Homework 1 Macroeconomic Terms

1. Aggregate Demand relation[1]
Aggregate demand is the total expenditures on gross domestic product. It relates the economy’s price level, usually measured by the GDP price deflator, and aggregate expenditures on domestic production, usually measured by real gross domestic product. The aggregate demand relation between aggregate expenditures and price level is inverse. A higher price level is related to a decrease in aggregate expenditures and a lower price level is related to an increase in aggregate expenditures. Above is an example of an Aggregate Demand curve showing the relationship between GDP and Price.
The curve shown below is aggregate demand curve.


2. Animal Spirits
According to Keynes one of the essential ingredients of economic prosperity is confidence and that animal spirits are a particular sort of confidence, “naive optimism”.[2] Undertaking responsibility for a commercial venture or middling between producers and consumers involves risk. The willingness to undertake such risks are what Keynes called the “animal spirits”.[3] An example of animal spirits in macroeconomic terms is where an investor converts a substantial amount of Euros into Dollars and sells the Dollars back to Euros in a year’s time without hedging their risk. The investor is anticipating the Dollar to strengthen over the course of the year and not to weaken even further. Therefore making reasonable profits without hedging their portfolio.

3. Bank Run
A 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 withdraws their deposits.[4] An example of this occurrence was the credit crisis in September 2007 where Northern Rock had to ask the Bank of England for an emergency financial assistance which led to an immediate“bank run”.

4. Bond
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and is obliged to repay the principal and interest (the coupon) at a later date, termed maturity. Other stipulations may also be attached to the bond issue, such as the obligation for the issuer to provide certain information to the bond holder, or limitations on the behavior of the issuer. Bonds are generally issued for a fixed term longer than ten years. U.S. Treasury securities issue debt with life of ten years or more, which is a bond. New debt between one year and ten years is a “note” and new debt less than a year is a “bill”.[5] There are several different types of bonds: Fixed rate bonds, Floating rate notes, High yield bonds, zero coupon bonds, Inflation linked bonds, Subordinated bonds, Perpetual bonds, Bearer bond, Bear bond, Municipal bond, Lottery bond and War bonds. Below is an example of a Zero Coupon Bond: Assuming that the investor wishes to buy a 5 year zero coupon bond today that costs $200 with zero rates of 5%, on maturity the investor will receive 200e(5 *0.05) = $256.5.

5.Capital Account
In economics, the capital account is one of two primary components of the balance of payments, the other being the current account. The capital account is referred to as the financial account in the IMF's (International monetary fund) definition; the IMF has a different definition of the term capital account. [6]
Capital Account = Increase in foreign ownership of domestic assets - Increase in domestic ownership of foreign assets = Foreign direct investment + Portfolio investment + Other investment The capital account measures monetary flows between countries used to purchase financial assets such as stocks, bonds, real estate and other related items.[7] An example of a capital account is when a foreign saver purchases shares of a U.S. corporation on the New York Stock Exchange, or a hotel located in the U.S., they are sending money into the U.S., leading to an increase in the capital account balance of the United States. In this case, the value of the assets (stocks bought and sold on the New York Stock Exchange) or the assets itself (the hotel) remains in the United States. If you decide to buy shares of a foreign company on the London exchange, you are sending money out of the U.S. through the capital account. A capital account surplus indicates that more foreign money in entering the U.S. than leaving it.

