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Unformatted text preview: 5/5/2011 Economics 1B UC Davis UC D i Professor Siegler Spring 2011 I. Introduction
Thus far, we ve been discussing how to measure the Thus far, we've been discussing how to measure the macroeconomy. Tonight, we will introduce our first macroeconomic model: the spending allocation model. The spending allocation model explains the longrun real interest rate and how much of GDP in the long run is allocated to each of the four expenditure components: consumption, investment, government purchases, and net exports. 2 1 5/5/2011 I. Introduction
The model has at least one glaring omission: g g potential GDP (denoted Y*) is an exogenous variable. In reality, saving and investment decisions affect the growth rate and level of potential output. In Chapter 9, we will examine how investment affects potential output, but for tonight, potential output is exogenously given. p g yg It is important, and necessary for success in economics, for you to stay within the confines of the given model to make predictions. Don't use a different mental model!
3 I. Introduction
Throughout most of Chapter 7, Taylor uses a four Throughout most of Chapter 7, Taylor uses a four panel diagram to graphically illustrate the predictions of the spending allocation model. I will present the model using the relationship between the savings rate and the investment and net export rates, on one diagram, consistent with Figures 10 and 11 in Chapter 7. 10 d 11 i Ch t 7 You can do either, but the onediagram depiction is easier and more intuitive to me. 4 2 5/5/2011 II. Saving, Investment, and Net Exports
Let s begin with the expenditure identity: Let's begin with the expenditure identity: Now, let's divide both sides by potential output (Y*): 5 II. Saving, Investment, and Net Exports
In the long run, the economy is at potential output, In the longrun, the economy is at potential output, so: Therefore, 6 3 5/5/2011 II. Saving, Investment, and Net Exports
Next, subtract the consumption share and the Next, subtract the consumption share and the government share from both sides of the equation: Note that the left hand side of the equation above is Note that the lefthand side of the equation above is the national savings rate. Therefore, 7 III. Interest Rates, Consumption and Saving
By definition, the national savings rate is equal to: By definition, the national savings rate is equal to: The price of consumption today relative to price of consumption tomorrow is the real interest rate. If consumption tomorrow is the real interest rate. If the real interest rate is high, the opportunity cost of consuming today is high since you will be foregoing greater future consumption. Therefore, as the real interest rate increases, consumption decreases.
8 4 5/5/2011 III. Interest Rates, Consumption and Saving
We can depict the inverse relationship between the real p p interest rate and the consumption share (and the positive relationship between the real interest rate and the saving share) as: So, higher real interest rates give people more incentive to consume less and save for the future. Empirically, however, the interest elasticity of the consumption share is low (meaning that the curve is quite "steep"). 9 III. Interest Rates, Consumption and Saving
The model also assumes that the government The model also assumes that the government spending share does not depend on the real interest rate. Combining a vertical government spending share and a relatively inelastic consumption spending share, the savings rate function is very steep: 10 5 5/5/2011 III. Interest Rates, Consumption and Saving
r An increase in the real interest rate Leads to a (modest) increase in the saving share (saving rate) Share of potential GDP
11 III. Interest Rates, Consumption and Saving
We need to distinguish between a movement along We need to distinguish between a movement along the saving share function (as a result of a change in the real interest rate) versus a shift in the function (when the saving rate is higher or lower at any given interest rate). If the government spending share increases (decreases), ceteris paribus, then the saving share decreases (increases) at any given real interest rate.
12 6 5/5/2011 III. Interest Rates, Consumption and Saving
There can also be exogenous changes in the There can also be exogenous changes in the consumption share. If there is an exogenous increase (decrease) in the consumption share, ceteris paribus, then the saving share decreases (increases) at any given real interest rate.
Example: The doomsday clock is a symbolic clock face, maintained since 1947 by the board of directors of the Bulletin of the Atomic Scientists at the University of Chicago. The closer the clock is to midnight, the closer the world is estimated to be to global disaster.
