MACROECONOMICS Midterms

Macroeconomics

The study of the behavior and performance of an economy as a whole.

Aggregate Indicators

Measures such as national income, unemployment, inflation, and economic growth used to assess economic performance.

Goals of Macroeconomics

• Economic Growth

• Low Unemployment

• Price Stability

• Balance of Payment Stability

• Income Equality

Who are the key thinkers of classical economics?

Adam Smith, David Ricardo, John Stuart Mill

Classical Economics

(18th-19th century) focuses on market self-regulation and minimal government intervention

Who is/are the key thinker/s of the Keynesian Revolution?

John Maynard Keynes

Keynesian Revolution

(1930s) Was triggered by the Great Depression. Argues that markets do not always self-correct, thereby needing government intervention for stabilization of demand

Who is/are the key thinker/s of Monetarism?

Milton Friedman

Monetarism

(1950s-1970s) Focuses on the importance of money supply control in regulating inflation

New Classical Economics

(1970s-1980s) Advocated for rational expectations and market efficiency with minimal government interference.

New Keynesian Economics

Combines Keynesian emphasis on sticky prices and wages with rational expectations. Acknowledges market failures and role of policy intervention in correcting

Contemporary Macroeconomics

Focuses on issues like financial crises, inequality, and climate change; makes use of data analytics and computational modeling in policy making decisions.

What are the key macroeconomic indicators?

GDP, Inflation, Unemployment, Interest Rates

Economic Growth

An increase in the production and consumption of goods and services, often measured by GDP.

Unemployment

The percentage of the labor force actively seeking but unable to find work.

Income Equality

The measure of how evenly income is distributed across a population.

Price Stability

A condition in which the prices of goods and services do not fluctuate significantly over time.

Balance of Payments Stability

A measure of a country's financial transactions with the rest of the world, focusing on exports and imports.

Monetary Flow

The movement of money for goods and services in an economy.

Inflation

The rate at which the general price level of goods and services rises, reducing purchasing power.

GDP

Gross Domestic Product; the total monetary value of all final goods and services produced within a country over a period.

Nominal GDP

GDP measured at current market prices, without adjusting for inflation.

Real GDP

GDP adjusted for inflation to reflect the true value of goods and services.

Per Capita GDP

GDP divided by the population, indicating average income and living standards.

Nominal Interest Rate

The stated interest rate without adjustment for inflation.

Real Interest Rate

The interest rate adjusted for inflation, reflecting the true cost of borrowing.

Consumer Price Index (CPI)

A measure that examines the weighted average of prices of a basket of consumer goods and services.

Producer Price Index (PPI)

An index that measures the average change over time in the selling prices received by domestic producers for their output.

Demand-Pull Inflation

Inflation that occurs when demand for goods and services exceeds supply.

Cost-Push Inflation

Inflation caused by rising production costs.

Cyclical Unemployment

Unemployment that occurs during economic downturns or recessions.

Frictional Unemployment

Short-term unemployment that occurs when people are between jobs or entering the workforce.

Structural Unemployment

Unemployment arising from a mismatch between workers' skills and job requirements.

Interest Rates

The cost of borrowing money or the return on savings, often set by central banks.

Expenditure Approach

A method of calculating GDP based on total spending on the nation’s final goods and services.

Income Approach

A method of calculating GDP by summing all incomes earned in the production of goods and services.

Production Approach

A method of calculating GDP based on the value of outputs minus the value of intermediate goods used in production.

Circular Flow Model

A theoretical model that describes the flow of goods, services, and money in an economy.

Long-Run Economic Growth

The sustained increase in a nation's productive capacity over time.

Key Factors driving Long run economic growth

Capital Accumulation, Technological Innovation, Human Capital Development, Institutional Quality, Natural Resources, Trade and Global Integration, Population Growth and Labor Force Expansion

What are the indicators of long-run economic growth?

Increase in GDP per capita, Productivity Growth, Structural Transformation

Solow Growth Model

a foundational framework in economics that explains long-run economic growth through the accumulation of capital, labor, and technological progress.

Steady State Growth

A condition where capital stock and output grow at a constant rate.

Endogenous Growth Theories

Theories that emphasize how human capital, innovation, and knowledge contribute to economic growth.

Human Capital Development

Investments in education and training to improve the workforce's productivity.

Innovation

Innovation is the creation and application of new technologies, products, and processes that improve productivity

Endogenous growth theories focus on how Research and Development efforts and technology are key drivers of growth

Resource Curse

While resource wealth can fuel growth, overreliance on resources can lead to volatility and economic stagnation

Business Cycle

fluctuations in economic activity over time, typically measured by changes in real GDP, employment, and other macroeconomic indicators

Phases of the Business Cycle

• Expansion

• Peak

• Contraction

• Trough

Expansion

characterized by economic growth, increasing employment, rising incomes, and higher consumer and business confidence

What are the key indicators of expansion?

