Introduction to
Macroeconomics II
Financial
Fi i l Programming
P i andd Policies
P li i
Vang Vieng, Lao PDR
May 5 – 16, 2014
Jan Gottschalk
TAOLAM
Outline
I. Circularity of Income and Spending
II. Income-Expenditure Framework
This training material is the property of the International Monetary Fund (IMF) and is intended for the use in IMF courses.
Any reuse requires the permission of the IMF.
2
Circularity of Income & Spending
Circularity of flows is central to National Accounts:
Estimate of GDP
Goods and services (real flo
Production Approach
Money
y ((financial flow)) ( sectoral "value
value added")
added )
"Goods Market" Expenditure Approach
(Y=C+I+X-M)
HOUSEHOLDS PRODUCERS
NON-RESIDENTS
"Factors Market"
Income Approach
(Y = wages + OS+TSP)
Wages (financial flow)
OS=gross operating surpluses of
enterprises (including profits, rents, interests)
Labor (real flow) TSP=taxes less subsidies
Exercise on Circularity of Income & Spending
Let’s simulate an economy with 3 sectors:
• Imagine each sector consists of one family business (so we do not have
to deal with wages!)
• There is no
government either (so
we don’t have to deal
with taxes and
government spending)
• The first sector /
family business is rice
farming:
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Exercise on Circularity of Income & Spending
Let’s simulate an economy with 3 sectors:
• The second sector / family business is fishing:
Exercise on Circularity of Income & Spending
Let’s simulate an economy with 3 sectors:
• The third sector / family business is running a restaurant, which
essentially processes the food grown or fished by the other two families:
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Exercise on Circularity of Income & Spending
Simulation will follow these steps:
• We will hold three auctions that will determine demand/supply as well
as the price of rice, fish, and restaurant meals:
Rice market: restaurant owner will buy rice from rice farmer
Fish market: restaurant owner will buy fish from fishermen/women
Restaurant market: rice-farming
rice farming and fishing families will buy meals
from the restaurant
• We will keep track of
Market-clearing prices and quantities
Income and spending of each family (and the change in their savings)
Economic output (GDP) of this three-sector economy
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Exercise on Circularity of Income & Spending
Baseline simulation:
You will learn
140
• Supply and
120
demand
schedules 100
• Role of prices
80
for equilibrating Supply
demand and 60 Demand
supply
40
• Spending of
20
one sector is
income of 0
another 0.0 10.0 20.0 30.0 40.0 50.0 60.0
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Exercise on Circularity of Income & Spending
Simulation of a crisis situation:
Assume a situation where a housing or stock market crash has wiped
out part of the wealth of households (the precise cause does not
matter!) and households want to rebuild their wealth by increasing
their savings. We will simulate this situation by assuming that all of our
three sectors reduce their spending simultaneously in order to save
more. You will learn:
• The simultaneous reduction in spending leads to a fall in income for
all three sectors
• GDP declines
• None of the sectors succeeds in increasing their savings
Exercise on Circularity of Income & Spending
This mechanism is central to understand the sharp
drop in Thailand
Thailand’ss GDP during the crisis:
• You will have to think about Annual Real GDP Growth
macroeconomic policies that can 15.0%
limit the output drop when you 10.0%
develop an alternative policy 5.0%
scenario next week 0.0%
-5.0%
• To do so, it is useful to have a -10.0%
better understanding of -15.0%
aggregate demand and supply … -20.0%20 0%
1994Q1
1994Q3
1995Q1
1995Q3
1996Q1
1996Q3
1997Q1
1997Q3
1998Q1
1998Q3
1999Q1
1999Q3
2000Q1
2000Q3
2001Q1
2001Q3
• … and especially the role of
macroeconomic policies in
stabilizing
t bili i d demand
d Annual change in % (y-o-y)
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Outline
I. Circularity of Income and Spending
II. Income-Expenditure Framework
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Income--Expenditure Framework
Income
In the short run, the level of real GDP is
d
determined
i d by
b the
h level
l l off aggregate demand:
d d
• The level of aggregate demand is determined by the level of expenditures
[E] by domestic households, businesses and foreigners
• In the short run, businesses can’t adjust their prices [prices are sticky] and
have to meet demand at prevailing prices, which means production and,
hence, economy
economy-wide
wide output [Y] has to be adjusted in line with demand
conditions:
Y=E
• Given the circularity of income and spending, the level of expenditures also
determines the level of incomes
• The income
income-expenditure
expenditure framework is a useful tool for analyzing
expenditure (and therefore aggregate demand) levels in the economy
Source: Brad DeLong: Lecture Notes: Chapter 9: The Income-Expenditure Framework: Consumption and the Multiplier 12
Income--Expenditure Framework
Income
Four components of spending:
• Consumption spending by households [C]
• Investment (spending by corporations building plant and installing
equipment and purchasing inventories) [I]
• Government purchases (taxes and transfer payments don't count) [G]
• Net-exports (exports minus imports) [NX]
These all add up to total spending E: C + I + G + NX = E
In equilibrium, this is the same as total incomes or GDP Y: E = Y
Source: Brad DeLong: Econ 2, Spring 2014, The Income-Expenditure Framework 13
Income--Expenditure Framework
Income
Behind the scenes:
• B hi d d
Behind decisions
ii to spend
d are:
Incomes
Desires to save—deleverage—or dis-save—leverage up
Desires to build up or spend down money balances
• Intermediate goods and services don't count
• In equilibrium: Expenditure = Income = Factor Payments = Receipts
Source: Brad DeLong: Econ 2, Spring 2014, The Income-Expenditure Framework 14
Income--Expenditure Framework
Income
Who does what?
C + I + G + NX = E
• C: households depends on taxes T, income Y, wealth W,
expectations
i
• I: businesses depends on real interest rates r, capacity utilization,
current profits, expected future profits
• G: government fiscal policy
• NX:
Exports: foreigners depends on exchange rate—value of
home currency—and foreign variables
Imports: domestic households & businesses depends on
exchange rate and income
Source: Brad DeLong: Econ 2, Spring 2014, Summing Up the Income-Expenditure Framework 15
Income--Expenditure Framework
Income
Why does the income-expenditure framework look
so much like the expenditure approach to
measuring GDP in the national accounts?
• Dividing planned expenditures into consumption [C],
investment [I], government purchases [G] and net exports
[NX] is useful because each of these expenditures is
determined by a different group of people acting on
different motives, and so planned expenditures on each can
and should be analyzed separately
• The expenditure approach to measuring GDP in the
national accounts was designed to facilitate this analysis—
that is,
is it is based on the income-expenditure
income expenditure framework
Source: Brad DeLong: Econ 2, Spring 2014, Summing Up the Income-Expenditure Framework 16
Income--Expenditure Framework
Income
Role of interest rates for expenditures:
What tends to happen to planned expenditure E when the
real interest rate r goes up?
A It tends to rise
A. rise.
B. It tends to fall.
C. Y can’t
You ’t make
k generall statements.
t t t
D. Investment spending tends to rise, but government
purchases tend to fall because taxes are cut
cut.
E. None of the above.
Source: Brad DeLong: Econ 2, Spring 2014, Summing Up the Income-Expenditure Framework 17
Outlook
Next up:
• We will take a closer look at
role of interest rates for aggregate demand
aggregate supply l
the link between aggregate demand, supply and inflation
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