13 III. Interest Rates, Consumption and Saving
"The hypothesis of this article is that . . . the rate of The hypothesis of this article is that . . . the rate of saving in the postwar U.S. economy has been influenced by the changes in the public perception of the threat of a catastrophic nuclear war. An increased threat shortens the expected horizon of individuals, and thus reduces their willingness to postpone present consumption. . . . The tests all support a present consumption The tests all support a large and statistically significant impact of the threat of nuclear war on the rate of private saving." Joel Slemrod, Journal of Conflict Resolution, September 1986.
14 7 5/5/2011 III. Interest Rates, Consumption and Saving
r If the doomsday clock moves closer to midnight, the saving rate decreases at any given real interest rate. Share of potential GDP
15 IV. Interest Rates, Investment, and Net Exports
Real Interest Rates and the Investment Share Real Interest Rates and the Investment Share
Higher real interest rates raise the cost of borrowing. A firm compares the benefits of a new investment project to the cost of borrowing funds to undertake the investment. As the real interest rate rises, fewer investment projects are profitable, therefore, there is e i e e a ig e i e e a e o eo e , e less investment at higher interest rates. Moreover, the investment spending share is more sensitive to changes in the real interest rate (compared to the consumption share): 16 8 5/5/2011 IV. Interest Rates, Investment, and Net Exports
Real Interest Rates and the Net Export Share Real Interest Rates and the Net Export Share
The exchange rate is defined as the number of units of foreign currency per unit of domestic currency. If e increases, then the dollar has appreciated. If e decreases, then the dollar has depreciated.
17 IV. Interest Rates, Investment, and Net Exports
Real Interest Rates and the Net Export Share Real Interest Rates and the Net Export Share
Step 1: The real interest rate and the exchange rate are positively correlated. If real interest rates in the U.S. increase, ceteris paribus, then international investors have a greater incentive to put more funds in dollardenominated assets, like bonds and other interestearning accounts. assets like bonds and other interestearning accounts To buy dollardenominated assets, you need to have U.S. dollars. Therefore the demand for dollars will increase on foreignexchange markets, increasing the price of dollars (the exchange rate). 18 9 5/5/2011 IV. Interest Rates, Investment, and Net Exports
Real Interest Rates and the Net Export Share Real Interest Rates and the Net Export Share
Step 2: The exchange rate and net exports are inversely or negatively related. If the dollar appreciates, then U.S. exports are more expensive to foreigners, so our exports fall. However, if the dollar appreciates, then imports are cheaper so imports increase. Therefore: imports increase Therefore: 19 IV. Interest Rates, Investment, and Net Exports
Real Interest Rates and the Net Export Share Real Interest Rates and the Net Export Share
The easiest (only?) way to remember the relationship between the exchange rate (e) and net exports (X) is to make up an example. Suppose that the exchange rate is initially 100 Yen per Dollar and it increases to 150 Yen per Dollar. Consider an export to Japan that costs $1. Initially this Consider an export to Japan that costs $1 Initially this costs someone in Japan 100 Yen, but the price rises to 150 Yen with the exchange rate appreciation. Since the good is more expensive to the Japanese, exports to Japan will fall.
