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Economics 1B Lecture 10 S2011

Economics 1B Lecture 10 S2011 - Economics 1B UC Davis UC D...

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5/5/2011 1 Economics 1B UC D i UC Davis Professor Siegler Spring 2011 I. Introduction y Thus far, we’ve been discussing how to measure the Thus far, we ve been discussing how to measure the macroeconomy. y Tonight, we will introduce our first macroeconomic model: the spending allocation model . y The spending allocation model explains the long run 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
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5/5/2011 2 I. Introduction y The model has at least one glaring omission: potential GDP (denoted Y * ) is an exogenous variable. y In reality, saving and investment decisions affect the growth rate and level of potential output. y In Chapter 9, we will examine how investment affects potential output, but for tonight, potential output is exogenously given. y 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 y Throughout most of Chapter 7, Taylor uses a four panel diagram to graphically illustrate the predictions of the spending allocation model. y 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 d 11 i Ch t 7 10 and 11 in Chapter 7. y You can do either, but the one diagram depiction is easier and more intuitive to me. 4
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5/5/2011 3 II. Saving, Investment, and Net Exports y Let’s begin with the expenditure identity: Let s begin with the expenditure identity: y Now, let’s divide both sides by potential output (Y*): 5 II. Saving, Investment, and Net Exports y In the long run, the economy is at potential output, In the long run, the economy is at potential output, so: y Therefore, 6
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5/5/2011 4 II. Saving, Investment, and Net Exports y Next, subtract the consumption share and the government share from both sides of the equation: y Note that the left hand side of the equation above is Note that the left hand side of the equation above is the national savings rate. Therefore, 7 III. Interest Rates, Consumption and Saving y By definition, the national savings rate is equal to: y The price of consumption today relative to price of 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
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5/5/2011 5 III. Interest Rates, Consumption and Saving y We can depict the inverse relationship between the real interest rate and the consumption share (and the positive relationship between the real interest rate and the saving share) as: y 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”).
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