IAS 107 Lecture: IncomeExpenditure and InvestmentSavings J. Bradford DeLong U.C. Berkeley IAS107 Lecture Notes http://delong.typepad.com/berkeley_econ_101b_spring/ February 15, 2011 Resolution for screencast capture: 1024x768

Logistics: IAS 107 J. Bradford DeLong U.C. Berkeley IAS107 Lecture Notes http://delong.typepad.com/berkeley_econ_101b_spring/ February 15, 2011 Resolution for screencast capture: 1024x768

Office Hours Today 12:30-2 Tomorrow 2-4

Commercial...

Problem Set 3 Due now... Please write your section time on your problem sets...

Problem Set 4 Please write your section time on your problem sets... Depression economics problem set due on Thursday... <http://delong.typepad.com/ berkeley_econ_101b_spring/2011/02/ problem-set-4-placeholder.html>

To Your iClickers...

Suppose I=$2 trillion, G=$2 trillion, GX=$2 trillion, imy=.1, cy = .8, t = 0.25, c0=$3 trillion. What is Y going to be? A. $13.5 trillion B. $18.0 trillion C. $20.2 trillion D. $15.3 trillion E. $9.0 trillion

Answer...

3+2 +2 +2 Y= 1 − (1 − t)c y + im y 9 Y= 1 − (1 − .025)0.8 + 0.1 9 9 Y= = = 18 1 − 0.6 + 0.1 0.5

All the Devils Are Here

For sections between Th Feb 10 @ 12:30 and Th Feb 17 @ 11:00: Skim chapters 1-5 on “securitization”: how it was that people thought that taking a whole bunch of mortgages, mashing them together, and selling the results as bonds made sense... For sections between Th Feb 17 @ 12:30 and Th Feb 24 @ 11:00: Read chapters 6-8 on “policy”: why the American government decided at the end of the 1990s to back off of financial regulation, and let the financial sector “experiment”... For sections between Th Feb 24 @ 12:30 and Th Mar 3 @ 11:00: Read chapters 9-15 on the bubble in subprime mortgages: how mortgage companies, banks, and investors concluded that diversified investments in even risky mortgages carried very little risk indeed...

All the Devils Are Here For sections between Th Mar 3@ 12:30 and Th Mar 10 @ 11:00: Read chapters 16-19 on how the smart guys go short: how the more clever of the investment banks began to figure out ways to profit from the forthcoming housing crash, but how the bulk of investment and commercial bankers were not so clever... For sections in the last week before spring break: Read chapters 20-Epilogue on the slow-motion panic that was the impulse that generated our current economic downturn...

Recapitulations: Things You Really Should Know J. Bradford DeLong U.C. Berkeley IAS107 Lecture Notes http://delong.typepad.com/berkeley_econ_101b_spring/ February 15, 2011 Resolution for screencast capture: 1024x768

#1: You Got This

#2: You Got This...

Seasonal Adjustment Makes Me Nervous...

#3: You Got This...

#4: You Got This...

#5: The Magic Equation for Depression Economics

Income-Expenditure J. Bradford DeLong U.C. Berkeley IAS107 Lecture Notes http://delong.typepad.com/berkeley_econ_101b_spring February 15, 2011

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#3: You Got This...

The Income-Expenditure Model

Y = C + I + G + (GX – IM) C = c0 + cy(1-t)Y IM = imyY

To Your iClickers...

Suppose I=$2 trillion, G=$2 trillion, GX=$2 trillion, imy=.267, cy = .8, t = 0.25, c0=$4 trillion. What is Y going to be? A. $13.5 trillion B. $18.0 trillion C. $20.0 trillion D. $15.0 trillion E. $9.0 trillion

Answer... c 0 + I + G + GX Y= 1 − (1 − t)c y + im y 4 +2+2+2 Y= 1 − (1 − t)c y + im y 10 Y= 1 − (1 − .025)0.8 + 0.267 10 10 Y= = = 15 1 − 0.6 + 0.267 0.667

The Income-Expenditure Model in Words

There is income on the one hand, and there is production and spending on the other When spending is less than income and people are trying to build up their stocks of financial assets... Businesses see their inventories rising, and fire workers...