20 10 5/5/2011 IV. Interest Rates, Investment, and Net Exports
Real Interest Rates and the Net Export Share Real Interest Rates and the Net Export Share
Now consider an import from Japan that costs 300 Yen. Initially, this costs someone in the U.S. $3 (when the exchange rate is 100 Yen per Dollar). After the dollar appreciates to 150 Yen per Dollar, it only costs someone in the U.S. $2 to buy this good. only costs someone in the U S $2 to buy this good As a result of the goods from Japan becoming cheaper to U.S. residents, imports from Japan will increase. 21 IV. Interest Rates, Investment, and Net Exports
Real Interest Rates and the Net Export Share Real Interest Rates and the Net Export Share
To summarize: 22 11 5/5/2011 V. Equilibrium
r r0 Share of potential GDP
23 VI. Crowding Out and the Twin Deficits
Let s examine national savings in greater detail. Let's examine national savings in greater detail. Earlier we derived: We can break national saving (S) into the sum of We can break national saving (S) into the sum of private saving and public saving: 24 12 5/5/2011 VI. Crowding Out and the Twin Deficits
Let s next both add and subtract net taxes (T tax Let's next both add and subtract net taxes (T = tax transfers) from the righthand side: National saving private saving public saving National saving = private saving + public saving 25 VI. Crowding Out and the Twin Deficits
Finally, if we divide both sides by potential output, Finally, if we divide both sides by potential output, we get: Using the relationship between saving, investment, Using the relationship between saving, investment, and net exports we get: 26 13 5/5/2011 VI. Crowding Out and the Twin Deficits
Over the next few decades, the aging population in Over the next few decades, the aging population in the United States is projected to result in a higher government spending share or a lower public saving share (in fact, the public saving share will become even more negative than it currently is). What will be the impact of this on real interest rates, the investment share, and the net export share? th i t t h d th t t h ? 27 VI. Crowding Out and the Twin Deficits
If the rising demands of an aging society cause government budget deficits, as a percentage of potential output, to b d t d fi it t f t ti l t t t increase, one of more of the following outcomes will occur: 1) The private saving rate will increase to partially offset the decrease in public saving. 2) The investment share will decrease as real interest rates rise, crowding out private investment (and leading to less capital accumulation and slower economic growth in the future). 3) The trade balance (trade deficit) will worsen, and we will buy more foreign goods while foreigners will buy less of our goods. Government budget deficits and trade deficits are called the "twin deficits." The spending allocation model predicts that all three will occur.
28 14 5/5/2011 Question 10.1
A higher real interest rate today makes current g y consumption i A) more expensive relative to future consumption because the return on savings is lowered. B) more expensive relative to future consumption because the return on savings is increased. C) less expensive relative to future consumption because the return on savings is increased. D) less expensive relative to future consumption because the return on savings is lowered. E) just as expensive as future consumption because the return on saving is uncertain. Answer: B 29 Question 10.2
An increase in optimism about the strength of the p g economy will ill A) cause the investment share line to shift to the left lowering real interest rates. B) cause a leftward movement along the investment share line increasing real interest rates. C) have no effect on the investment share line. D) cause the investment share line to shift to the right ) g increasing real interest rates. E) cause a rightward movement along the investment share line lowering real interest rates. Answer: D
30 15 5/5/2011 Question 10.3
Which of the following statements is true? g A) A higher exchange rate means cheaper exports and cheaper imports. B) A higher exchange rate means more expensive exports and more expensive imports. C) A higher exchange rate means more expensive exports and cheaper imports. D) A higher exchange rate means cheaper exports and ) g g p p more expensive imports. E) A higher exchange rate has no effect on the price of exports and imports. Answer: C
31 Question 10.4
Which of the following best describes what would happen if all private retirement accounts were taxed? i ate eti e e t a ou t e e ta ed? A) Consumption expenditures would decline, driving up interest rates and resulting in investment expenditures declining. B) Consumption expenditures would increase, driving up interest rates and resulting in investment expenditures declining. C) Government expenditures would increase, causing p p , consumption expenditures to decline, which would result in interest rates declining, which would cause investment expenditures to rise. D) Consumption expenditures would decline, driving down interest rates and resulting in investment expenditures increasing. Answer: B
32 16 5/5/2011 Question 10.5
The national saving rate A) is positively related to the real interest rate because it depends on consumption, which is negatively related to the real interest rate. B) is negatively related to the real interest rate because it depends on consumption, which is positively related to the real interest rate. C) is positively related to the real interest rate because it depends on consumption, which is positively related to p p p y the real interest rate. D) is positively related to the exchange rate because it depends on net exports, which is negatively related to the real interest rate. Answer: A
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This note was uploaded on 02/07/2012 for the course ECON 1b taught by Professor Sheffrin during the Spring '07 term at UC Davis.
 Spring '07
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 Economics

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