they swarm in the banks for withdrawals which would intensify the crisis. In general this kind of bank run is always associated with currency crisis and credit crisis.

For example: American S&L Crisis in 1980s’ which began with S&L’s golden period as houses demand was strong and ended with its bankruptcy which was in contagion with other financial institutions quickly.

4. Bond
A bond is a fixed interest financial asset issued by governments, companies, banks, public utilities and other large entities which attracts investors by promise to repay the principal along with interest (coupons) on a specified date (maturity).

Compared with equity, two characteristics stands out as: a. The buyer does not gain any kind of ownership rights to the issuer. b. A bond holder has a greater claim on an issuer’s income than shareholder in the case of financial distress. The yield from a bond is made up of three components: coupon, interest, capital gains and interest on interest.
(http://www.investorwords.com/521/bond.html)

5. Capital Account
It is one of two primary components of the balance of payments, which is referred to as the financial account in the IMF’s definition.

Capital account= Increase in foreign ownership of domestic assets- Increase of domestic ownership of foreign assets (Foreign direct investment)- Portfolio investment+ Other investment
(http://en.wikipedia.org/wiki/Capital_account)

6. Debt to GDP ratio
It is a measure of a country’s federal debt in relation to its GDP, which indicates the country’s ability to pay back its debt. If a country were unable to pay its debt, it would default, which could cause a panic in the domestic and international markets. The high the debt-to-GDP ration, the less likely the country will pay its debt back and the higher its risk of default.
(http://www.investopedia.com/terms/d/debtgdpratio.asp)
Suppose country A has such ratio of 1, country B with 1.5. Undoubtedly, we can say the former is positioned better in their debt payment than the later although situations are disadvantageous for both countries.

Latin American debt crisis in 1982 is a good example for further explanation: For the reason of frustrating integration of regional markets, imbalance of foreign trade, severe dependence on outside funds and technologies, no timely structure and development mode adjustment, GDP of most countries located in Latin America grew negatively with great gap between borrowing amount. It is well-known the result was devastating.

7. Effective Demand
Effective demand refers to the simple economic idea that says that it's not enough to want something such as food or luxuries. One must also have money or other assets (purchasing power) or some product to sell in order to make that demand effective.
Source : (http://www.investordictionary.com/definition/effective+demand.aspx)

Example: A business man has to decide at the beginning of the week the number of workers to hire sufficient to bring his goods to market at the weekend. The workers hired by the businessman work throughout the week and are paid on a Friday for their efforts. On the weekend the employees as well as other customers, come to the market to purchase the goods from the businessman using the income they have earned. Ideally the businessman expects to sell the last product to the last customer if his expectations regarding demand are met.

8. Deflation
Deflation is a decrease in the general price levels over a period of time.

Example: One famous historical example of deflation was the Great Depression when the American economy collapsed as a result of a variety of strains, and a world-wide depression was triggered. People in the middle classes lost their jobs and stopped buying products. People in the upper classes had to cut back on their consumption of luxury products. As a result, there was a decreasing demand for products. Manufacturers cut prices with the hope that more people would buy their products, and fired people to pay for the drop in prices. Essentially as prices dropped, the same amount of money could buy more goods.

9. Consumption Function
In economic terms this function calculates the amount of total consumption in an economy. In essence the consumption function says that the amount people spend depends on their income, and that as income increases, so does consumption.
Source:(http://en.wikipedia.org/wiki/Consumption_function).

Example: Increased levels of affluence experienced in Ireland during the Celtic Tiger years enabled Irish people to spend much more on luxury items than ever before in the country’s history.

10. Consumer Price Index:
This is an index measuring the average price of consumer goods and services purchased by households.

Graphical example:

Data source: (http://www.cso.ie/statistics/cpi2008.htm)

11. Investment Function:
This economic concept explains how changes in national income induce changes in investment patterns in the national economy.

istorical Example: After terrorists leveled the World Trade center in 2001 business expectations would have decreased significantly. This resulted in a decrease in planned income and investment decreased at every level of income. This would have had the effect of a shift in the investment function graph downwards.

