Today we started with the “intermediate term” analysis of markets. This is basically a period of time which is not long enough to see the long-run growth of the Solow Growth Model, but is long enough so that wages and prices have a chance to adjust to equilibrium. It varies from anywhere between a quarter to less than a decade.
We started out by talking about the concept of potential output – or that output level where the economy is at its full-employment potential. Basically, the output of the economy when it is using all of its resources. The potential output is calculated using a slight variation on the Cobb-Douglas production function, one where labor is held constant, along with efficiency and alpha. This production function relates the amount of capital with the total output.
We also talked about the marginal productivity of labor, which is the additional unit of output produced by an adding an additional unit of labor to your firm. A firm’s optimal output will be when the dollar value of the marginal productivity of labor is equal to the wage rate (or when marginal revenues equal marginal costs). Essentially, it’s when the last person you employ is producing enough to balance out his or her wage-rate. This is how firms calculate how many workers to employ. Since the labor market is always in equilibrium, and the output is at its potential-output-level, we assume that all firms in the economy are at their optimal hiring point and their corresponding optimal production levels, and (again) that everyone in the labor force is employed. That is, everyone who wants to work, is working.
Since markets are in equilibrium, nothing alters the output of the economy. If anything affects labor or prices, the markets adjust so that they are in equilibrium again. However, what does change are the components of output. The components of output, as you well know by now, are Y = C + I + G + NX, where C is consumption, I is investment, G is governmental expenditure and NX are net exports (gross exports minus imports).
Assuming away foreign markets for the time-being, we look at domestic spending, which is just consumption, investment and governmental spending.
This is the amount of income households spend after they have paid their taxes, and saved their money. Assuming an average tax rate for all the economy’s residents (say, t), the total tax paid will be $T = tY. So disposable income (another new term) or YD is income after taxes, or Y – T = Y – tY = Y(1-t).
Since consumption is what households spend after they save and pay their taxes, we get that C = Y – T – SH, but Y – T = YD, so C = YD – SH.
Now what we are interested in really is by how much does consumption really change with changes in disposable income. For that, we divide consumption into two parts: baseline consumption and the marginal propensity to consume. The former is fixed and does not vary with changes in disposable income, but the latter is the change in consumption for every dollar change in disposable income. We also assume that there is a linear relationship between consumption spending and disposable income. In fact, we say that C = C0 + Cy(YD), where C0 is baseline consumption and Cy is the marginal propensity to consume.
One thing we should remember is that the usual factors that affect consumption (i.e., risk tolerance, wealth expectations, etc.) affect the baseline consumption, but not the marginal propensity to consume (MPC).
Investment can be divided either based on what its used to buy (residential, non-residential, inventories or durables), or based on the kind of capital it buys (new vs. repairing old or depreciation). The two things that investment depends on are the real interest rates and “animal spirits”. The latter represents confidence and “irrational exuberance” – the kinds of things that affect the stock market.
We are more interested in the real interest rate, and how the present value of a particular investment stream determines whether we will invest in something or not.
Although I talked a little bit about present value in today’s class, I will pick up from this point in the next class.