Who lose incomes...

And the process repeats...

Until incomes have fallen so low that spending is no longer less than incomes...

Some Prefer Algebra

Others Prefer Graphs...

Others Prefer Graphs...

Others Prefer Graphs...

Others Prefer Graphs...

Others Prefer Graphs...

Others Prefer Graphs...

Others Prefer Graphs...

Others Prefer Graphs...

Others Prefer Graphs...

The “Excess Demand for Financial Assets” Stuff

Suppose we started from the idea that there should be no excess demand for financial assets—that the flow of savings into financial markets should be equal to the number of financial assets created...

The “Excess Demand for Financial Assets” Stuff II

Financial assets created: (G-T) + I Flow of savings: (Y-T-C) – NX Let us set these equal... (G-T) + I = (Y-T-C) – NX And then let’s play with it...

The “Excess Demand for Financial Assets” Stuff III

The “Excess Demand for Financial Assets” Stuff IV

This is our equation for businesses being happy with what they produce—spending equal to income, no big unexpected and unwanted change in inventories This is also our equation for no excess demand for (or supply of) financial assets Why? Circular flow principle: as John Stuart Mill and Jean-Baptiste Say said back in 1829: an excess of demand for financial assets is a deficient demand for currently-produced goods and services

Investment-Savings J. Bradford DeLong U.C. Berkeley IAS107 Lecture Notes http://delong.typepad.com/berkeley_econ_101b_spring February 15, 2011

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Starting from This...

We Are Going to Look at Changes Relative to Baselines...

Why? So that we can have simpler formulas Simply by dropping terms that do not change

We Are Going to Define Autonomous Spending...

ď Źâ€Ż

If we know the change in autonomous spending A, we know the change in income, production, output, aggregate demand, spending Y

And We Are Going to Go a Little Deeper...

A = c0 + G + I + GX G is determined by politics (t is too) c0 is determined by consumer confidence What determines I and GX?

The Interest-Sensitivity of Aggregate Demand What determines I and GX? Investment spending is determined by (a) business confidence, and (b) the cost of capital to businesses—the long-term risky real interest rate r Exports are determined by (a) foreigners’ incomes and (b) the real exchange rate ε

Determinants of Business Investment Spending Investment spending is determined by: (a) business confidence, and (b) the cost of capital to businesses—the longterm risky real interest rate r ΔI = ΔI – I (Δr) 0 r Why? The higher is r, the higher is the expected hurdle an investment project must clear for it to be profitable

Determinants of Business Investment Spending II

Determinants of the Real Exchange Rate The real exchange rate—the value of the home currency—is determined by: (a) confidence in the long-run value of the currency (b) the difference in interest rates between home and abroad Why? The balance between fear, optimism, and greed on the part of foreign-exchange speculators Δε = Δε + ε (Δr-Δr*) 0 r

Determinants of the Real Exchange Rate II

Determinants of Exports

Exports are determined by: (a) foreigners’ incomes Y*, and

(b) the real exchange rate ε

When foreigners are richer they buy more stuff When our stuff is more expensive foreigners buy less of it ΔGX = X (ΔY*) – X (Δε) y* r

Determinants of Exports II

Determinants of Exports III ΔGX = Xy*(ΔY*) – Xr(Δε) We can substitute in our exchange rate equation:

Δε = Δε0 + εr(Δr-Δr*) To get: ΔGX = Xy*(ΔY*)-XεΔε0+Xεεr(Δr*)-Xεεr(Δr)

Determinants of Exports IV

Autonomous Spending Once Again

ΔA = Δc0 + ΔG + ΔI + ΔGX ΔA = Δc0 + ΔG + ΔI0 – Ir(Δr) + Xy*(ΔY*)XεΔε0+Xεεr(Δr*)-Xεεr(Δr) ΔA= ΔG + Δc0 + ΔI0 - XεΔε0 + Xy*(ΔY*) + Xεεr(Δr*) – [Ir+Xεεr](Δr)