12. Fiscal Expansion:
This is the increase of government expenditures or budget.

Example: Essentially a fiscal expansion is the raising of aggregate demand through one of two means. Firstly, a government can increase purchases but keep taxes the same, this will increase demand directly. Secondly, if the government cuts 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.

13. GDP Deflator:
This is the measure of the change in prices of all new, nationally produced, final goods and services in an economy.

Numerical Example: For a farmer, we could define a “unit” to be a crop with a specific level of output, size, produce etc. A price deflator of 200 means that the current-year price of this crop is twice its base-year price - price inflation. A price deflator of 50 means that the current-year price is half the base year price - price deflation.


14. Imports:
In reference to international trade, these are goods brought into one country from another (http://www.investopedia.com/terms/i/import.asp).

Example:

Data from http://www.uschina.org/statistics/tradetable.html

15. Monetary Contraction:
A reduction in the size of the money supply. A central bank can implement contractionary policy by reducing the size of the monetary base, which directly reduces the total amount of money circulating in the economy (http://en.wikipedia.org/wiki/Contractionary_monetary_policy).

Example: Contractionary monetary policy can have the effect of reducing inflation by reducing upward pressure on price levels. The ECB’s mandate is to control inflation (the Fed has a dual mandate of price stability and full employment). Under renewed pressure by the Federal Reserve’s action to recently cut its base rate Jean Claude Trichet, ECB President, acknowledged that there were downside risks to growth, but added, “Particularly in demanding times of significant market correction and turbulence, it is the responsibility of the central bank to solidly anchor inflation expectations to avoid additional volatility in already highly volatile markets.” Consequently, the ECB has left its main interest rate unchanged at 4% since June 2007.

16. Nominal GDP:
A gross domestic product (GDP) figure that has not been adjusted for inflation (http://www.investopedia.com/terms/n/nominalgdp.asp).

Example: If the nominal GDP figure has increased by 8% but inflation has been 4%, the real GDP has only increased 4%.

17. Propensity to consume:
This is an inclination to spend what one earns on the consumption of goods and services, as opposed to being saved. Marginal propensity to consume (MPC) represents the proportion of an aggregate raise in pay that is spent on the consumption of goods and services. (http://www.investopedia.com/terms/m/marginalpropensitytoconsume.asp).

Example: Suppose someone receives a bonus of €500. If they decide to spend €400 of this marginal increase in income on a new watch, their marginal propensity to consume will be 0.8 (€400 divided by €500).

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

Average cost per unit is minimised at a range of output between 350 and 400 units. Thereafter, because the marginal cost of production exceeds the previous average, so the average cost rises (for example the marginal cost of each extra unit between 450 and 500 is 4.8 and this increase in output has the effect of raising the cost per unit from 1.8 to 2.1). From http://tutor2u.net/economics/revision-notes/a2-micro-supply-shortrun-costs.html.

19. Real Exchange rate:
The real exchange rate is the nominal exchange rate multiplied by (P*/P), where P* is the foreign price level and P is the domestic price level.

Example: If the price of goods in Japan increases by 5% but the € appreciates 5% against the ¥, then the price of goods remains the same for someone in the Euro zone.
20. Trade Surplus:
A positive balance of trade is known as a trade surplus and consists of exporting more than is imported.

Example: Ireland’s trade surplus in 2006 comprised:

Data source: http://www.cso.ie/statistics/botmaintrpartners.htm

Lecture 2 Exercise 3

Y* = G/q
if q falls, then Y* rises­
Or subsequently
If q rises ­, then Y*falls

This will happen because when the Personal Income Tax Rate (q) falls then Taxes (T=qY) fall. This will cause a rise in Disposable Income of Households (YD=Y-T), which will result in a rise in Consumption (C=a1YD+a2H-1) and vice versa. This will result in a rise in National Income (Y=G+C).

Amendment (05/05/08) - The effect of lowering the tax rate from 20% to 10% can be seen from the following workings, where the "n" column represents the steady state:

Names

Anthony Carroll - 9512616
Orla Doyle - 0332429
Hui Hong - 0700266