Summary of Macroeconomics – ECB1 MACR – Full Course Summary:
Regression Analysis:
Linear Regression line – y = β0 + β1 * X; line which fits best through a set of data (correlated variables).
GDP – Gross Domestic Product; domestic market value of output over a given period; level of GDP can be
explained with the business cycle (booms and recessions, which is a time of declining GDP, or growing less
than ‘usual’); Income Y, Expenditure (C + I + G + X – M) or Production (added value); all these ways of measuring
GDP are equal.
Okun’s Law – negative correlation between GDP (growth rate) and unemployment fluctuations; when GDP
increases, unemployment decreases; the Okun’s Coefficient is the percentage with which unemployment
decreases (or increases) when GDP increases (or decreases) with 1%; this coefficient is the slope of the
regression line, which is negative due to the negative correlation.
GDP, Components, Shocks / Fluctuations, Consumption Smoothing:
National accounts – information about individual behaviour to forecast or estimate domestic behaviour (of a whole
country).
Aggregate – “as a whole” or economy-wide; aggregate income Y = C + I + G + X – M.
Consumption – C; consumer goods and services; this process can be smoothened by keeping the level of
consumption constant in good and bad times (forecasting income in the future is important here).
Investments – I; expenditure to gain more out of; capital goods and buildings.
Government Spending – G; added value of production costs; education / healthcare / infrastructure; governmental
transfers.
Net Exports – exports (domestically produced, sold in foreign countries) – imports (produced in foreign countries,
domestically consumed); X > M means a trade surplus, X < M means a deficit.
Shock – exogenous or external change in data or conditions (political, economic, demographic, etc.); cause of
fluctuations in the business cycle.
Idiosyncratic shock – strikes one or a small number of households.
Economy-wide shock – strikes a domestic economy as a whole.
Self-insurance – consumption smoothing; saving in good times to be able to spend a similar amount in bad times
(fall in income).
Co-insurance – pooling savings so that people in good times can help others in need (due to fall in income etc.);
reciprocity and trust; this is mostly effective for idiosyncratic shocks.
Limitations of Consumption Smoothing – lack of information (no confidence about the future); credit constraints
(limited borrowing making it impossible to smooth C); weakness of will (inability to save or commit to course of
action); impatience (willingness to spend more now because it gives more satisfaction than future expenditure);
limited co-insurance (little reciprocity, small network).
Volatility of Investments – investment spending is not smoothened because firms (or investors) oftentimes all
invest at the same time (clusters) in order not to be left behind; this means that investment booms occur if all
invest and no investment occurs when nobody does; investing has to do with confidence in the future and the
extent of potential forecasting.
Capacity Utilisation Rate – measure of extent to which a firm, industry or economy is producing as much as the
stock of capital goods would allow; by investing and hiring new employees, the rate can be increased due to
higher demand.
Business confidence has a major role in fluctuations in economies as a whole; optimistic beliefs lead to higher
confidence; increase in spending helps to coordinate future plans and stimulates investment spending.
Investment spending is more volatile than GDP; consumption is less volatile than GDP.
Government spending is less volatile than investments; exports fluctuate with the business cycle.
The increased role of the government in the economy leads to more stability.
Great Moderation – period from 1980s until approximately 2008, the financial crisis; period of stable aggregate
output in advanced (developed) economies.
Multiplier Model:
Aggregate Demand (AD) – total of components of spending added to get GDP (Y = C + I + G + X – M), amount
of demand for goods and services produced in an economy; change in current income influence spending which
affects income of others and therefore AD.
, Multiplier Process – mechanism through which is measured how direct and indirect effects of changes in
autonomous spending affect output (AD); if the total increase or decrease in GDP is greater than the initial
increase or decrease in one of the components, the multiplier is greater than 1.
Aggregate Consumption function – combining consuming patterns of smoothing and non-smoothing households
to represent the economy as a whole; consumption depends on disposable income (MPC) and autonomous
consumption (fixed part); the fixed part is independent of current income and the variable amount is dependent on
current income.
Function – Aggregate Consumption = Autonomous Consumption + Income-Dependent Consumption.
C = CG + CH * Y or C = C0 + C1 * Y, where C1 is the slope of the line; C1 is called MPC, the Marginal Propensity to
Consume; the higher the MPC rate, the more consumption change to an increase or decrease (of a unit) of
income.
Example – in the current situation of COVID-19 affecting the economy, people or households are fearful about
their jobs and therefore consumption decreases more than income does.
The function line depends on the C0 (intercept) and the C1 (slope); the 45 degrees line is the line where Y = AD,
so where national income or output is equal to aggregate demand.
Changes in C0 or Investments I displace the Equilibrium (the place where the function line and Y = AD line
cross); a change in equilibrium leads to a change in output and employment; in other words, shocks can lead to
decreases in AD, meaning that there will be a new, lower market equilibrium.
In summary – a fall in demand (AD) leads to a fall in production and an equivalent fall in income (Y).
AD = Y = C0 + C1 * Y + I
Y – (C1 * Y) = C0 + I
Y(1 – C1) = C0 + I
Y = (1 / (1 – C1)) * (C0 + 1)
Multiplier – the multiplier is derived by bringing every component containing Y to one side, factoring everything,
and then mathematically calculating the multiplier; sometimes, values can be filled in.
Indicators for Booms and Recessions, and Wealth Indicators:
Precautionary Saving – reaction to save more in case of a decrease in household value (house or income).
Target Wealth – a level of wealth which households aim to hold, representing economic goals or expectations;
when target wealth is above expected wealth, households will cut back on consumption and save more; when
target wealth is below expected wealth, households will consume more and save less.
Broad Wealth = home equity + financial wealth + expected future earnings from employment.
Home Equity = value of house – debts.
Value of House = debts + home equity.
Net Worth = home equity + financial wealth.
Reasons for a fall in C0 (e.g. in time of crisis) – consumption independent of income can be cut back because of
cuts in consumer spending and the realisation that a downturn is not just temporary (more permanent);
Uncertainty about economy; Pessimism and the fear of employment, leading to lower earnings in the future and
saving more in the present; Banking Crisis and collapse of credit, because largely unregulated banks failed.
Financial Accelerator – mechanism through which firms’ and households’ ability to borrow increases when the
value of collateral (house) that has been pledged to the lender (bank) increases; however, when the value falls,
households and firms can become credit-constrained.
Increase in house price (collateral) leads to increase in consumption – for non-credit-constrained households and
firms wealth is raised relative to target wealth so precautionary savings are reduced and more is consumed; for
credit-constrained households and firms consumption increases because borrowing can be increased.
Ways of Investing with accumulated profits – saving, paying dividends to shareholders, investing abroad or
investing domestically (the last one is Investments in the GDP Multiplier model).
Firm owners can either consume now or invest, or consume later by saving money.
Discount Rate ρ of owners – the rate of return used to discount cash flows, which influences the desirability of
consuming more now rather than later.
Interest rate r – return on savings or asset invested in.
Profit rate on Investments П – return on investments in productive capacity.
When ρ > r and П, owners will increase consumption and keep funds.
When r > ρ and П, owners will repay debts or purchase financial assets.
