Macroeconomics

Microeconomics

The study of individual household and firm behavior, individual markets, and industries

Macroeconomics

The study of aggregate behavior at the country or world level

Income must equal expenditure because

Every transaction has a buyer and a seller

Every dollar of spending by some buyer is a dollar of income for some seller

Gross Domestic Product (GDP)

A measure of the income and expenditures of an economy, it is the total market value of all final goods and services produced within a country in a given time period

Six important feature of GDP

• Market prices

• Final goods, not intermediate goods

• Goods and services

• Only goods and servicies currently produced

• Production within the geographic confines of a country

• Production within a specific interval of time

GDP Formula

Y=C+I+G+NX

Y

Output/GDP

C

Consumption, the spending by households on goods and services

I

Investment, the spending on capital equipment, structures and inventories

G

Government purchases, the spending on goods and services by local and central governments (excluding transfer payments)

NX (or xn)

Net exports, exports minus imports

Nominal GDP

Production of goods and services at current prices / sum of (price per good x quantity of good)

Real GDP

Production of goods and services at constant prices / sum of(base year price per good x quantity of good)

Higher GDP per person indicates

A higher standard of living

Factors that contribute to well-being that are not included in GDP are

The value of leisure

The value of the environment

The value of home production

The effects of unequal income distribution

The Consumer Price Index (CPI)

Measure of the overall cost of the goods and services in a fixed basket bought by a typical consumer, used to monitor changes in the cost of living over time, used to correct for inflation for comparing cost of living over time / (base year basket quantities x current year prices/base year basket quantities x base year prices) x 100

Inflation Equation

100% x (CPI2-CPI1)/CPI1

Factors that contribute to cost of living that are not taken into account in the CPI

Substitution bias

Introduction of new goods

Unmeasured quality change

Interest

Represents a payment in the future for a transfer of money from the past

Nominal Interest Rate

The interest rate not corrected for inflation (i)

Real Interest Rate

The nominal interest rate that is corrected for inflation (r )

Real interest rate= nominal interest rate - inflation

Factors of production

Capital and Labor

K

Capital (tools, machines, and structures) used in production

L

Labor, the physical and mental efforts of workers

Production function

Y=F(K,L)

Shows how much output (Y) the economy can produce from K units of capital and L units of labor, reflects the economy’s level of technology, exhibits constant returns to scale

Wage

Price of labor

Rental rate

Price of capital

Diminishing Marginal Returns

As one input is increased (holding other inputs constant) its marginal product falls. If L increases while holding K fixed machines per worker falls, worker productivity falls

Aggregate Demand

Demand for goods and services

C= consumer demand for goods and services, I= demand for investment goods, G= government demand for goods and services (if closed economy no NX)

Marginal Propensity to Consume (MPC)

The change in C when disposable income increases by one dollar

The real interest rate

The cost of borrowing, the opportunity cost of using one’s own funds to finance investment spending

Budget Surplus

Government spending is less than taxes

Budget Deficit

Taxes are less than government spending

Natural rate of unemployment

The average rate of unemployment around which the economy fluctuates (U/L)

U

Unemployed workers

L

Workers in the work force, endogenously fixed

Frictional Unemployment

Caused by the time it takes workers the search for a job, even when wages are flexible and there are enough jobs to go around because workers have different abilities and preferences, jobs have different skill requirements, geographic mobility of workers is not instantaneous, flow of information about vacancies and job candidates is imperfect.

Unemployment Insurance

Pays part of a worker’s former wages for a limited time after the worker loses his/her job, increases frictional unemployment. May lead to better matches between jobs and workers, leading to increased productivity and higher incomes

Structural Unemployment

Unemployment resulting from real wage rigidity and job rationing, minimum wage, unions, efficiency wages, hiring and firing costs

Minimum Wage

Government standard of lowest wage per hour, may exceed equilibrium wage of unskilled workers

Labor Unions

Exercise monopoly powers to secure higher wages for their members, at the cost of losing jobs when union wage exceeds equilibrium wages

Efficiency Wages

Firms willingly pay above equilibrium wages to raise worker productivity, attracting higher quality job applicants, increasing worker effort, reducing “shirking”, reducing turnover (which is costly to firms), improving health of workers (in developing countries)

Money

The set of assets in the economy that agents regularly use to buy goods and services from other agents, functions as a medium of exchange, unit of account, and a store of value

Medium of Exchange

Anything that is readily acceptable as payment

Unit of Account

The yardstick people use to record prices and debts

Store of Value

An item that people can use to transfer purchasing power from the present to the future

Liquidity

The ease with which an asset can be converted into the economy’s medium of exchange, money is the most liquid asset

Commodity Money

Takes the form of a commodity with intrinsic value (Gold, silver, cigarettes)

Fiat Money

Used as money because of government decree, no intrinsic value (Coins, currency, bank deposits)

Function of the Central Bank

Regulates banks, acts as a banker’s bank, making loans to banks and as a lender of last resort, conducts monetary policy

Monetary Policy

Controlling the money supply or the nominal interest rate with open market operations

Open Market Operations

Buying or selling of government bonds to change the money supply

Monetary Base

Notes and coins in circulation and reserves

Money supply

Total currency circulating in the public plus the non-bank deposits with commercial banks

Fractional Reserve Banking

Banks hold a fraction of the money deposited as reserves and lend out the rest

Money Multiplier

The reciprocal of the reserve ratio

Reserve Requirements

Imposing minimum reserve requirements limits the ability of commercial banks to create money

Velocity of Money

(V) Average number of times a pound is used in a given period, the velocity of money is relatively stable over long periods of time, this is an alternative way for saying that the main determinant of money demand is nominal expenditure. Money demand and velocity are inversely related.

Quantity Theory of Money

M x V=P x Y

V is stable and Y is determined by the quantity of inputs and the production function, so changes in M cause proportional changes in P

Inflation

If the central bank causes the money supply to increase continuously then the price level will rise at the same rate (on average)

Long Run

Prices are flexible and respond to changes in supply or demand, output and employment are always at their natural rates, and the classical theory applies

Short Run

Many prices are “sticky” at a predetermined level. The economy behaves very differently when prices are sticky, shocks can push output and employment away from their natural rates

Full Employment

Unemployment equals its natural rate (not zero)

Shocks

Exogenous changes in aggregate supply or demand that temporarily push the economy away from full employment

Supply Shocks

Alters production costs, affects the prices that firms charge (also called price shocks) can be favorable and adverse (weather, unions, governmental regulations.

Y

Aggregate output

Reasons for sticky prices

Long term contracts between firms and customers, menu costs, firms not wishing to annoy customers with frequent price changes, assumption that firms set their own prices

Cyclical Unemployment

The deviation of the actual rate of unemployment from the natural rate

Technological Knowledge

The “stock of ideas” about the best products and the best production processes

Technology

The state of knowledge and production techniques which determines the quantity of a output that is obtainable from a given quantity of inputs

Technological progress

Any change in the state of knowledge and production techniques which make it possible to obtain more output from the same quantity of inputs, arises from research and development- either public (universities and public research institutes) or private (within firms)

Human Capital

(H) the stock of skills and knowledge embodied in a given set of workers

Human Capital Accumulation

The change in the stock of knowledge and skills. Requires training, education, or learning-by-doing