- The basic objective of macroeconomics is to develop theoretical tools, called models, capable of describing the processes which determine the values of these variables.
- Specifically, the models attempt to provide theoretical explanation to questions such as what causes periods of slow growth or recessions in the economy, or increment in the price level, or a rise in unemployment.
- difficult to account for all the variables at the same time.
- on the determination of a particular variable, we must hold the values of all other variables constant.
- This is a stylisation typical of almost any theoretical exercise and is called the assumption of ceteris paribus, which literally means „other things remaining equal‟.
EX ANTE AND X POST
- In a theoretical model of the economy the ex-ante values of these variables should be our primary concern. „If anybody wants to predict what the equilibrium value of the final goods output or GDP will be, it is important for her to know what quantities of the final goods people plan to demand or supply‟.
- Different people plan to save different fractions of their additional incomes (with the rich typically saving a greater proportion of their income than the poor), and if we average these we may arrive at a fraction which will give us an idea of what proportion of the total additional income of the economy people wish to save as a whole.
- We call this fraction the marginal propensity to save (mps).
- It gives us the ratio of total additional planned savings in an economy to the total additional income of the economy.
- Since consumption is the complement of savings (additional income of the economy is either put into additional savings or used for extra consumption by the people), if we subtract the mps from 1, we get the marginal propensity to consume (mpc), which, in a similar way, is the fraction of total additional income that people use for consumption. Suppose, mpc of an economy is c, where 0 < c < 1. If the total income of the economy increases from 0 to Y , then total consumption of the economy should be C = c (Y – 0) = c.Y.
- If the income of the economy in a certain year is zero, the above equation tells us that the economy has to starve for an entire year, which is, obviously, an outrageous idea.
- If your income is zero in a certain period you use your past savings to buy certain minimum consumption items in order to survive.
- Hence we must add the minimum or subsistence level of consumption of the economy in the above equation, which, therefore, becomes C = C + c.Y
- Where C > 0 is the minimum consumption level and is a given or exogenous item to our model, which, therefore, is treated as a constant. The equation tells us that as the income of the economy increases above zero, the economy uses c proportion of this extra income to increase its consumption above the minimum level.
Ex Ante Investment:
- Investment is defined as addition to the stock of physical capital (such as machines, buildings, roads etc., i.e. anything that adds to the future productive capacity of the economy) and changes in the inventory (or the stock of finished goods) of a producer.
- Note that „investment goods‟ (such as machines) are also part of the final goods – they are not intermediate goods like raw materials.
- Investment decisions by producers, such as whether to buy a new machine, depend, to a large extent, on the market rate of interest. However, for simplicity, we assume here that firms plan to invest the same amount every year.
- Where I is a positive constant which represents the autonomous (given or exogenous) investment in the economy in a given year. Ex Ante Aggregate Demand for Final Goods:
- In an economy without a government, the ex ante aggregate demand for final goods is the sum total of the ex ante consumption expenditure and ex ante investment expenditure on such goods
- Ex ante supply is equal to ex ante demand only when the final goods market, and hence the economy, is in equilibrium.
The Multiplier Mechanism:
- In the absence of a government imposing indirect taxes or disbursing subsidies, the value of the total output of final goods or GDP is equal to National Income.
- The production of final goods employs factors such as labour, capital, land and entrepreneurship.
- In the absence of indirect taxes or subsidies, the total value of the final goods output is disbursed among different factors of production – wages to labour, interest to capital, rent to land etc.
- Whatever is left over is appropriated by the entrepreneur and is called profit.
- Thus the sum total of aggregate factor payments in the economy, National Income, is equal to the aggregate value of the output of final goods, GDP.
- When process goes on, round after round, with producers increasing their output to clear the excess demand in each round and consumers spending a part of their additional income from this extra production on consumption items – thereby creating further excess demand in the next round.