Rising GDP, Increasing employment rates, Higher consumer spending, Growing Business investments, Stock markets performing well

Peak

the highest point of economic growth. Economic indicators reach maximum levels in this phase, however, inflation also rises due to high demand and resources become scarce, leading to increased costs.

What are the indicators of a peak?

GDP growth slows but remains high, Unemployment rates at lowest point, Rising inflation, Consumer spending remains strong, Interest rates beginning to rise

Contraction

also known as recession or slowdown. The decline of economic activity and reduction of business sales and consumer confidence

What are the indicators of contraction?

Decreasing GDP, Rising unemployment, Lower consumer and business spending, Failing stock market values, Central banks lowering interest rates to stimulate economy

Trough

lowest point of the business cycle. Economic activity begins to stabilize, and the groundwork is laid for a new phase of expansion. Governments and central banks often intervene with stimulus measures to encourage recovery.

What are the indicators of a trough?

GDP stops declining and stabilizes, Unemployment remaining high but stops rising, Improvement of consumer confidence, Slow recovery of business activity

Demand-side shocks

influences aggregate demand (total spending in the economy). Either a positive shock boosting demand or a negative shock reducing demand, leading to expansions or recessions, respectively

Causes of Demand-side shocks

Changes in consumer confidence, Government fiscal or monetary policies, Changes in global demand for goods and services, Major financial crises affecting credit availability

Supply-side shocks

An event that affects aggregate supply or the total production of goods and services in an economy. They either increase or decrease supply, influencing prices, production costs, and employment levels.

Causes of supply side shocks

Natural disasters, Wars, Changes in resource availability, Technological advancements

Savings

The portion of income not spent on consumption, set aside for future use.

Investment

The use of saved funds to purchase capital goods or financial assets to generate returns.

Savings and Economic Growth

The relationship where higher savings provide funds for investment, which contributes to economic growth.

What role/s do savings have for economic growth?

Savings:

• provide capital for investment

• increased savings lower interest rates and boost investment

• enable long-term economic stability

• lead to infrastructure development

• support entrepreneurship and innovation

Importance of Savings

Financial Security, Future Goals, Wealth Building, Retirement Planning, Economic Growth

Personal Savings

money individuals set aside for future use

Business Savings

Funds that businesses retain rather than distributing them to owners or shareholders

National Savings

total savings of a country, which includes both public and private savings. It represents the portion of a nation's income that is not spent on consumption but is instead saved for future use

Life Cycle Hypothesis

The theory developed by Franco Modigliani that individuals plan their savings and consumption over their lifetime.

Phases of the Life Cycle Hypothesis

Youth and Early Working Years (Borrowing Phase)

- low income, but consumption needs are high

Middle Age (Saving Phase)

- higher income and peak earnings

- save for retirement and invest in assets

Retirement (Dissaving Phase)

- income decreases or stops

- savings are withdrawn and individuals rely on pensions or government benefits

Relative Income Hypothesis (RIH)

The theory that consumption is influenced by an individual's income relative to others.

Permanent Income Hypothesis (PIH)

The theory that people's consumption choices are based on expected long-term income rather than current income.

Ricardian Equivalence Theorem

proposed by David Ricardo and later developed by Robert Barro, suggest that government borrowing does not affect overall demand in the economy because private individuals anticipate future taxation and adjust their savings accordingly.

Savings Rates in Developed Countries

Lower savings rates due to strong social security systems, pension plans, and access to credit.

Savings Rates in Developing Countries

Higher savings rates due to limited social safety nets and higher uncertainty in income. Individuals save more for healthcare, education, and emergencies due to lack of government support.

Behavioral Factors affecting Savings and Investment

Present Bias (Hyperbolic Discounting), Loss Aversion, Mental Accounting, Herd Behavior, Overconfidence Bias

Present Bias

also known as Hyperbolic Discounting, people tend to prioritize short-term rewards over long-term benefits, leading to low savings rates

Loss Aversion

people fear losing money more than they value potential gains

Mental Accounting

People categorize money differently based on its source or purpose

Herd Behavior

follow the crowd when making investment decisions

Overconfidence Bias

overestimation of ability to predict market trends, which lead to risky investments

Marginal Propensity to Consume (MPC)

The proportion of additional income that is spent on consumption.

Formula for MPC

∆C / ∆y

∆C = Change in consumption

∆Y = Change in income

What does MPC = 1 indicate?

all additional income is spent

What does MPC = 0 indicate?

all additional income is saved

What does MPC indicate for the Economy?

High MPC leads to stronger economic growth, while Low MPC slows economic growth

The MPC reflects how much people spend when their income rises, in turn influencing economic activity and policy decisions

Aggregate Expenditure (AE)

The total spending on final goods and services in an economy within a specific period.

Formula for AE

C + I + G

C = Consumption Spending

I = Investment Spending

G = Government Spending

What is the importance of AE for the economy?

Helps determine GDP and economic growth, Guides government policies, Influences business investment decisions

Fiscal Policy

Government policies regarding taxation and spending to influence economic conditions.

Wealth Building

The accumulation of assets and savings over time to increase financial resources.