6. Debt to GDP Ratio
This 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. This measure gives an idea of the ability of a country to make future payments on 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 higher the debt-to-GDP ratio, the less likely the country will pay its debt back, and the higher its risk of default.[8] Below is a graphical representation of the Debt to GDP ratio for the Irish economy which has fallen from over 90% during the first half of the 1990s to an estimated 25.1% at end 2007. [9]



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.[10]
The term effective demand is used to differentiate between individuals and groups who have the will and the means to buy a product and those who have the will but not the means to buy the product. For example, the willingness of low income individuals to purchase an expensive car may be very strong, but they do not have the means to purchase the car. Effective demand only includes those individuals who have the will and the means to purchase a product. [11]

8. Deflation
Deflation is a reduction in national income and output.[12] Alternatively, it might refer to a sharp fall in the prices of financial assets or a sustained decrease in the general price level (a negative rate of inflation). The 'general price level' comprises the price of wages, consumption goods and services. The term ‘deflation’ was used by the classical economists to refer to a decrease in the money supply. The meanings are closely related, since a decrease in the money supply is likely to cause a decrease in the price level.
Below is a graph which illustrates deflation in Japan from 1990 to 2005. The reasons for this included the fall in asset prices which reduced the money supply, and a high level of non-performing loans.[13]




9. Consumption Function
The consumption function is the relationship between total consumer expenditures and total disposable income in the economy, holding all other determinants of consumer spending constant.[14]
The slope of the consumption curve is set by the marginal propensity to consume (the proportion of an increase in national income that is consumed). The higher the MPC, the steeper the curve will be. The consumption function can be represented by a graph showing how much is spent by households at different income levels. The example below illustrates the relationship between real income and spending from 1980 to 2005 in the U.K.









10. Consumer Price Index
The Consumer Price Index (CPI) is an index number measuring the average price of consumer goods and services purchased by households. It is one of several price indices calculated by national statistical agencies. The percent change in the CPI is a measure of inflation. The CPI can be used to index (i.e., adjust for the effects of inflation) wages, salaries, pensions, or regulated or contracted prices.[15]
Below is a graph of the U.S. Consumer Price Index CPI from December 2006 to April 2008
Past Trend Present Value & Future Projection





11. Investment Function
The relationship between the level of real investment and the value of the real interest rate; also called the investment schedule.[16]Investment is often modeled as a function of income and interest rates, given by the relation I = f(Y, r). For example, an increase in income encourages higher investment, whereas a higher interest rate may discourage investment. The interest rate represents an opportunity cost of investing funds rather than loaning them out for interest.[17]

12. Fiscal Expansion
Fiscal policy is the use of the government budget to affect an economy. The most immediate impact of fiscal policy is to change the aggregate demand for goods and services. A fiscal expansion raises aggregate demand through increasing government purchases or decreasing taxes. The resulting rise in consumption will raise aggregate demand. [18]Below is a graph showing the shift of the DD (equilibrium output) curve caused by an increase in government spending:[19]













13. GDP deflator
GDP, gross domestic product, deflator is a method to measure the price change of all new domestic goods and services in the economic system. It gives the net value of all goods and services procured over a specific time. Like consumer price index, GDP deflator doesn't rely upon a constant market basket. The basket is changeable, so new consumption patterns can be shown through this deflator according to the people's reaction to the changing market prices.
The GDP deflator can be depicted mathematically by this equation given below: GDP deflator = ( Nominal GDP / Real GDP)*100.
The graph below shows the U.S. GDP implicit price deflator from 1947 to 2007.[20]





14. Imports
Goods, services and capital assets purchased from overseas countries.[21]
An example of an importing is merchandise that is made in a foreign country and sold domestically, such as importing bananas from Africa and selling them on the Irish market.

15. Monetary Contraction
This occurs when the size of money supply is reduced with the aim of affecting interest rate and the level of aggregate demand.

16. Nominal GDP
The production of goods and services valued at current prices, while real GDP is the production of goods and services valued at constant prices.[22]
Imagine we want to compare output in 2005 and output in 2006 in our apple-and-orange economy. We could begin by choosing a set of prices, called base-year prices, such as the prices that prevailed in 2005. Goods and services are then added up using these base-year prices to value the different goods in both years. Real GDP for 2005 would be
Real GDP= (2005 Price of Apples*2005 Quantity of Apples)+(2005 Price of Oranges *2005 Quantity of Oranges).
Similarly, real GDP in 2006 would be
Real GDP = (2005 Price of Apples*2006 Quantity of Apples)+(2005 Price of Oranges*2006 Quantity of Oranges).
Nominal GDP in 2006 would be
Nominal GDP= (2006 Price of Apples*2006 Quantity of Apples)+(2006 Price of Oranges*2006 Quantity of Oranges).