Autonomous Spending Once Again II

Now Letâ€™s Go Back to Our Master Equation I

To Your iClickers... ΔA0 + ΔG − ( Ir + Xε ε r ) Δr ΔY = 1 − (1 − t)c y + im y

Suppose imy=0.1, cy=0.8, t=0.25, Ir=10, Xε=1, εr=10. Suppose that the Federal Reserve and financial markets together cut the long-term risky real interest rate r by 2%. € will happen to Y? What A. Y will rise by $0.3 trillion/year B. Y will rise by $0.6 trillion/year C. Y will rise by $0.8 trillion/year D. Y will fall by $0.6 trillion/year E. Y will fall by $0.3 trillion/year

Answer... ΔA0 + ΔG − ( Ir + Xε ε r ) Δr ΔY = 1 − (1 − t)c y + im y ΔA0 + ΔG − ( Ir + Xε ε r ) Δr ΔY = 1 − (1 − 0.25)0.8 + 0.1 −(10 + (1)(10)) Δr ΔY = 0.5 −(10 + (1)(10))(−.02) −(20))(−.02) +0.4 ΔY = = = = 0.8 0.5 0.5 0.5

The Investment-Savings Relationship

ΔY = ΔA0/[1-(1-t)cy+imy]

+ (1/[1-(1-t)cy+imy])(ΔG)

+ ([Ir+Xεεr]/[1-(1-t)cy+imy])(Δr)

And remember: ΔA0 = Δc0+ΔI0–XεΔε0+Xy*(ΔY*)+Xεεr(Δr*)

For Those of You Who Prefer Graphs... slope = ([Ir+Xεεr]/[1-(1-t)cy+imy]) A0/[1-(1-t)cy+imy] + G/[1-(1-t)cy+imy]

Using the IS Curve

ΔY = ΔA0/[1-(1-t)cy+imy] + (1/[1-(1-t)cy+imy]) (ΔG) + ([Ir+Xεεr]/[1-(1-t)cy+imy])(Δr) Foreigners and confidence will pick out a point on the x-axis... Fiscal policy will shift the IS curve left or right from that point on the x-axis... Monetary policy and financial markets give you a real interest rate that picks out a point on the IS curve... And that tells you what the level of icnome and spending in the economy is...

Why Is It Called “IS”?

“IS” stands for “Investment-Savings”... Curve first drawn by John Hicks back in... 1937, I think... It tells us at what combinations of (real, risky, long-term) interest rates and aggregate demand levels is there neither excess nor deficient demand for “bonds”—for savings vehicles When you are on the IS curve, there is neither deficient nor excess demand for the financial assets that are “bonds”— savings vehicles And hence neither excess nor deficient demand for currently-produced goods and services as a whole is pushing production up or down... If you aren’t on the IS curve, production is either rising or falling and you are heading for a position on the IS curve quickly

To Your iClickers... ΔA0 + ΔG − ( Ir + Xε ε r ) Δr ΔY = 1 − (1 − t)c y + im y

Suppose imy=0.117, cy=0.6, t=0.25, Ir=10, Xε=0.5, εr=10. Suppose that the Federal Reserve and financial markets together raise the long-term risky real interest rate r by 2%. € will happen to Y? What A. Y will rise by $0.3 trillion/year B. Y will rise by $0.6 trillion/year C. Y will rise by $0.45 trillion/year D. Y will fall by $0.45 trillion/year E. Y will fall by $0.3 trillion/year

Answer...

ΔY =

ΔA0 + ΔG − ( Ir + Xε ε r ) Δr 1 − (1 − t)c y + im y

ΔA0 + ΔG − ( Ir + Xε ε r ) Δr ΔY = 1 − (1 − 0.25)0.6 + 0.117 −(10 + (0.5)(10)) Δr ΔY = 0.667 −(10 + (0.5)(10))(+.02) −(15))(+.02) −0.3 ΔY = = = = −0.45 0.667 0.667 0.667