17. Propensity to consume
The functional relationship between income level and consumption. The amount of consumption depends mainly on the amount of income, objective surroundings and people’s subjective needs, psychological propensity, habits and the rule of income distribution.[23]

18. Short run
The period of time in which quantities of one or more production factors cannot be changed, relative to long run which means amount of time needed to make all production inputs variable.[24]

For example, taking three factors of production - raw materials, labour and factory space - it is possible in the short run to increase production by increasing the first two variables, however it is only in the long run that all three are variable.

19. Real exchange rate
The rate at which a person can trade the goods and services of one country for the goods and services of another, while nominal exchange rate means the rate at which a person can trade the currency of one country for the currency of another.[25]
nominal real exchange rate= real exchange rate*(P*/P)

20. Trade surplus
An excess of a country’s exports over its import in a specific period of time. [26]

Reference:

[1]http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=aggregate+demand
[2]http://www.economist.com/research/Economics/alphabetic.cfm?letter=A#animalspirits
[3]http://members.shaw.ca/h-chartrand/Macro%20+%201.0.htm
[4]http://en.wikipedia.org/wiki/Bank_run
[5] http://en.wikipedia.org/wiki/Bond_(finance)
[6]http://en.wikipedia.org/wiki/Capital_account
[7]http://www.colorado.edu/Economics/courses/econ2020/section12/section12.html
[8]http://www.investopedia.com/terms/d/debtgdpratio.asp
[9]http://www.ntma.ie/NationalDebt/debtGDP.php
[10]http://en.wikipedia.org/wiki/Effective_demand
[11]http://www.extension.iastate.edu/agdm/wholefarm/html/c5-204.html
[12]http://www.bized.co.uk/glossary/econglos.htm
[13]http://www.scotland.gov.uk/Publications/2006/06/27171110/10
[14]Baumol, W. & Blinder, A. (2005) Macroeconomics, Principles and Policy, Thomson & Western: Ohio
[15]http://en.wikipedia.org/wiki/Consumer_price_index
[16] http://www.google.ie/search?hl=en&client=firefox-a&rls=org.mozilla:en-GB:official&hs=HhT&defl=en&q=define:investment+function&sa=X&oi=glossary_definition&ct=title
[17] http://en.wikipedia.org/wiki/Investment
[18]http://www.econlib.org/library/Enc/FiscalPolicy.html
[19] http://images.google.ie/imgres?imgurl=http://www.federalreserve.gov/boarddocs/Speeches/2005/20050420/figures1.gif&imgrefurl
[20]The St.Louis Federal Reserve Bank; U.S. Department of Commerce: Bureau of Economic Analysis - www.data360.org
[21]http://www.investordictionary.com/definition/imports.aspx
[22]Mankiw, G. (1997), Principles of Macroeconomics, 3rd Ed. Worth Publishers: New York
[23]Eatwell, J., Milgate, M. & Newman, P. (1987). The New Palgrave: A dictionary of economics. The Macmillan Press
[24]Pindyck, R., Rubinfeld D.L, (2001). Microeconomics. Prentice Hall
[25] Mankiw, G. (1997), Principles of Macroeconomics, 3rd Ed. Worth Publishers: New York
[26] Mankiw, G. (1997), Principles of Macroeconomics, 3rd Ed. Worth Publishers: New York

Homework 2 Exercise 3

When θ changes, the steady state value of output will remain the same.
Y*= G/θ
Y*= output
Θ = Personal Income Tax Rate
G = Government Expenditure
When θ increases, government expenditures increases by the same amount. This is due to the correlated relationship between the two variables.
So in the long run, we can see that in the steady state condition, Y* (output) remains the same when θ changes.